Economics Notes - 1

TABLE OF CONTENTS
COURSE SYLLABUS.......................................................................................................................ii
1.0 INTRODUCTION TO ECONOMICS.......................................................................................1
1.1 The Meaning of Economics........................................................................................................1
1.2 The Scope of Economics............................................................................................................1
1.3 Human wants..............................................................................................................................2
1.4 Economic resources....................................................................................................................4
1.5 scarcity and choice......................................................................................................................5
1.6 Opportunity Cost........................................................................................................................6
1.7 Resource Allocation...................................................................................................................6
1.8 Review Questions.....................................................................................................................11
2.0 DEMAND ANALYSIS...............................................................................................................11
2.1 Concept of Demand..................................................................................................................12
2.2 Factors Determining Demand of a Product..............................................................................17
2.3 The Concept of Elasticity of Demand......................................................................................19
3.0 SUPPLY ANALYSIS.................................................................................................................24
3.1Concept of Supply.....................................................................................................................24
3.2 Factors Affecting Supply of a Product.....................................................................................27
3.3 The Concept of Elasticity of Supply.........................................................................................29
4.0 PRICE DETERMINATION.....................................................................................................36
4.1 Concept of Price Determination...............................................................................................36
4.2 Determination of Prices in a Free Market Economy................................................................36
4.3 Role of Government in Price Determination............................................................................44
5.0 PRODUCTION...........................................................................................................................46
5.1 Meaning of Production.............................................................................................................46
5.2 Factors of Production................................................................................................................47
5.3 Concept of Return to Scale in Production................................................................................53
5.4 Economies of Scale..................................................................................................................57
6.0 THEORY OF THE FIRM.........................................................................................................61
6.1 Concept of the Firm..................................................................................................................61
6.2 Various costs in a firm..............................................................................................................65
6.3 Concept of Revenue..................................................................................................................68
6.4 Review Questions....................................................................................................................74
7.0 MARKET STRUCTURES........................................................................................................74
7.1 Meaning of Market Structures..................................................................................................74
7.2 Types of Market Structures......................................................................................................74
8.0 LABOUR MARKET..................................................................................................................87
8.1 Demand and Supply of Labour.................................................................................................89
8.2 Factors Influencing Demand and Supply of Labour................................................................91
8.3 Types of Reward for Labour....................................................................................................95
8.4 Review Questions...................................................................................................................100
9.0 NATIONAL INCOME............................................................................................................100
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9.1 Meaning of National Income..................................................................................................100
9.2 Determination of National Income.........................................................................................101
9.3 Indicators of Standards Of Living..........................................................................................106
9.4 Review Questions...................................................................................................................110
10.0 INFLATION...........................................................................................................................110
10.1 Meaning of Inflation.............................................................................................................110
10.2 Causes of Inflation................................................................................................................111
10.3 Effects of Inflation on the Economy.....................................................................................112
10.4 Measures to Control Inflation...............................................................................................113
11.5 Review Questions.................................................................................................................113
11.0 MONEY AND BANKING..................................................................................................113
11.1 Concept of Money................................................................................................................113
11.2 Types of Banks.....................................................................................................................118
11.3 Role of Central Bank in the Economy..................................................................................121
11.4 Review questions..................................................................................................................121
12.0 PUBLIC FINANCE................................................................................................................122
12.1 Sources of Government Revenue.........................................................................................122
12.2 Government Expenditure......................................................................................................124
12.3 Purpose of Taxation..............................................................................................................127
12.4 Review questions..................................................................................................................134
13.0 UNEMPLOYMENT...............................................................................................................134
13.1 Meaning of Unemployment..................................................................................................134
13.2 Types of Unemployment......................................................................................................135
13.3 Causes of Unemployment.....................................................................................................135
13.4Ways of Managing Unemployment.......................................................................................137
13.5 Review Questions.................................................................................................................138
KNEC Revision Papers..................................................................................................................138

COURSE SYLLABUS
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WEEK TOPIC SUB-TOPIC
1 INTRODUCTION TO -Meaning of the term economics

ECONOMICS  Scope of economics
 Human wants
 Economic resources
 scarcity and choice
 Opportunity cost
 Resource allocation
2 DEMAND ANALYSIS -Meaning of demand
- Factors determining demand
- the concept of elasticity of demand
3 SUPPLY ANALYSIS -Meaning of supply
- Factors determining supply
- The concept of elasticity of supply
4 PRICE -Concept of price determination

DETERMINATION -Determination of price in a free market economy
-Role of government in price determination
5 PRODUCTION -Meaning of production

-Factors of production
-The concept of return to scale in production
-Economies of scale
6 THE THEORY OF THE -The concept of the firm
FIRM -Various costs in a firm
-The concept of revenue in a firm
-Meaning of economics of scale
7 MARKET - CAT
STRUCTURES -Meaning of market structures
-Various market structures
8 LABOUR MARKET -Meaning of demand and supply of labour

-Factors influencing demand and supply of labour
-Types of reward for labour
9 NATIONAL INCOME -Meaning of national income

-Determination of national income
- Indicators of standards of living
10 INFLATION -Meaning of inflation

- Causes of inflation
- Effects of inflation on the economy
- Measures to control inflation
11 MONEY AND -Concept of money

BANKING -Types of banks
-functions of money

-Role of the central bank in the economy
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12 PUBLIC FINANCE -Sources of government revenue
- Government expenditure
- Purpose of taxation
13 UNEMPLOYMENT -Meaning of unemployment

-Types of unemployment
-Causes of unemployment
-Ways of managing unemployment
12-13 REVISION AND END TERM EXAMS
ASSESSMENT
CAT …………………………….30%
End Term Exams……………….70%
References
1. Mudida,R.(2010). Modern Economics (2nd Ed).Focus Publishers.Nairobi
2. Sanjay, R., ( 2013). Modern Economics (1st Ed), Manmohan. Canada
3. Waynt, J., (2013), Basic Economics for Students and Non-students,Bookboon.com
4. Krugman & Wells,(2013), Microeconomics 2d ed. ( Worth)
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TOPIC 1
1.0 INTRODUCTION TO ECONOMICS
1.1 The Meaning of Economics

The modern word "Economics" has its origin in the Greek word "Oikonomos" meaning a steward.
The two parts of this word "Oikos", a house and "nomos", a manager sum up what economics is all
about. How do we manage our house?
There is an economic aspect to almost any topic education, employment, housing, transport, defense
etc. Economics is a comprehensive theory of how the society works. Alfred Marshal defined
economics as the "Study of man in the ordinary business of life". Paul Samuelson, an American
Economist defined it as: "The study of how people and society choose to employ scarce resources
that could have alternative uses in order to produce various commodities and to distribute them for
consumption, now or in future amongst various persons and groups in society.
The word scarcity as used in economics means that; All resources are scarce in the sense that there
are not enough to fill everyone's wants to the point of satiety. i.e. We have limited resources, both in
rich countries and in poor countries. The economist ‘s job is to evaluate the choices that exist for the
use of these resources. Thus, we have another characteristic of economics; it is concerned with
choice.
In summary, Economics is defined as "The social science which is concerned with the allocation of
scarce resources to provide goods and services which meet the needs and wants of the consumers"
Reasons for Studying Economics

a) Economics provides underlying principles for optical resources allocation which enable
individuals and firms to make economically rational decision.
b) Economics enables individuals and organization to appreciate constricts imposed by the
economic development within which the entity operate.
c) Economics enables citizens to the appreciate parameters that determines development process so
that they can contribute in facilitating in development and solve economic problems that
characterize their society.
d) Economic is analytical and its study helps to develop logical reasoning
1.2 The Scope of Economics

The study of economics begins with understanding of human ―wants‖. Scarcity forces us to
economize. We weigh up the various alternatives and select that particular assortment of goods
which yields the highest return from our limited resources. Modern economists use this idea to
define the scope of their studies.
Although economics is closely connected with such social sciences as ethics, politics, sociology,
psychology and anthropology, it is distinguished from them by its concentration on one particular
aspect of human behaviour – choosing between alternatives in order to obtain the maximum
satisfaction from limited resources.
In effect, the economist limits the study by selecting four fundamental characteristics of human
existence and investigating what happens when they are all found together, as they usually are.
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First, the ends of human beings are without limit. Second, those ends are of varying importance.
Third, the means available for achieving those ends – human time and energy and material
resources – are limited. Fourth, the means can be used in many different ways: that is, they can
produce many different goods.But no single characteristic by itself is necessarily of interest to the
economist. Only when all four characteristics are found together does an economic problem arise.
Resources are the ingredients that are combined together by economists and termed economic
goods i.e. goods that are scarce in relation to the demand for them.
(i)Economic Goods: All things which people want are lumped together by economists and
termed economic goods i.e. goods that are scarce in relation to the demand for them.
(ii)Free Goods: These are goods which people can have as much as they want, e.g. air.
Economic resources are scarce or limited in supply and command a price i.e. they have money
value. Examples include Land, Labour, and Capital/Entrepreneurship. They are also called factors
of production. The rewards from these factors are;
Land-rent/loyalty Labour- salary/wages
Capital –interest Entrepreneurship – profit/loss
Non-economic resources are unlimited in supply and are free. They do not require the use of scarce
resources to produce and have no monetary value e.g. air, sunshine, rain etc. Economics is
concerned with economic resources since scarcity poses an economic problem and therefore
allocation decisions have to be made.
1.3 Human wants

Human want may be defined as an insatiable desire or need by human beings to own goods or
services that give satisfaction or the capacity of satisfying ones needs. The basic needs of man
include; food, housing and clothing. They include tangible goods like houses, cars, chairs, television
set, radio, e.t.c. while the others are in form of services, e.g. tailoring, carpentry, medical; e.t.c.
Human wants and needs are many and are usually described as insatiable because the means of
satisfying them are limited or scarce. Human needs are the effective desires for certain things which
express themselves in sacrifices or efforts necessary to obtain them.
Types of Human wants

Human wants can be classified into three categories necessaries, comforts and luxuries.
a. Necessaries:
Necessaries refer to the basic or primary wants for food, clothing, shelter, medical care, education,
etc. These are the urgent needs of human beings. A person has to face several difficulties without
the satisfaction of these wants. Necessaries may be further classified into three categories.
(i) Necessaries of existence: There are the goods and services without which human life is
impossible. Food, water, air, clothing and accommodation are examples of such
necessaries.
(ii) Necessaries for efficiency: These refer to the goods and services which are not required for
survival. Rather they are necessary to make people efficient. For example, a person can
survive without books and stationery. But their use will make him more efficient.
(iii) Conventional necessaries: These mean the things which have become necessary due to
habits, customs and traditions. For example, wearing of new clothes on marriage,
decorating houses, cutting cakes on birthdays are not required for maintaining life or
increasing efficiency. These have become necessary by force of habits and social
customs.
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b. Comforts:
Comforts refer to the goods and services which make life easier and comfortable. They provide
freedom from suffering, anxiety, pain, etc. Comforts improve our health and efficiency. For
example, a chair may be necessary for efficiency but a cushion on it will make us comfortable.
Comforts like fans, coolers, well furnished houses cheer our minds.
c. Luxuries:
Luxuries refer to the goods and services which give us pleasure and prestige. Motor cars, air
conditioners, diamond jewelry, designer clothes, etc. are examples of luxuries. These things may
not increase efficiency or comfort but they provide us happiness and status in society.
The above classification of wants is not rigid. A thing which is a comfort or luxury for one person
or at one point of time may become a necessity for another person or at another point of time.For
example; a car may be a luxury for a laborer, a comfort for a teacher but a necessity for a doctor.
Whether a certain want is a necessity, a comfort or a luxury depends upon the person, the place, the
time and the circumstances. Sometimes, human wants are also broadly classified into Primary wants
which refer to wants for necessaries of life without which man cannot exists and Secondary wants
referring to wants for things over and above the necessaries.
Characteristics of Human Wants:

The following are the important characteristics of wants.
(i) Wants are unlimited: Famous economist Marshall has rightly said that human wants are
countless in number and are varied in kind As soon as one want is satisfied another want takes
its place. This endless circle of wants continues throughout life. For example, a person who has
never used a fan would wish to have a fan. When this want is satisfied, he would wish to get an
air cooler. Once these wants are satisfied, and then he would wish to have an air conditioner, a
car and so on. Thus, we see wants never come to an end.
(ii) A single want is satiable: Each want taken separately can be satisfied. It has rightly been said
that there is a limit to each particular want. For example, if a man is thirsty he can satisfy his
thirst by taking one, two or three glasses of water and after that he does not want water at that
point of time.
(iii) Some wants arise again and again: Most wants recur. If they are satisfied once, they arise
again after a certain period. We eat food and hunger is satisfied but after a few hours, we again
feel
hungry and we have to satisfy our hunger again with food. Therefore, hunger, thirst etc. are such
wants which occur again and again.
(iv) Varying nature of wants: Wants vary with time, place and person. They are also influenced by
many factors like income, customs, fashion, advertisement etc. For example, we want medicines
only when we are sick. Ice is needed in summer season only. We need coats when it is cold.
Similarly, people have started using things like T.V. Sets, mobile phones, car and many other
luxury goods due to increase in their income and change in fashion. Thus, wants have been
found to vary and to multiply with the economic development of a country.
(v) Present wants are more important than future wants:Present wants are more important. A
person uses most of his limited resources for the satisfaction of present wants. He does not
worry much about his future wants because future is uncertain and less urgent. For example,
providing for the education of children in the present is more important than providing for old
age security in future.
(vi) Wants change and expand with development: A simple example to show how wants are
changing is the telephone. Earlier, in the rural areas there were not many telephones, but today
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telephone has become a necessity for everybody for keeping in touch with their near and dear
ones. People using telephone earlier, are now using mobile phones. They want more and more
facilities in their mobile phones such as, Camera, Internet and so on.
(vii)Wants are complementary: It is a common experience that we want things in groups. A single
article out of group can not satisfy human wants by itself. It needs other things to complete its
use e.g. a motor-car needs petrol and mobile oil it starts working. Thus, the relationship between
motor-car and petrol is complementary.
(viii)Wants are competitive: Some wants competes to other. We all have a limited amount of money
at our disposal; therefore, we must choose some things and reject the other. E.g. tea and coffee
(ix)Some Wants are both complimentary and competitive: When use of machinery is done the use of
labour needs to be reduced. This indicates competitive nature. But to run the machinery the
labour is also required and as such it indicates complimentary relationship.
(x)Wants are alternative: There are several ways of satisfying a particular want. For example, a
person who wants to travel from one place to another may hire a taxi or may board a bus or
train. The final choice depends upon their relative prices, the money available and the time
available.
(ix)Wants create economic activity: Human wants give rise to economic activities. Unlimited and
ever increasing human wants accelerate the pace of industry, commerce and trade.
1.4 Economic resources

Economic resources are the goods or services available to individuals and businesses used to
produce valuable consumer products. The classic economic resources include land, labor and
capital. Entrepreneurship is also considered an economic resource because individuals are
responsible for creating businesses and moving economic resources in the business environment.
These economic resources are also called the factors of production. The factors of production
describe the function that each resource performs in the business environment.
a) Land
The term land in economics is used in a special sense. It does not mean soil or earth surface alone.
Land in economics means natural resources. It includes all those things which are found under and
over the surface of earth. In the words of Marshall, the land means the material and the forces which
Nature gives freely to man‘s aid in land and water, in air and light and heat. Land thus include soil,
crops, mineral deposits, forests, oceans etc. Land as a factor of production cannot be increased
because it‘s impossible to get additional land apart from one given by nature. It can only be
improved in quality so as to produce more goods. Its reward is /remuneration is rent/loyalty.
Characteristics of Land
 It‘s a basic factor of production i.e. production cannot take place without it
 It‘s supply is fixed i.e. earth‘s surface cannot be added
 it lacks geographical mobility i.e. cannot be moved from one geographical area to another
 it‘s quality is not uniform i.e. productivity of one piece of land is different from another
 Productivity can be increased by increasing unit of capital and land
 it‘s a natural resource
 It‘s subject to the law of diminishing returns.

b) Labour

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Labour refers to any human effort whether physical or mental applied in production However, not
all human effort is labour. For it to be labour, it must be aimed at production i.e. paid for. The
reward for labour is wages and salaries.
In economics, the term human resources include both labour and entrepreneurial ability. It may be
noted that it is the services‘ of labour which are bought and sold for money and not the labor itself.
As regards the supply of labour, it depends upon the (i) size of total population (ii) age composition
of the population (iii) the availability working population, (iv) the working hours devoted to
production (v) the remuneration paid to the workers, etc., The entrepreneur or enterprise is the
person who takes initiative and combines resources for the production of goods and services
c) Capital
The term capital refers to all manmade resources which aid to production. Thus machinery,
equipment, tools, factories, storage, transportation, etc., which are used in the production of
new goods and supplying them, to the ultimate consumers are capital resources. Capital also
includes those goods used to produce other goods (producer goods). Its reward is interest
Characteristics of Capital
 It‘s man-made hence its supply is under man‘s control
 it‘s a basic factor of production
 it‘s subject to depreciation i.e. through wear and tear
 Can be improved by technology
d) Entrepreneurship
It‘s the ability to organize other factors of production for effective production. This is done by an
entrepreneur an (organizer, a manager or a risk taker) and its reward is Profit or Loss
Functions of Entrepreneur
 Control of business
 Start the business
 Make decisions (policy maker)
 Acquire and pay for all factors of production
 Bear all the risks and enjoys the profit
 owns the whole project
1.5 scarcity and choice

To the economists all things are said to be scarce, since by ―scarce‖ they mean simply ―that there
are not enough to fill everyone‘s wants to the point of satiety‖. Most people would probably like to
have more of many things or goods of better quality than they possess at present: larger houses
perhaps in which to live, better furnished with the latest labour-saving devices, such as electric
washers, cookers, refrigeration; more visits to theatre or the concert hall; more travel; the latest
models in motor cars; radios and television sets; and most women exhibit an apparently insatiable
desire for clothes. People‘s wants are many, but the resources for making the things they want –
labour, land, raw materials, factory buildings, machinery – are themselves limited in supply. There
are insufficient productive resources in the world, therefore, to produce the amount of goods and
services that would be required to satisfy everyone‘s wants fully. Consequently, to the economist all
things are at all times said to be ―scarce‖.

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1.6 Opportunity Cost
Because there are not enough resources to produce everything we want, a choice must be made
about which of the wants to satisfy. In economics, it is assumed that people always choose the
alternative that will yield them the greatest satisfaction. We therefore talk of Economic Man.
Choice involves sacrifice. If there is a choice between having guns and having butter, and a country
chooses to have guns, it will be giving up butter to the guns. The cost of having guns can therefore
be regarded as the sacrifice of not being able to have butter. The cost of an item measured in terms
of the alternative forgone is called its opportunity cost.
1.7 Resource Allocation

Resources are the means to achieve certain ends. One of the most important functions of the
economic system is the allocation of scarce resources and commodities. Resource allocation
―refers to the way in which the available factors of production are allocated among the various
uses to which they might be put‖. Allocation in economics is therefore studying of how resources
that are scarce are delivered by producers. It also examines It also examines how scarce goods and
services are among consumers. It is a very important theme in economics.
The allocation of resources enables us to determine how much of the various kinds of goods and
services will actually be produced. Uses of resources in one industry should be interpreted as if they
have been drawn from some other industry having relationship through common input. If output of
one product is increased with given resources, the output of another product is decreased.
Therefore, the optimum allocation of resources between two products shall depend upon the degree
of urgency of demand for them and the resultant cost savings there from to the society.
Allocation of resources is a problem in welfare economics. It has close relationship with the theory
of general equilibrium. It is advisable to introduce the topic of resource allocation at macro level
first and then extend the arguments to cover the problems of a firm.
The allocation of resources thus involves sharing of resources among competing sectors. Whatever,
the type of economy be it capitalist, socialist or mixed, decision has to be made regarding allocation
of resources. In a capitalist economy decision about the allocation of resources are made through the
free market price mechanism. A capitalist or free market economy uses impersonal forces of
demand and supply to decide what quantities and thereby determining the allocation of resources.
The producers in a free market economy motivated as they are by profit consideration take decisions
regarding what goods are to be produced and in what quantity by taking into account the relative
prices of various goods.
Significance of resource allocation

Resource allocation is important in that it helps solve the following problems:
a) What to produce? Because resources are scarce production of all goods and services needed by a
society are beyond its capacity. It is simply not possible for any economy. So, it has to select a
set among various alternatives production which must meet the maximum social need. An
economy should follow social efficiency while allocating resources. The social norms and
values should guide to maximize social satisfaction so allocation is best which satisfies the
most. The problem of what to produce and how much to produce depends on the needs of the
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b) How to produce? This is concerned with the method of production. In some cases, labor may
play a major role. It is called labor intensive technology. In others, capital may play a major
role. It is called capital intensive. A labor intensive method creates more jobs favouring more
employment. It helps in mitigating unemployment problem. Capital intensive production goes
for large volume of production. It commends rapid growth rate.
c)For whom to produce? Production for masses or productions for profit are two major choices that
every economy has to decide. Basic needs of common people cannot be ignored. Of course, the
priority goes to wage goods production. In the quality is determined by the level of living
standard, which is the outcome of the development level of the economy. Therefore, as the
development level of goods, higher production of superior goods proceeds towards fetching
super profits. This issue is also related with maintaining social justice. Meeting the basic
requirements of all segments of population is the main criteria of resources allocation.
d) Promotion of Efficiency in Economy: How to run an economy efficiently is the first concern of
resource allocation. Economics efficiency is measured in additional welfare achieved without
worsening any result. It means that new reallocation of resource must not only be able to
maintain the existing level but also achieving new heights. Alternatively, reallocation may be
profitable somewhere but incurring losses elsewhere. The main objective is to increase
aggregate profitability of the economy.
e) Achieving Balance in Economy: Another purpose of resource allocation is the maintenance of
balance among different sectors of an economy. The balance between rural and urban sectors,
between home consumption and export promotion, between consumer goods and capital goods
and regional balance are the healthy signs of an economy. Investments in these different sectors
are very important. How much to invest in what sector? This is the major question, which is
studied in this topic.
Economic Systems and Resource Allocation

When we look around the world we find that there are only a limited number of ways in which
societies have set about answering the four fundamental economic questions. These ways or
methods are called Economic systems. They are free enterprise, centrally planned and mixed
economies. We will now examine these briefly.
a) The free enterprise (the price system)
The free market system is where the decision about what is produced is the outcome of millions of
separate individual decisions made by consumers, producers and owners of productive services. The
decisions reflect private preferences and interests. For the free enterprise to operate there must be a
price system/mechanism which is a situation where the vital economic decisions in the economy are
reached through the workings of the market price.
Thus, everything – houses, labour, food, land etc come to have its market price, and it is through the
workings of the market prices that the "What?", "How?", and "For whom?" decisions are taken. The
free market thus gives rise to what is called Consumer Sovereignty – a situation in which consumers
are the ultimate dictators, subject to the level of technology, of the kind and quantity of
commodities to be produced. Consumers are said to exercise this power by bidding up the prices of
the goods they want most; and suppliers, following the lure of higher prices and profits, produce
more of the goods.
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(i)Ownership of Means of Production: Individuals are free to own the means of production i.e. land,
capital and enjoy incomes from them in the form of rent, interest and profits.
(ii)Freedom of Choice and Enterprise: Entrepreneurs are free to invest in businesses of their choice,
produce any product of their choice, workers are free to sell their labour in occupations and
industries of their choice; Consumers are free to consume products of their choice.
(iii)Self Interest as the Dominating Motive: Firms aim at maximising their profits, workers aim at
maximising their wages, landowners aim at maximising their return from their land, and
consumers at maximising their satisfaction
(iv)Competition: Economic rivalry or competition envisages a situation where, in the market for
each commodity, there are a large number of buyers and sellers. It is the forces of total demand
and total supply which determine the market price, and each participant, whether buyer or
seller, must take this price as given since it's beyond his or her influence or control.
(v)Reliance on the Price Mechanism: Price mechanism is where the prices are determined on the
market by supply and demand, and consumers base their expenditure plans and producers their
production plans on market prices. Price mechanism rations the scarce goods and services in
that, those who can afford the price will buy and those who cannot afford the price will not
pay.
(vi)Limited Role of Government: In these systems, apart from playing its traditional role of
providing defence, police service and such infrastructural facilities as roads for public
transport, the Government plays a very limited role in directly economic profit making
activities.
Resource allocation in a free enterprise

Although there are no central committees organising the allocation of resources, there is supposed
to be no chaos but order. The major price and allocation decisions are made in the markets. The
market being the process by which the buyers and sellers of a good interact to determine its price
and quantity.
If more is wanted of any commodity say wheat – a flood of new orders will be placed for it. As the
buyers scramble around to buy more wheat, the sellers will raise the price of wheat to ration out a
limited supply. And the higher price will cause more wheat to be produced. The reverse will also be
true. What is true of the market for commodities is also true for the markets for factors of
production such as labour, land and capital inputs.
People, by being willing to spend money, signal to producers what it is they wish to be produced.
Thus what things will be produced will is determined by the shilling votes of consumers, not every
five years at the polls, but every day in their decisions to purchase this item and not that.
The ―How?‖ questions is answered because one producer has to compete with others in the market;
if that producer cannot produce as cheaply as possible then customers will be lost to competitors.
Prices are the signals for the appropriate technology.
The ―for whom?‖ question is answered by the fact that anyone who has the money and is willing to
spend it can receive the goods produced. Who has the money is determined by supply and demand
in the markets for factors of production (i.e. land, labour, and capital). These markets determine the
wage rates, land rents, interest rates and profits that go to make up people‘s incomes. The
distribution of income among the population is thus determined by amounts of factors (person-
hours, Acres etc) owned and the prices of the factors (wages-rates, land-rents etc).
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Advantages of a Free Market System
i) Incentive: People are encouraged to work hard because opportunities exist for individuals to
accumulate high levels of wealth.
ii) Choice: People can spend their money how they want; they can choose to set up their own firm
or they can choose for whom they want to work.
iii) Competition: Through competition, less efficient producers are priced out of the market; more
efficient producers supply their own products at lower prices for the consumers and use factors
of production more efficiently. The factors of production which are no longer needed can be
used in production elsewhere. Competition also stimulates new ideas and processes,
which again leads to efficient use of resources.
iv Flexibility: A free market also responds well to changes in consumer wishes, that is, it is flexible.
v)Reduced size of civil service: Because the decision happen in response to change in the market
there is no need to use additional resources to make decisions, record them and check on
whether or not they are being carried out. The size of the civil service is reduced.
Disadvantages of a Free Economy

The free market gives rise to certain inefficiencies called market failures i.e. where the market
system fails to provide an optimal allocation of resources. These include:
i) Unequal distribution of wealth: The wealthier members of the society tend to hold most of the
economic and political power, while the poorer members have much less influence. There is an
unequal distribution of resources and sometimes production concentrates on luxuries i.e. the
wants of the rich. This can lead to excessive numbers of luxury goods being produced in the
economy. It may also result to social problems like crimes, corruption, etc.
ii) Public goods: These are goods which provide benefits which are not confined to one individual
household i.e. possess the characteristic of non-rival consumption and non-exclusion. The price
mechanism may therefore not work efficiently to provide these services e.g. defence, education
and health services.
iii) Externalities: Since the profit motive is all important to producers, they may ignore social costs
production, such as pollution. Alternatively, the market system may not reward producers
whose activities have positive or beneficial effects on society.
iv)Hardship: Although in theory factors of production such as labour are ―mobile‖ and can be
switched from one market to another, in practice this is a major problem and can lead to
hardship through unemployment. It also leads to these scarce factors of production being
wasted by not using them to fullest advantage.
v) Wasted or reduced competition: some firms may use expensive advertising campaigns to sell
―new‖ products which are basically the same as many other products currently on sale. Other
firms, who control most of the supply of some goods, may choose to restrict supply and
therefore keep prices artificially high; or, with other suppliers, they may agree on the prices to
charge and so price will not be determined by the interaction of supply and demand.
vi) The operation of a free market depends upon producers having the confidence that they will be
able to sell what they produce. If they see the risk as being unacceptable, they will not employ
resources, including labour and the general standard of living of the country will fall.
b) Planned economies
Is a system where all major economic decisions are made by a government ministry or planning
organisation. Here all questions about the allocation of resources are determined by the government.
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Features of this system
The command economies rely exclusively on the state. The government will decide what is made,
how it is made, how much is made and how distribution takes place. The resources and factors of
production are owned by the government on behalf of the producers and consumers. Price levels are
not determined by the forces of supply and demand but are fixed by the government. Although
division of labour and specialisation are found, the planned economies tend to be more self-
sufficient and tend to take part in less international trade than market economies.
Advantages of Planned System
i)Uses of resources: Central planning can lead to the full use of all the factors of production, so
reducing or ending unemployment.
ii) Large scale production: Economies of scale become possible due to mass production taking
place.
iii) Public services: ―Natural monopolies‖ such as the supply of domestic power or defence can be
provided efficiently through central planning.
iv) Basic services: There is less concentration on making luxuries for those who can afford them
and greater emphasis on providing a range of goods and services for all the population.
v) Wealth and income distribution: There are less dramatic differences in wealth and income
distribution than in market economy
Disadvantages of the Planned System
The centrally planned economies suffer from the following limitations:
i) Lack of choice: Consumers have little influence over what is produced and people may have little
to say in what they do as a career.
ii) Little incentive: Since competition between different producers is not as important as in the
market economy, there is no great incentive to improve existing systems of production or work.
Workers are given no real incentives to work harder and so production levels are not as high as
they could be.
iii) Centralised control: Because the state makes all the decisions, there must be large influential
government departments. The existence of such a powerful and large bureaucracy can lead to
inefficient planning and to problems of communication. Furthermore, government officials can
become over privileged and use their position for personal gain, rather than for the good of the
rest of the society.
iv)Centralised decision making: The task of assessing the available resources and deciding on what
to produce, how much to produce and how to produce and distribute can be too much for the
central planning committee. Also the maintenance of such a committee can be quite costly.
c)The Mixed Economy

There are no economies in the world which are entirely ‗free market‘ or planned, all will contain
elements of both systems. The degree of mix in any one economy is the result of a complex
interaction of cultural, historic and political factors. For example the USA which is a typical
example of a largely work-based society, but the government still plans certain areas of the
economy such as defence and provides very basic care for those who cannot afford medical
insurance.
Features of this system

The mixed economy includes elements of both market and planned economies. The government
operates and controls the public sector, which typically consists of a range of public services such
as
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health and education, as well as some local government services. The private sector is largely
governed by the force of mechanism and ―market forces‖, although in practice it is also controlled
by various regulations and laws.
Some services may be subsidised, provided at a loss but kept for the benefit of society in
general(many national railways, for example, are loss making), other services such as education or
the police may be provided free of charge (though they are paid for through the taxation system).
The private sector is regulated, i.e. influenced by the price mechanism but also subject to some
further government control, such as through pollution, safety and employment regulation.
Advantages of the Mixed Economy
i) Necessary services are provided in a true market economy, services which were not able to make
profit would not be provided.
ii) Incentive: Since there is a private sector where individuals can make a lot of money, incentives
still exist in the mixed economy.
iii) Competition: Prices of goods and services in the private sector are kept down through
competition taking place.
Disadvantages of Mixed Economy
i) Large monopolies can still exist in the private sector, and so competition does not really take
place
ii) There is likely to be a lot of bureaucracy and ―red tape‖ due to existence of a public sector.
1.8 Review Questions

1. Define the following terms as used in
economics i) Choice ii) Opportunity cost
2. Explain four reasons for studying economics
3. Discuss five characteristics of human wants
4. Explain the importance of resource allocation in an economy
5. Outline five disadvantages of a free market system
6. a) What are the main factors of production?
b) What determines the supply of demand for the factors of production that you have identified in
a) above?
References
2. Sanjay, R., (2013). Modern Economics (1st Ed), Manmohan. Canada
3 Waynt, J., (2013), Basic Economics for Students and Non-students, Bookboon.com
4. Krugman & Wells, (2013), Microeconomics 2d ed. ( Worth)
TOPIC 2
2.0 DEMAND ANALYSIS
In any economy there are millions of individuals and institutions and to reduce things to a
manageable proportion they are consolidated into three important groups; namely; Households,
Firms and Central Authorities. Household refers to all the people who live under one roof and who
make or are subject to others making for them, joint financial decisions. The household decisions
are assumed to be consistent, aimed at maximizing utility and they are the principal owners of the
factors of production. The firm is the unit that uses factors of production to produce commodities
then it sells either to other firms, to household, or to central authorities. The firm is thus the unit that
makes the decisions
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regarding the employment of the factors of production and the output of commodities. They are
assumed to be aiming at maximizing profits. Central authorities which is a comprehensive term
includes all public agencies, government bodies and other organizations belonging to or under the
direct control of the government. They exist at the centre of legal and political power and exert
some control over individual decisions taken and over markets.
2.1 Concept of Demand

Demand is the quantity or amount of a commodity that buyers are willing and able to buy at a given
price over a given period of time. The quantity demanded is the amount of a product people are
willing to buy at a certain price; the relationship between price and quantity demanded is known as
the demand. The term demand signifies the ability or the willingness to buy a particular commodity
at a given point of time. Effective demand is the ability to buy a commodity supported by the
willingness to buy. Desire to buy but no money or having money but no will to buy isn‘t demand
hence it is called desire.
Law of demand
The law of demand states that, if all other factors remain equal (ceteris peribus), the higher the price
of a good, the less people will demand that good. In other words, the higher the price, the lower the
quantity demanded. The amount of a good that buyers purchase at a higher price is less because as
the price of a good goes up, so does the opportunity cost of buying that good. As a result, people
will naturally avoid buying a product that will force them to forgo the consumption of something
else they value more. The chart below shows that the curve is a downward slope.
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation
between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and
the price will be P1, and so on. The demand relationship curve illustrates the negative relationship
between price and quantity demanded. The higher the price of a good the lower the quantity
demanded (A), and the lower the price, the more the good will be in demand (C).
Abnormal Demand Curves
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The law of demand does not hold for all commodities in all situations. There are exceptions when
more is demanded when the price increases. These happen in the case of:
(i) Inferior goods: Cheap necessary foodstuffs provide one of the best examples of exceptional
demand. When the price of such a commodity increases, the consumers may give up the less
essential compliments in an effort to continue consuming the same amount of the foodstuff,
which will mean that he will spend more on it. He may find that there is some money left, and
this he spends on more of the foodstuff and thus ends up consuming more of it than before the
price rise. A highly inferior good is called Giffen good after Sir Robert Giffen. In addition,
Increase in prices of some low quality goods may mean improvement in quality therefore the
demand will increase with increases in price.
(ii) Articles of ostentation (snob appeal or conspicuous consumption): There are some
commodities that appear desirable only if they are expensive. In such cases the consumer
buys the good or service to show off or impress others. When the price rises, it becomes more
impressive to consume the product and he may increase his consumption. Some articles of
jewellery, perfumes- and fashion goods fall in this category.
(iii) Speculative demand: If prices are rising rapidly, a rise in price may cause more of a
commodity to be demanded for fear that prices may rise further. Alternatively, people may
buy hoping to resell it at higher prices. In all the above three cases, the demand curve will be
positively sloped i.e. the higher the price, the greater the quantity bought. These demand
curves are called reverse demand curves (also called perverse or abnormal demand curve).
(iv) Necessities: These are things that one cannot do without; hence demand will not change even
if the prices go up e.g. Maize flour.
(v) Habitual goods and services: Some goods and services will be consumed at the same quantities
at any price because goods and services become habitual e.g. alcohol, cigarettes.
Different types of demand

a)Negative demand: If the market response to a product is negative, it shows that people are not
aware of the features of the service and the benefits offered. Under such circumstances, the
marketing unit of a service firm has to understand the psyche of the potential buyers and find out
the prime reason for the rejection of the service. For example: if passengers refuse a bus
conductor's call to board the bus. The service firm has to come up with an appropriate strategy to
remove the misunderstandings of the potential buyers. A strategy needs to be designed to
transform the negative demand into a positive demand.
b) No demand: If people are unaware, have insufficient information about a service or due to the
consumer's indifference this type of a demand situation could occur. The marketing unit of the
firm should focus on promotional campaigns and communicating reasons for potential customers
to use the firm's services. Service differentiation is one of the popular strategies used to compete
in a no demand situation in the market.
c)Latent demand: At any given time, it is impossible to have a set of services that offer total
satisfaction to all the needs and wants of society. In the market there exists a gap between
desirables and the available. There is always a search on for better and newer offers to fill the gap
between desirability and availability. Latent demand is a phenomenon of any economy at any
given time, it should be looked upon as a business opportunity by service firms and they should
orient themselves to identify and exploit such opportunities at the right time. For example a
passenger traveling in an ordinary bus dreams of traveling in a luxury bus. Therefore, latent
demand is nothing but the gap between desirability and availability.
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d)Seasonal demand: Some services do not have an all year-round demand; they might be required
only at a certain period of time. Seasons all over the world are very diverse. Seasonal demands
create many problems to service organizations, such as: - idling the capacity, fixed cost and
excess expenditure on marketing and promotions. Strategies used by firms to overcome this
hurdle are like - to nurture the service consumption habit of customers so as to make the demand
unseasonal, or other than that firms recognize markets elsewhere in the world during the off-
season period. Hence, this presents and opportunity to target different markets with the
appropriate season in different parts of the world. For example the need for Christmas cards
comes around once a year or the, seasonal fruits in a country.
Other types of demand
 Effective demand: This occurs when a consumers desire to buy a good can be backed up by
his ability to afford it.
 Derived demand: This occurs when a good or factor of production such as labour is
demanded for another reason
 Composite Demand – A good which is demanded for multiple different uses
 Joint demand – goods bought together e.g. printer and printer ink.
Demand Curve
Derivation a) Demand
schedule
The plan of the possible quantities that will be demanded at different prices is called demand
schedule. The plan of the possible quantities that will be demanded at different prices by an
individual is called individual demand schedule. Such a demand schedule is purely hypothetical, but
it serves to illustrate the First Law of Demand and Supply that more of a commodity will be bought
at a lower than a higher price. Theoretically, the demand schedule of all consumers of a given
commodity can be combined to form a composite demand schedule, representing the total demand
for that commodity at various prices. This is called the Market demand schedule as shown in the
table below;.
Price (Ksh) 20 18 16 14 13 12 10 11 9 8
Quantity demanded 100 120 135 150 165 180 200 240 300 350
(per week) (000)
These prices are called Demand Prices. Thus, the demand price for 200,000 units per week is KShs
11 per unit.
b) Demand Curves
The quantities and prices in the demand schedule can be plotted on a graph. Such a graph after the
individual demand schedule is called The Individual Demand Curve and is downward sloping. An
individual demand curve is the graph relating prices to quantities demanded at those prices by an
individual consumer of a given commodity. The curve can also be drawn for the entire market
demand and is called a Market Demand Curve as below:
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Consider a market consisting of two consumers:
.At price P1 above, consumer 1 demands q1, consumer II demands quantity q2, and total market
demand at that price is (q1+q2). At price p2, consumer 1 demands q'1, and consumer II demands
quantity q'2 and total market demand at that price is (q'1+q'2). DD is the total market demand curve.
Changes in the price of a product bring about changes in quantity demanded, such that when the
price falls more is demanded. This can be illustrated mathematically as follows:
Q d = a - bp
Where Qd is quantity demanded
a is the factor by which price
changes p is the price
Thus, ceteris paribus (all other things constant), there is an inverse relationship between price and
quantity demanded. Thus the normal demand curve slopes downwards from left to right as follows:
Shift and Movement along Demand

Curve a)Movement along demand curve
A movement refers to a change along a curve. On the demand curve, a movement denotes a change
in both price and quantity demanded from one point to another on the curve. The movement implies
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that the demand relationship remains consistent. Therefore, a movement along the demand curve
will occur when the price of the good changes and the quantity demanded changes in accordance to
the original demand relationship. In other words, a movement occurs when a change in the quantity
demanded is caused only by a change in price, and vice versa.
Price
When price falls from p1 to p2, quantity demanded increases from q1 to q2 and movement along
the demand curve is from A to B. Conversely when price rises from p2 to p1 quantity demanded
falls from q2 to q1 and movement along the demand curve is from B to A.
b) Shifts in Demand Curve

A shift in a demand curve occurs when a good's quantity demanded changes even though price
remains the same. This occurs when, even at the same price, consumers are willing to buy a higher
quantity of goods. The position of the demand curve will shift to the left or right following a change
in an underlying determinant of demand.
Increases in demand are shown by a shift to the right in the demand curve. This could be caused by
a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the price
of a complement. Conversely, demand can decrease and cause a shift to the left of the demand
curve for a number of reasons, including a fall in income, assuming a good is a normal good, a fall
in the price of a substitute and a rise in the price of a complement. Decreases in demand are shown
by a shift of the demand curve to the left as explained in the figure below.
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Price
In the figure below, DD represents the initial demand before the changes. When the demand
increases, the demand curve shifts to the right from position DD to positions D2D2. The quantity
demanded at price P1 increases from q1 to q'1. Conversely, a fall in demand is indicated by a shift to
the left of the demand curve from D2D2 to DD. The quantity demanded at price P1 decreases from q1
to q1
Factors That Cause Shifts in Demand Curve

Some of the factors that can cause a demand curve to shift include:
i) Change in income - If consumer incomes increase, we might reasonably expect that demand for
some luxury goods will increase.
ii Change in preferences/tastes - If a product becomes more (less) liked, the quantity demanded will
increase (decrease).
iii)Change in prices of goods that are complimentary - If the price of gasoline goes up substantially,
the demand curve for large SUV's should shift down.
iv) Changes in prices of goods that are substitutes - If the price of pork increases (decreases),
demand for beef would likely increase (decrease).
v) Advertising - An effective advertising campaign could increase the quantity demanded of a
particular good. It could also decrease the demand for a competing good.
vi) Expectations - If consumers expect a good to become more expensive or hard to get in the
future, it could alter current demand
vii) Shifts in market demographics - As segments of the population age or their composition
changes, their demands also change. Because segments are not equally distributed – that is,
there are not a consistent number of people in every age category – larger segments have a more
noticeable impact on demand. The baby boomers are an excellent example of this.
viii) Distribution of income - For example, if the rich get richer, and the poor get poorer, demand for
luxury goods could increase.
2.2 Factors Determining Demand of a Product

Even though the focus in economics is on the relationship between the price of a product and how
much consumers are willing and able to buy, it is important to examine all of the factors that affect
the demand for a good or service. These factors are also called Determinants of demand and they
include;
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a) Price of the Product
There is an inverse (negative) relationship between the price of a product and the amount of that
product consumers are willing and able to buy. Consumers want to buy more of a product at a
low price and less of a product at a high price. This inverse relationship between price and the
amount consumers are willing and able to buy is often referred to as The Law of Demand. E.g. if
there is an increase in price from p2 to p1 then there will be a fall in demand from Q2 to Q1
b)The Price of Related Goods

demand of some commodities is affected by demand of other commodities depending on their
relationship e.g. for complimentary goods – goods used together like pen and ink, when prices
of ink increases, the demand for a pen will fall as a result of decrease in demand for ink. For
Substitutes which are commodities that can be used instead of each other e.g. coffee and tea. A
rise in price of coffee reduces its demand and instead consumers will tend to consume more tea
thereby raising its demand i.e some goods are considered to be substitutes for one another: you
don't consume both of them together, but instead choose to consume one or the other.
c) The Aggregate National Income and its distribution among the population
In normal circumstances as income goes up the quantity demanded goes up. In such a case
the good is called a normal good. However, there are certain goods whose demand shall
increase with income up to a certain point, then remain constant. In such a case the good is
called a necessity e.g. salt. Also there are some goods whose demand shall increase with
income up to a certain point then fall as the income continues to increase. In such a case the
good is called an inferior good.
d) Changes in taste, fashion and preferences of consumers

Individual tastes and preferences greatly influence the demand for a commodity. If taste change
in favor of a commodity, more of the commodity is likely to be bought even if it is expensive
e.g. imported goods change in fashion which affects demand since more of the commodity is
demanded when in fashion and less when out of fashion.
e) Government policy
Governments may come up with policies to encourage or discourage consumption of a
commodity through;
i) Tax-increase in taxes leads to increase in price leading to low demand and vice versa
ii) Subsidies-Leads to decrease in price leading to high demand.
iii) Legislation – passing laws made to encourage or discourage consumption e.g. opening
bars for a few hours to discourage alcohol consumption.
iv) Price control- Controlling prices to ensure that they do not go beyond certain limits
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f) The Consumer's Expectations
One‘s expectations for the future can also affect how much of a product one is willing and able
to buy. For example, if you hear that Apple will soon introduce a new iPod that has more
memory and longer battery life, you (and other consumers) may decide to wait to buy an iPod
until the new product comes out. When people decide to wait, they are decreasing the current
demand for iPods because of what they expect to happen in the future. Similarly, if you expect
the price of petrol to go up tomorrow, you may fill up your car with petrol now. So your
demand for petrol today increased because of what you expect to happen tomorrow.
g) The Size and Structure of the Population
A larger population, other things being equal, will mean a higher demand for all goods and
services. Changes in the way the population is structured also influences demand. Many
European countries have an ageing population and this leads to a change in the demand. Goods
and services required by the elderly increase in demand as a result. The demand for retirement
homes, insurance policies suitable for elderly drivers and smaller cars may increase as a result.
Also as population increases, the population structure changes in such away that an increasing
proportion of the population consists of young age group. This will lead to a relatively higher
demand for those goods and services consumed mostly by young age group e.g. fashions, films,
nightclubs, schools, toys, etc.
h) Advertising
An effective advertising campaign could increase the quantity demanded of a particular good. It
could also decrease the demand for a competing good.
2.3 The Concept of Elasticity of Demand

Elasticity is a term widely used in economics to denote the ―responsiveness of one variable to
changes in another.‖ In proper words, it is the relative response of one variable to changes in another
variable. The phrase ―relative response‖ is best interpreted as the percentage change.
The quantity of a commodity demanded per unit of time depends upon various factors such as the
price of a commodity, the money income of consumers, the prices of related goods, the tastes of the
people, etc., etc. Whenever there is a change in any of the variables stated above, it brings about a
change in the quantity of the commodity purchased over a specified period of time. The elasticity of
demand measures the responsiveness of quantity demanded to a change in any one of the above
factors by keeping other factors constant.
When the relative responsiveness or sensitiveness of the quantity demanded is measured to changes
in its price, the elasticity is said be price elasticity of demand. When the change in demand is the
result of the given change in income, it is named income elasticity of demand. Sometimes, a change
in the price of one good causes a change in the demand for the other. The elasticity here is called
cross electricity of demand. The three Main types of elasticity are now discussed in brief.
Types of Elasticity of
Demand a) Price elasticity of
demand
Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a
change in its price. Precisely, it is defined as the ratio of proportionate change in the quantity
demanded of a good caused by a given proportionate change in price (ceteris paribus, i.e. holding
constant all the other determinants of demand, such as income).. The formula for measuring price
elasticity of demand is:
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Price elasticity of demand= Proportionate (percentage) change in quantity
demanded Proportionate (percentage) change in price
It can be described in symbolic terms.
Ed= (ΔQ/Q)×100/(ΔP/P)×1OO = (ΔQ×P)/(ΔP×Q)
Where ΔQ is change in quantity demanded, Q is initial quantity demanded, ΔP is change
in price, P is the initial price, Ed is price elasticity of demand.
Example: Let us suppose that price of a good falls from sh. 10 per unit to sh. 9 per unit in a day.
The decline in price causes the quantity of the good demanded to increase from 125 units to 150
units per day. The price elasticity using the simplified formula will be:
Ed= (ΔQ/Q)×100/(ΔP/P)×1OO = (ΔQ×P)/(ΔP×Q)
= ({150-125}/125)×100/ ({10-9}/10)×1OO = (25×10)/(1×125) = 2
The elasticity coefficient is greater than one. Therefore the demand for the good is elastic.
The concept of price elasticity of demand can be used to divide the goods into three groups.
(i). Elastic: When the percent change in quantity of a good is greater than the percent change in
its price, the demand is said to be elastic. When elasticity of demand is greater than one, a
fall in price increases the total revenue (expenditure) and a rise in price lowers the total
revenue (expenditure)
(ii) Unitary elasticity: When the percentage change in the quantity of a good demanded equals
percentage in its price, the price elasticity of demand is said to have unitary elasticity.
When elasticity of demand is equal to one or unitary, a rise or fall in price leaves total
revenue unchanged.
(iii)Inelastic: When the percent change in quantity of a good demanded is less than the
percentage change in its price, the demand is called inelastic. When elasticity of demand is
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inelastic or less than one, a fall in price decreases total revenue and .a rise in its price
increases total revenue
Factors influencing Price Elasticity of Demand:

Price elasticity of demand is influenced by:
a) Nature of Commodity
b) Availability of Substitutes
c) Number of Uses
d) Durability of commodity
e) Consumer‘s income
(b) Income Elasticity of Demand

Income is an important variable affecting the demand for a good. When there is a change in the
level of income of a consumer, there is a change in the quantity demanded of a good, other factors
remaining the same. The degree of change or responsiveness of quantity demanded of a good to a
change in the income of a consumer is called income elasticity of demand. Income elasticity of
demand can be defined as the ratio of percentage change in the quantity of a good purchased, per
unit of time to a percentage change in the income of a consumer. The formula for measuring the
income elasticity of demand is:
Income elasticity of demand= Proportionate (percentage) change in

demand Proportionate (percentage) change
in income
Putting this in symbol gives;

Ei= (ΔQ/Q)×100/ ( Y/Y)×1OO = (ΔQ×Y)/( Y×Q)
Where ΔQ is change in quantity demanded, Q is initial quantity demanded, Y is change in
income, Y is the initial income, Ei is income elasticity of demand.
A simple example will show how income elasticity. of demand can be calculated. Let us assume
that the income of a person is sh. 4000 per month and he purchases six CD‘s per month. Let us
assume that the monthly income of the consumer increase to sh. 6000 and the quantity demanded of
CD‘s per month rises to eight. The elasticity of demand for‘ CD‘s will be calculated as under:
ΔQ =8-6=2, Y= 6000-4000 = sh 2000, original quantity demanded = 6, original income sh. 4000
Ei=2×4000/ 2000×6 = 0.66
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The income elasticity is .66 which is less than one.
Categories of income elasticity

When the income of a person increases, his demand for goods also changes depending upon
whether the good is a normal good or an inferior good. For normal goods, the value of elasticity is
greater than zero but less than one. Goods with an income elasticity of less than 1 are called inferior
goods. For example, people buy more food as their income rises but the % increase in its demand is
less than the % increase in income.
c) Cross Elasticity of Demand:

The concept of cross elasticity of demand is used for measuring the responsiveness of quantity
demanded of a good to changes in the price of related goods. Cross elasticity of demand is defined
as the percentage change in the demand of one good as a result of the percentage change in the
price of
Cross elasticity of demand= Proportionate (percentage) change in demand of commodity

A Proportionate (percentage) change in price of commodity B
another good. The formula for measuring cross elasticity of ‗demand is:
Putting this in symbol gives;

EAB= (ΔQA/QA) / ( PB/PB) = (ΔQA×PB)/( PB×QA)
Where ΔQA is change in quantity of A demanded, QA is initial quantity of a demanded, PB
is change in price of B, P is the initial price of B, EAB is cross elasticity of demand of
commodities A&B.
The numerical value of cross elasticity depends on whether the two goods in question are
substitutes, complements or unrelated.
(i)Substitute good: When two goods are substitute of each other, such as coke and Pepsi, an
increase in the price of one good will lead to an increase in demand for the other good. The
numerical value of goods is positive Coke and Pepsi which are close substitutes. If there is
increase in the price of Pepsi called good A by 10% and it increases the demand for Coke called
good B by 5%, the cross elasticity would be 0.2, therefore, Coke and Pepsi are close substitutes.
(ii) Complementary goods: However, in case of complementary goods such as car and petrol,
cricket bat and ball, a rise in the price of one good say cricket bat by 7% will bring a fall in the
demand for the balls (say by 6%). The cross elasticity of demand (-6/7)= - 0.85 (negative).
(iii)Unrelated goods: The two goods which are unrelated to each other, say apples and pens, if the
price of apple rises in the market, it is unlikely to result in a change in quantity demanded of
pens. The elasticity is zero of unrelated goods.
2
2

Two goods that complement Two goods that are substitutes Two goods that are
each other show a negative cross have a positive cross elasticity independent have a zero cross
elasticity of demand: as the of demand: as the price of good elasticity of demand: as the
price of good Y rises, the Y rises, the demand for good X price of good Y rises, the
demand for good X falls rises demand for good X stays
constant

1. Outline the factors that influence price elasticity of demand of a product
2. Explain the concept of shift in demand curve and highlight the factors that causes the shift
3. State the factors that may lead to increase or decrease of demand of a commodity
4. Highlight five exemptions to the law of demand
5. State the difference between a demand schedule and a demand curve
References
23

TOPIC 3
3.0 SUPPLY
ANALYSIS 3.1Concept
of Supply
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Supply represents how much the market can offer. Supply is the
quantity of goods/services per unit of time which suppliers/producers are willing and able to put on
the market for sale at alternative prices other things held constant. The quantity supplied refers to
the amount of a certain good producers are willing to supply when receiving a certain price.
The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain
price. But unlike the law of demand, the supply relationship shows an upward slope. This means
that the higher the price, the higher the quantity supplied. Producers supply more at a higher price
because selling a higher quantity at a higher price increases revenue. Thus the normal supply curve
slopes upwards from left to right as follows:
A, B and C are points on the supply curve in the figure below. Each point on the curve reflects a
direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will
be Q2 and the price will be P2, and so on.
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is
important to supply because suppliers must, but cannot always, react quickly to a change in demand
or price. So it is important to try and determine whether a price change that is caused by demand
will be temporary or permanent. For example; if there's a sudden increase in the demand and price
for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using
their production equipment more intensively. If, however, there is a climate change, and the
population will need umbrellas year-round, the change in demand and price will be expected to be
long term; suppliers will have to change their equipment and production facilities in order to meet
the long-term levels of demand.
Exceptional supply curves

In have some situations the slope of the supply curve may be reversed.
i) Regressive Supply: In this case, the higher the price within a certain range, the smaller the
amount offered to the market. This may occur for example in some labour markets where above
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certain level, higher wages has a disincentive effect as the leisure preference becomes high. This
may also occur in undeveloped peasant economies where producers have a static view of the
income they receive. Lastly regressive supply curves may occur with target workers.
ii) Fixed Supply: Where the commodity is rare e.g. the ―Mona Lisa‖, the supply remains the same
regardless of price. This will be true in the short term of the supply of all things, particularly raw
materials and agricultural products, since time must elapse before it is physically possible to
increase output.
Supply curve
derivations a) Supply
schedules
The plan or table of possible quantities that will be offered for sale at different prices by individual
firms for a commodity is called supply schedule as in the following table. Theoretically the supply
schedules of all firms within the industry can be combined to form the market or industry supply
schedule, representing the total supply for that commodity at various prices.
Price per unit (KShs) 20 25 30 35 40 45 50

Quantity offered for Sales per month (in ‘000) 80 120 160 200 240 285 320
These prices are called the supply prices.
b) Supply curves
The quantities and prices in the supply schedule can be plotted on a graph. Such a graph is called
the firm supply curve. A supply curve is a graph relating the price and the quantities of a
commodity a firm is prepared to supply at those prices. The typical supply curve slopes upwards
from left to right. This illustrates the second law of supply and demand ―which states that the
higher the price the greater the quantity that will be supplied‖. The supply curve representing the
above schedule would appear as below;
60
5
0 Price
per Unit
40
30
20
10
7
0 10 20 30 40 50 60 0
Number of Units Supplied (in
000's)
The market supply curve is obtained by horizontal summation of the individual firm supply curves
i.e. taking the sum of the quantities supplied by the different firms at each price. If we consider an
industry consisting of two firms, At price P 1, firm I (diagram below) supplies quantity q 1, firm II
supplies quantity q2, and the total market supply is q 1+q2. At price P2, firm I supplies q‘1, firm II
supplies quantity q‘2, and the total market supply is q‘1+q‘2,. SS is the total market supply curve.

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Shift in supply curve and movement along the same supply curve
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent
very different market phenomena:
a) Movements along the supply curve
A movement along the supply curve means that the supply relationship remains consistent.
Therefore, a movement along the supply curve will occur when the price of the good changes and
the quantity supplied changes in accordance to the original supply relationship. In other words, a
movement occurs when a change in quantity supplied is caused only by a change in price, and vice
versa.
When price increases from P1 to P2, quantity supplied increases from Q1 to Q2 and movement
along the supply curve is from A to B. Conversely when price falls from P2 to P1, quantity supplied
falls from q2 to q1 and movement along the supply curve is from B to A.
b) Shifts in the supply curve

Shifts in the supply curve are brought about by changes in factors other than the price of the
commodity. A shift in supply is indicated by an entire movement (shift) of the supply curve to the
right (downwards) or to the left (upwards) of the original curve.
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When supply increases, the supply curve shifts to the right from S1S1 to S2S2. At price P 1, supply
increases from q1 to q‘1 and at price P2 supply increases from q2 to q‘2. Conversely, a fall in
supply is indicated by a shift to the left or upwards of the supply curve and less is supplied at all
prices. Thus, when supply falls, the supply curve shifts to the left from position S2S2 to position
S1S1. At price p1, supply falls from q‘1 to q1 and at price p2, supply falls from q‘2 to q2.
Factors that would cause a shift in the supply curve include:

i) Cost e.g. An increase in crude oil costs for a plastic manufacturer would shift the supply curve up
and to the left. Changes in technology can dramatically decrease costs.
ii) Government tax policy - Increases in business taxes will cause the supply curve to shift up and to
the left. A government subsidy to producers will cause more supply to be available i.e. the supply
curve will shift down and to the right.
iii) Weather/climate - Changes in weather and/or climate will especially influence agricultural
product supply.
iv)Prices of substitute products - If farmers can grow wheat instead of corn, and the price of wheat
goes up, then the supply curve for corn will shift up and to the left as more farmers switch from
corn to wheat.
v) Number of producers - As the number of firms/individuals producing a product increases, we
would expect more supply to be available
3.2 Factors Affecting Supply of a Product

They are also referred to as determinants of supply and include:
a) Price of the product
There is a direct relationship between quantity supplied and the price so that the higher the price,
the more people shall bring forth to the market. As a general rule, price of a commodity and its
supply are directly related. It means, as price increases, the quantity supplied of the given
commodity also rises and vice-versa. Mathematically this can be illustrated as follows:
Qs = -c + dp
Where: Qs is the quantity supplied
-c is a constant
d is the factor by which price
changes P is the price
2
7

The reason why a greater quantity is supplied at a higher price is because, as the price increases,
organizations which could not produce profitably at the lower price would find it possible to do so
at a higher price. One way of looking at his is that as price goes up, less and less efficient firms are
brought into the industry. The direct relationship between price and supply, known as ‗Law of
Supply‘ and the other determinants are termed as ‗other factors‘ or factors other than price‘.
b) Price of other product
The influence depends on the relationship between the goods or if the products share same inputs
i) Substitutes: If X and Y are substitutes, then if the price X increases, the quantity demanded
of X falls. This will lead to increased demand for Y, and this way eventually lead to
increased supply of Y.
ii) Complements: If two commodities, say A and B are used jointly, then an increase in the
price of A shall lead to a fall in the demand for A, which will cause the demand for B to
fall too.
iii) Shared inputs: Increase in the prices of other goods makes them more profitable in
comparison to the given commodity. As a result, the firm shifts its limited resources from
production of the given commodity to production of other goods. For example, increase in
the price of other good (say, wheat) will induce the farmer to use land for cultivation of
wheat in place of the given commodity (say, rice).
c) Production costs
As the prices of those factors of production used intensively by X producers rise, so do the firms‘
costs. This decreases the profitability and cause supply to fall, as some firms reduce output and
other, less efficient firms make losses and eventually leave the industry. Similarly, if the price of
one factor of production would rise (say, land), some firms may be tempted to move out of the
production of land intensive products, like wheat, into the production of a good which is intensive
in some other factor of production. On the other hand, decrease in prices of factors of production or
inputs, increases the supply due to fall in cost of production and subsequent rise in profit margin.
d) Means of transport
Goods transport and communication facilitates free and quick mobility of factors of production to
the producing centers and the final products to the market. Presence of good means of transport
and communication thus increases the supply of a good. Changes in supply of inputs due to
inefficient transport will affect the quantity supplied; if this falls, less shall be supplied and vice
versa.
e) Stability of the government
Existence of internal peace and stability will increase the production and supply of a good. With
political disturbances, labor unrest and wars production and supply of a good will be hampered.
f) Government policy
The imposition of a tax on a commodity by the government is equivalent to increasing the costs of
production to the producer because the tax ―eats‖ into the firm‘s profits. Hence taxes tend to
discourage production and hence reduce supply. Conversely, the granting of a subsidy is equivalent
to covering the costs of production. Hence subsidies tend to encourage production and increase
supply
g) Natural hazards/ climate
Natural events like weather, pests, floods, etc also affect supply. These affect particularly the supply
of agricultural products. If weather conditions are favourable, the supply of agricultural products
will increase. Conversely, if weather conditions are unfavourable the supply of such products will
fall.
h) State of technology
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Technological changes influence the supply of a commodity. Advanced and improved technology
reduces the cost of production, which raises the profit margin. It induces the seller to increase the
supply. However, technological degradation or complex and out-dated technology will increase the
cost of production and it will lead to decrease in supply.
i)Time
Given that it takes time for firms to adjust the quantities they produce, the supply is likely to be
more elastic the longer the period of time under consideration. In the momentary period, supply
cannot be increased even if there is a substantial rise in price. In the short-run, supply can be
increased by employing more variable factors of production. This is because in the long-run, the
quantities of all factors of production can be increased.
j) Goals / Objectives of the firm:
Generally, the aim of the firm is to maximize profits. Besides, maximum sales, maximum output
and maximum employment are also the goals of the firm. These goals and change in them affect the
supply of the commodity. Normally, supply of a commodity increases only at higher prices as it
fulfills the objective of profit maximization. However, with change in trend, some firms are willing
to supply more even at those prices, which do not maximise their profits. The objective of such
firms is to capture extensive markets and to enhance their status and prestige.
k) Expected change in price:
In case producers expect an increase in the price, they will withdraw goods from the market.
Consequently, supply will decrease. If price is expected to fall in future, supply will naturally
increase.
3.3 The Concept of Elasticity of Supply

Elasticity of supply of a commodity is the degree of responsiveness of the quantity supplies to
changes in price. Like the elasticity of demand, the elasticity of supply is the relative measure of the
responsiveness of quantity supplied of a commodity to a change in its price. The, greater the
responsiveness of quantity supplied of a commodity to the change in its price, the greater is its
elasticity of supply. Precisely, the elasticity of supply is defined as a percentage change in the
quantity supplied of a product divided by the percentage change in price. It is calculated using the
following formula:
The calculation of elasticity of supply is comparable to the calculation of elasticity of demand,

except that the quantities used refer to quantities supplied instead of quantities demanded. Over a
short time period, firms may be able to increase output only slightly in response to an increase in
prices. Over a longer period of time, the level of production can be adjusted greatly as production
processes can be altered, additional workers can be hired, more plants can be built, etc. Therefore,
elasticity of supply is expected to be greater over longer periods of time.e.g. the supply elasticity of
wheat to be very high as farmers can easily switch land that is used for wheat over to other crops
such as corn and soybeans. On the other hand, an oil refinery cannot easily switch its production
capacity over to another product, so low oil-refining margins do not reduce the quantity supplied by
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very much. Due to high capital costs, higher refining margins do not necessarily induce much
greater supply. So the supply elasticity for oil refining is fairly low.
Factors that determines the elasticity of supply of a commodity

Elasticity of supply plays a very important role in determining prices of products. The extent of rise
in price of a commodity depends on the elasticity of supply. Various factors, which determine the
elasticity of supply of a product, are given below.
(i) Marginal Cost: Elasticity of supply of a commodity depends on the marginal cost of production.
The elasticity of supply of a commodity would be less if the marginal cost of production goes
up. In the short run, diminishing marginal returns operates as some factors are fixed. This gives
rise to expansion of marginal cost of production. The expansion of marginal cost causes the
elasticity of supply in the short run to be less elastic. On the other hand, in the long run the
supply curve of a commodity is more elastic. In an increasing cost industry the supply of a
commodity is more elastic. In the constant cost industry the supply of a commodity is perfectly
elastic. In the decreasing cost industry the supply curve slopes negatively.
(ii) Producers response: The elasticity of supply for a product depends on the producers‘
responsiveness to the change in its price. The quantity supplied of a commodity will not change
if the producers do not react positively to the increase in prices. Producers do not always
increase the quantity supplied of a commodity to a rise in price. e.g. In some developed
countries agricultural producers meet their fixed money income by selling smaller quantities of
food grain. Thus with further rise in price they produce and sell smaller quantities rather that
more.
(iii) Infrastructural facilities: The expansion of supply of a commodity also depends on the
availability of productive facilities and inputs. The agricultural producer cannot increase in
response to the rise in price unless there is sufficient flow of fertilizers, irrigation etc. In case of
industrial goods the expansion of supply is inhibited by the shortage of power, storage facilities,
fuel and the essential raw materials.
(iv) Possibility of Substitution: The change in supply in response to the change in price depends on
the possibility of substitution of a product for others. If the market price of potato rises,
resources will be shifted from other cultivations like tomato and employed in the cultivation of
potato. The greater the possibility of shifting of resources to the potato cultivation, the greater is
the elasticity of supply of potato.
(v) Duration of time: The elasticity of a product also depends on the length of time. If the time is
longer producers get sufficient time to make adjustment for changing output in response to the
change in price, the greater the reaction of output, the greater the elasticity of supply. On the
basis of time market is divided into three types, (i) Market period (ii) Short-run (iii) long-run. In
the market period the supply is perfectly inelastic as there is no more production. In the short
run, output can be changed by changing the variable factors only. Thus during short period the
supply is elastic. In the long run supply of a commodity is more elastic as the firms can adjust
all factors of production and also new firms can enter or leave the industry.
Price Elasticity of Supply

Price elasticity of supply measures how responsive producers are to a change in the price of good.
It is defined as a measure of the responsiveness of quantity supplied to change in price. It is
measured by dividing the percentage change in quantity supplied by the percentage change in price.
Thus the Percentage Method formula is:

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Price elasticity of supply= Percentage change in quantity
supplied Percentage change in price
This can be epresses as;

Es= (ΔQs/Qs)×100/ (ΔP/P) ×1OO = (ΔQs×Qs)/(ΔP×P)
Where ΔQs is change in quantity supplied, Qs is original quantity supplied, ΔP is
change in price, Y is the original price.
Price Elasticity of supply measures the degree of responsiveness of quantity supplied to changes in
price. Because of the positive relationship between price and quantity supplied the price elasticity of
supply ranges from zero to infinity.
Price Elasticity of Supply and the Slope of the Slope Curve
For a straight line supply curve, the gradient is constant along the whole length of the curve, but
elasticity is not necessarily constant. However, at any given point the steeper the supply curve, the
more inelastic will be the supply. For this reason, steeply sloped supply curves are usually
associated with inelastic supply and non-steeply sloped supply curves are usually associated with
elastic supply.
Types of Price Elasticity of Supply

There are five types of elasticity of supply;
i) Perfectly Inelastic (Zero Elastic) Supply:
Supply is said to be perfectly inelastic if the quantity supplied is constant at all prices. The supply
curve is a vertical straight line and the elasticity of supply is equal to zero. When price rises from P1
to P2, quantity supplied stays fixed at q, and when price falls from P2 to P1, quantity supplied stays
fixed.
In the case of a price rise, this is the situation of the very short-run or the momentary period which
is so short that the quantity supplied cannot be increased, e.g. food brought to the market in the
morning. It is also the case where the commodity is fixed in supply e.g. land. In the case of a price
fall, this is the case of a highly perishable commodity which cannot be stored, e.g. fresh fish.
A perfectly inelastic supply curve is a straight line parallel to the Y- axis as shown in Fig. 3.9. It is
clear from the figure that in this case, supply will not increase at all how so ever much price may
rise. The producers dump the produced quantity of a commodity for whatever it would bring. Here,
the price of the commodity depends upon the demand of the commodity. The higher the demand,
the higher will be the price.
31

ii)Inelastic Supply (Es < 1):
Supply is said to be price inelastic if changes in price bring about changes in quantity supplied in
less proportion. Thus, when price increases quantity supplied increases in less proportion, and when
price fall quantity supplied falls in less proportion. The supply curve is steeply sloped and the
elasticity of supply is less than one. When price increases from P1 to P2, quantity supplied increases
in less proportion from q1 to q2. This is the case when there are limited stocks of the product or the
product takes a long time to produce such that when price rises, quantity supplied cannot be
increased substantially.
Conversely, if price falls from P2 to P1, quantity supplied falls in less proportion from q2 to q1.
This is the case of a commodity which is perishable and cannot be easily stored, e.g. fresh foods
like bananas and tomatoes. These are perishable but not so highly perishable as fresh fish. When
price falls, quantity supplied cannot be drastically reduced.
When the percentage change in quantity supplied is less than the percentage change in price, supply
of the commodity is said to be inelastic or less than unit elastic (Fig. 3.12). This type of supply
curve passes through the quantity (X) axis
iii) Unit Elasticity of Supply Elastic (Es =1):

Supply is said to be of unit elasticity if changes in price bring about changes in quantity supplied in
the same proportion. Thus, when price rises, quantity supplied increases in the same proportion,
32

and when price falls, quantity supplied falls in the same proportion. The supply curve is a straight
line through the origin, and the elasticity of supply is equal to one or unity.
When price rises from P1 to P2, quantity supplied increases in the same proportion from q1 to q2.
This is the case of a commodity of which there is a fair amount of stocks or which can be produced
within a fairly short period of time. Conversely, when price falls from P2 to P1, quantity supplied
falls in the same proportion from q2 to q1. This is the case of a commodity which is fairly easily
stockable e.g. dry foods, like dry beans and dry maize.
Supply of a commodity is said to be unit elastic, if the percentage change in quantity supplied is
equal to the percentage change in price. Any straight line supply curve passing through the origin
has an elasticity of supply equal to unity irrespective of the slope of this straight line and the scales
of the two axis. But, it is important to realise that unitary elasticity of supply unlike unitary
elasticity of demand, has no special economic significance.
iv) Elastic Supply (E s> 1):

Supply is said to be price elastic if changes in price bring about changes in quantity supplied in
greater proportion. Thus, when price increases, quantity supplied increases in greater proportion.
The supply curve is not steeply sloped and the elasticity of supply is greater than one. When price
rises from P1 to P2, quantity supplied rises in greater proportion from q1 to q2. This is the case
when there are a lot of stocks of the commodity or the commodity can be produced within fairly
short period of time so that when price rises, quantity supplied can be increased substantially.
Conversely, if price falls from P2 to P1, quantity supplied falls in greater proportion from q2 to q1.
This is the case of a commodity which is easily stockable e.g. manufactured articles. When price
falls, quantity supplied can be substantially reduced. The commodity is then stored instead of being
sold at a loss or for very reduced profit. When the percentage change in quantity supplied exceeds
the percentage change in price, supply of the commodity is said to be elastic or more than unit
elastic (Fig. 3.11). This type of supply curve passes through the price (Y) axis.
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v)Perfectly Elastic Supply (Es =∞)
It means that at a price, any quantity of the good can be supplied. But, at a slightly lower price, the
firm will not sell at all. It is purely an imaginary concept and can only be explained with the help of
an imaginary supply schedule.
In this case, the elasticity of supply is infinity and the supply curve is a straight line parallel to the
X-axis as shown in Fig. 3.8. Price remains OP irrespective of changes in supply and a small rise in
price evokes an indefinitely large increase in the amount supplied. Further, a small drop in price
would reduce the quantity, producers are willing to supply to zero. This is the case of Government
price control.
Importance of the Price Elasticity of Supply

i) If the supply of a commodity is elastic with respect to a price rise, producers will benefit by
prices not rising excessively. But if the supply is inelastic with respect to a price rise, they will
tend to be overpricing of the commodity to the disadvantage of the consumers. Even the
producers will not benefit as much as they would if the supply was elastic because although
they are charging high prices, the supply is limited.
ii) If the supply is inelastic with respect to a price fall: This increases the risk of the business
because it means that producers may be forced to sell the commodity at very low prices as the
3
4

commodity cannot be easily stored. But if the supply is elastic with respect to a price fall, the
business is less risky as the commodity can easily be stored, and producers will not be forced
to sell at low prices.
iii) The price elasticity of supply is responsible for the fact that the prices of agricultural products
tend to fluctuate more than those of manufactured products.

1. Explain what is meant by elasticity of supply and state the factors that determine the supply of a
good in the market.
2. Explain the concept of movement along a supply curve
3. State the law of supply and explain two conditions under which it cannot apply.
References
35

[Type text]
TOPIC 4
4.0 PRICE DETERMINATION
4.1 Concept of Price
Determination Definition of price
The price of an item is the point where the supply at a given price intersects the demand at a specific
price. If it costs sh1 to manufacture a sweet, then a sweet manufacturer may be willing to supply
100,000 sweets if customers pay sh10 for each, 50,000 for sh 5, and 1,000 for sh1. Customers,
however, would buy 100,000 at sh1, and only 1,000 at sh10. By determining how many units the
supplier will provide at a given price, and overlaying that with how many units the consumers will
buy at a given price, economists can determine the "equilibrium point," the point where suppliers
and customers are both willing to buy a certain amount of product at a certain price. For these
sweets, a manufacturer may be willing to produce 45,000 sweets at sh4.75 because customers will
demand 45,000 sweets at that price. Pricing at the equilibrium point is efficient because suppliers
will produce only what the market will purchase, without over- or under-producing and thereby
incurring extra costs or foregoing potential revenue.
Factors Affecting Price

The final sale price of a good or service can be affected by factors other than supply or demand. For
example, the government may impose special taxes that are added to the list price at the time of
sale. Some governments set mandatory minimum prices for controlled products like alcohol.
Governments also monitor retailers for signs of collusion and price-fixing. For example, if there are
two sellers of milk in a small town, they could agree to both charge the same high price for the milk
in order to increase their profits. However, this practice is illegal under many countries and, if found
guilty, the retailers could face substantial penalties.
4.2 Determination of Prices in a Free Market Economy

a) Interaction of supply and demand, equilibrium price and quantity
In perfectly competitive markets the market price is determined by the interaction of the forces of
demand and supply. In such markets the price adjusts upwards or downwards to achieve a balance,
or equilibrium, between the goods coming in for sale and those requested for purchase. Demand and
supply react on one another until a position of stable equilibrium is reached where the quantities of
goods demanded equal the quantities of goods supplied. The price at which goods are changing
hands varies with supply and demand. If the supply exceeds demand at the start of the week, prices
will fall. This may discourage some of the suppliers, who will withdraw from the market, and at the
same time it will encourage consumers, who will increase their demands. This is known as buyers
market.
Conversely, when the price is low, suppliers are only willing to supply fewer products but
consumers are trying to buy a larger quantity than supplied. There are therefore many disappointed
customers, and producers realise that they can raise prices. This is known as sellers market. There is
thus an upward pressure on price and it will rise. This may encourage some suppliers, who will
enter the market, and at the same time it will discourage consumers, who will decrease their
demand.
This can be shown by comparing the demand and supply schedule below.
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Price of Quantity
Quantity Supplied Pressure
Commodity of X Demanded of X
of X (kg/week) on Price
(£/kg) (kg/week)
A 10 100 20 Upward
B 20 85 36 Upward
C 30 70 53 Upward
D 40 55 70 Downward
E 50 40 87 Downward
F 60 25 103 Downward
G 70 10 120 Downward
A Twin force is therefore always at work to achieve only one price where there is neither upward
nor downward pressure on price. This is termed the equilibrium or market price which is the market
condition which once achieved tends to persist or at which the wishes of buyers and sellers
coincide. This can be identified by drawing a demand curve and supply curve then identifying their
point of intersection as shown
From the chart, equilibrium occurs at the intersection of the demand and supply curve, which
indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity
will be Q*. These figures are referred to as equilibrium price and quantity. In the real market place
equilibrium can only ever be reached in theory, so the prices of goods and services are constantly
changing in relation to fluctuations in demand and supply.
Any other price anywhere is called disequilibrium price. As the price falls the quantity demanded
increases, but the quantity offered by suppliers is reduced, since the least efficient suppliers cannot
offer the goods at the lower prices. This illustrates the third ―law‖ of demand and supply that
―Price adjusts to that level which equates demand and supply‖.
A Mathematical Approach to Equilibrium Analysis

The demand and supply relationships explained earlier on can be expressed in mathematical form.
The standard problem is one of finding a set of values which will satisfy the equilibrium condition
of the market model.

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Equilibrium in a single market model
A single market model has three variables: the quantity demanded of the commodity (Q d), the
quantity supplied of the commodity (Qs) and the price of the commodity (P). Equilibrium is
assumed to hold in the market when the quantity demanded (Q d) = Quantity Supplied (Qs) . It is
assumed that both Qd and Qs are functions. A function such as y = f (x) expresses a relationship
between two variables x and y such that for each value of x there exists one and only one value of y.
Qd is assumed to be a decreasing linear function of P which implies that as P increases, Q d
decreases and Vice Versa. Qs on the other hand is assumed to be an increasing linear function of P
which implies that as P increases, so does Qs.
Mathematically, this can be expressed as follows:

Qd = Qs
Qd = a – bP where a,b > 0. ……………………….(i)
Qs = -c + dp where c,d >0. ………………………(ii)
Both the Qd and Qs functions in this case are linear and can be expressed graphically as follows:
Qd = a - bP QS = -c + dP
Once the model has been constructed it can be solved.

At equilibrium,
Qd = Qs
a – bP = -c + dP
P =a+c
b+d
To find the equilibrium quantity Q , we can substitute into either function (i) or (ii).
Substituting P into equation (i) we obtain:
Q = a – b (a+c) = a (b+d) – b (a+c) = ad -bc
b+d b+d b+d
Taking a numerical example, assume the following demand and supply functions:
P = 100 – 2P
Qs = 40 + 4P
At equilibrium, Qd = Qs
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 100 – 2 P = 40 + 4 P
6 P = 60
 P = 10
Substituting P = 10, in either equation.

Qd = 100 – 2 (10) = 100 – 20 = 80 = Qs
A single market model may contain a quadratic function instead of a linear function. A quadratic
function is one which involves the square of a variable as the highest power. The key difference
between a quadratic function and a linear one is that the quadratic function will yield two solution
values.
In general, a quadratic equation takes the following

form: ax2 + bx + c = 0 where a  0.
Its two roots can be obtained from the following quadratic formula:
X = -b + ( b2 – 4ac)
2a
Given the following market model:

Qd = 3 – P2
2
= 6P – 4
At
equilibrium: 3
– P2 = 6P – 4
P2 + 6P – 7 = 0
Substituting in the quadratic formula:

a =1, b = 6, c = -7
= - 6 + 62 – 4 (1 x – 7) 2
x1
= 
62 4(1x7)
6
2x1
P = 1 or –7 (ignoring –7 since price cannot be
negative)  P = 1
Substituting P = 1 into either equation:
Qd = 3 – (1)2 = 2 = Qs
Q=2
Equilibrium in a two commodity market

Let us consider a two-commodity market model in which the two commodities are related to each
other. Let us assume the functions for both commodities are linear. The two commodities are
complementary commodities say (cars (c ) and petrol (P). The functions representing the
commodities are as follows:
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Qdc = 820 – 10 Pc – 4Pp Qdp = 590 – 2Pc – 6Pp
Qsc = -120 + 6Pc Qsp = - 240 + 4Pp
At equilibrium,
1) Qdc = Qsc
820 – 10Pc – 4Pp = - 120 +
6Pc 940 – 16Pc – 4Pp = 0
2) Qdp = Qsp
590 – 2Pc – 6Pp = -240 + 4Pp
830 – 2Pc – 10Pp = 0
There are now therefore two equations: 940

– 16Pc – 4Pp = 0. …………………(i) 830
– 2Pc – 10Pp = 0 ………………….(ii)
Multiply (ii) by 8 which gives (iii). Subtract (i) from (iii) to eliminate Pc and solve for Pp.
6,640 – 16 Pc – 80Pp = 0..(iii)
- (940 – 16Pc – 4Pp = 0 ……………….(i)
5,700 - 76Pp = 0
Pp = 75
Substituting Pp = 75 in (i) we
obtain: 940 – 16Pc – 4(75) = 0
16pc =
640 Pc =
40
Substituting Pc = 40 and Pp = 75 into Qd or Qs for each market.

1) Qdc = 820 – 10 (40) – 4 (75)
= 820 – 400 – 300
Qdc = 120 = Qsc
2) Qdp = 590 – 2 (40) – 6 ( 75)
= 590 – 80 – 450
Qdp = 60 = Qsp
b. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*. This occurs when the
market has;
i. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be
allocative inefficiency.
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At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1,
however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2.
Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The
suppliers are trying to produce more goods, which they hope to sell to increase profits, but those
consuming the goods will find the product less attractive and purchase less because the price is too
high.
ii. Excess Demand

Excess demand is created when price is set below the equilibrium price. Because the price is so low,
too many consumers want the good while producers are not making enough of it.
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus,
there are too few goods being produced to satisfy the wants (demand) of the consumers. However,
as consumers have to compete with one other to buy the good at this price, the demand will push the
price up, making suppliers want to supply more and bringing the price closer to its equilibrium.
c) Stable and Unstable Equilibrium
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Equilibrium is said to be stable equilibrium when economic forces tend to push the market towards
it. In other words, any divergence from the equilibrium position sets up forces, which tend to restore
the equilibrium i.e. At prices below equilibrium price there is an excess demand which pushes the
price up.
Unstable equilibrium on the other hand is one such that any divergence from the equilibrium sets up
forces which push the price further away from the equilibrium price. it mostly occurs in cases of
inferior good or a veblen good which exhibit an ―abnormal‖ demand curve which means that at
prices above equilibrium, there is excess demand which pushes the price upwards and away from
the equilibrium. Similarly, at prices below equilibrium, there is excess supply which pushes the
prices even further down.
Equilibrium Position
The equilibrium position shifts as a result of;
a) Changes in
demand i) Increase in
demand
P
D2 S
D1
p2
p1
S D2
q1 q2qd Q
SS is the supply curve and D1D1 the initial demand curve shifts to the right, to position D2D2. P1 is
the initial equilibrium price and q1 the initial equilibrium quantity. When demand increases to
D2D2, then at price P1, the quantity demanded increases from q1 to qd. But the quantity supplied at
that price is still q1. This leads to excess demand over supply (qd – q1). This causes prices to rise to
a new equilibrium level P2 and the quantity supplied to rise to a new equilibrium level, q2. A
decrease in demand would have an opposite effect
ii) Decrease in demand
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P
D1 S
D2
p1
p2
S
D1
D2
qd q2 q1 Q
At the initial equilibrium price P1, quantity demanded falls from q1 to qd. But the quantity supplied
is still q1 at this price. Hence, this creates excess of supply over demand, and this causes price to
fall to a new equilibrium level P2 and quantity to fall to a new equilibrium level q2.
b) Changes in supply
i) Increase in Supply
P
S1 S2
p1
p2
S1
S2 D
q1 q q2
DD is the demand curve and S1S1 the initial supply curve. If supply increases, the supply curve
shifts to the right to position S2S2. At the initial equilibrium price P1, quantity supplied increase
from q1 to q2. This creates a glut in the market and this causes the price to the new P 2 and the
quantity increases to a new equilibrium level q2.
ii) Fall in Supply
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P
S1 S2
D
p2
p1
S2 D
q2 q1 q2
When the supply falls, the supply curve shifts to the left to position S1S1. At the initial equilibrium
price P1, quantity supplied falls from q1 to q 21 but the quantity demanded is still q1. This creates
excess of demand over supply which causes price to rise to a new equilibrium level P 21 and quantity
to fall to a new equilibrium level q21 and quantity to fall to a new equilibrium level q2.
4.3 Role of Government in Price Determination

The government may intervene in the market and mandate a maximum price (price ceiling) or
minimum price (price floor) for a good or service. For example, some governments legislate the
maximum price that a landlord can charge a tenant for rent. Such rent-control policies, though well-
intentioned, result in disequilibrium in the housing market since, at the government-mandated price
ling, the quantity of housing supplied falls short of the quantity of housing demanded. An example
of minimum prices (price floors) in the United States is the minimum wage, which specifies the
lowest hourly wage an employer can pay an employee. Price floors result in market disequilibrium
in that quantity supplied at the mandated price exceeds quantity demanded. For example, suppose
the market equilibrium price is Pe in figure below. If the government mandates a price floor at
which is above equilibrium price Pe, quantity supplied will be Q3, which is greater than the Q1
demanded at the price. A mandated price ceiling of Pc, on the other hand, causes quantity demanded
Q4 to exceed the Q2 quantity supplied.
The government can alter an equilibrium price by changing market demand and/or market supply.
The government can restrict demand by rationing a good, i.e., by shifting the demand schedule
down and to left. When a good is rationed, an individual not only must be willing and financially
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able to buy a commodity but also must possess a government-issued coupon which permits
purchase.
Equilibrium price can be altered by shifting the market supply curve. A tax on a good raises its
supply price-shifts the market supply curve up and to the left- and causes the equilibrium price to
increase and the equilibrium quantity to fall. A subsidy to the producer lowers the commodity's
supply price, shifts market supply down and to the right, and results in a lower equilibrium price
and larger equilibrium quantity.
For example In the figure below, a market supply S and demand D for gasoline is presented.
Equilibrium price is initially P0 while equilibrium quantity is Q0. Suppose the government seeks to
reduce gasoline consumption, i.e., decrease the quantity demanded. A tax of 50 cents on each gallon
sold would decrease market supply, shift market supply curve to the left to S', and raise the
equilibrium price to P1; equilibrium quantity falls from Q0 to Q1 gallons.

1. Distinguish between supply, demand and equilibrium price.
2. The table below shows the demand and supply schedules for a product:
PRICE (KShs. per kg) DEMAND (kg) SUPPLY (kg)

10 100 20
20 85 36
30 70 53
40 55 70
50 40 87
60 25 103
70 10 120
Draw the demand and supply curves and draw the equilibrium price and quantity.
3. Given the market model
= Qs,
P
Qd = 48 – 4Qs= -6 + 14P, Find P and Q
TOPIC 5
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5.0 PRODUCTION
5.1 Meaning of Production
Production theory is the study of production, or the economic process of converting inputs into
outputs. Production uses resources to create a good or service that are suitable for use. This can
include manufacturing, storing, shipping, and packaging. Some economists define production
broadly as all economic activity other than consumption. They see every commercial activity other
than the final purchase as some form of production.
Production is a process, and as such it occurs through time and space. Because it is a flow concept,
production is measured as a ―rate of output per period of time‖. There are three aspects to
production processes: the quantity of the good or service; produced the form of the good or service
created; and the temporal and spatial distribution of the good or service produced.
A production process can be defined as any activity that increases the similarity between the pattern
of demand for goods and services, and the quantity, form, shape, size, length and distribution of
these goods and services available to the market place.
Purpose of Production
There are not enough resources (land, labor, and capital) to produce enough goods and services
(consumer goods and services, capital goods, and government goods and services,) to achieve
everyone's goals. Scarcity implies that "overproduction" is not a plausible explanation for recession,
and that overproduction of some goods should always be understood as implying the under
production of other, more valuable goods. While there may be a "general glut" of goods, the
problem is some kind of coordination failure rather than too much production of everything.
Increasing the productive capacity of the economy--the supplies of resources like land, labor, and
capital and the enhancement of resource productivity--is a "good" thing, and the key issue is the
allocation of resources to produce the most valuable goods and services.
However, a more fundamental principle of macroeconomics is that the purpose of production is

consumption. This principle is worth emphasizing because some criticisms of Keynesian economics
by free market economists go too far in dismissing the importance of consumer expenditure for the
economy. Production by firms in consumer goods industries is driven by expectations of consumer
expenditures in the near future. And the production of many intermediate goods--materials and
partially finished goods--while directly driven by expectations of purchases by other firms in the
near future, are indirectly driven by expected future consumer expenditures. Since firms will not
produce what they do not expect sell, expected consumer expenditures are important in determining
both output and employment.
It is not only productive capacity, or "supply" that drives production, employment, and income, it is
also expenditure on that productive capacity, or "demand." Both supply and demand are important.
In a social order, including a market order, people produce goods and services for other people to
consume, and they consume goods and services that other people produce. However, in a market
system, people directly provide resources for sale to others, who use those resources to produce
goods and services, in order to sell products to others. They sell these resources and products for
money, and then use that money to purchase goods and services.
Adam Smith's metaphor of the invisible hand suggests even if the people in a market economic
order fail to see that the purpose of their production is consumption, prices should create signals and
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incentives that coordinate their activities so that their production is directed towards consumption.
For example, someone may think that they work to accumulate wealth, but some prices will adjust
to a level where their efforts to accumulate wealth become consistent with the purpose of
production--the consumption of goods and services.
The reason households want to earn income is consumption, buying consumer goods and services.
So while people directly provide resources to firms is to earn income, and the reason firms use the
resources to produce goods and services is to pay for the resources and earn profit, people do this
mostly to spend the income they earn on consumer goods and services. The provision of resources
and the production of goods and services is mostly being directed towards consumption. For the
most part, the market economic system creates a flow of employment of resources, production of
goods and services, and expenditures on those goods and services consistent with the basic principle
that the purpose of production is consumption. Saving and investment are consistent with the
principle that the purpose of production is consumption to the degree that households save in order
to fund future consumption and firms invest in order to produce consumer goods in the future.
Governments fund their purchases of resources (like labor) and government goods and services by
taxation. Those earning incomes pay taxes to the government. This reduces their disposable income
(after tax income) and so their ability to purchase consumer goods and services. The government
hires workers and purchases various goods and services. Sadly, this reduces the capacity of the
private sector to produce goods and services, which matches the reduction in the ability of
households to buy consumer goods and services.
5.2 Factors of Production

The sum totals of the economic resources which we have in order to provide for our economic
wants are termed as factors of production. Traditionally economists have classified these under four
headings. They are:
a)Land
b)Labour
c)Capital
d)Enterprise
The first two are termed primary factors since they are not the result of the economic process; they
are, so to speak, what we have to start with. The secondary factors, however are a consequences of
an economic system. The various incomes which the factors receive can be termed factor rewards
or factor returns. Labour receives wages and salaries, land earns rent, capital earns interest and
enterprise earns profit.
a)Land
The term land is used in the widest sense to include all the free gifts of nature; farmlands, minerals
wealth such as coal mines, fishing grounds, forests, rivers and lakes. In practise it may be very
difficult to separate land from other factors of production such as capital but, theoretically, it has
two unique features which distinguish it. Firstly, it is fixed in supply. As land includes the sea in
definition, then we are thus talking about the whole planet, and it is obvious that we cannot acquire
more land in this sense. Secondly, land has no cost of production. The individual who is trying to
rent a piece of land may have to pay a great deal of money but it never cost society as a whole
anything to produce land.
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b)Capital
Capital as a factor of production can be defined either as the stock of wealth existing at any one
time and as such, capital consists of all the real physical assets of society. An alternative
formulation of capital is that it refers to all those goods, which are used in the production of further
wealth.
Capital can be divided into fixed capital, which is such things as building, roads, machinery etc and
working capital or circulating capital which consists of stocks of raw materials and semi-
manufactured goods. The distinction is that fixed capital continues through many rounds of
production while working capital is used up in one round; For example, a classroom would be fixed
capital, while stocks of chalk to be used for writing would be circulating/working capital.
As stated previously, capital is a secondary factor of production, which means that results from the
economics system. Capital has been created by individuals forgoing current consumption, i.e.
people have refrained from consuming all their wealth immediately and have saved resources which
can then be used in the production of further wealth.
c) Labour
Labour is the exercise of human, physical and mental effort directed to the production of goods and
services. Included in this definition is all the labour which people undertake for reward, either in
form of wages and salaries or incomes from self employment. We would not, therefore include
housework or the efforts of do-it-yourself enthusiasts, even though these may be hard work.
Labour is no doubt the most important of all factor or production, for the efficiency of any
production will to a large extent depend on the efficiency and supply of the labour working in the
process. Besides labour is also the end for which all production is undertaken. Supply of labour
refers to the number of workers (or, more generally, the number of labour hours) available to an
econo my. The supply of labour is determined by:
i. Population Size: In any given economy, the population size determines the upper limit of
labour supply. Clearly there cannot be more labour than there is population.
ii. Age Structure : The population is divided into three age groups. These are:
 The young age group usually below the age of 18, which is considered to be the
minimum age of adulthood. People below this age are not in the labour supply, i.e. they
are not supposed to be working or looking for work.
 The working age group, usually between 18 and 60, although the upper age limit for
this group varies from country to country. In Kenya for example, for public servants, it
is 55 years. It is the size of this group which determines the labour supply.
 The old age group, i.e. above 60 years is not in the labour force.
iii. The Working Population: Not everybody in the working age group will be in the labour force.
What is called the working population refers to the people who are in the working group, and
are either working or are actively looking for work, I.e. would take up work if work was
offered to them. These are sometimes called the actively active people. Hence this group
excludes the sick, the aged, the disabled and (full time) housewives, as well as students. These
are people who are working and are not willing or are not in a position to take up work was
given to them.
iv. Education System: If the children are kept in school longer, then this will affect the size of the
labour force of the country.
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v. Length of the Working Week: This determines labour supply in terms of Man-hours. Hence the
fewer the holidays there are, the higher will be the labour supply. This does not, however
mean that if the number of working hours in the week are reduced, productivity if there is a
high degree of automation.
vi. Remuneration: The preceding five factors affect the supply of labour in totality. Remuneration
affects the supply of labour to a particular industry. Thus, an industry which offers higher
wages than other industries will attract labour from those other industries.
vii) The Extent to Barriers to Entry into a Particular Occupation: If there are strong barriers to
the occupation mobility of labour into a particular occupation, e.g. special talents required or
long periods of training, the supply of labour to that occupation will be limited.
viii) Efficiency of Labour: Efficiency of labour refers to the ability to achieve a greater output in a
shorter time without any falling off in the quality of the work that is, increase productivity per
man employed. The efficiency of a country‘s labour force depends on a number of influences
 Climate: This can be an important influence on willingness to work, for extremes of
temperatures or high, humidity are not conducive to concentration even on congenial
tasks.
 Education and training: Education and training produce skills and therefore efficient
labour. Education has three aspects: general education, technical education and training
within industry. A high standard of general education is essential for developing
intelligence and providing a foundation upon which more specialized vocational
training can be based. Technical training provided in the universities, colleges and by
industry itself. Training within industry is given by each firm to its employees.
 Working Conditions: Research has shown that if working conditions are safe and
hygienic, the efficiency of labour will be higher than if the conditions were unsafe or
unhygienic.
 Health of the worker: The efficiency of the worker is closely related to his state of
health which depends on his being adequately fed, clothed, and housed.
 Peace of Mind: Anxiety is detrimental to efficiency. People (workers) may be tempted
to overwork themselves to save at the expense of health to provide for contingencies
like times of sickness, unemployment and old age. Others may be worried about their
work or their private problems.
 Efficiency of the Factors: The productivity of labour will be increased if the quality of
the factors is high. The more fertile the land, the greater will be the output per mass,
other things being equal. Similarly, the greater the amount and the better the quality of
the capital employed, the greater will be the productivity of the labour. Efficiency of the
organization is even more important since this determines whether the best use is being
made of factors of production.
 Motivating factors: These are factors which boost the morale of the workers and hence
increase the efficiency. They include such things as free or subsidized housing, free
medical benefits, paid sick leave, allowing workers to buy shares in the company and
incorporating workers‘ representatives in the decision-making of the firm, In this way
the workers feel that they are part and parcel of the organization and are not being use
 The Extent of Specialization and Division of Labour: The greater the amount of
specialization, the greater will be the output per man; Division of labour increases the
efficiency of labour.
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d)The Entrepreneur:
Land, capital and labour are of no economic importance unless they are organised for production.
The entrepreneur is responsible not only for deciding what method of production shall be adopted
but for organising the work of others. He has to make many other important decisions such as what
to produce and how much to produce. The major functions of an entrepreneur are; first Uncertainty
bearing since ost production is undertaken in anticipation of demand. Firms will produce those
things which they believe will yield profit. They do not know that they will do so because the future
is unknown and second, Management Control which involves responsibility for broad decisions of
policy and the ability to ensure that these decisions are carried out.
Factor Mobility
Factor mobility means the ease with which a factor can be moved from one form or area of
employment to another. There are two aspects to mobility. Movement from one employment to
another is called occupational mobility and movement from one place of employment to another is
called geographical mobility.
i)Mobility of Land
Land is geographically immobile in that a given piece of land cannot be moved from one place to
another. However, land can be occupationally mobile in that it can be put to different uses, e.g.
farming, grazing and building. Some forms of land have limited occupational mobility in that they
can be put to a limited number of uses e.g. arid or desert areas and mountainous land. The former
may be used as grazing land by nomadic people, unless it is found to have mineral deposits, while
the latter may be used as a tourist attraction or for pleasure in mountain climbing. Immobility
geographically implies that it cannot be used to increase production of a particular product unless
this is done at the expense of other products.
ii)Mobility Capital
Some forms of capital are immobile in both geographical and occupational sense e.g. heavy
machinery and railway networks. Usually once such equipment has been installed on land in a
particular place, it becomes uneconomical to uproot it and move it to another place. Hence, because
of the heavy costs that such an operation would involve, it is for all practical purposes
geographically immobile. Also such equipment can usually be put to only the use for which it was
intended and it is occupationally immobile.
Other forms of capital are geographically immobile but are occupationally mobile e.g. buildings.
Once a building has been set up in a place, it cannot be moved intact to another place, but it can be
converted to a hotel or bar. Other forms of capital are mobile both geographically and
occupationally e.g. vehicles and hand tools which can be moved from place to place and can also be
put to different uses. Mobility geographically facilitates production. Immobility occupationally
makes it difficult to increase output in the short run.
iii) Mobility of Entrepreneur
The most mobile of the factors of production is probably the entrepreneur. This is because the basic
functions of the entrepreneur are common to all industries. Whatever the type of economic activity,
there will be a need to raise capital, to organise the factors of production and to take the
fundamental decisions on where, what and how to produce.
iv) Mobility of Labour

Mobility of labour means the capacity and ability of labour to move from one place to another or
from one occupation to another or from one job to another or from one industry to another.
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Labour is relatively mobile geographically, but less so occupationally in that people can be moved
from one place to another but find it hard to change occupations if it is highly specialized
Types of Mobility of Labour
Mobility of labour is of the following
types: a. Geographical Mobility:
When a worker moves from one place to another within a country or from one country to
another, it is called geographical mobility of labour. For example, the movement of labour from
Kisumu to Nairobi or from Kenya to England is geographical mobility.
b. Occupational Mobility:
Occupational mobility refers to the movement of workers from one occupation to another. This
mobility is further divided into the following two types:
(i) Horizontal Mobility: The movement of labour from one occupation to another in the same
grade or level is called horizontal mobility. For example, a bank clerk joins as an accounts
clerk in a company.
(ii) Vertical Mobility: When a worker of a lower grade and status in an occupation moves to
another occupation in a higher grade and status, it is vertical mobility. Just as a school lecturer
becomes a college lecturer, a clerk becomes a manager, etc.
c. Mobility between Industries:
The movement of labour from one industry to another in the same occupation is industrial
mobility. For example, a fitter leaving a steel mill and joining an automobile factory.
Factors Determining Mobility of Labour:

The mobility of labour depends upon the following factors:
 Education and Training: The mobility of labour depends on the extent to which labour is
educated and trained. The more a person is educated and skilled, the greater are his chances
of moving from one occupation or place to another. Geographical and vertical mobility
depend on education and training.
 Outlook or Urge:The outlook or urge of workers to rise in life determines their mobility. If
they are optimist and broad minded, they will move to other jobs and places. Differences in
language, habits, religion, caste, etc. will not be hindrances in their mobility.
 Social Set-up: The mobility of labour also depends upon the social set-up. A society
dominated by caste system and joint family system lacks in mobility of labour. But where
the joint family and caste system do not exist or have disintegrated the mobility of labour
increases.
 Means of Transport: Well developed means of transport and communications encourage
mobility labour. The worker knows that in case of emergency at home, he can easily
communicate with his father phone or travel back by train within the country or by
aeroplane if he is abroad.
 Agricultural Developments: With agricultural development, labour moves from high
population to low population areas during busy seasons.
 Industrialisation: The mobility of labour is determined by industrial development. Workers
move from different occupations and places to work in factories. Industrialisation also leads
to urbanisation and workers move from rural and semi-urban areas to industrial centres and
big cities.
 Advertisement: Advertisements relating to jobs in newspapers also determine the mobility of
labour. Accordingly, workers move between places and occupations.
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 State Help: When the state starts industrial centres, and estates, employment exchanges,
dams, public works, etc., they encourage mobility of labour.
 Peace and Security: The mobility of labour depends to a large extent on law and order in the
country. If the life and property of the people are not safe, they will not move from their
present places and occupations to others.
Obstacles in Mobility of Labour:

There are many factors which hinder mobility of labour. They are differences in climate, religion,
caste, habits, language, customs, tastes, etc. The other factors are illiteracy, ignorance, indebtedness,
attachment to property and place, poverty, economic backwardness, lack of means of transport and
communications and employment opportunities, etc.
Levels of Production
A nation‘s economy can be divided into three sectors (levels) to define the proportion of the
population engaged in the production sector. This categorization is seen as a continuum of distance
from the natural environment. The continuum starts with the primary sector, which concerns itself
with the utilization of raw materials from the earth such as agriculture and mining. From there, the
distance from the raw materials of the earth increases. The three levels are;
a)Primary level
This is the basic level where production starts. It‘s sometimes known as extraction level and
involves production of raw materials. At this level, products are extracted or harvested products
from the earth. The primary sector includes the production of raw material and basic foods.
Activities associated with the primary sector include agriculture (both subsistence and commercial),
mining, forestry, farming, grazing, hunting and gathering, fishing, and quarrying. The packaging
and processing of the raw material associated with this sector is also considered to be part of this
sector.
b) Secondary level
The secondary sector of the economy manufactures finished goods. It involves the transformation of
raw or intermediate materials into goods e.g. manufacturing steel into cars, or textiles into clothing.
All of manufacturing, processing, and construction lies within the secondary sector. Activities
associated with the secondary sector include metal working and smelting, automobile production,
textile production, chemical and engineering industries, aerospace manufacturing, energy utilities,
engineering, breweries and bottlers, construction, and shipbuilding.
c) Tertiary level
The tertiary sector of the economy is the service industry. This sector provides services to the
general population and to businesses. Activities associated with this sector include retail and
wholesale sales, transportation and distribution, entertainment (movies, television, radio, music,
theater, etc.), restaurants, clerical services, media, tourism, insurance, banking, healthcare, and law.
The services at this level can be divided into; Commercial services which concerned with the
movement, storage and distribution of goods and wholesaling, retailing, banking, insurance etc and
Direct personal service which includes services offered directly to consumers e.g. medicine,
teaching, legal practice, pastoral duties etc
Types of production
Broadly, there are two types of production; Direct and
indirect a) Direct production
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This is the lowest level of production and is also referred to as subsistence production . Subsistence
productions refers to output from the production process that is just enough for the survival. This
amount of production is therefore not adequate to meet all needs and wants of a family, community
or a country, hence the products are not marketed i.e. there is no exchange of goods and services..
For example, subsistence farming involves the production of crops to feed the family and for
survival.
The disadvantages of direct production include; Lack of volume production, Hindering innovation
and development, Encouraging individualism since it is self-centered, lack of specialization because
ability is spread over many years and production of low quality of goods and services because of
lack of control and specialization
b) Indirect production
Indirect production refers to production that is more than survival level. It involves production of
Goods and services with the aim of exchanging them for other goods or services or for money. It
provides output that is enough to satisfy domestic needs and wants. This production is adequate to
supply local demand and the excess if available can be exported. Large industries can produce large
quantities of output to satisfy local consumption and earn foreign exchange from export, for
example, the sugar and banana industries. This production is geared towards satisfying the wants of
an individual and those of others and it is characterized by; production with a view of exchange,
results to supply of goods and services and the producer specializes in one or a few areas of
production. The advantages of this type of production include allowing one to get goods and
services he cannot produce and enabling specialization which leads to greater production and saves
a lot of time.
5.3 Concept of Return to Scale in Production

In the short run, a firm's growth potential is usually characterized by the firm's marginal product of
labor, i.e. the additional output that a firm can generate when one more unit of labor is added. This
is done in part because economists generally assume that, in the short run, the amount of capital in a
firm (i.e. the size of a factory and so on) is fixed, in which case labor is the only input to production
that can be increased. In the long run, however, firms have the flexibility to choose both the amount
of capital and the amount of labor that they want to employ- in other words; the firm can choose a
particular scale of production. Therefore, it's important to understand whether a firm gains or losses
efficiency in its production processes as it grows in scale.
Returns to scale are determined by analyzing the firm's long-run production function, which gives
output quantity as a function of the amount of capital (K) and the amount of labor (L) that the firm
uses. In the long run, companies and production processes can exhibit various forms of returns to
scale- increasing returns to scale, decreasing returns to scale, or constant returns to scale as
discussed below.
Decreasing Returns to Scale

Decreasing returns to scale occur when a firm's output less than scales in comparison to its inputs.
i.e. Decreasing returns to scale is closely associated with diseconomies of scale (the upward part of
the long-run average total curve).For example, a firm exhibits decreasing returns to scale if its
output is less than double when all of its inputs are doubled. Decreasing returns to scale happen
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when the firm's output rises proportionately less than its inputs rise. For example, in year one, a
firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year two it employs
400 workers, uses 100 machines (inputs doubled), and produces 1,500 products (output less than
doubled). Common examples of decreasing returns to scale are found in many agricultural and
natural resource extraction industries. In these industries, it's often the case that increasing output
gets more and more difficult as the operation grows in scale since an organization may become too
big, thus creating too many layers of management, too many departments, and too much red tape
leading to a lack of communications, inefficiency, delays in decision-making, and inefficient
production.
Constant Returns to Scale

Constant returns to scale occur when a firm's output exactly scales in comparison to its inputs. For
example, a firm exhibits constant returns to scale if its output exactly doubles when all of its inputs
are doubled. Equivalently, one could say that increasing returns to scale occur when it requires
exactly double the quantity of inputs in order to produce twice as much output. Firms that exhibit
constant returns to scale often do so because, in order to expand, the firm essentially just replicates
existing processes rather than reorganizing the use of capital and labor. In this way, you can
envision constant returns to scale as a company expanding by building a second factory that looks
and functions exactly like the existing one.
Increasing Returns to Scale

Increasing returns to scale is closely associated with economies of scale (the downward sloping part
of the long-run average total cost curve in the previous section). Increasing returns to scale occur
when a firm increases its inputs, and a more-than-proportionate increase in production results. For
example, in year one a firm employs 200 workers, uses 50 machines, and produces 1,000 products.
In year two it employs 400 workers, uses 100 machines (inputs doubled), and produces 2,500
products (output more than doubled) and input prices remain constant, increasing returns to scale
results in decreasing long-run average costs (economies of scale). A firm that gets bigger
experiences lower costs because of increased specialization, more efficient use of large pieces of
machinery (for example, use of assembly lines), volume discounts, and other advantages of
producing in large quantities.
Law of Diminishing Returns (Law of Variable Proportions)

The law of diminishing returns states that adding more of one factor of production will at some
point yield lower per-unit returns. The law of diminishing returns occurs because factors of
production such as labour and capital inputs are not perfect substitutes for each other. This means
that resources used in producing one type of product are not necessarily as efficient (or productive)
when switched to the production of another good or service. For example, workers employed in
producing glass for use in the construction industry may not be as efficient if they have to be re-
employed in producing cement or kitchen units. Likewise many items of capital equipment are
specific to one type of production. They would be much less efficient in generating output if they
were to be switched to other uses. This can be explained using the example below;
In the example of productivity given below, the labour input is assumed to be the only variable
factor by a firm. Other factor inputs such as capital are assumed to be fixed in supply. The
―returns‖ to adding more labour to the production process are measured in two ways:
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Marginal product (MP) = Change in total output from adding one extra unit of labour
Average product (AP) = Total Output divided by the total units of labour employed
In the example below, a business hires extra units of labour to produce a higher quantity of
wheat. The table below tracks the output that results from each level of employment.
Units of Labour Total Physical Product Marginal Physical Average Physical

(TPP) (tonnes of Product (MPP) Product(APP) (tonnes of
Employed
wheat) (tonnes of wheat) wheat)
0 0
1 3 3 3
2 10 7 5
3 24 14 8
4 36 12 9
5 40 4 8
6 42 2 7
7 42 0 6
8 40 -2 5
This illustrates one of the most important and fundamental principles involved in economics called
the law of diminishing returns or variable proportions. The law of diminishing returns comes about
because of several reasons:
i) The ability of labour to substitute for the fixed quantity of land i.e ability of factors of
production to substitute each other.
ii)The marginal physical output of labour increases for a time, as the benefits of specialization
and division of labour make for greater efficiency.
iii) Later all the advantages of specialization are exhausted.
iv)The law of diminishing returns comes about because each successive unit of the variable
factor has less of the fixed factor to work with. In fact, they therefore start getting in the way
of others with the fixed factor with consequent decline in output.
From the figure (next page) we can see the law leads to three stages of production as indicated in the
following graphs, namely, stage of:
Stage I: Increasing returns
Stage II: Diminishing
returns Stage III: Negative
returns
Characteristics of the Three Stages

Stage I
Here the Total Physical Product, Average Physical Product and Marginal Physical Product are all
increasing. However MPP later starts decreasing. The stage is called stage of increasing returns
because either the APP or MPP is increasing. Short-run production Stage I arises due to increasing
average product. As more of the variable input is added to the fixed input, the marginal product of
the variable input increases. Most importantly, marginal product is greater than average product,
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which causes average product to increase. This is directly illustrated by the slope of the average
product curve.
The observations about the shapes and slopes of the three product curves in Stage I show that:
 The total product curve has a positive slope.
 Marginal product is greater than average product. Marginal product initially increases, the
decreases until it is equal to average product at the end of Stage I.
 Average product is positive and the average product curve has a positive slope.
Stage II
Is a stage of diminishing returns and we have: Diminishing Average Physical Product, Diminishing
MPP and Increasing Total Physical Product. APP and MPP are declining but since the MPP is still
positive, the TPP keeps on rising. The stage where MPP reaches zero, TPP reaches maximum.
The three product curves reveal the following patterns in Stage II.
 The total product curve has a decreasing positive slope. In other words, the slope becomes
flatter with each additional unit of variable input.
 Marginal product is positive and the marginal product curve has a negative slope. The
marginal product curve intersects the horizontal quantity axis at the end of Stage II.
 Average product is positive and the average product curve has a negative slope. The average
product curve is at its a peak at the onset of Stage II. At this peak, average product is equal
to marginal product.
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Stage III
Marks a change in the direction of TPP curve. The APP continues to diminish the MPP continues to
diminish too, but it is negative and is what distinguishes stage III from II and I. This is the stage of
negative returns. The onset of Stage III results due to negative marginal returns. In this stage of
short-run production, the law of diminishing marginal returns causes marginal product to decrease
so much that it becomes negative.
Stage III production is most obvious for the marginal product curve, but is also indicated by the
total product curve.
 The total product curve has a negative slope. It has passed its peak and is heading down.
 Marginal product is negative and the marginal product curve has a negative slope. The
marginal product curve has intersected the horizontal axis and is moving down.
 Average product remains positive but the average product curve has a negative slope.
Relevance of the Law of Diminishing Returns

The law of diminishing returns is important in that it is seen to operate in practical situations where
its conditions are fulfilled. Thus, in a number of developing countries with peasant agricultural
economies populations are increasing rapidly on relatively fixed land, and with unchanging
traditional methods of production. Consequently, productivity in terms of output per head is
declining, and in some cases total productivity is falling.
Also the law of diminishing returns is important in the short run. The aim of the firm is to maximize
profits. This happens when the firm is in a state of least-cost-factor-combination. This is achieved
when the firm maximises the productivity of its most expensive factor of production. Productivity is
measured in terms of output per unit of the factor. Thus, if the variable factor is the most expensive
factor, the firm should employ the variable factor until APP is at the maximum. If the fixed factor is
most expensive the firm should employ the variable factor up to the level when TPP is at maximum.
Where Does the Firm Operate?

The firm will avoid stages I and III and will instead choose stage II. It will avoid stage I because
this shall involve using the fixed factor inefficiently because its MPP is increasing since the variable
input is spread to scarcely (thinly) over the fixed input. Expansion of the variable input will permit
specialization, hence increased output because of effective use of the variable input.
The firm shall avoid stage III because MPP for the variable input is negative.
Stage II is chosen because the marginal returns for both resources are diminishing. Here the MPP
and APP are declining but the MPP of both resources is positive. With one factor fixed, and
additional unit of the variable input increases total product. Therefore the firm which attempts to be
economically efficient operates in stage II.
5.4 Economies of Scale

Economies of scale in production mean that production at a larger scale (more output) can be
achieved at a lower cost (i.e. with economies or savings). The cost advantage that arises with
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increased output of a product. Economies of scale arise because of the inverse relationship between
the quantity produced and per-unit fixed costs; i.e. the greater the quantity of a good produced, the
lower the per-unit fixed cost because these costs are shared over a larger number of goods.
Economies of scale may also reduce variable costs per unit because of operational efficiencies and
synergies. Economies of scale are the cost advantages that a business can exploit by expanding their
scale of production. The effect of economies of scale is to reduce the average (unit) costs of
production. Economies of scale are most likely to be found in industries with large fixed costs in
production and hence economies of scale are prevalent in highly capital intensive industries such as
chemicals, petroleum, steel, automobiles etc.
The table below illustrates the concept of economics of scale i.e. that as output increases, average
cost per unit decreases.
Long Run Output (units per Total Costs (sh) Long Run
month) Average Cost (sh
per unit)
1,000 8,500 8.5
2,000 15,000 7.5
5,000 36,000 7.2
10,000 65,000 6.5

20,000 120,000 6.0
50,000 280,000 5.6
100,000 490,000 4.9
500,000 2,300,000 4.6
Economies of scale can be classified into two main types: Internal – arising from within the
company; and External – arising from extraneous factors such as industry size.
i) Internal Economies of Scale

Internal economies of scale are those obtained within the organisation as a result of the growth
irrespective of what is happening outside. They are a key advantage for a business that is able to
grow. Most firms find that, as their production output increases, they can achieve lower costs per
unit. They take the following forms:
a)Technical Economies Of Scale:
Technical economies of scale may occur due to the following;
i. Indivisibilities: These may occur when a large firm is able to take advantage of an industrial
process which cannot be reproduced on a small scale, for example, a blast furnace which
cannot be reproduced on a small scale while retaining its efficiency.
ii. Increased Dimensions: These occur when it is possible to increase the size of the firm‘s
equipment and hence realize a higher volume of output without necessarily increasing the
costs at the same rate. For example, a matatu and a bus each require one driver and conductor.
The output from the bus is much higher than that from the matatu in any given period of time,
and although the bus driver and conductor will earn more than their matatu counterparts, they
will not earn by as many times as the bus output exceeds the matatu output, i.e. if the bus
output is 3 times that of the matatu counterparts.
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iii. Economies of Linked Processes: Technical economies are also sometimes gained by linking
processes together, e.g. in the iron and steel industry, where iron and steel production is
carried out in the same plant, thus saving both transport and fuel costs.
iv. Specialisation: Specialisation of labour and machinery can lead to the production of better
quality output and higher volume of output.
v. Research: A large firm will be in a better financial position to devote funds to research and
improvement of its product than a small firm.
b) Marketing Economies of Scale
This can be achieved through;
i. The buying advantage: A large-scale organisation may buy its materials in bulk and therefore
get preferential treatment and buy at a discount more easily than a small firm.
ii. The packaging advantage: It is easier to pack in bulk than in small quantities and although for
a large firm the packaging costs will be higher than for small firms, they will be spread over a
large volume of output and the cost per unit will be lower.
iii. The selling advantage: A large-scale organisation may be able to make fuller use of sales and
distribution facilities than a small-scale one. For example, a company with a large transport
fleet will probably be able to ensure that they transport mainly full loads, whereas small
business may have to hire transport or dispatch part loads.
c) Organisational Economies of Scale
As a firm becomes larger, the day-to-day organisation can be delegated to office staff, leaving
managers free to concentrate on the important tasks. When a firm is large enough to have a
management staff they will be able to specialise in different functions such as accounting, law
and market research.
d) Financial Economies
A large firm will have more assets than a small firm. Hence, it will find it cheaper and easier to
borrow money from financial institutions like commercial banks than a small firm. i.e. Larger
firms are usually rated by the financial markets to be more ‗credit worthy‘ and have access to
credit facilities, with favourable rates of borrowing. In contrast, smaller firms often face higher
rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally
raise fresh money (i.e. extra financial capital) more cheaply through the issue of shares. They are
also likely to pay a lower rate of interest on new company bonds issued through the capital
markets.
e) Risk-bearing Economies
All firms run risks, but risks taken in large numbers become more predictable. In addition to this,
if an organisation is so large as to be a monopoly, this considerably reduces its commercial risks.
f) Overhead Processes For some products, very large overhead costs or processes must be
undertaken to develop a product, for example an airliner. Cleary these costs can only be justified if
large numbers of units are subsequently produced.
g) Diversification
As the firm becomes very large it may be able to safeguard its position by diversifying its products,
process, markets and the location of the production.
ii) External Economies

These are advantages enjoyed by a large size firm when a number of organisations group together in
an area irrespective of what is happening within the firm. They include
a) Economies of concentration
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When a number of firms in the same industry band together in area they can derive a great
deal of mutual advantages from one another. Advantages might include a pool of skilled
workers, a better infrastructure (such as transport, specialised warehousing, banking, etc.)
and the stimulation of improvements. The lack of such external economies is serious
handicap to less developed countries.
b) Economies of information
Under this heading we could consider the setting up of specialist research facilities and the
publication of specialist journals.
c) Economies of disintegration
This refers to the splitting off or subcontracting of specialist processes. A simple example is
to be seen in the high street of most towns where there are specialist research photocopying
firms.
Diseconomies of scale
Diseconomies of scale occur when the size of a business becomes so large that, rather than
decreasing; the unit cost of production actually becomes greater. Diseconomies of scale flow from
administrative rather than technical problems.
a) Bureaucracy: As an organisation becomes larger there is a tendency for it to become more
bureaucratic. Decisions can no longer be made quickly at the local levels of management. This
may lead to loss of flexibility.
b) Loss of control: Large organizations often find it more difficult to monitor effectively the
performance of their workers. Industrial relations can also deteriorate with a large workforce and
a management, which seem remote and anonymous.
Optimal Size of a Firm

This is the most efficient size of the firm, at which its costs of production per unit of output will be
at a minimum, so that it has no motive either to expand or reduce its scale of production. Thus, as a
firm expands towards the optimum size it will enjoy economies of scale, but if it goes beyond the
optimum diseconomies will set in.
In the short-run, a firm would build the scale of plant and operate it at a point where the average
cost is at its minimum. This is regarded as the optimum level of production for the firm concerned,
if the demand for the product increases from this least cost output; it cannot change the amount of
land, buildings, machinery and other input in short period of time. It has to move along the same
scale or type of plant. The average total cost, therefore, begins to rise due to the diseconomies of the
scale.
In the long run, all inputs are variable. The firm can build larger plant sizes or revert to smaller
plants to deal with the changed demand for the product. If the size of plant increases to cope with
the increased demand, the average cost per unit begins to fall due to the economies of scale such as
increased specialization of labor, better and greater specialization of management, efficient
utilization of productive equipment, etc., etc. So long as the resources are successfully utilized, the
average cost of production continues declining.
Eventually a stage comes when the firm is not able to use the least cost combination of inputs. The
building of a still larger plant cause the average cost of production to go up. The point at which the
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per unit cost is the lowest is the optimum level of production for the firm is the firms the most
efficient size.

1. (a) What are factors of production?
(b) Explain the meaning of mobility of factors of production. To what extent are factors of
Production mobile
(c) State the aspects of significance of factor mobility
2. (a) What are the main factors of production?
(b) What determines the supply and demand of the factors of production that you have
identified in (a) above?
3.(a) (i) State the law of variable proportions
(ii) What key assumptions underlie this law?
(b) Discuss fully the three main stages associated with the law
TOPIC 6
6.0 THEORY OF THE FIRM
6.1 Concept of the Firm
The theory of the firm is a microeconomic concept founded in neoclassical economics that states
that firms (corporations) exist and make decisions in order to maximize profits. Businesses interact
with the market to determine pricing and demand and then allocate resources according to models
that look to maximize net profits. The theory of the firm goes along with the theory of the
consumer, which states that consumers seek to maximize their overall utility
The theory of the firm is always being re-analyzed and adapted to suit changing economies and
markets. Early economic analysis focused on broad industries, but as the nineteenth century
progressed, more economists began to look at the firm level to answer basic questions about why
companies produce what they do, and what motivates their choices when allocating capital and
labor. Modern takes on the theory of the firm take such facts as low equity ownership by many
decision-makers into account; some feel that CEOs of publicly held companies are interested not
only in profit maximization, but also in goals based on sales maximization, public relations and
market share.
Distinction between Firm and Industry

A firm is an organization that combines scarce resources for the production and supply of goods and
services. The firm is used by entrepreneurs to bring together otherwise idle resources. The term firm
is often used synonymously with the business, enterprise, or company. If there is a difference, a
firm is functionally defined and need not be a typical for-profit business. A firm can be profit
oriented, nonprofit, privately owned, or government controlled. The key role played by a firm is the
production of output using scarce resources. Firms are the means through which society transforms
less satisfying resources into more satisfying goods and services.
A firm is more or less similar to the concept of a business establishment. The term is mostly used in
relation to companies providing judicial services to clients who are known as law firms, but applies
to all businesses. A firm can be a sole proprietorship or a partnership, but the basic premise is that it
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is run for making profits. A firm operates inside an industry such as a firm that makes and supplies
steel to other companies requiring steel while all these companies exist under the steel industry.
In economics, the economy of a country is divided into an umbrella of industries where an industry
consists of all organized activities for production and processing of products. However, industry is
also described as retail and wholesale depending upon the nature of transactions with the customers.
There are also industries in services sector such as the banking industry or the insurance industry.
An industry covers all economic activities that are organized and carried on by all individuals, units,
firms, businesses, and organizations existing and working inside it.
The differences between Firm and Industry are therefore;

• Industry refers to a kind of business inside an economy while a firm is a business
establishment inside an industry.
• There can be many firms inside an industry.
• Industry is not an entity while a firm is a type of company.
• A firm is a type of business whereas an industry is a sub sector of an economy.
• Rules and regulations are made for an industry, and that typically apply to all firms inside
the industry.
Localization of Industries
Localization of industries means the tendency on the part of industries to be concentrated in regions
which are most suited for their development. Some industries are carried on and developed in
certain areas because of their natural or acquired advantages. For example, sugar industry is
localized in sugar growing areas simply on the basis of nearness to source of raw material.
Factors Affecting Location of Industries

The important factors which influence the localization of industries are:
(i) Nearness to raw material
One of the very important factor which affects the birth of an industry in certain areas is the
nearness to sources of raw material. The availability of raw material near the location of the
industry helps considerably in reducing the transport cost and so the total cost of production of
the commodity. It is due to this reason that most of the industries are established in regions where
the raw material is available in abundance.
(ii) Availability of source of power
Availability of cheap power resources is another important factor which influences the
concentration of industries in particular areas. If for instance, electricity is to be carried over to a
long distance where the industry is located or the coal which serves as raw material is to be
transported at a far-off distance from whereat is extracted, it will not then he economical to set up
the industry at such places which are far away from the sources of power.
(iii) Physical and climate conditions
Physical and climatic conditions have important considerations on the growth of industry. If
suitable climate and desirable physical conditions exist for a particular industry, that will he
established and developed in that region then.
(iv) Nearness to market
Industries have a tendency to be localized in those areas where the market is near at hand. The
goods produced can be easily brought in the market and there can be much saving in the cost of
transportation.
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(v) Supply of trained labor
Supply of trained labor is another great attraction for the concentration of an industry in a
particular area
(vi) Availability of capital
Industries may spring up in those areas where capital is available at a lower rate.
(vii) Momentum of an early start
Sometimes, it so happens, that an industry gets itself established and developed in a particularly
locality not due to the reasons discussed above but Just by some chance or other. Later on, that
locality acquires reputation in the production of the commodity and more industries are set up
there.
Advantages of Localization:
When an industry is localised in a particular locality, it enjoys a number of advantages which are
enumerated below.
(i) Reputation: The place where an industry is localised gains reputation, and so do the products
manufactured there. As a result, products bearing the name of that place find wide markets, such as
Sheffield cutlery, Swiss watches, Ludhiana hosiery, etc.
(ii) Skilled Labour: Localisation leads to specialisation in particular trades. As a result, workers
skilled in those trades are attracted to that place. The localised industry is continuously fed by a
regular supply of skilled labour that also attracts new firms into the industry. Besides, there is the
local supply of skilled labour which children of the workers inherit from them. The developments of
the watch industry in Switzerland, of the shawl industry in Kashmir are primarily due to this factor.
(iii) Growth of Facilities: Concentration of an industry in particular locality leads to the growth of
certain facilities there. To cater to the needs of the industry, banks and financial institutions open
their branches, whereby the firms are able to get timely credit facilities. Railways and transport
companies provide special transport facilities which the firms utilise for bringing inputs and
transporting outputs. Similarly, insurance companies provide insurance facilities and thus cover
risks of fire, accidents, etc.
(iv) Subsidiary Industries: Where industries are localised, subsidiary industries grow up to supply
machines, tools, implements and other materials, and to utilise their by-products. For example,
where the sugar industry is localised, plants to manufacture sugar machinery, tools and implements
are set up, and subsidiary industries crop up for the manufacture of spirit from molasses and for
rearing poultry which utilise molasses in feed.
(v) Employment Opportunities: With the localisation of an industry in a particular locality and the
establishment of subsidiary industries, employment opportunities considerably increase in that
locality.
(vi) Common Problems: All firms form an association to solve their common problems. This
association secures various types of facilities from the government and other agencies for
expanding business, establishes research laboratory, publishes technical and trade journals, and
opens training centres for technical personnel. As a result, all firms benefit.
(vii) Economy Gains: Localisation leads to the lowering of production costs and improvement in the
quality of the products when the firms benefit from the availability of skilled labour, timely credit,
quality materials, research facilities, market intelligence, transport facilities, etc. Besides, the trade
gains through the reputation of the place, the people gain through larger employment opportunities,
the government gains through larger tax revenue, and thus the economy gains on the whole.
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Disadvantages of Localization:
Localization has certain disadvantages too. They are as follows:
(i) Dependence :When an industry is localised in a particular locality, it makes the economy
dependent for its requirements of the products manufactured there. Such dependence is dangerous
in the event of a war, a depression, or a natural calamity because the supplies of the products will be
disrupted and the entire economy will suffer.
(ii) Social Problems: Localisation of industries in a particular locality creates many social problems,
such as congestion, emergence of slums, accidents, strikes, etc. These adversely affect the
efficiency of labour and the productive capacity of the industry.
(iii) Limited Employment: Where an industry is localised, employment opportunities are limited to a
particular type of labour. In the event of a recession in that industry, specialized labour fails to get
alternative employment elsewhere. Again, if such specialized labour organizes itself into a powerful
trade union, it can force the employers to pay higher wages which may raise the cost of production
and adversely affect the industry.
(iv) Diseconomies: With the passage of time, the concentration of industries in a particular locality,
economies of scale may give way to diseconomies. Transport bottlenecks emerge. There are
frequent power break-downs. Financial institutions are unable to meet the credit requirements of the
entire industry due to financial stringency. As already noted above, labour asks for higher wages
and better living conditions. All these tend to raise costs of production and reduce production.
(v) Regional Imbalances: Concentration of industries in one region or area leads to the lop-sided
development of the economy. When one industry is localised in a region, it attracts more
entrepreneurs who establish other industries there because of the availability of infrastructure
facilities like power, transport, finance, labour, etc. Thus such regions develop more while the
other regions remain backward.
Employment opportunities, the level of income, and the standard of living increase at a much higher
rate in these regions as compared with the other regions of the country. The people of the backward
regions feel envious and jealous of the people of the developed regions and the government has to
start its own industries or encourage private enterprise to start industries by giving a number of
concessions.
Delocalization
To overcome the disadvantages of localization of industries, delocalization which is also known as
decentralization is recommended. Decentralization refers to the policy of dispersal of industries,
whereby an industry is scattered in different regions of the country. Besides removing the defects of
localization of industries, the policy of decentralization is essential from the strategic and defence
points of view. The policy of decentralization of industries requires the development of sources of
power and means of transport in all areas of the country.
To encourage private enterprise to set up industries in backward areas, the state government should
provide land, power and other infrastructure facilities at concessional rates. The central government
should give tax concessions and various financial institutions should provide cheap credit facilities.
It is in this way that the disadvantages of localization can be removed and the different regions
develop in a balanced way.
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6.2 Various costs in a firm
Like in the theory of production or output, the theory of costs is concerned with the Short Run and
the Long Run. In the short run a firm will have fixed and variable costs of production. Total cost is
made up of fixed costs and variable costs. The long run is a period of time in which all factor
inputs can be changed. The firm can therefore alter the scale of production.
i) Short-run Costs
The table below gives an example of the short run costs of a firm
Output Total Fixed Cost Total Variable Cost Total Cost Average Total Cost Marginal Cost
Units TFC (sh) TVC (sh) TC (sh) ATC (sh per unit) MC (sh)
0 100 0 100
20 100 40 140 7.0 2.0
40 100 60 160 4.0 1.0
60 100 74 174 2.9 0.7
80 100 84 184 2.3 0.5
100 100 90 190 1.9 0.3
120 100 104 204 1.7 0.7
140 100 138 238 1.7 1.7
160 100 188 288 1.8 2.5
180 100 260 360 2.0 3.6
200 100 360 460 2.3 5.0
Plotting this gives us Total Cost, Total Variable Cost, and Total Fixed Cost.
a. Fixed Costs (FC):

These are costs which do not vary with the level of production i.e. they are fixed at all levels of
production. They are associated with fixed factors of production in the Short Run. Fixed costs relate
to the fixed factors of production and do not vary directly with the level of output. (I.e. they are
exogenous of the level of production in the short run). Examples of fixed costs include; buildings,
leasing of capital equipment, the annual business rates charged by local authorities, the costs of full-
time contracted salaried staff, interest rates on loans, the depreciation of fixed capital and insurance.
Total fixed costs (TFC) remain constant as output increases upto a certain level.
b) Variable Costs (VC)
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These are costs, which vary with the level of production. The higher the level of production, the
higher will be the variable costs. They are associated with variable factors of production in the
Short Run. Examples are costs of materials, cost of fuels, labour costs and selling costs
c. Total Cost (TC)
This is the sum of fixed costs and variable costs i.e. Total Costs (Tc) = Total Fixed Cost (Tfc) +
Total Variable Costs (Tvc)
Total Fixed costs and Total Variable costs are the respective areas under the Average Fixed and
Average Variable cost curves.
d) Average Fixed Cost (AFC)

This is fixed cost per unit of output, obtained by dividing fixed costs by total output i.e.
AFC = Total Fixed Costs

Total output
Average fixed costs are found by dividing total fixed costs by output. Average fixed costs will fall
continuously with output because the total fixed costs are being spread over a higher level of
production causing the average cost to fall.
The average fixed cost (AFC) curve will slope down continuously, from left to right.
e. Average Variable Cost (AVC)
This is the average cost per unit of output, obtained by dividing variable costs by total output i.e.
AVC = Variable Cost

Total Output
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The average variable cost (AVC) curve will at first slope down from left to right, then reach a
minimum point, and rise again. AVC is ‗U‘ shaped because of the principle of variable Proportions,
which explains the three phases of the curve:
a) Increasing returns to the variable factors, which cause average costs to fall, followed by:
b) Constant returns, followed by:
c) Diminishing returns, which cause costs to rise.
f. Average Total Costs (ATC)

This is total cost per unit of output, obtained by dividing total cost by total output
i.e. ATC = Total Cost
Total Output
Average total cost (ATC) can be found by adding average fixed costs (AFC) and average variable
costs (AVC). The ATC curve is also ‗U‘ shaped because it takes its shape from the AVC curve,
with the upturn reflecting the onset of diminishing returns to the variable factor. Average total cost
(ATC) is also called average cost or unit cost. Average total costs are a key cost in the theory of the
firm because they indicate how efficiently scarce resources are being used
g. Marginal costs
Marginal cost is the cost of producing one extra unit of output. It can be found by calculating the
change in total cost when output is increased by one unit. Thus, if TC n is the total cost of producing
n units of output and TCn -1 is the total cost of producing n-1 units of output, then the marginal cost
of producing the ‗nth‘ of unit of output is calculated as:
Marginal Cost = TCn - TCn-1
It is therefore derived solely from variable costs, and not fixed costs. The marginal cost curve falls
briefly at first, then rises. Marginal costs are derived from variable costs and are subject to the
principle of variable proportions.
The marginal cost curve is significant in the theory of the firm for two reasons: It is the leading cost
curve, because changes in total and average costs are derived from changes in marginal cost and
The lowest price a firm is prepared to supply at is the price that just covers marginal cost.
Average total cost and marginal cost are connected because they are derived from the same basic
numerical cost data. The general rules governing the relationship are:
a)Marginal cost will always cut average total cost from below.
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b)When marginal cost is below average total cost, average total cost will be falling, and when
marginal cost is above average total cost, average total cost will be rising.
c)A firm is most productively efficient at the lowest average total cost, which is also where
average total cost (ATC) = marginal cost (MC).
Since Marginal costs are derived exclusively from variable costs, and are unaffected by changes in
fixed costs. The MC curve is the gradient of the TC curve, and the positive gradient of the total cost
curve only exists because of a positive variable cost. This is shown below:
h) Sunk costs
Sunk costs are those that cannot be recovered if a firm goes out of business. Examples of sunk costs
include spending on advertising and marketing, specialist machines that have no scrap value, and
stocks which cannot be sold off.
ii) Long run Cost

In the Long Run, all factors of production are variable. The firm is thus constrained by economies
or diseconomies to scale. The long run is a period of time in which all factor inputs can be changed.
The firm can therefore alter the scale of production. If as a result of such an expansion, the firm
experiences a fall in long run average total cost, it is experiencing economies of scale. Conversely,
if average total cost rises as the firm expands, diseconomies of scale are happening.
6.3 Concept of Revenue

The revenue of a firm together with its costs determines profits. The term ‗revenue‘ refers to the
receipts/ amounts received obtained by a firm from the sale of certain quantities of a commodity at
various prices.. For example, if a firm gets sh. 16,000 from sale of 100 chairs, then the amount of
sh. 16,000 is known as revenue. Revenue is an important concept in economic analysis and directly
influenced by sales level, i.e., as sales increases, revenue also increases. The concept of revenue
consists of three important terms; Total Revenue, Average Revenue and Marginal Revenue.
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Revenue concepts
i) Total Revenue (TR):
Total Revenue refers to total receipts from the sale of a given quantity of a commodity or the total
sale proceeds of a firm by selling a commodity at a given price. It is the total income of a firm.
Total revenue is obtained by multiplying the quantity of the commodity sold with the price of the
commodity.
Total Revenue = Quantity × Price i.e. R=P x Q
For example, if a firm sells 10 chairs at a price of sh. 160 per chair, then the total revenue will be:
10 Chairs × sh. 160 = sh 1,600
ii)Average Revenue (AR):

This is the revenue per unit of the commodity sold. It is obtained by dividing Total Revenue by
total quantity sold.
Average Revenue = Total Revenue/Quantity
For example, if total revenue from the sale of 10 chairs @ sh. 160 per chair is sh. 1,600, then:
Average Revenue = Total Revenue/Quantity = 1,600/10 = sh 160
For a firm in a perfectly competitive market, the AR is the same as price. Therefore, if price is
denoted by P, then we can say:
P = AR
This can be explained as under:

TR = Quantity × Price … (1)
AR = TR/Quantity …… (2)
Putting the value of TR from equation (1) in equation (2), we get

AR = Quantity × Price / Quantity
AR = Price
A buyer‘s demand curve graphically represents the quantities demanded by a buyer at various
prices. In other words, it shows the various levels of average revenue at which different quantities
of the good are sold by the seller. Therefore, in economics, it is customary to refer AR curve as
the Demand Curve of a firm.
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iii) Marginal Revenue (MR)
This is the increase in Total Revenue resulting from the sale of an extra unit of output. i.e. the
additional revenue generated from the sale of an additional unit of output. Thus, if TRn-1 is Total
Revenue from the sale of (n-1) units and TRn is total revenue from the sale of n units, then the
marginal revenue of the nth unit is given as:
MRn = TRn-TRn-1
For example, if the total revenue realised from sale of 10 chairs is sh. 1,600 and that from sale of
11 chairs is sh. 1,780, then MR of the 11th chair will be:
MR11 = TR11 – TR10
MR11 = sh. 1,780 – sh. 1,600 = sh. 180
However, when change in units sold is more than one, then MR can also be calculated as:
MR = Change in Total Revenue/ Change in number of units = ∆TR/∆Q
For example: If the total revenue realised from sale of 10 chairs is sh. 1,600 and that from sale of
14 chairs is sh. 2,200, then the marginal revenue will be:
MR = TR of 14 chairs – TR of 10 chairs / 14 chairs -10 chairs = 600/4 = sh. 150
Total Revenue (TR)can also be calculated as the sum of marginal revenues of all the units sold.
It means, TRn = MR1 + M2 + MR3 + ……….MRn or, TR = ∑MR
Relationship between revenue concepts

The relationship between different revenue concepts can be discussed under two situations:
 When Price remains Constant (It happens under Perfect Competition). In this situation, firm
has to accept the same price as determined by the industry. It means, any quantity of a
commodity can be sold at that particular price.
 When Price falls with rise in output (It happens under Imperfect Competition). In this
situation, firm follows its own pricing policy. However, it can increase sales only by
reducing the price.
The relationship between different revenue concepts can be discussed, When Price remains constant
and when Price falls with rise in output.
i) Relationship between AR and MR (When Price remains Constant):

When price remains same at all output levels (like in case of perfect competition), no firm is in a
position to influence the market price of the product. A firm can sell more quantity of output at the
same price. This means, the revenue from every additional unit (MR) is equal to AR. As a result,
both AR and MR curves coincide in a horizontal straight line parallel to the X-axis as shown in
Figure below
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As shown in the figure, price (AR) remains same at all level of output and is equal to MR. As a
result, demand curve (or AR curve) is perfectly elastic.
ii) Relationship between TR and MR (When Price remains Constant):

When price remains constant, firms can sell any quantity of output at the price fixed by the market.
As a result, MR curve (and AR curve) is a horizontal straight line parallel to the X-axis. Since MR
remains constant, TR also increases at a constant rate Due to this reason, the TR curve is a
positively sloped straight line (see Figure below). As TR is zero at zero level of output, the TR
curve starts from the origin.
iii) Relationship between TR and Price line:
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When price remains constant at all the levels of output, then Price = AR = MR. Therefore, price line
is the same as MR curve. Also, TR = I MR. So, the area under MR curve or price line will be equal
to TR. In Figure below, TR at MR level of output = OP x OQ = Area under price line.
iv) Relationship between AR and MR (When Price Falls with rise in output):
When firms can increase their volume of sales only by decreasing the price, then AR falls with
increase in sale. It means, revenue from every additional unit (i.e. MR) will be less than AR. As a
result, both AR and MR curves slope downwards from left to right. This relationship can be better
understood through Figure. 7.4 below: In the figure, MR and AR fall with increase in output.
However, fall in MR is double than that in AR, i.e., MR falls at a rate which is twice the rate of fall
in AR. As a result, MR curve is steeper than the AR curve because MR is limited to one unit,
whereas, AR is derived by all the units. It leads to comparatively lesser fall in AR than fall in MR.
It must be noted that MR can fall to zero and can even become negative. However, AR can be
neither zero nor negative as TR it is always positive.
v) General relationship between AR and MR:
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The relationship between AR and MR depends on whether the price remains same or falls with rise
in output. However, if nothing is mentioned about the nature of price with rise in output, then the
following general relation exists between AR and MR:
 AR increases as long as MR is higher than AR (or when MR > AR, AR increases).
 AR is maximum and constant when MR is equal to AR (or when MR = AR, AR is
maximum).
 AR falls when MR is less than AR (or when MR < AR, AR falls)
It must be noted that specific relationship between AR and MR depends upon the relation of price
with output, i.e., whether price remains same or varies inversely with output.
Importance of Revenue Concept

Four important areas where the concept of revenue has great significance are profit: determination,
determination of full capacity, equilibrium determination of the firm and factor pricing.
i) Profit Determination:
The AR and MR curves form important tools for economic analysis. The AR curve is the price line
for the producer in all market situations. By relating the AR curve to the AC curve of a firm, it can
be found out whether it is earning supernormal or normal profits or incurring losses.
If the AR curve is tangent to the AC curve at the point of equilibrium, the firm earns
normal profits.
 If the AR curve is above the AC curve, it makes supernormal profits.
In case the AR curve is below the AC curve at the equilibrium point, the firm incurs losses.
ii) Determination of Full Capacity
It can also be known from their relationship whether the firm is producing at its full capacity or
under capacity. If the AR curve is tangent to the AC curve at its minimum point, (as under perfect
competition) the firm produces at its full capacity. Where it is not so (as under monopoly or
monopolistic competition), the firm possesses idle capacity.
ii). Equilibrium Determination of the Firm
The MR curve when intersected by the MC curve determines the equilibrium position of the firm
under all market situations. Their point of intersection determines price, output, profit or loss of a
firm.
iv) Factor Pricing:
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The use of the average marginal revenue concepts helps in determining the prices of factor services.
In factor pricing they are inverted U-shaped and the average and marginal revenue curves become
the average revenue productivity and marginal revenue productivity curves (ARP and MRP) and are
useful tools in explaining the equilibrium of the firm under different market conditions.

1. Distinguish between technical economics of scale and market economics of scale
2. Define the term revenues and explain three types of revenue
3. What is meant by an optimum size of a firm?
4. Outline five disadvantages of localization of industries
5. Using a well labeled diagram, explain the terms total cost, fixed costs, variable costs and
marginal costs
References
TOPIC 7
7.0 MARKET STRUCTURES
7.1 Meaning of Market Structures
A Market may be defined as an area over which buyers and sellers meet to negotiate the exchange
of a well-defined commodity. Markets may also mean the extent of the sale for a commodity as in
the phrase, ―There is a wide market for this or that commodity‖. In a monetary economy, market
means the business of buying and selling of goods and services of some kind.
Market Structures refers to the nature and degree of competition within a particular market.
Capitalist economies are characterized by a large range of different market structures. These include
the following: perfect competition, monopoly, monopolistic competition, oligopoly and duopoly
7.2 Types of Market Structures

a) Perfect Competition
The model of perfect competition serves as a benchmark of economic efficiency against which real
world markets can be measured. Although there are few real world examples of pure competition, it
is still beneficial to study it as a model. Market power refers to the ability to influence price of a
product. In a perfectly competitive market, there is little market power for producers.
The closest example of a perfectly competitive market would be a farmers market. Many farmers
bring their produce to the same location. This meets the first condition of a perfectly competitive
market. The goods and services need to be identical to one another. Let's suppose you are looking
for tomatoes at the farmers market. One tomato should be able to be substituted in for another. The
third condition is that all the farmers should be aware of all the different market conditions, so that
no farmer is able to offer a huge reduction in price. This means farmers are equally aware of
growing conditions, transportation costs, cost for rental of space to sell the product at the market,
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and so on. Finally, if it is known that the price of tomatoes is high, other people need to be able to
enter the market and sell tomatoes. There cannot be barriers to entry.
The characteristics (conditions) of this market are summarized as follows;

i. There are many buyers and sellers to the extent that the supply of one firm makes a very
insignificant contribution on the total supply. Both the sellers and buyers take the price as
given. This implies that a firm in a perfectly competitive market can sell any quantity at the
market price of its product and so faces a perfectly price elastic demand curve.
ii. The product sold is homogenous so that a consumer is indifferent as to whom to buy from.
iii.There is free entry into the industry and exit out of the industry.
iv. Each firm aims at maximising profit.
v.There is free mobility of resources i.e. Perfect market for the resources.
vi. There is perfect knowledge about the market.
vii.There is no government regulation and only the invisible hand of the price allocates the
resources.
viii.There are no transport costs, or if there are, they are the same for all the producers.
Advantages of Perfect Market

 It achieves, subject to certain conditions, an allocation of resources which is: socially
optimal‖ or ―economically efficient‖ or ―pareto efficient‖.
 Perfectly competitive firms are technically efficient in the long run, in that they produce that
level of output, which minimizes their average costs, given their small capacity.
 Perfect competition achieves an automatic allocation of resources in response to changes in
demand.
 The consumer is not exploited. The price of goods, in the long run will be as low as
possible. Producers can only earn a normal profit, which are the minimum levels of profits
necessary to retain firms in the industry, due to the existence of free entry into the markets.
Disadvantages of Perfect Competition

 There is a great deal of duplication of production and distribution facilities amongst firms
and consequent waste.
 Economies of scale cannot be taken advantage of because firms are operating on such a
small scale. Therefore although the firms may be highly competitive and their prices may be
as low as is possible, given their scale of production, nevertheless it is a higher price that
could take advantage of economies of scale.
 There may be lack of innovation in a situation of perfect competition. Two reasons account
for this:
i) The small size and low profits of the firm limit the availability of funds for research and
development
ii)The assumption of free flow of information, and no barriers to entry, implies that
innovations, will immediately be copied by all competitors, so that ultimately
individual firms will not find it worthwhile to innovate.
Realism of Perfect Competition
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The assumptions of perfect competition are obviously at variance with the conditions which actually
exist in real world markets. Some markets approximately conform to individual assumptions, for
example, the stock exchange is characterized by a fairly free-flow of information but the
information requires expertise to grasp. However, no markets exactly conform to the assumption of
the model, with peasant agriculture probably the nearest to the mark.
We however study the model of perfect competition to enable us to see:

 How competition operates in the real world situation, within a highly simplified
model.
 The advantageous features of perfect competition which governments may wish to
encourage in real world markets.
 The disadvantageous features of perfect competition which the governments may wish to
avoid.
 A standard against which to oil the degree of competition prevailing in a given market. We
can discuss how closely a specific market resembles the perfectly competitive ideal
 For the student attempting a serious study of economics, a study of the perfect market is
essential since no understanding of the literature of micro-economics over the century can
be achieved without it.
 On a rather more mundane level, students will find themselves confronted with questions
on perfect competition in examinations.
b) Monopoly
Monopoly in the market place indicates the existence of a sole seller. This may take the form of a
unified business organization, or it may be association of separately controlled firms, which
combine, or act together, for the purposes of marketing their products (e.g. they may charge
common prices). The main point is that buyers are facing a single seller.
Sources of Monopoly power:
i. Exclusive ownership and control of factors inputs.
ii. Patent rights e.g. beer brands like Tusker, Soft drinks like Coca Cola etc.
iii. Natural monopoly, which results from a minimum average cost of production. The firm could
produce at the least cost possible and supply the market.
iv. Market Franchise i.e. the exclusive right by law to supply the product or commodity e.g.
Kenya Bus Service before the coming of the Matatu business in Nairobi.
A monopolist, being the sole (producer and) supplier of the commodity is a price maker rather than
a price-taker as the price and quantity he will sell will be determined by the level of demand at that
price, and if he decided on the quantity to sell, the price he will charge, will be determined by the
level of demand. The monopolist, because he is the sole seller faces a market demand curve which
is downward sloping.
Monopolistic Practices
The following practices may be said to characterize
monopolies. i) Exclusive dealing to supply and collective
boycott
Producers agree to supply only to recognized dealers, normally only one dealer in each area, on
condition that the dealer does not stock the products of any producer outside the group (or trade
association). Should the dealer break the agreement, all members of the group agree to withhold
supplies from the offender. This practice has proved a very effective restriction on competition
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for it ensures that any new firms would find it extremely difficult to secure market outlets for
their products.
ii) Barriers
The creation of barriers to ensure that there is no competition against them. E.g price
undercutting, individual ensure that actual text printed collective boycott and exclusive holding
of patent rights.
iii) Resale Price Maintenance (PRM)
A monopolistic firm may dictate to wholesalers and retailers the price at which its products
would be sold. This is another way of ensuring that other firms are not attracted into the industry,
if such firms can sell their products at more competitive prices.
iv) Consumer Exploitation
Perhaps the most notorious practice for which monopolists are known is that of exploiting
consumers by overcharging their products. There are three ways in which the monopolist can
overcharge his products.
v) Profit maximization
The price charged by the monopolists in order to maximize his profits is higher than would be the
case if competitive firm was also maximizing its profits because in the case of the monopolist,
supply cannot exceed what he has produced.
vi) Cartels:
A cartel is a selling syndicate of producers of a particular product whose aim is to restrict output
so that they can overcharge for the product. Thus, they collectively act as a monopoly and each
producer is given his quota of output to produce.
vii) Price discrimination:
There are two forms of price discrimination:
a) The practice employed by firms of charging different prices to different groups of buyers
and
b) That of charging the same consumer different prices for different units of the same good.
In the first case, each group of buyers has a different price elasticity of demand. The firm can by
equalizing the marginal revenue generated by each group earn a higher level of profits than would
be the cases of a uniform price were charged. The preconditions for the successful operation of this
form of discrimination are
 Ability of the monopolistic firm to identify different segments of the market a
according to price elasticity of demand and
 Prevention of resale by those customers who buy at a lower price.
In the second case, the operation involves the firm appropriating all the consumer surplus that each
consumer would have got if the price were constant. This can be achieved by setting the price of
each unit equal to the maximum amount an individual would be willing to pay as given by the
individual‘s demand curve and is therefore to be employed.
Arguments For and Against Monopolies

Although monopolies are hated mainly because of their practice of consumer exploitation, there are
some aspects of monopolies that are favorable. The following arguments can be put forward in
favour of monopoles:
i) Economies of Scale
As it has the whole market to itself, the monopolistic firm will grow to large size and exploit
economies of large scale production. Hence its product is likely to be of higher quantity than
product of a competitive firm that has less changes of expanding and lowering of the long run
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average cost (LRAC) of the firm. The price charged by the monopolistic firm may not be as
high as is usually assumed to be the case.
ii) No wastage of resources
As there is no competition from other firms, the monopolistic firm does not waste resources in
product differentiation and advertising in an effort to capture consumers from rival firms.
iii) Price stability
Since the monopolist is price maker, prices under a monopoly tend to be more stable than in
competition where they are bound to change due to changes in supply and demand beyond the
control of the individual firm.
iv) Research
A monopolistic firm is in a better financial position to carryout research and improve its
products than a competitive firm
However monopolies have been accused of the following

weaknesses. i) Diseconomies of scale
While the monopolistic firm can grow to large size and exploit economies of scale, there is danger
that it eventually suffers from diseconomies of scale. This will raise its LRAC and hence also
raise its price.
ii) Inefficiency
Since there is no competition, the firm can be inefficient as it has no fear of losing customers to
rival firms.
iii) Lack of innovation
Although the firm is in a better financial position to carry out research and improve its product
than a firm in a competitive market, it may NOT actually do so because of the absence of
competition.
iv) Exploitation
Exploitation of consumer is the most notorious practice for which monopolists are known as in
over-pricing so as to maximize profits, and price discrimination.
Characteristics of a Monopoly Market

There are a number of characteristics that define a monopoly market. The first is that there is a
single seller or supplier. This means that one firm provides the entire supply of a market. The
second is that there exist no close substitutes. This means that the monopolist faces no competition.
The idea that there exists a good or service which has no close substitute is difficult to prove. A
third characteristic is that there are barriers to entry. These may be created by circumstance or by
law. Examples would be the location of minerals or a legal barrier like a patent. The last feature is
that monopolies have some control over price.
Types of Monopolies
There are three different types of monopolies which to some degree all receive government support.
They are outlined below.
i. Natural Monopolies
A natural monopoly exists when one firm can supply the entire market at a lower per unit cost than
could two or more separate firms. Natural monopolies exist because of economies of scale. Costs
keep falling as the size of the firm increases. Public utilities, such as water, gas and electricity, are
examples of natural monopolies. It wouldn't make sense or be economically practical, if there were
multiple water or gas lines running under our streets.
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ii. Government Created or Legal Monopolies
There are times when the government awards a monopoly. This is usually done to promote and
reward new ideas. Examples of government created monopolies are:
 Patents: A patent is an exclusive right to sell a product for a specific amount of time.
 Copyrights: a monopoly given to an author for their lifetime
 Trademark: a special design, name, or symbol that identifies a product, service or company,
e.g. the Olympic rings or the Nike swoosh.
 Government franchise: when the government designates a single firm to sell a good or
service, such as bandwidth for local radio stations.
iii. Resource Monopoly
The third type, resource monopoly, is rare. This is where a natural resource, because of its location,
is controlled by one company. An example would be DeBeers diamonds. DeBeers controls about
80% of the world's diamonds. When this occurs there is usually some government oversight of the
industry. Other examples of resource monopolies would be the Aluminum Company of America
(ALCOA) and the International Nickel Company of Canada.
C. Monopolistic Competition
Monopolistic competition also known as imperfect competition, combines features from both
perfect competition and monopoly. It has the following features from perfect competition.
 There are many producers and consumers. The producers produce differentiated
substitutes. Hence there is competition between them. The difference from perfect
competition is that the products area not homogeneous
 There is freedom of entry into the industry so that an individual firm can make surplus
profits in the short-run but will make normal profits in the long-run as new firms enter the
industry.
Characteristics of monopolistic competition
Monopolistic competition has the following features from monopoly:
 As the products are differentiated substitutes, each brand or type has its own sole seller e.g.
each brand of toilet soap is produced by only one firm.
 If one firm raises its price it is likely to lose a substantial proportion of its customers to its
rivals. If it lowers price it is likely to capture a proportion of customers from its rivals. But
in the first case some of its customers will remain loyal to it and in the second case some
customers will remain loyal to their traditional suppliers. Hence, as in monopoly the demand
curve for the firm slopes downwards but it is more elastic than in monopoly. However, the
level of elasticity will depend on the strength of product differentiation.
Product Differentiation
Product differentiation describes a situation in which there is a single product being manufactured
by several suppliers, and the product of each supplier is basically the same. However, the suppliers
try to create differences between their own product and the products of their rivals. It can be
achieved through quality of service, after sales service, delivery dates, performance, reliability,
branding, packaging, advertising or in some cases the differences may be more in the minds of the
customers rather than real differences, but a successful advertising can create a belief that a service
or product is better than others and thus enable one firm to sell more and at higher price than its
competitors.
Advantages of Product Differentiation
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The advantages can be distinguished between those advantages for the firm itself and those for the
consumer:
i) For the firm.
 The ability to increase prices without losing loyal consumers
 The stability of sales, due to brand loyalty. The firm will not be subject to the risks and
uncertainties of intense price competition.
ii) For the Customer
 Consistent Product quality
 Wide consumer choice, between differentiated products.
Disadvantages of product differentiation
i) Product differentiation generally reduces the degree of competition in the market. It does this in
two ways:
 It reduces competition amongst existing firms because consumers are reluctant to substitute
one product for another, since they have developed brand loyalty.
 It makes it more difficult for new firms to enter the industry in the long run if the consumers
are already loyal to existing products.
ii)All the effort and expense that the firms put into product differentiation are wasteful. Too much is
spent on packaging, advertising and design changes. The price of goods could have been reduced
instead.
iii)Too many brands on the market, produced by large number of firms, could prevent the
realization of full economies of scale in the production of goods.
iv) Since the firms cannot expand their output to the level of minimum average cost output without
making a loss, the ―excess capacity theorem‖ predicts that industries marked by monopolistic
competition will always tend to have excess capacity i.e. output is at less than capacity and price
is above the average cost.
Waste in Imperfect Competition
Monopolistic competition involves some degree of waste in two aspects.
 When new firms enter the industry and the demand for the individual firm‘s product falls it
will be forced to reduce productions. This means that part of its plant equipment will be
unused. It is said to be operating under conditions of excess of the demand or the market for
its product.
In practice, the firm will not allow a situation where it is reduced to a state of lower than
normal profits. It will try to maintain its customers against new firms through product
differentiation and advertising in an effort to convince customers that its products are the best.
This wastage of resources, which could be used to expand and exploit economies of scale.
d. Oligopoly
Oligopoly refers to a market where a few large firms sell a product which may be alike or different
which dominates an industry. Steel and aluminum are examples of products that are alike that make
up an oligopoly market. Cars and cigarettes are examples of products that are different that
constitute an oligopoly market. Economists often use a concentration ratio, to measure if a market is
an oligopoly. Economists usually use a four-firm concentration ratio. If four firms control over 40%
of a market, then it is an oligopoly. For example, in the cigarette industry, the four-firm ratio is
95%. What can increase the concentration ratio? One way would be through mergers within the
industry or a second way would be if one of the larger firms in the industry gained market share at
the expense of one of the smaller firms.
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Characteristics of an Oligopoly Market
There are a number of characteristics that define an oligopoly market. The first is that price is not
determined by the market, but by the actions of a few large firms. Each firm is trying to hold onto or
enlarge their share of the market. Consequently, each firm is aware of the actions and reactions of
all its competitors. An example of this is how mobile phone companies in Kenya adjust their prices
to those of their competitors. Mutual interdependence is a term used in economics to describe how
an action by one oligopoly firm will cause a reaction by other oligopoly firms. e.g. If General
Motors produces a new type of vehicle or a price change, it needs to consider how the other
automobile manufacturers will react. In an oligopoly market there also exists price leadership. This
is when a dominant firm sets a price, and others follow. For example, if Phillip Morris decides to
increase the price of cigarettes, other cigarette producing firms will follow. There are often many
barriers that exist to discourage entry into the oligopoly market. Most of these barriers are related to
economies of scale. This is because there are huge stars up costs to enter an oligopoly market. In
summary, Oligopoly in the market describes a situation in which:
 Firms are price makers
 Few but large firms exist
 There are close substitutes
 Non-price competition exist like the form of product differentiation
 Supernormal profits re earned both in the short run and long run.
Pricing and Output Decisions of the Firm in oligopoly
The price and output shall depend on whether the firm operates in Pure oligopoly or Differentiated
oligopoly
a) Pure Oligopoly
Oligopolists normally differentiate their products. But this differentiation might either be weak
or strong. Pure oligopoly describes the situation where differentiation of the product is weak.
Pricing and output in pure oligopoly can be collusive or non-collusive.
i)Collusive Oligopoly
Collusive oligopoly refers to where there is co-operation among the sellers i.e. co-ordination of
prices. Collusion can be Formal or Informal.
 Formal Collusive Oligopoly: This is where the firms come together to protect their
interests e.g. cartels like OPEC. In this case the members enter into a formal
agreement by which the market is shared among them. The single decision maker
will set the market price and quantity offered for sale by the industry. There is a
central agency which sets the price and quarters produce by the firms and all firms
aside by the decisions of the central agency. The maximized joint profits are
distributed among firms based on agreed formula.
 Informal Collusive Oligopoly: Informal collusive oligopoly can arise into two cases,
namely:
a) Where the cartel is not possible may be because it‘s illegal or some firms don‘t want
to enter into an agreement or lose their freedom of action completely.
b) Firms may find it mutually beneficial for them not to engage in price competition.
When in outright cartel does not exist then firms will collude by covert gentlemanly
agreement or by spontaneous co-ordination designed to avoid the effects of price
war.
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One such means by which firms can agree is by price leadership. One firm sets the price and the
others follow with or without understanding. When this policy is adopted firms enter into a tacit
market sharing agreement.
There are two types of price leadership, namely:
 By a low-cost firm: When there is a conflict of interests among oligopolists arising from cost
differentials, the firms can explicitly or implicitly agree on how to share the market in which
the low-cost firm sets the price. We can assume that the low cost firm takes the biggest share
of the market.
 Price leadership by a large firm: Some oligopolists consist of one large firm and a number of
smaller ones. In this case the larger firm sets the price and allows the smaller firms to sell at
that price and then supplies the rest of the quantity. Each smaller firm behaves as if in a purely
competitive market where price is given and each firm sells without affecting the price
because each will sell where MC = P = MR = AR
ii)Non-Collusive Oligopoly
This Operates in the absence of collusion and in a situation of great uncertainty. In this case if one
firm raises price, it is likely to lose a substantial proportion of customers to its rivals. They will not
raise price because it is the interests to charge a price lower than that of their rivals. If the firm lower
price, it will attract a large proportion of customers from other firms. The other firms are likely to
retaliate by lowering price either to the same extent or a large extent. The first firm will retaliate by
lowering the price even further.
As the firms will always expect a counter-strategy from rival firms, each price and output decision
the firms comes up with is a tactical move within the framework of a broader strategy. This then
leads to a price war. If it goes on there will come a time when the prices are so low that if one firm
lowers price, the consumers will see no point in changing from their traditional suppliers. Thus, the
demand for the product of the individual firm will start by being elastic and it will end by being
inelastic. The demand curve for the product of the individual firm thus consists of two parts, the
elastic part and the inelastic part. It is said to be ―kinked‘ demand curve as shown below. If the
firm is on the inelastic part and it raises price, the others will not follow suit. But on this part prices
are so low that is likely to retain most of its customers. If it raises price beyond the kink, it will lose
most of its customers to rivals. Hence the price p will be the stable price because above it prices are
unstable in that rising price means substantial loss of customers and lowering price may lead to
price war. Below p prices are considered to be too low.
Elastic Demand
p Kink
Inelastic Demand
AR
Barriers to entry in pure oligopoly

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The barriers to entry can be artificial or natural. Artificial Barriers can be acquired through:
 State protection through issuance of exclusive market (franchise) licences and patent rights.
 Control of supply of raw materials
 Threat of price war, if financial resources can sustain loses temporarily the cartel or price
leader can threaten the new entrant by threatening to lower prices sufficiently to scare new
firms.
Disadvantages of Oligopolies
There are a number of reasons why economists don't like oligopolies. An oligopoly produces less
than it can which means there is a shortage, which means prices will be higher than in a perfectly
competitive market. There is always the temptation to collude, which would result in lower
production and higher prices. Price wars may emerge, which in the short run benefit consumers, but
which in the long run will drive competitors out of the market and force prices up. There may be
waste to society in the form of high advertising costs. Finally, the size of oligopolies may allow
such companies in an oligopolistic industry to have too much influence on politicians, who might
legislate laws in their favor.
e)Duopoly Market
This is a situation in which two companies own all or nearly all of the market for a given product or
service. A duopoly is the most basic form of oligopoly, a market dominated by a small number of
companies. A duopoly can have the same impact on the market as a monopoly if the two players
collude on prices or output. Collusion results in consumers paying higher prices than they would in
a truly competitive market.
The theory of duopoly forms a special ease of the theory of oligopoly, which is applied to the
situation, some way between monopoly and perfect competition, in which the number of sellers is
not large enough to make the influence of any one on the price negligible. A monopoly exists when
there is only one seller, oligopoly when there are few sellers; the simplest ease of oligopoly is that
of two sellers, duopoly.
Duopoly provides a simplified model for showing the main principles of the theory of oligopoly:
the conclusions drawn from analysing the problem of two sellers can be extended to cover
situations in which there are three or more sellers.
If there are only two sellers producing a commodity a change in the price or output of one will
affect the other; and his reactions in turn will affect the first. Thus each seller realizes that a change
in his price or output will set up a chain of reactions. He has to make assumptions about how the
other will react to a change in his policy. The essential characteristic of the theory of duopoly is that
neither seller can ignore the reactions of the other. The two sellers' fortunes are not independent;
neither can take the other's policy for granted, bemuse it is in part determined by his own.
Under pure competition, or monopoly, price or output can be decided by reference to the conditions
of demand and cost that face individual producers. But there is no simple answer in duopoly. It will
depend upon the assumptions made by each seller about the reactions of the other. The answer is in
this sense 'indeterminate'. Two limiting solutions are possible. Both sellers may charge the
monopoly price as a result of agreement or independent experience. This supposes that both sell
identical products and have the same costs, and that consumers are indifferent between them when
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both ask the same price. If a duopot moves his price above or below the monopoly price he will be
worse off because profits are maximized at the monopoly price. The two thus behave as a single
monopolist, and the market is shared between them. The other possible solution occurs when, as a
result of a price war, each seller is making only normal competitive profits. Price is then fixed at the
competitive level. Between these two Iimits there are indeterminate number of possibilities about
which theory can say little.
The table below summarizes the characteristics of each of the four main sarket structures;
Market Number of Type of Product Entry Examples

Structure Sellers Condition
Perfect Large Homogenous Very Easy Agriculture
Competition
Monopolistic Many Differentiated Easy Retail trade
Competition
Oligopoly Few Homogenous or Difficult Autos, steel, oil
differentiated
Monopoly One Unique Impossible Public utilities
Market Power
Market power is the ability of a firm to profitably raise the market price of a good or service over
marginal cost. In perfectly competitive markets, market participants have no market power. A firm
with total market power can raise prices without losing any customers to competitors. Market
participants that have market power are therefore sometimes referred to as "price makers," while
those without are sometimes called "price takers." Significant market power is when prices exceed
marginal cost and long run average cost, so the firm makes economic profits.
A firm with market power has the ability to individually affect either the total quantity or the
prevailing price in the market. Price makers face a downward-sloping demand curve, such that price
increases lead to a lower quantity demanded. The decrease in supply as a result of the exercise of
market power creates an economic deadweight loss which is often viewed as socially undesirable.
As a result, many countries have anti-trust or other legislation intended to limit the ability of firms
to accrue market power. Such legislation often regulates mergers and sometimes introduces a
judicial power to compel divestiture.
Market power gives firms the ability to engage in unilateral behavior. Some of the behaviours that
firms with market power are accused of engaging in include predatory pricing, product tying, and
creation of overcapacity or other barriers to entry. If no individual participant in the market has
significant market power, then anti-competitive behavior can take place only through collusion, or
the exercise of a group of participants' collective market power.
When several firms control a significant share of market sales, the resulting market structure is
called an oligopoly or oligopsony. An oligopoly may engage in collusion, either tacit or overt, and
thereby exercise market power. An explicit agreement in an oligopoly to affect market price or
output is called a cartel.
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Sources of Market Power
A monopoly can raise prices and retain customers because the monopoly has no competitors. If a
customer has no other place to go to obtain the goods or services, they either pay the increased price
or do without. Thus the key to market power is to preclude competition through high barriers of
entry. Barriers to entry those are significant sources of market power are control of scarce resources,
increasing returns to scale, technological superiority and government created barriers to entry.
OPEC is an example of an organization that has market power due to control over scarce resources -
oil.
Increasing returns to scale are another important source of market power. Firms experiencing
increasing returns to scale are also experiencing decreasing average total costs. Firms in such
industries become more profitable with size. Therefore over time the industry is dominated by a few
large firms. This dominance makes it difficult for startup firms to succeed. Firms like power
companies, cable television companies and wireless communication companies with large start up
costs fall within this category. A company wishing to enter such industries must have the financial
ability to spend millions of shillings before starting operations and generating any revenue.
Similarly established firms also have a competitive advantage over new firms. An established firm
threatened by a new competitor can lower prices to drive out the competition.
Finally government created barriers to entry can be a source of market power. Prime examples are
patents granted to pharmaceutical companies. These patents give the drug companies a virtual
monopoly in the protected product for the term of the patent.
Ways of Controlling Powers in Market

Structures a) Price control
Price control has been defined as the government effort to restrict the prices of commodities in the
market. The restriction can act on either the lowest prices or the highest prices. When the
government decide to restrict the highest price that a good or service should be sold at in the market
then this type of restriction is known as the price ceiling. Price floor on the other hand is the
restriction imposed by the government on the minimum prices that a goods or service should be
sold at in the market. The government arguments in support of price control are that;
 The government wants to protect consumers from exploitation by the suppliers. This way
the basic goods will become affordable to all the citizens.
 The government also sets the prices for commodity to control the rate of inflation in that
economy. The government does this by ensuring that all the producers in the market has a
minimum income for their producers
 The government will also set price controls to ensure there is no gouging when there is
shortage in supply. Price gouging is a term used to refer to the action of the producers to
increase the prices of commodities to unreasonable levels.
Advantages of price control
 Setting the maximum prices will protect consumers from exploitation because prices cannot
rise above a certain limit. This way the consumers purchase commodity at lower prices.
 Setting the price limit above a certain point will help the producers to increase their
production proceeds. Price floor is mostly used in the farming sectors to protect the farmers
from exploitation by the buyers.
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 Price control eliminates transaction costs in production. This is done by minimizing the cost
incurred in doing business among the companies hence eliminating the unnecessary costs in
production.
 Price control brings in transparency in pricing of commodities. Government will have set the
maximum or the minimum prices for a commodity therefore creating awareness in the economy
on the prices of different commodities.
 Price controls will eliminate the uncertainty caused by the fluctuation in the exchange rates.
Creating a universal currency in a trading bloc will eliminate the uncertainty caused by
exchange rates differences.
Disadvantages of price control.
 Price ceiling will reduce the supply of commodities in the market. The supplier‘s profits are
reduced by the price restriction therefore driving out some suppliers out of the markets.
 Price floors will affect the market by; increasing the prices for the consumers, the costs of
imports will also increase due to increase in import tariffs, price floors might encourage
inefficiency and oversupply in production
b) Regulation and other measures

To protect consumers, governments often try to control the market power of monopolies. One way
to do this is through regulation. A regulatory agency typically will give privately-owned firm
exclusive rights to a market, but regulate the firm's prices and standards of service. The agency
usually sets the price so as to give the firm a modest profit.
Regulating a monopoly's profit prevents it from exploiting its market power, but it causes other
problems. Most firms are eager to cut costs so that they can earn more profits. But if a regulated
monopoly succeeds in cutting costs, its regulatory agency will often take away any excess profits
that it makes by forcing the firm to lower its price. This means, of course, that regulated monopolies
don't have much incentive to cut their costs. To correct for this, regulatory agencies often monitor
their operations carefully to make sure that they're being well managed.
Another way to control the market power of monopolies is through nationalization, in which the
government owns and operates the monopoly. Like regulated private monopolies, nationalized
monopolies lack the incentive of profits to spur them to cut costs. Nationalized monopolies turn any
profits they earn over to the government; if they lose money, taxpayers make up the difference.
c. Taxes and subsidies

Taxes are primarily a source of revenue for Government to fund its activities and services. Taxes
can be indirect and levied on transactions, such as VAT, that do not vary with the income or status
of the consumer, or direct such as income tax, which varies with income and other characteristics,
such as whether a person has children.
Common types of subsidy include direct grants, tax exemptions, capital injections, equity
participation, soft loans, and guarantees. Support can also involve providing economic advantages,
for example allowing a firm to buy or rent publicly owned land at less than the market price, or by
giving a firm privileged access to infrastructure without paying a fee.
Taxes and subsidies can be used to influence the incentives and behaviour of private firms. There
are several reasons why taxes and subsidies might be used in this way, including:
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• To address market failures: common examples include the subsidy of education,
innovation, and low-carbon and environmentally friendly goods or the taxation of pollution.
• To address cyclical difficulties, subsidies might be used to temporarily s
• To address cyclical difficulties: subsidies might be used to temporarily support companies
in financial trouble, particularly when their collapse would have wide-ranging
Subsidies can have important effects on competition, particularly where they have a differential
impact on firms in a market. Government should make sure that the benefit of giving aid outweighs
the potential costs of distorting competition. The first risk to competition is that the subsidy
increases the potential for anti-competitive behaviour by firms. This might be the case if the subsidy
results in the recipient firm significantly increasing its market share to a level where:
• It can act independently of competitive constraints
• There is consolidation amongst competitors that either reduces competition or increases
the risk of collusion, or
• Entry barriers are raised so that potential future competition is prevented.
A second risk is that the subsidy might undermine the mechanisms that ensure efficiency in the
market. For example, the recipient firm could be under less financial pressure to be competitive or a
subsidy may mean that an inefficient firm stays in the market.

1. What is monopolist market?
2. With the help of a well-labelled diagram, explain the relationship between the average fixed
cost, average variable cost, total cost and marginal cost curves.
3. Discuss the necessary and sufficient conditions for profit maximization by a firm. Support
your answer with appropriate illustrations.
4. Outline three strategies that can be used to control market power in an economy
5. Explain three disadvantages of product differentiation
6. State the economic circumstances under which a perfectly competitive market may tribe.
7. In what ways does a perfect market differ from a monopoly, oligopoly and monopolistic
competition?
References
TOPIC 8
8.0 LABOUR MARKET
Labour includes both physical and mental work undertaken for some monetary reward. In this way,
workers working in factories, services of doctors, advocates, ministers, officers and teachers are all
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included in labour. Any physical or mental work which is not undertaken for getting income, but
simply to attain pleasure or happiness, is not labour.
Labour economics seeks to understand the functioning and dynamics of the markets for wage
labour. In economics, labour is a measure of the work done by human beings. It is conventionally
contrasted with such other factors of production as land and capital.
Labour market is the place where workers and employees interact with each other. In the labour
market, employers compete to hire the best, and the workers compete for the best satisfying job.
The labour market in an economy functions with demand and supply of labour. In this market,
labour demand is the firm's demand for labour and supply is the worker's supply of labour. The
supply and demand of labour in the market is influenced by changes in the bargaining power.
Characteristics of Labour
Labour has the following characteristics:
a. Labour is Perishable: Labour is more perishable than other factors of production. It means
labour cannot be stored. The labour of an unemployed worker is lost forever for that day
when he does not work. Labour can neither be postponed nor accumulated for the next day. It
will perish. Once time is lost, it is lost forever.
b. Labour cannot be separated from the Labourer: Land and capital can be separated from their
owner, but labour cannot he separated from a labourer. Labour and labourer are indispensable
for each other. For example, it is not possible to bring the ability of a teacher to teach in the
school, leaving the teacher at home. The labour of a teacher can work only if he himself is
present in the class. Therefore, labour and labourer cannot be separated from each other.
c. Less Mobility of Labour: As compared to capital and other goods, labour is less mobile.
Capital can be easily transported from one place to other, but labour cannot be transported
easily from its present place to other places. A labourer is not ready to go too far off places
leaving his native place. Therefore, labour has less mobility.
d. Weak Bargaining Power of Labour: The ability of the buyer to purchase goods at the lowest
price and the ability of the seller to sell his goods at the highest possible price is called the
bargaining power. A labourer sells his labour for wages and an employer purchases labour by
paying wages. Labourers have a very weak bargaining power, because their labour cannot be
stored and they are poor, ignorant and less organised. Moreover, labour as a class does not
have reserves to fall back upon when either there is no work or the wage rate is so low that it
is not worth working. Poor labourers have to work for their subsistence. Therefore, the
labourers have a weak bargaining power as compared to the employers.
e. Inelastic Supply of labour: The supply of labour is inelastic in a country at a particular time. It
means their supply can neither be increased nor decreased if the need demands so. For
example, if a country has a scarcity of a particular type of workers, their supply cannot be
increased within a day, month or year. Labourers cannot be ‗made to order‘ like other goods.
The supply of labour can be increased to a limited extent by importing labour from other
countries in the short period. The supply of labour depends upon the size of population.
Population cannot be increased or decreased quickly. Therefore, the supply of labour is
inelastic to a great extent. It cannot be increased or decreased immediately.
f. Labourer is a Human being and not a Machine: Every labourer has his own tastes, habits and
feelings. Therefore, labourers cannot be made to work like machines. Labourers cannot work
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round the clock like machines. After continuous work for a few hours, leisure is essential for
them.
g. A Labourer sells his Labour and not Himself: A labourer sells his labour for wages and not
himself. ‗The worker sells work but he himself remains his own property‘. For example,
when we purchase an animal, we become owners of the services as well as the body of that
animal. But we cannot become the owner of a labourer in this sense.
h. Increase in Wages may reduce the Supply of Labour: The supply of goods increases, when
their prices increase, but the supply of labourers decreases, when their wages are increased.
For example, when wages are low, all men, women and children in a labourer‘s family have
to work to earn their livelihood. But when wage rates are increased, the labourer may work
alone and his wife and children may stop working. In this way, the increase in wage rates
decreases the supply of labourers. Labourers also work for less hours when they are paid
more and hence again their supply decreases.
i. Labour is both the Beginning and the End of Production: The presence of land and capital
alone cannot make production. Production can be started only with the help of labour. It
means labour is the beginning of production. Goods are produced to satisfy human wants.
When we consume them, production comes to an end. Therefore, labour is both the beginning
and the end of production.
j. Differences in the Efficiency of Labour: Labourer differs in efficiency. Some labourers are
more efficient due to their ability, training and skill, whereas others are less efficient on
account of their illiteracy, ignorance, etc.
k. Indirect Demand for Labour: The consumer goods like bread, vegetables, fruit, milk, etc.
have direct demand as they satisfy our wants directly. But the demand for labourers is not
direct, it is indirect. They are demanded so as to produce other goods, which satisfy our
wants. So the demand for labourers depends upon the demand for goods which they help to
produce. Therefore, the demand for labourers arises because of their productive capacity to
produce other goods.
l. Difficult to find out the Cost of Production of Labour: We can easily calculate the cost of
production of a machine. But it is not easy to calculate the cost of production of a labourer
i.e., of an advocate, teacher, doctor, etc. If a person becomes an engineer at the age of twenty,
it is difficult to find out the total cost on his education, food, clothes, etc. Therefore, it is
difficult to calculate the cost of production of a labourer.
m. Labour creates Capital: Capital, which is considered as a separate factor of production is, in
fact, the result of the reward for labour. Labour earns wealth by way of production. We know
that capital is that portion of wealth which is used to earn income. Therefore, capital is
formulated and accumulated by labour. It is evident that labour is more important in the
process of production than capital because capital is the result of the working of labour.
n. Labour is an Active Factor of Production: Land and capital are considered as the passive
factors of production, because they alone cannot start the production process. Production
from land and capital starts only when a man makes efforts. Production begins with the active
participation of man. Therefore, labour is an active factor of production.
8.1 Demand and Supply of Labour

In many of the markets we encounter, individuals demand goods and services and firms supply
those goods and services. Although the labor market works in a similar way, the roles reverse. In the
labor market, firms demand labor and individuals supply that labor. The labour supply refers to the
total number of hours that labour is willing and able to supply at a given wage rate. Labor
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demand is a decision by management or ownership concerning how many employees or labor hours
to use to complete a necessary task. Usually, the decision is heavily influenced by money. It is in
the company's best interests to use as little labor as necessary to save money while still
accomplishing the workload that is required.
The demand for labor is derived demand meaning there is no demand for labor apart from the
demand for the goods and services labor can produce. When demand for an output good or service
decreases, total labor income in the affected industry will decrease. As demand for the good
decreases, demand for labor must also decrease. Possible results include: Workers are laid off;
Workers‘ hours are cut; Workers‘ wages are reduced. The magnitude of the impact on individuals‘
income depends on the alternatives available to workers in other employment. An increase in
demand for an output good that generates a positive impact on industry revenue also increases total
labor income, the latter by increasing the demand for labor.
Employers demand labor because workers are an important part of the production process. Workers
use tools and equipment to turn inputs into output. Without workers, employers couldn't produce
goods and services and earn profits. When graphed, the demand for labor looks much like the
demand for other goods and services-it has a downward slope. This indicates that a greater quantity
of labor is demanded at lower prices than at higher prices. That is, in the labor market, employers
are willing to buy more hours of labor at lower wages than at a higher wages.
Although employers, who demand labor, prefer lower wages, workers, who supply that labor, prefer
higher wages. Workers are willing to supply labor because the wages they earn enable them to buy
the goods and services they want. When graphed, the supply of labor looks much like the supply of
other goods and services, it has an upward slope. This indicates that workers are willing to supply a
greater quantity of labor hours—that is, they are willing to work more—at higher wages than at
lower wages.
Like other markets, the demand for labor and the supply of labor interact and result in an
equilibrium price. In this case the price is called a wage. And, like other markets, the demand for
labor and the supply of labor shift, which can cause wages to increase and decrease.
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8.2 Factors Influencing Demand and Supply of Labour
The demand of labour is influenced by:
a) Derived demand: The demand for labour is always derived from the demand for the good or
service it produces. Thus if the demand for a particular goods or service increase it will lead to
a rise in demand for labour used to produce those commodities. . For example, the demand for
nurses is determined by the demand for healthcare services. If the demand for healthcare
services increased dramatically, the demand for nurses to provide those services would
increase. In such a case, the demand curve would shift to the right and wages for nurses would
increase. On the other hand, if the demand for healthcare services were to decrease, the
demand for nurses would decrease as well. The demand curve would shift to the left and wages
for nurses would stagnate or even decline over time
b)Wage rates: A fall in wages will cause an extension in the demand for labour while a rise in
wages paid to works will cause a contraction in demand.
c)Technology used: In industries where there is improved technology can be used, the demand
for labour will tend to fall as producers will replace labour with sophisticated machinery.
Factors affecting the supply for labour

The supply of labour to a particular occupation is influenced by:
a)The wage rate on offer in the industry itself : Higher wages should boost the number of people
willing and able to work. In a strong economy, industries compete with each other for skilled
labor, which drives up compensation costs. The opposite generally holds true during a
recession, when industries are able to negotiate favorable compensation contracts with labor
unions. For example, if higher wages or better working conditions make nursing more
attractive than other jobs, more people may be willing to work in nursing, which would shift
the supply curve for nursing to the right. This rightward shift would decrease wages for nurses.
Likewise, if nursing were to become a less attractive occupation, some nurses would leave for
other professions. This decrease in supply would result in higher wages for the nurses who
remain.
b)Substitution and Income effect: As the price of a good is raised its supply also increases. Thus
we get a normal upward sloping curve. In the same way, a higher wage rate will influence
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people to work for more hours. This would mean that the worker will spend less on leisure
because the price of leisure has gone up, in terms of opportunity cost. This is known as
Substitution effect. As a result, the supply curve will be sloping upwards. But when the hourly
rate rises above a certain level a worker may wish to work fewer hours per week, because he
can earn higher income within a shorter period of time. This is known as Income effect. This
will result in the supply curve bending backward.
c)Barriers to entry: Artificial limits through the introduction of minimum entry requirements or
other legal barriers to entry can restrict labour supply and force average pay levels higher. For
example, if the government were to require nurses to have an additional, more difficult to earn,
license. This regulation would decrease the number of nurses able to work at all wage levels.
The supply curve for nursing would shift to the left and wages for nurses would increase. On
the other hand, if the government were to reduce qualifications or subsidize the training of new
nurses, the supply curve would shift to the right and wages would fall.
d) Improvements in the occupational mobility of labour: For example if more people are trained
with the necessary skills required to work in a particular occupation.
f)Non-monetary characteristics of specific jobs: Include factors such as the level of risk, the
requirement to work anti-social hours, job security, opportunities for promotion and the chance
to live and work overseas, employer-provided in-work training, subsidised health and leisure
facilities and occupational pension schemes.
g) Economy: Macroeconomic conditions affect labor supply and demand. Job losses during a
recession mean less disposable income for consumers and less demand for goods and services
produced, thus industries respond by reducing production, which leads to layoffs and reduced
labor demand. Demand for goods and services usually increase in a growing economy.
Industries increase production levels and hire new workers, which increases labor demand.
However, No-layoff clauses in union contracts, hiring limits and the tendency of some
companies to maintain employment through downturns have led to employment stability in the
some sectors.
h)Net migration of labour :A rising flow of people seeking work in the other countries is making
labour migration an important factor in determining the supply of labour available to many
industries – be it to relieve shortages of skilled labour or to meet the seasonal demand for
workers in agriculture and the construction industry. The recession has caused inward
migration to slow down and in some cases to reverse.
i)Globalization: Globalization involves the import of foreign labour and relocation of
manufacturing facilities overseas. Regional integration trade agreements, such as the Free
Trade Agreement and the European Union, have shifted production to low-cost locations in the
same continent, which reduces labor demand in the home country.
j)Other Factors: Other factors affecting labor supply and demand include new technologies
which my require workers with specialized skills and unforeseen events, such as the March
2011 earthquake in Japan that disrupted operations in several industries.
Specialisation / Division of labour

This way of doing the work is called division of labour because different workers are engaged in
performing different parts of production. In the words of Watson, ―Production by division of
labour consists in splitting up the productive process into its component parts.‖ Different workers
perform different parts of production on the basis of their specialisation. The result is that goods
come to the final shape with the cooperation of many workers. Thus, division of labour means that
the main
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process of production is split up into many simple parts and each part is taken up by different
workers who are specialised in the production of that specific part.
Forms of Division of Labour:

The division of labour has been divided into different forms by the economists who explain it as
follows:
i. Simple Division of Labour: When the production is split up into different parts and many
workers come together to complete the work, but the contribution of each worker cannot be
known, it is called simple division of labour. For example, when many persons carry a huge
log of wood, it is difficult to assign how much labour has been contributed by an individual
worker. It is simple division of labour.
ii. Complex Division of Labour: When the production is split up into different parts and each part
is performed by different workers who have specialised in it, it is called complex division of
labour. For example, in a shoe factory one worker makes the upper portion, the second one
prepares the soles, the third one stitches them, the fourth one polishes them, and so on. In this
way, shoes are manufactured. It is a case of complex division of labour.
iii.Occupational Division of Labour: When the production of a commodity becomes the
occupation of the worker, it is called occupational division of labour. Thus, the production of
different goods has created different occupations. The caste system in India is perhaps the best
example of the occupational division of labour. The work of farmers, cobblers, carpenters,
weavers and blacksmiths is known as occupational division of labour.
iv. Geographical or Territorial Division of Labour: Sometimes, due to different reasons, the
production of goods is concentrated at a particular, place, state or country. This particular type
of division of labour comes into being when the workers or factories having specialised in the
production of a particular commodity are found at a particular place. That place may be the
most suitable geographically for the production of that commodity. This is called the
geographical or territorial division of labour.
Advantages of Division of Labour

 Practice makes perfect: Worker specialises in a particular task and gives in the best, thus
producing goods faster and less wastage of material. In addition, When the worker is
entrusted with the work for which he is best suited, he will produce superior quality goods.
 Use of machinery: The division of labour is the result of the large-scale production, which
implies more use of machines. On the other hand, the division of labour increases the
possibility of the use of machines in the small-scale production also. Therefore, in modern
times the use of machines is increasing continuously due to the increase in the division of
labour.
 Increased Output: with improvement in efficiency and use of machinery output is increased.
 Saves time: There is no need for the worker to shift from one process to another. He is
employed in a definite process with certain tools. He, therefore, goes on working without
loss of time, sitting at one place. Continuity in work also saves time and helps in more
production at less cost.
 Increase in Mobility of Labour: Division of labour facilitates greater mobility of labour. In
it, the production is split up into different parts and a worker becomes trained in that very
specific task in the production of the commodity which he performs time and again. He
becomes professional, which leads to the occupational mobility. On the other hand, division
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of labour implies a large-scale production and labourers come to work from far and near.
Thus, it increases geographical mobility of labour.
 Increase in Employment Opportunities: Division of labour leads to the diversity of
occupations which further leads to the employment opportunities. On the other hand, the
scale of production being large, the number of employment opportunities also increases.
 Saving of Capital and Tools: Division of labour helps in the saving of capital and tools. It is
not essential to provide a complete set of tools to every worker. He needs a few tools only
for the job he has to do. Thus there is the saving of tools as well as capital. For instance, if a
tailor stitches the shirt, he requires a sewing machine, scissors, etc. But on the basis of
division of labour, one can do the cutting and the other can stitch the clothes. In this way,
two tailors can work with the help of one pair of scissors and one machine only.
 Development of International Trade: Division of labour increases the tendency of
specialisation not only in the workers or industries, but in different countries also. On the
basis of specialisation, every country produces only those goods in which it has a
comparative advantage and imports such goods from those countries which have also greater
comparative advantage. Therefore, division of labour is beneficial for the development of
international trade also.
Disadvantages of Division of Labour

 Boredom: Under division of labour, a worker has to do the same job time and again for
years together. Therefore, after some time, the worker feels bored or the work becomes
irksome and monotonous. There remains no happiness or pleasure in the job for him. It has
an adverse effect on the production.
 Loss of Mental Development: When the labourer is made to work only on a part of the
work, he does not possess complete knowledge of the work. Thus, division of labour proves
to be a hurdle in the way of mental development. Furthermore, though the number of goods
produced increases they are identical or standardized.
 Loss of Responsibility: Many workers join hands to produce a commodity. If the production
is not good and adequate, none can be held responsible for it. It is generally said that ‗every
man‘s responsibility is no man‘s responsibility.‘ Therefore, the division of labour has the
disadvantage of loss of responsibility.
 Reduction in Mobility of Labour: The mobility of labour is reduced on account of division
of labour. The worker performs only a part of the whole task. He is trained to do that much
part only. So, it may not be easy for him to trace out exactly the same job somewhere else, if
he wants to change the place. In this way, the mobility of labour gets retarded.
 Increased Dependence: When the production is split up into a number of processes and each
part is performed by different workers, it may lead to over-dependence. For instance, in the
case of a readymade garments factory, if the man cutting cloth is lazy, the work of stitching,
buttoning, etc. will suffer. Therefore, increased dependence is the result of division of
labour.
 Danger of Unemployment: The danger of unemployment is another disadvantage of division
of labour. When the worker produces a small part of goods, he gets specialised in it and he
does not have complete knowledge of the production of goods. For instance, a man is expert
in buttoning the clothes. If he is dismissed from the factory, it is difficult for him to find the
job of buttoning. Thus division of labour has a fear of unemployment.
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 Danger of Over-Production: Over-production means that the supply of production is
comparatively more than its demand in the market. Because of the division of labour, when
production is done on a large scale, the demand for production lags much behind its
increased supply. Such conditions create overproduction which is very harmful for the
producers as well as for the workers when they become unemployed.
8.3 Types of Reward for Labour

Wages are the price paid for the services of labour. Like any other factor of production, labour also
contributes to production. Wages may also be paid for any type of human effort, either physical or
mental. Wages are based on certain periods of time. It may be a day, a week, a month or a year. In
ordinary language, wages are variously called salaries, pay, fees, allowances or commission. For
higher officers, the term salary is used. Similarly, fees are paid to professionals like doctors and
lawyers while payments made to middlemen like sales agents is known as commission. Wages are
usually expressed as a rate. When wage payments are based on a day, a week, or a month, such
payments are known as time wages. When wages are paid according to number of units produced,
this mode of payment is called piece rate or piece wages. Wages can also be distinguished as money
wages and nominal wages. The amount of money paid as wages is called nominal or money wage.
Real wages mean the amount of necessaries, comforts and luxuries that can be purchased with the
money wage.
Theories of wage
determination a) Early theories
about wages
The earliest theories about wage determination were those put forward by Thomas Malthus, David
Ricardo and Karl Marx.
i. Thomas Robert Malthus (1766 – 1834) and the Subsistence Theory of Wages:
The germ of Malthus‘ Theory does come from the French ―physioirats‖ who held that it was
in the nature of things that wages could never rises above a bare subsistence level. When
wages did for a time rise much above the bare necessities of life, the illusion of prosperity
produced larger families, and the severe competition among workers was soon at work to
reduce wages again. In a world where child labour was the rule it was only a few years before
the children forced unemployment upon the parents, and all were again reduced to poverty.
Such was the subsistence theory of wages.
ii. Ricardo and the Wages Fund Theory:

Ricardo held that, like any other commodity, the price of labour depended on supply and
demand. On the demand side, the capital available to entrepreneurs was the sole source of
payment for the workers, and represented a wages fund from which they could be paid. On the
supply side, labour supply depended upon Malthus‘ arguments about population. The intense
competition of labourers one with another, at a time when combinations of workers to
withdraw their labour from the market were illegal, kept the price of labour low.
iii. Karl Marx (1818 – 83) and the ‘Full Fruits of Production’ Theory of Wages:
His labour theory of value held that a commodity‘s worth was directly proportional to the
hours of work that had gone into making it, under the normal conditions of production and the
worth the average degree of skill and intensity prevalent at that time. Because only labour
created value, the worker was entitled to the full fruits of production. Those sums distributed
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as rent, interest and profits, which Marx called surplus values, were stolen from the worker by
the capitalist class.
b)Modern theories of wage determination

i. Real and nominal wages
Wages are wanted only for what they will buy, real wages being wages in terms of the goods
and services that can be bought with them. Nominal wages are wages in terms of money, and
the term money wages is perhaps to be preferred. In determining nominal wages of people in
different occupations; account must be taken of payments in kind, such as free uniform for
policemen, railway workers and may others, free travel to and from work for those engaged in
the passenger transport undertakings, the use of the car by some business executives, free board
and lodging for some hotel workers and nurses. ― The labourer‖, say Adam Smith, ―is rich or
poor, is well or ill rewarded, in proportion to the real, not to the nominal price of his labour.‖
ii. Marginal productivity theory of wages

According to the Marginal theory of distribution, the producer will pay no more for any factor
of production that the value of its marginal product, since to do so will raise his costs by a
greater amount than his revenue. As applied to labour this provides us with the Marginal
Productivity theory of wages.
At this wage rate the firm will employ L units of labour. At this level of employment, R is the
average revenue product. Thus, the total revenue of the firm is represented by area ORBL, and
Labour cost is represented by area OWAL. Thus, the firm makes loss (on labour above)
represented by area RWAB. The firm will, therefore, not employ labour at wage rates above
average revenue product. It follows, therefore, that the demand curve for labor is that part of
the Marginal revenue product curve below the average revenue product curve, and is generally
represented as follows:-
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This theory has been criticized for following reasons
 It is too theoretical a concept, since it does not appear to agree with what actually takes
place.
 In practice it is impossible to calculate the amount or the value of the marginal product of
any factor of production.
 The employment of one man more or one man less may completely upset the method of
production in use at the time. To employ an extra man may simply mean that there will be
more labour than necessary; to take away a man may remove a vital link in the chain of
production. For this reason a small rise or fall in wages is not likely to bring about an
immediate change in the amount of labour employed.
 The productivity of labour does not depend entirely on its own effort and efficiency, but
very largely on the quality of the other factors of production employed, especially capital.
 According to this theory, the higher the wage, the smaller the amount of labour the
entrepreneur will employ. Surveys that have been taken appear to indicate that not all
employers take account of the wage rate when considering how many men to employ but are
being influenced more by business prospects.
 Lord Keynes said the theory was valid only in static conditions, and therefore, to lower the
wage rate in trade depression would not necessarily increase the demand for labour.
iii. Market theory of wages

Here the approach is to regard wages as a price – the price of labour – and, therefore, like all
other prices determined by the interaction of the market forces of supply and demand. In terms
of geometry, this corresponds to the point of intersection between the demand curve and the
supply curve

W is the equilibrium wage rate and L the equilibrium level of employment of labour. At wage
rates above w, there is excess of supply over demand, and hence wages will be forced
downwards.

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Below W, there is excess of demand oversupply and hence wages will be forced
upwards. The Market Theory of Wages, however, does not run counter to the Marginal
Productivity Theory. In the same way that marginal utility forms the basis of individual
demand, so marginal productivity forms the basis of demand for labour and other factors
of production
iv. The institutional intervention theories
Collective bargaining provides an example of what is sometimes called bilateral
monopoly; the trade union being the monopolist supplier and the employers‘ association
the monopolist buyer of a particular kind of labour. Those who support the Bargaining
strength of the trade union concerned, so that, differences in wages in different
occupations are the result of the differences of the strength of the respective trade unions
v. The comparability principle
Associations representing workers providing services – clerical, postal, teaching, etc. –
have always attempted to apply the ―principle of comparability‖ with wages of those in
similar occupations, though it is often very difficult to compare workers in different
occupations, since no two jobs are alike.
vi. The effect of inventions
In the long run, new inventions will have the effect of increasing output and lowering
prices, with the result that real wages of workers rise and in consequence their demand for
all kinds of goods and services.
Factors Responsible for Wage Differentials between Occupations

The major cause is demand and supply for the particular labour concerned, but other causes could
be:
 Differences in the cost of training: Some occupations require large investments in training,
while others require a much smaller expenditure for training. A physicist must spend eight
years on undergraduate and graduate training. A surgeon may require ten or more years of
training. During this period, income is foregone and heavy educational costs are incurred.
 Differences in the cost of performing the job: For example dentists, psychologists and
doctors in general require expensive equipment and incur high expenditure for running their
practice. In order for net compensation to be equalized, such ‗workers‘ must be paid more
than others.
 Differences in the degree of difficulty or unpleasantness of the wok: For example, miners
work under unpleasant conditions relative to farmers.
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Economics Notes. Prepared by Karoki Lawrence

 Differences in the risk of the occupation: For example, a racing driver or an airplane pilot
run more risks than a college teacher.
 Differences in the number of hours required for an “adequate” practice: For example,
doctors are required to put longer hours in practicing their professional than post office
employees.
 Differences in the stability of employment: Construction work and athletic or football
coaching are subject to frequent lay-offs and hence have little job security, whereas tenure
University teachers have a high job security.
 Differences in the length of employment: For example boxers and football players have a
short working-life.
 Differences in the prestige of various jobs: For example a white-collar worker has a more
prestigious position in Society than a truck driver.
 Differences in sex: In most cases occupations which are predominantly womens‘ occupation
tend to pay less than occupations which are predominantly mens‘ occupations.
 Effectiveness of Trade Unions: If trade unions in one industry or firm are more effective in
their wage negotiations with employers than those in another industry or firm, the workers
in the industry or firm are likely to earn higher wages than those in the second.
Factors Responsible For Wage Differentials within the Same Occupation

 Differences in the environment: For example a doctor sent to Mandera County may be paid
more than a doctor working in Nairobi to persuade him to go.
 Differences in the cost of living in various areas: Living costs generally are lower in small
towns than in big cities.
 Differences in the price of commodities, which labour produces: For example, consider two
mechanics, one servicing Mercedes car and the other Probox. Both mechanics are equally
skilled, but the value of their output differs because the price of Mercedes is higher than that
of Probox. In this case the difference in wages paid to the two individuals may be due to the
differences in the total value of their output.
 Biological and acquired quality differences: Human beings are born with different abilities
and in different environments, which define largely the opportunities to develop their
inherent qualities. For example, not many people are born with the biological qualities
required for becoming successful tennis players or surgeons, writers or artist. The marginal
productivity of workers thus differs. These differences are called non-equalizing or non-
compensating wage differentials because they are due to differences in the marginal
production of individuals.
 Job Security: Two people may do the same kind of work for different employers and earn
differently if the lower paid person feels safer with present employer. For example, a doctor
may prefer to work in a Government hospital rather than a Private hospital because there is
more job security in the civil service.
 Experience: It is often assumed that if a person does the same job for a long time, he gets
experienced and skilled at it. Hence he is likely to earn more than a person in the same
profession who joined more recently.
 Paid-by-results jobs: There are some jobs which pay according to one‘s output, e.g. jobs of
salesmen and insurance agents. Hence two people may do the same job, and earn differently
if one of them works harder
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Economics Notes. Prepared by
Karoki Lawrence

[Type text]
1. Define the term derived demand as applied in labour economics
2. Discuss five factors may influence supply of labour
3. Outline ten characteristics of labour
4. Explain four modern theories of wage determination
5. Justify why workers in the same occupations may be paid different salaries.
TOPIC 9
9.0 NATIONAL INCOME
9.1 Meaning of National Income
National Income is a measure of the money value of goods and services becoming available to a
nation from economic activities. It can also be defined as the total money value of all final goods
and services produced by the nationals of a country during some specific period of time ( usually an
year ) and the total of all incomes earned over the same period of time by the nationals.
Terms used in national income

Gross Domestic Product: The money value of all goods and services produced within the country
but excluding net income from abroad.
Gross National Product: The sum of the values of all final goods and services produced by the
nationals or citizens of a country during the year, both within and outside the country.
Net National Product: The money value of the total volume of production (that is, the gross national
product) after allowance has been made for depreciation (capital consumption allowance).
Nominal Gross National Product: The value, at current market prices, of all final goods and
services produced within some period by a nation without any deduction for depreciation of capital
goods. Real Gross National Product: This is the national output valued at the prices during some
base year or nominal GNP corrected for inflation.
Circular Flow of Money

The sources of national income can be explained using the Circular Flow of Income and
Expenditure model which illustrates the flow of payments and receipts between domestic firms and
domestic households. The households supply factor services to the firms. In return, they get factor
incomes. With factor incomes, they buy goods and services from the firms. These flows can be
illustrated diagrammatically as follows:
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The points at which flows from one sector meets the other sector and generate other flows are called
critical points. In the above diagram, the critical points are A, B and C. At A, the flow of factor
services from the households sector meets the firm sector and generates the flow of factors incomes
from the firms to the households. At B, the flow of factor incomes meets the household sector and
generates the flow of consumer spending. At C, the flow of consumer spending meets the firms
sector and generates the flow of goods and services. Therefore, Incomes keep moving from
households or the individuals to the firms to the government and the back in a cycle. However, a
country can‘t survive without international trade (exports and imports).When goods and services are
exported, the country earns income and spends when importing.
Factors that increase income are referred to as injections while those that reduce income are called
withdrawals or leakages.
Examples of withdrawals
i. Savings: Income that is not spent but kept aside. When individuals save incomes, they reduce
the amount of income received by firms.
ii. Government tax: This reduces amount of money available to individuals for spending
iii. Imports: When money is spent on imports, it leaves the economy.
Examples of injections
i. Selling of products to foreign countries
ii. Government spending inform of salaries, projects and construction of roads
ii. Investments by firms and individuals like shares, land, putting up industry etc
9.2 Determination of National Income

The compilation of national income statistics is a very laborious task. The total wealth of a nation
has to be added up and there are millions of nationals. Moreover, in order to double check and triple
check the statistics, the national income statistician has to work out the figures out in three different
ways, each way being based on a different aspect. The three approaches are:
a. The national output (Output method): The creation of wealth by the nation‘s industries. This
is valued at factor cost, so it must be the same as b) below.
b. The national income (Income method): The incomes of all the citizens.
c. The national expenditure (Expenditure method): because whatever we receive we spend, or
lend to the banks to invest it, so that the addition of all the expenditure should come to the
same as the other two figures. Put in its simplest form we can express this as an identity:
National output  National Income  National Expenditure
Expenditure approach
The expenditure approach centres on the components of final demand which generate production. It
thus measures GDP as the total sum of expenditure on final goods and services produced in an
economy. It includes all consumers‘ expenditure on goods and services, except for the purchase of
new houses which is included in gross fixed capital formulation. Secondly we included all general
government final consumption. This includes all current expenditure by central and local
government on goods and services, including wages and salaries of government employees. To
these we add gross fixed capital formation or expenditure on fixed assets (buildings, machinery,
vehicles etc) either for replacing or adding to the stock of existing fixed assets. This is the major
part of the investment which takes place in the economy. In addition we add the value of physical
increases in the stocks, or inventories, during the course of the year. The total of all this gives us
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Total domestic expenditure (TDE). We then add expenditure on exports to the TDE and arrive at a
measure known as Total Final Expenditure. It is so called because it represents the total of all
spending on final goods. However, much of the final expenditure is on imported goods and we
therefore subtract spending on imports. Having done this we arrive at a measure known as gross
domestic product at market prices. To gross domestic product at market price we subtract the taxes
on expenditure levied by the government and add on the amount of subsidy. When this has been
done we arrive at a figure known as Gross Domestic Product at factor cost. National Income
however is affected by rent, profit interest and dividends paid to, or received from, overseas. This is
added to GDP as net property income from abroad. This figure may be either positive or negative.
When this has been taken into account we arrive at the gross national product at factor cost. As
production takes place, the capital stock of a country wears out. Part of the gross fixed capital
formation is therefore, to replace worn out capital and is referred to as Capital Consumption. When
this has been subtracted we arrive at a figure known as the net national product. Thus, summarising
the above, we can say:
Y = C + I + G + (X – M)
Disadvantages / problems of expenditure approach

a. No accurate record on expenditure
b. In subsistence sector, the records don‘t exist at all hence approximations are used.
c. There is a problem of double counting i.e. some figures are calculate d more than once
d. When the market prices are used to measure the value of goods and services, they may not
give an accurate figure due to factors like inflation that makes goods more expensive
e. Fluctuations / changes in value exchange rate may bring about a problem/challenge when trying
to measure imports and exports.
Income approach
A second method is to sum up all the incomes to individuals in the form of wages, rents, interests
and profits to get domestic incomes. This is because each time something is produced and sold
someone obtains income from producing it. It follows that if we add up all incomes we should get
the value of total expenditure, or output. Incomes earned for purposes other than rewards for
producing goods and services are ignored. Such incomes are gifts, unemployment or relief benefits,
lottery, pensions, grants for students etc. These payments are known as transfer income (payments)
and including them will lead to double counting. The test for inclusion in the national income
calculation is therefore that there should be a ―quid pro quo‖ that the money should have been paid
against the exchange of a good or service. Alternatively, we can say that there should be a ―real‖
flow in the opposite direction to the money flow. We must also include income obtained from
subsistence output. This is the opposite case from transfer payments since there is a flow of real
goods and services, but no corresponding money flow. It becomes necessary to ―impute‘‘ values
for the income that would have been received.
Similarly workers may, in addition to cash income, receive income in kind; if employees are
provided with rent free housing, the rent which they would have to pay for those houses on the open
market should, in principle, be ―imputed‖ as part of their income from employment. The sum of
these incomes gives gross domestic product GDP. This includes incomes earned by foreigners at
home and excludes incomes earned by nationals abroad. Thus, to Gross Domestic Income we add
Net property Income from abroad. This gives Gross National Income. From this we deduct
depreciation to give Net National Income.
This method takes into account the sum of money received as income by individuals who
contributes to the production of goods and services. It may include;
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a) The estimated income in the subsistence sector
b) Income from formal employment
c) Income from self-employment
d) Profits made by private and public company
e) Rent earned by use of land
f) Government income from fines, taxes etc
g) Interest on money borrowed from banks and other financial institutions.
NB; payments for which no goods/commodities have been received are not included when
calculating national income, this is referred to as transfer payment i.e. money is paid without any
supply of goods or services e.g. a gift from a friends, bursaries to students, pension to retiring
people (these are savings from that person), payment to unemployed people under insurance,
donations to relief programmes etc. These are excluded because they are incomes transferred from
one group to another. Income by foreigners based in the country is also excluded.
Problems in income approach

i. Inaccurate data; people may not tell the truth on how much money they earn. Companies may
also not tell the truth about their incomes to avoid tax, citizens working abroad cannot also
tell how much they earn.
ii. It‘s difficult to calculate transfer payments e.g. gifts
iii. Inaccurate data on people working abroad
iv. There are so many illegal and unrecorded activities which bring income.
Output approaches
A final method which is more direct is the ―output method‖ or the value added approach. This
involves adding up the total contributions made by the various sectors of the economy. ―Value
Added‖ is the value added by each industry to the raw materials or processed products that it has
bought from other industries before passing on the product to the next stage in the production
process. This approach therefore centres on final products. Final products will include capital goods
as well as consumer goods since while intermediate goods are used up during the period in
producing other goods, capital goods are not used up (apart from ―wear and tear‖ or depreciation)
during the period and may be thought of as consumer goods ―stored up‖ for future periods. Final
output will include ―subsistence output‖, which is simply the output produced and consumed by
households themselves.
Because subsistence output is not sold in the market, some assumption has to be made to value them
at some price. We also take into account the final output of government, which provides services
such as education, medical care and general administrative services. However, since state education
and other governmental services are not sold on the market we shall not have market prices at which
to value them. The only obvious means of doing this is to value public services at what it costs the
government to supply them, that is, by the wages bill spent on teachers, doctors, and the like. When
calculating the GDP in this matter it is necessary to avoid double counting.
Problems in Output approach

a) Inaccurate data i.e. many people don‘t keep records especially in subsistence sector
b) The method is affected by inflation since prices of goods may change due to inflation
c) Sometimes it is difficult to decide what to include in output e.g. services provided by
housewives cannot be measured in terms of money.
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Difficulties in Measuring National Income
National income accounting is generally beset with several difficulties. These
are: a. What goods and services to include
Although the general principle is to take into account only those products which change hands
for money, the application of this principle involves some arbitrary decisions and distortions.
For example, unpaid services such as those performed by a housewife are not included but the
same services if provided by a paid housekeeper would be.
Many farmers regularly consume part of their produce with no money changing hands. An
imputed value is usually assigned to this income. Many durable consumer goods render services
over a period of time. It would be impossible to estimate this value and hence these goods are
included when they are first bought and subsequent services ignored. Furthermore, there are a
number of governmental services such as medical care and education, which are provided either
'free' or for a small charge. All these provide a service and are included in the national income at
cost. Finally, there are many illegal activities, which are ordinary business and produce goods
and services that are sold on the market and generate factor incomes.
b. Danger of Double Counting
The problem of double counting arises because of the inter-relationships between industries and
sectors. Thus we find that the output of one sector is the input of another. If the values of the
outputs of all the sectors were added, some would be added more than once, giving an
erroneously large figure of national income. This may be avoided either by only including the
value of the final product or alternatively by summing the values added at each stage which will
give the same result. Some incomes such as social security benefits are received without any
corresponding contribution to production. These are transfer payments from the taxpayer to the
recipient and are not included. Taxes and subsidies on goods will distort the true value of goods.
To give the correct figure, the former should not be counted as an increase in national income
for it does not represent any growth in real output.
c. Inadequate Information
The sources from which information is obtained are not designed specifically to enable national
income to be calculated. Income tax returns are likely to err on the side of understatement.
There are also some incomes that have to be estimated. Also, some income is not recorded, as
for example when a joiner, electrician or plumber does a job in his spare time for a friend or
neighbour. Also information on foreign payments or receipts may not all be recorded.
Individuals and firms may not give complete data about their income, expenditure and output.
d. Activities considered illegal: e.g. illicit brews and prostitution are not counted when
measuring national income and yet they are involved in exchange of money.
e. The value of resources keep on changing e.g. land keep on appreciating while machinery
depreciates which is difficult to calculate. In addition, Change in value of money during inflation
makes goods expensive and it would be wrong to assume that a country has made money and yet
it‘s because of inflation
f. Income from foreign firms: These are firms operating away from their mother country. The
international monetary fund argues that their output should be calculated as belonging to the host
country while the profit goes to the parent countries.
Advantages of using national income data
i. It is used for indicating standards of living of people in a country. This means the type of life of
the citizens can live according to the amount of income they have (NB it assume proper
distribution of income)
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ii. Standards of living in various countries may be compared. a country with high national income is
likely to have high standards of living e.g. developed countries in most cases have higher
national income than developing countries.
iii. It helps to identify which sectors are growing e.g. agriculture, manufacturing, building etc which
helps entrepreneurs decide where they can invest their money
Disadvantages of using national income

i. It does not show proper distribution of income: there may be very few people in country earning
high income and so many people who are poor.
ii. Gross national output is a measure of production and consumption hence it measures changes in
economic activities but not quality of life e.g. if people work extra hours, the GNP may go up
but denies people leisure
iii. Per capita income may not be very god measure of welfare because most of the time it
is calculated using inadequate data.
iv. Production activities bring about income but may not necessarily bring about high quality of life
because of pollution and environmental degradation.
v. Economic growth (increase in GNP) does not necessarily measure economic
development (quality of life of the people), better education, health, sanitation,
infrastructure etc
Importance of National Income Statistics

The following are the importance of national income data;
 National income statistics measures the size of the "National cake' of goods and services
available for competing uses of private consumers, government, capital formation and
exports (less imports).
 National Income statistics are also used in comparing the standard of living of a country
over time and also the standards of living between countries.
 National Income Statistics provide information on the stability of performance of the
economy over time e.g. a steadily increasing income would be indicative of increasing
national income.
 If National Income Statistics enable us to assess the relative importance of the various
sectors in the economy. This is done by considering the contribution of the various sectors to
Gross National Product over time which is crucial for planning purposes for it reveals to
planners where constraints to economic development lie.
 By assessing exports and imports as a percentage of Gross national Product i.e. using
national statistics, it is possible to determine the extent to which a country depends on
external trade.
 National Income Statistics also help in estimating the saving potential and hence investment
potential of a country.
Factors Affecting National Income

The size of a nation‘s income depends on the quantity and quality of the factors of production at its
disposal. A nation will be rich if its endowments of natural resources are large, its people are
skilled, and it has a useful accumulation of capital assets. The following factors affect national
income: a)Natural Resources: These include the minerals of the earth; the timber, shrubs and
pasturage
available; the agricultural potential (fertile soil, regular rainfall, temperature or tropical climate);
the fauna and flora; the fish etc of the rivers and sea; the energy resources, including oil, gas,
hydro-electric, geothermal, wind and wave power.
b) Human Resources: A country is likely to prosper if it has a large population; literate and

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knowledgeable about wealth creating processes. It should be well educated and skilled, with a
nice mixture of theory and practice. It should show enterprise, being inventive, energetic and
determined in the pursuit of a better standard of living.
c) Capital Resources: A nation must create and then conserve capital resources. This includes not
only tools, plant and machinery, factories, mines, domestic dwellings, schools, colleges, etc, but
a widespread infrastructure of roads, railways, airports and ports. Transport creates the utility of
space. It makes remote resources accessible and high-cost goods into low-cost goods by opening
up remote areas and bringing them into production.
d) Self-sufficiency: A nation cannot enjoy a large national income if its citizens are not mainly self-
supporting. If the majority of the enterprises are foreign –owned there will be a withdrawal of
wealth in the form of profits or goods transferred to the investing nation.
e) Technology: The development of technology affects the level of national income and innovation
in production i.e. the more the use of technology, the high the national income.
f) Political Stability:A stable economic and political system helps in the allocation of resources.
Wars strikes and social unrest discourage investment and business activities.
9.3 Indicators of Standards Of Living

Standard of living refers to the level of wealth, comfort, material goods and necessities available to
a certain socioeconomic class in a certain geographic area. The standard of living includes factors
such as income, quality and availability of employment, class disparity, poverty rate, quality and
affordability of housing, people, hours of work required to purchase necessities, gross domestic
product, inflation rate, number of holiday days per year, affordable (or free) access to quality
healthcare, quality and availability of education, life expectancy, incidence of disease, cost of goods
and services, infrastructure, national economic growth, economic and political stability, political
and religious freedom, environmental quality, climate and safety. The standard of living is closely
related to quality of life.
Indicators of Economic standard of living

Economic standard of living concerns the physical circumstances in which people live, the goods
and services they are able to consume and the economic resources to which they have access. It is
concerned with the average level of resources as well as the distribution of those resources across
the society.
Five indicators are used to provide information on different aspects of economic standards of living.
They are: market income per person, income inequality, the population with low incomes, housing
affordability and household crowding. Together, the indicators provide information about overall
trends in living standards, levels of hardship and how equitably resources are distributed. All are
relevant to the adequacy of people‘s incomes and their ability to participate in society and to choose
how to live their lives.
Market income per person gives an indication of the average level of income and therefore the
overall material quality of life available. This also includes economic value of unpaid work. It is the
total value of goods and services available to citizens, expressed in Dollars or shillings, per head of
population, also known as real gross national disposable income (RGNDI) per person. A nation with
a rising per person RGNDI will have a greater capacity to deliver a better quality of life and
standard of living to its population.
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Income inequality is the extent of disparity between high income and low income households.
It is measured by comparing the disposable household income distribution of higher income
households (80th percentile) with the incomes of lower income households (20th percentile). The
higher this ratio, the greater the level of inequality .High levels of inequality are associated with
lower levels of social cohesion and overall life satisfaction, even when less well-off people have
adequate incomes to meet their basic needs.
The proportion of the population with low incomes also provides information about how equitably
resources are distributed and how many people may be experiencing difficulty in participating fully
in society through a lack of income. It is argued that having insufficient economic resources limits
people‘s ability to participate in and belong to their community and wider society, and otherwise
restricts their quality of life. Furthermore, long-lasting low family income in childhood is associated
with negative outcomes, such as lower educational attainment and poorer health.
Housing affordability measures the proportion of the population spending more than 30 percent of
their disposable income on housing. Housing costs have a major impact on overall material living
standards, especially for low-income households. Affordable housing is important for people‘s
wellbeing. For lower-income households especially, high housing costs relative to income are often
associated with severe financial difficulty, and can leave households with insufficient income to
meet other basic needs such as food, clothing, transport, medical care and education. High
outgoings-to-income ratios are not as critical for higher-income households, as there is still
sufficient income left for their basic needs.
The final indicator measures the proportion of the population living in crowded households.
Crowded housing is a well-known health risk and this indicator provides a direct measure of the
extent of this problem over time. Housing space adequate to the needs and desires of a family is a
core component of quality of life. National and international studies show an association between
the prevalence of certain infectious diseases and crowding, between crowding and poor educational
attainment, and between residential crowding and psychological distress.
Causes of Income Disparities

There are many reasons for economic inequality within societies. Recent growth in overall income
inequality has been driven mostly by increasing inequality in wages and salaries. Economist argues
that widening economic disparity is an inevitable phenomenon of free market capitalism. Common
factors thought to impact economic inequality include:
i)The labor market
A major cause of economic inequality within modern market economies is the determination of
wages by the market. Some small part of economic inequality is caused by the differences in the
supply and demand for different types of work. However, where competition is imperfect;
information unevenly distributed; opportunities to acquire education and skills unequal; and since
many such imperfect conditions exist in virtually every market, there is in fact little presumption
that markets are in general efficient. This means that there is an enormous potential role for
government to correct these market failures.
In a purely capitalist mode of production (i.e. where professional and labor organizations cannot
limit the number of workers) the workers wages will not be controlled by these organizations, or by
the employer, but rather by the market. Wages work in the same way as prices for any other good.
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Thus, wages can be considered as a function of market price of skill. And therefore, inequality is
driven by this price. Under the law of supply and demand, the price of skill is determined by a race
between the demand for the skilled worker and the supply of the skilled worker. "
ii)Taxes
Another cause is the rate at which income is taxed coupled with the progressivity of the tax system.
A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. In a
progressive tax system, the level of the top tax rate will often have a direct impact on the level of
inequality within a society, either increasing it or decreasing it, provided that income does not
change as a result of the change in tax regime.
There is debate between politicians and economists over the role of tax policy in mitigating or
exacerbating wealth inequality. Economists such as have argued that tax policy in the post World
War II era has indeed increased income inequality by enabling the wealthiest far greater access to
capital than lower-income ones.
iii) Education
An important factor in the creation of inequality is variation in individuals' access to education.
Education, especially in an area where there is a high demand for workers, creates high wages for
those with this education, however, increases in education first increase and then decrease growth as
well as income inequality. As a result, those who are unable to afford an education, or choose not to
pursue optional education, generally receive much lower wages. The justification for this is that a
lack of education leads directly to lower incomes, and thus lower aggregate savings and investment.
In particular, the increase in family income and wealth inequality leads to greater dispersion of
educational attainment, primarily because those at the bottom of the educational distribution have
fallen further below the average level of education. Conversely, education raises incomes and
promotes growth because it helps to unleash the productive potential of the poor.
iv) Trade Liberization
Trade liberalization may shift economic inequality from a global to a domestic scale. When rich
countries trade with poor countries, the low-skilled workers in the rich countries may see reduced
wages as a result of the competition, while low-skilled workers in the poor countries may see
increased wages. Trade economists estimates that trade liberalisation has had a measurable effect on
the rising inequality. this trend is attributed to increased trade with poor countries and the
fragmentation of the means of production, resulting in low skilled jobs becoming more tradeable
v)Impact of gender
In many countries, there is a gender income gap which favors males in the labor market. Several
factors other than discrimination may contribute to this gap. On average, women are more likely
than men to consider factors other than pay when looking for work, and may be less willing to travel
or relocateGender inequality and discrimination is argued to cause and perpetuate poverty and
vulnerability in society as a whole.
vi) Stages of Development
Economist argues that levels of economic inequality are in large part the result of stages of
development. According to Kuznets, countries with low levels of development have relatively equal
distributions of wealth. As a country develops, it acquires more capital, which leads to the owners of
this capital having more wealth and income and introducing inequality. Eventually, through various
possible redistribution mechanisms such as social welfare programs, more developed countries
move back to lower levels of inequality.
vii) Diversity of preferences
Related to cultural issues, diversity of preferences within a society may contribute to economic
inequality. When faced with the choice between working harder to earn more money or enjoying
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more leisure time, equally capable individuals with identical earning potential may choose different
strategies. The trade-off between work and leisure is particularly important in the supply side of the
labor market in labor economics.
Likewise, individuals in a society often have different levels of risk aversion. When equally-able
individuals undertake risky activities with the potential of large payoffs, such as starting new
businesses, some ventures succeed and some fail. The presence of both successful and unsuccessful
ventures in a society results in economic inequality even when all individuals are identical.
viii) Wealth concentration
Wealth concentration is a theoretical process by which, under certain conditions, newly created
wealth concentrates in the possession of already-wealthy individuals or entities. According to this
theory, those who already hold wealth have the means to invest in new sources of creating wealth or
to otherwise leverage the accumulation of wealth, thus are the beneficiaries of the new wealth. Over
time, wealth condensation can significantly contribute to the persistence of inequality within
society.
ix) Single-parent families
There is statistical evidence shows strong links between single-parent families and lower income.
Inspite of the statistical evidence about the economic advantages enjoyed by married couples and
also by their children, evidence that is at odds with ideological positions of many influential voices,
Maranto and Crouch point out that "in the current discussions about increased inequality, few
researchers... directly address what seems to be the strongest statistical correlate of inequality: the
rise of single-parent families during the past half century."
Measures to Overcome Income Inequalities

Many economists suggest that developing nations must reform their treatment of, and tax policies
towards, big businesses and high net worth individuals, as well as reform a globally uncompetitive
education system, if they hope to unlock their nation‘s suppressed economic potential. The
government should make sure, ―corporations and individuals whose income is derived from
investments pay taxes commensurate with the benefits they get from the citizenship.‖ Although
technological change and globalisation have played a role in widening the distribution of labour
income, the marked cross-country variation is likely due to differences in policies and institutions.
Generally, developing nations need to implement the following measures in order to reduce income
inequalities;
● Education policies; have policies that increase graduation rates from upper secondary and tertiary
education and that also promote equal access to education help reduce inequality.
● Well-designed labour market policies and institutions can reduce inequality. A relatively high
minimum wage narrows the distribution of labour income, but if set too high it may reduce
employment, which dampens its inequality-reducing effect. Institutional arrangements that
strengthen trade unions also tend to reduce labour earnings inequality by ensuring a more equal
distribution of earnings.
● removing product market regulations that stifle competition can reduce labour income inequality
by boosting employment. The empirical evidence for the link between product market reform
and the dispersion of earnings is rather mixed.
● Policies that foster the integration of immigrants and fight all forms of discrimination reduce
inequality.
● Tax and transfer systems play a key role in lowering overall income inequality. Three quarters of
the average reduction in inequality they achieve is due to transfers. However, the redistributive
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impact of cash transfers varies widely across countries, reflecting both the size and progressivity
of these transfers.
● Personal income tax tends to be progressive, while social security contributions, consumption
taxes and real estate taxes tend to be regressive. But progressivity could be strengthened by
cutting back tax expenditures that benefit mainly high-income groups (e.g. tax relief on
mortgage interest). In addition, removing other tax reliefs – such as reduced taxation of capital
gains from the sale of a principal or secondary residence, stock options and carried interest –
would increase equity and allow a growth-enhancing cut in marginal labour income tax rates. It
would also reduce tax avoidance instruments for top-income earners.

1. Briefly explain the circular flow of money
2. Explain the challenges experienced in measurement of national income
3. Discuss the three methods used in measuring national income
4. Highlight five causes of income inequalities in a country.
TOPIC 10
10.0 INFLATION
10.1 Meaning of Inflation
The word inflation means a persistent rise in the general level of prices, or alternatively a persistent
falls in the value of money. it can also refer to a situation where the volume of purchasing power is
persistently running ahead of the output of goods and services, so that there is a continuous
tendency of prices – both of commodities and factors of production – to rise because the supply of
goods and services and factors of production fails to keep pace with demand for them. This type of
inflation can, therefore, be described as persistent/creeping inflation. Inflation can also be runaway
inflation or hyper-inflation or galloping inflation where a persistent inflation gets out of control and
the value of money declines rapidly to a tiny fraction of its former value and eventually to almost
nothing, so that a new currency has to be adopted.
Types of inflation
There are four main types of inflation namely;
Creeping Inflation
Creeping or mild inflation is when prices rise 3% a year or less. when prices rise 2% or less, it's
actually beneficial to economic growth. That's because this mild inflation sets expectations that
prices will continue to rise. As a result, it sparks increased demand as consumers decide to buy now
before prices rise in the future. By increasing demand, mild inflation drives economic expansion.
Walking Inflation
This type of strong, or pernicious, inflation is between 3-10% a year. It is harmful to the economy
because it heats up economic growth too fast. People start to buy more than they need, just to avoid
tomorrow's much higher prices. This drives demand even further, so that suppliers can't keep up,
neither can wages. As a result, common goods and services are priced out of the reach of most
people.
Galloping Inflation
When inflation rises to ten percent or greater, it wreaks absolute havoc on the economy. Money
loses value so fast that business and employee income can't keep up with costs and prices. Foreign
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investors avoid the country, depriving it of needed capital. The economy becomes unstable, and
government leaders lose credibility. Galloping inflation must be prevented.
Hyperinflation
Hyperinflation is when the prices skyrocket more than 50% a month. It is fortunately very rare. In
fact, most examples of hyperinflation have occurred when the government printed money recklessly
to pay for war. Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s,
and during the American Civil War.
10.2 Causes of Inflation

At present three main explanations (causes) are put forward: cost-push, demand-pull, and monetary.
i) Cost-push inflation:
Occurs when increase in costs of production push up the general level of prices. It is therefore
inflation from the supply side of the economy. It occurs as a result of increase in:
a. Wage costs: Powerful trade unions will demand higher wages without corresponding
increases in productivity. The employers generally accede to these demands and pass the
increased wage cost on to the consumer in terms of higher prices.
b. Import prices: A country carrying out foreign trade with another is likely to import the
inflation of that country in the form of intermediate goods.
c.Exchange rates: It is estimated that each time a country devalues it‘s currency by 4 per cent,
this will lead to a rise of 1 per cent in domestic inflation.
d. Mark-up pricing: Many large firms fix their prices on unit cost plus profit basis. This makes
prices more sensitive to supply than to demand influences and can mean that they tend to go up
automatically with rising costs, whatever the state of economy.
e) Structural rigidity: The theory assumes that resources do not move quickly from one use to
another and that wages and prices can increase but not decrease. Given these conditions; when
patterns of demand and cost change real adjustments occur very slowly. Shortages appear in
potentially expanding sectors and prices rise because slow movement of resources prevent the
sector and prices rise because of slow sectors keep factors of production on part-time
employment or even full time employment because mobility is low in the economy. Because
their prices are rigid, there is no deflation in these potentially contracting sectors. Thus the
process of expanding sectors leads to price rises, and prices in contracting sectors stay the
same. On average, therefore, prices rise.
f. Expectational theory: This depends on a general set of expectations of price and wage
increases. Such expectations may have been generated by continuing demand inflation. Wage
contracts may be made on a cost plus basis.
ii) Demand-pull inflation

This when aggregate demand exceed the value of output (measured in constant prices) at full
employment. The excess demand of goods and services cannot be met in real terms and therefore is
met by rises in the prices of goods. Demand-pull inflation could be caused by:
a) Increases in general level of demand of goods and services. A rise in aggregate demand in a
situation of nearly full employment will create excess demand in many individual markets, and
prices will be bid upward. The rise in demand for goods and services will cause a rise in
demand for factors and their prices will be bid upward as will. Thus, inflation in the pries of
both consumer goods and factors of production is caused by a rise in aggregate demand.
b) General shortage of goods and services. If there is a general shortage of commodities e.g. in
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times of disasters like earthquakes, floods or wars, the general level of prices will rise because
of excess demand over supply.
c) Government spending: Hyper-inflation certainly rises as a result of government action.
Government may finance spending though budget deficits; either resorting to the printing press
to print money with which to pay bills or, what amounts to the same thing, borrowing from the
central bank for this purpose. Many economists believe that all inflation is caused by increases
in money supply.
iii) Monetary
Monetarist economists believe that ―inflation is always and everywhere a monetary phenomenon
in the sense that it can only be produced by a more rapid increase in the quantity of money than in
output‖ as Friedman wrote in 1970.
10.3 Effects of Inflation on the Economy

Inflation has different effects on different economic activities on both micro and macro levels.
Some of these problems are considered below:
i. During inflation money loses value. This implies that in the lending-borrowing process, lenders
will be losing and borrowers will be gaining, at least to the extent of the time value of money.
Cost of capital/credit will increase and the demand for funds is discouraged in the economy,
limiting the availability of investable funds. Moreover, the limited funds available will be
invested in physical facilities which appreciate in value over time. It‘s also impossible the
diversion of investment portfolio into speculative activities away from directly productive
ventures.
ii. During inflation more disposable incomes will be allocated to consumption since prices will be
high and real incomes very low. In this way, marginal propensity to save will decline culminating
in inadequate saved funds. This hinders the process of capital formation and thus the economic
prosperity to the country.
iii. The effects of inflation on economic growth have inconclusive evidence. Some scholars and
researchers have contended that inflation leads to an expansion in economic growth while others
associate inflation to economic stagnation i.e. inflation acts as an incentive to producers to
expand output and if the reverse happened, there will be a fall in production resulting into
stagflation i.e. a situation where there is inflation and stagnation in production activities.
iv.During inflation, domestic commodity prices are higher than the world market prices, a country‘s
exports fall while the import bill expands. This is due to the increased domestic demand for
imports much more than the foreign demand for domestic produced goods (exports). The effect is
a deficit in international trade account causing balance of payment problems for the country that
suffers inflation.
v. During inflation, income distribution in a country worsens. The low income strata get more
affected especially where the basic line sustaining commodities‘ prices rise persistently. In fact
such persistence accelerates the loss of purchasing power and the vicious cycle of poverty.
vi.Increased production: It is argued that if inflation is of the demand-pull type, this can lead to
increased production if the high demand stimulates further investment. This is a positive effect of
inflation as it will lead to increased employment.
vii) Political instability: When inflation progresses to hyper-inflation, the unit of currency is
destroyed and with it basis of a free contractual society.
vii. Inflation and Unemployment
For many years, it was believed that there was a trade-off between inflation and unemployment
i.e. reducing inflation would cause more unemployment and vice versa.
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10.4 Measures to Control Inflation
An inflationary situation can effectively be addressed /tackled if the cause is first and foremost
identified. Governments have basically three policy measures to adopt in order to control inflation,
namely:
i) Fiscal Policy: This policy is based on demand management in terms of either raising or lowering
the level of aggregate demand. The government could attempt to influence one of the components
of the aggregate demand by reducing government expenditure and raising taxes. This policy is
effective only against demand-pull inflation.
ii) Monetary Policy: Governments and central banks primarily use monetary policy to control
inflation. Central banks such increase the interest rate, slow or stop the growth of the money supply,
and reduce the money supply. Higher interest rates reduce the amount of money because less people
seek loans, and loans are usually made with new money. When banks make loans, they usually first
create new money, then lend it. A central bank usually creates money lent to a national government.
Therefore, when a person pays back a loan, the bank destroys the money and the quantity of money
falls.
Monetarists emphasize a steady growth rate of money and use monetary policy to control inflation
by increasing interest rates and slowing the rise in the money supply. Keynesians emphasize
reducing aggregate demand during economic expansions and increasing demand during recessions
to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy
and fiscal policy (increased taxation or reduced government spending to reduce demand).
iii) Direct Intervention: Prices and incomes policy: Direct intervention involves fixing wages and
prices to ensure there is almost equal rise in wages and other incomes alongside the improvements
in productivity in the economy. Nevertheless, these policies become successful for a short period as
they end up storing trouble further, once relaxed will lead to frequent price rises and wage
fluctuations.

1. Outline three causes of demand pull inflation
2. Discuss five effects of inflation
3. Explain three anti-inflationary measures used by governments to mitigate against inflation
4. Distinguish between moderate and hyper inflation
TOPIC 11
11.0 MONEY AND BANKING
11.1 Concept of Money
Money may be defined as anything generally acceptable in the settlement of debts. The
development of money was necessitated by specialization and exchange. Money was needed to
overcome the shortcomings and frustrations of the barter system which is system where goods and
services are exchanged for other goods and services.
Disadvantages of Barter Trade
 It is impossible to barter unless A has what B wants, and A wants what B has. This is called
double coincidence of wants and is difficult to fulfill in practice.
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 Even when each party wants what the other has, it does not follow they can agree on a fair
exchange. A good deal of time can be wasted sorting out equations of value.
 The indivisibility of large items is another problem. For instance if a cow is worth two sacks of
wheat, what is one sack of wheat worth? Once again we may need to carry over part of the
transaction to a later period of time.
 It is possible to confuse the use value and exchange value of goods and services in a barter
economy. Such confusion precludes a rational allocation of resources and promotion of
economic efficiency.
 When exchange takes place over time in an economy, it is necessary to store goods for future
exchange. If such goods are perishable by nature, then the system will break down.
 The development of industrial economies usually depends on a division of labour,
specialization and allocation of resources on the basis of choices and preferences. Economic
efficiency is achieved by economizing on the use of the most scarce resources. Without a
common medium of exchange and a common unit of account which is acceptable to both
consumers and producers, it is very difficult to achieve an efficient allocation of resources to
satisfy consumer preferences.
The Historical development of money

For the early forms of money, the intrinsic value of the commodities provided the basis for general
acceptability: For instance, corn, salt, tobacco, or cloths were widely used because they had obvious
value themselves. These could be regarded as commodity money. Commodity money had uses other
than as a medium of exchange (e.g. salt could be used to preserve meat, as well as in exchange). But
money commodities were not particularly convenient to use as money. Some were difficult to
transport, some deteriorated overtime, some could not be easily divided and some were valued
differently by different cultures.
As the trade developed between different cultures, many chose precious metals mainly gold or
silver as their commodity money. These had the advantage of being easily recognizable, portable,
indestructible and scarce (which meant it preserved its value over time). The value of the metal was
in terms of weight. Thus each time a transaction was made, the metal was weighed and payment
made. Due to the inconvenience of weighing each time a transaction was made, this led to the
development of coin money. The state took over the minting of coins by stamping each as being a
particular weight and purity (e.g. one pound of silver). They were later given a rough edge so that
people could guard against being cheated by an unscrupulous trade filling the edge down.
It became readily apparent, however, that what was important was public confidence in the
―currency‖ of money, it‘s ability to run from hand to hand and circulate freely, rather than its
intrinsic value. As a result there was deliberately reduced below the face value of the coinage. Any
person receiving such a coin could afford not to mind, so long as he was confident that anyone to
whom he passed on the coin would also ―not mind‖. Debasement represents an early form of
fiduciary issue, i.e. issuing of money dependent on the ―faith of the public‖ and was resorted to
because it permitted the extension of the supply of money beyond the availability of gold and silver.
Due to the risk of theft, members of the public who owned such metal money would deposit them
for safe keeping with goldsmiths and other reliable merchants who would issue a receipt to the
depositor. The metal could not be withdrawn without production of the receipt signed by the
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depositor. Each time a transaction was made, the required amount of the metal would be withdrawn
and payment made.
It was later discovered that as long as the person being paid was convinced the person paying had
gold and the reputation of the goldsmith was sufficient to ensure acceptability of his promise to pay,
it became convenient for the depositor to pass on the goldsmith‘s receipt and the person being paid
will withdraw the gold himself. Initially, the gold would be withdrawn immediately after the
transaction was made. But it was discovered that so long as each time a transaction was made the
person being paid was convinced that there was gold, the signed receipt could change hands more
than once. Eventually, the receipts were made payable to the bearer (rather than the depositor) and
started to circulate as a means of payment themselves, without the coins having to leave the vaults.
This led to the development of paper money, which had the added advantage of lightness.
Initially, paper money was backed by precious metal and convertible into precious metal on
demand. However, the goldsmiths or early bankers discovered that not all the gold they held was
claimed at the same time and that more gold kept on coming in (gold later became the only accepted
form of money). Consequently they started to issue more bank notes than they had gold to back
them, and the extra money created was lent out as loans on which interest was charged. This
became lucrative business, so much so that in the 18th and 19 th centuries there was a bank crisis in
England when the banks failed to honour their obligations to their depositors, i.e. there were more
demands than there was gold to meet them. This caused the government to intervene into the
banking system so as to restore confidence. Initially each bank was allowed to issue its own
currency and to issue more currency than it had gold to back it. This is called fractional backing,
but the Bank of England put restrictions on how much money could be issued.
Eventually, the role of issuing currency was completely taken over by the Central Bank for effective
control. Initially, the money issued by the Central Bank was backed by gold (fractionally), i.e. the
holder had the right to claim gold from the Central Bank. However, since money is essentially
needed for purchase of goods and services, present day money is not backed by gold, but it is based
on the level of production, the higher the output, the higher is the money supply. Thus, present day
money is called token money i.e. money backed by the level of output.
Characteristics of Money
Over time, therefore, it became clear that for an item to act as money it must possess the following
characteristics.
 Acceptability: If money is to be used as medium of exchange for goods and services, then it
must be generally accepted as having value in exchange. This was true of metallic money in
the past because it was in high and stable demand for its ornamental value. It is true of paper
money, due to the good name of the note-issuing authority.
 Portability: If an item is to be used as money, it must be easily portable, so that it is a
convenient means of exchange.
 Scarcity: If money is to be used in exchange for scarce goods and services, then it is
important that money is in scarce supply. For an item to be acceptable as money, it must be
scarce.
 Divisibility: It is essential that any asset which is used as money is divisible into small units,
so that it can be used in exchange for items of low value.
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 Durability: Money has to pass through many different hands during its working life. Precious
metals became popular because they do not deteriorate rapidly in use. Any asset which is to
be used as money must be durable. It must not depreciate over time so that it can be used as a
store of wealth.
Homogeneity: It is desirable that money should be as uniform as possible.
Functions of Money
a. Medium of exchange
Money facilitates the exchange of goods and services in the economy. Workers accept
money for their wages because they know that money can be exchanged for all the different
things they will need. Use of money as an intermediary in transactions therefore, removes the
requirement for double coincidence of wants between transactions. Without money, the
world‘s complicated economic systems which are based on specialization and the division of
labour, would be impossible. The use of money enables a person who receives payment for
services in money to obtain an exchange for it, the assortment of goods and services from the
particular amount of expenditure which will give maximum satisfaction.
b) Unit of account
Money is a means by which the prices of goods and services are quoted and accounts kept.
The use of money for accounting purposes makes possible the operation of the price system
and automatically provides the basis for keeping accounts, calculating profit and loss, costing
etc. It facilitates the evaluation of performance and forward planning. It also allows for the
comparison of the relative values of goods and services even without an intention of actually
spending (money) on them e.g. ―window shopping‖.
c) Store of Wealth/value
The use of money makes it possible to separate the act of sale from the act of purchase.
Money is the most convenient way of keeping any form of property which is surplus to
immediate use; thus in particular, money is a store of value of which all assets/property can
be converted. By refraining from spending a portion of one‘s current income for some time, it
becomes possible to set up a large sum of money to spend later (of course subject to the time
value of money). Less durable or otherwise perishable goods tend to depreciate considerably
over time, and owners of such goods avoid loss by converting them into money.
d)Standard of deferred payment
Many transactions involve future payment, e.g. hire purchase, mortgages, long term
construction works and bank credit facilities. Money thus provides the unit in which, given
the stability in its value, loans are advanced/made and future contracts fixed. Borrowers never
want money for its own sake, but only for the command it gives over real resources. The use
of money again allows a firm to borrow for the payment of wages, purchase of raw materials
or generally to offset outstanding debt obligations; with money borrowing and lending
become much easier, convenient and satisfying. It‘s about making commerce and industry
more viable.
Demand and Supply of Money

Since money is primarily a medium of exchange, the value of money means what money will buy.
If at one time a certain amount of money buys fewer things than at a previous time, it can be said
that the value of money has fallen. Since money itself is used as unit of account and a means of
measuring the ―value‖ of other things, its own value can be seen only through the prices of other
things. Changes in the value of money, therefore, are shown through changes in prices.
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a) Demand for money
The demand for money is a more difficult concept than the demand for goods and services. It refers
to the desire to hold one‟s assets as money rather than as income-earning assets (or stocks).
Holding money therefore involves a loss of the interest it might otherwise have earned. There are
two schools of thought to explain the demand for money, namely the Keynesian Theory and the
Monetarist Theory.
The demand for money and saving are quite different things. Saving is simply that part of income
which is not spent. It adds to a person‘s wealth. Liquidity preference is concerned with the form in
which that wealth is held. The motives for liquidity preference explain why there is desire to hold
some wealth in the form of cash rather than in goods affording utility or in securities.
b) The supply of money

Supply of money refers to the total amount of money in the economy. Most countries of the world
have two measures of the money stock – broad money supply and narrow money supply. Narrow
money supply consists of all the purchasing power that is immediately available for spending. Two
narrow measures are recognized by many countries. The first, M 0 (or monetary base), consists of
notes and coins in circulation and the commercial banks‘ deposits of cash with the central banks.
The other measure is M2 which consists of notes and coins in circulation and the NIB (non-interest-
bearing) bank deposits, particularly current accounts. Also in the M2 definition are the other interest-
bearing retail deposits of building societies. Retail deposits are the deposits of the private sector
which can be withdrawn easily. Since all this money is readily available for spending it is
sometimes referred to as the ―transaction balance‖.
Any bank deposit which can be withdrawn without incurring (a loss of) interest penalty is referred
to as a ―sight deposit‖. The broad measure of the money supply includes most of bank deposits
(both sight and time), most building society deposits and some money-market deposits such as CDs
(certificates of deposit).
Determinants of money supply

Two extreme situations are imaginable. In the first situation, the money supply can be determined at
exactly the amount decided on by the Central Bank. In such a case, economists say that the money
supply is exogenous and speak of an exogenous money supply.
In the other extreme situation, the money supply is completely determined by things that are
happening in the economy such as the level of business activity and rates of interest and is wholly
out of the control of the Central Bank. In such a case economists would say that there was an
Endogenous money supply, which means that the size of the money supply is not imposed from
outside by the decisions of the Central Bank, but is determined by what is happening within the
economy.
In practice, the money supply is partly endogenous, because commercial banks are able to change it
in response to economic incentives, and partly exogenous, because the Central Bank is able to set
limits beyond which the commercial banks are unable to increase the money supply.
Measurement of changes in the value of money
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Goods and services are valued in terms of money. Their prices indicate their relative value. When
prices go up, the amount which can be bought with a given sum of money goes down; when prices
fall, the value of money rises; and when prices rise, the value of money falls. The economist is
interested in measuring these changes in the value of money. The usual method adopted to measure
changes in the value of money is by means of an index number of prices i.e. a statistical device used
to express price changes as percentage of prices in a base year or at a base date.
In preparing index numbers, a group of commodities is selected, their prices noted in some
particular year which becomes the base year for the index number and to which the number 100 is
given. If the prices of these commodities rise by 1 per cent during the ensuing twelve months the
index number next year will be 101. Examples of Index Number are Cost-of Living-Index, Retail
Price Index, Wholesale Price Index, Export Prices Index, etc.
The construction of Index Numbers presents some very serious problems and, as they cannot be
ideally solved, the index numbers by themselves are limited in their value and reliability as a
measurement of changes in the level of prices. The problems are:
i) The problems of weighting: The greatest difficulty facing the compiler of index number is to
decide on how much of each commodity to select. This is the problem of weighting.
Different ―weights‖ will yield different results.
ii) The other problem is to decide what grades and quantities to take into account. By including
more than one grade an attempt is made to make a representative selection. An even greater
difficulty occurs when the prices of a commodity remain unchanged, although the quantity has
declined.
iii) The choice of the base year. This would preferably be a year when prices are reasonably
steady, and so years during periods either of severe inflation or deflation are to be avoided.
iv) Index numbers are of limited value for comparisons over long periods of time because:
 New commodities come on the market.
 Changes in taste or fashion reduce the demand for some commodities and increase the
demand for others.
 The composition of the community is likely to change.
 Changes may occur in the distribution of the population among the various age groups.
 The rise in the Standard of living.
v) Changes in the taxation of goods and services affect the index.
11.2 Types of Banks

Banking can be defined as the business activity of accepting and safeguarding money owned by
other individuals and entities, and then lending out this money in order to earn a profit. A bank is
therefore a financial institution that undertakes the banking activity ie. Accepts deposits and then
lends the same to earn certain profit. However, with the passage of time, the activities covered by
banking business have widened and now various other services are also offered by banks. The
banking services these days include issuance of debit and credit cards, providing safe custody of
valuable items, lockers, ATM services and online transfer of funds across the country / world.
Banking activities encourages the flow of money to productive use and investments. This in turn
allows the economy to grow. In the absence of banking business, savings would sit idle in our
homes, the entrepreneurs would not be in a position to raise the money, ordinary people dreaming
for a new car or house would not be able to purchase cars or houses.
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Banking systems can be defined as a mechanism through which the money supply of the country is
created and controlled. The system consists of all those institutions which determine the supply of
money. The main element of the banking system is the Commercial Bank (in Kenya). The second
main element of banking system is the Central Bank and finally most banking systems also have a
variety of other specialized institutions often called Financial Intermediaries.
Functions of Commercial Banks

In modern economy, commercial banks have the following functions:
i. They provide a safe deposit for money and other valuables. Bank notes and coins constitute
the currency in circulation. But they form only a part of the total money supply. The larger
part of the money supply in circulation today consists of bank deposits. Bank deposits can
either be a current account or deposit account.
ii. They lend money to borrowers partly because they charge interest on the loans, which is a
source of income for them, and partly because they usually lend to commercial enterprises and
help in bringing about development.
iii. They provide safe and non-inflationary means for debt settlements through the use of
cheques, in that no cash is actually handled. This is particularly important where large
amounts of money are involved.
iv. They act as agents of the central banks in dealings involving foreign exchange on behalf of
the central bank and issue travelers ‘cheques on instructions from the central bank. e.g. the
Barclays Bank (Kenya). This is useful in that it guards against loss and theft for if the cheques
are lost or stolen; the lost or stolen numbers can be cancelled, which cannot easily be done
with cash. This also safe if large amount of money is involved.
v. They offer management advisory services especially to enterprises which borrow from them
to ensure that their loans are properly utilized.
vi.Some commercial banks offer insurance services to their customers eg. The Standard Bank
(Kenya) which offers insurance services to those who hold savings accounts with it.
Non-banking financial institutions

NBFIs were set up to fill a gap in the financial system and rectify inefficiencies in loan facilities.
These specialized financial institutions supplement the availability of finance provided by
commercial banks. The NBFIs are both public and private. These institutions mobilize savings, in
competition with commercial banks. The savings are then channeled into credit for commerce,
agriculture, industry and household sectors. Kenya continues to develop a wider range of these
financial institutions.
In 1980s, (NBFIS) grew rapidly in number, assets and liabilities. This growth mainly reflected some
defects in the banking act such as:
• The minimum capital required to establish NBFIS was lower than needed by Commercial
banks.
• Unlike banks, NBFIS were not required to maintain cash reserve ratio.
• NBFIs were permitted to impose higher lending rates on their facilities.
• Banks were restricted from undertaking mortgaging lending.
• Banks would only lend the equivalent of 25% or less of their capital to any one single
borrower.
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The growth of non-banking institutions was a development that was so positive. Initially, they
provided financial services that were specialized. This included hire purchase, leasing and merchant
banking. The regulatory differences encouraged commercial banks to set up non-banking financial
institutions to avoid the restrictions enforced on them and benefit from the higher interest rates. As
a result, the restrictions between banks and NBFIs started to lessen with time, causing the
competition between them to increase.
The increasing competition forced many of the NBFIs to become unusually aggressive. Some
undertook risky lending and mismatched maturities whereby they accepted lower matches. The
operation of non-banking financial institutions became unsustainable and contributed to the collapse
of several institutions in mid 1980s and early 1990s. As a result, there was a flight of equality
depository institutions as most depositors shifted funds from small NBFIs to larger and more
established banks.
The Central Bank, on realizing that NBFIs were no longer complimenting activities of commercial
banks, took the following measures:
i. It broadened the definition of money supply so as to include the deposits held at NBFIs.
Ii.With effects from 1995 NBFIs were required to observe cash ratio requirements at
stipulated levels. They were to do this by involving reserves at the Central
Bank. iii. It adopted the policy of universal banking in 1995.
Since then, the central bank has encouraged NBFIS to convert into Commercial banks and merge
with commercial bank where possible. By August 2000, 25 conversions and 12 mergers had
occurred, leaving only 11 institutions still operating as NBFIs.
Role in NBFIs in economic development

NBFIs supplement banks by providing the infrastructure to allocate surplus resources to individuals
and companies with deficits. Additionally, NBFIs also introduces competition in the provision of
financial services. While banks may offer a set of financial services as a packaged deal, NBFIs
unbundle and tailor these services to meet the needs of specific clients. Additionally, individual
NBFIs may specialize in one particular sector and develop an informational advantage. Through the
process of unbundling, targeting, and specializing, NBFIs enhances competition within the financial
services industry and enhances;
a) Growth: research suggests a high correlation between a financial development and economic
growth. Generally, a market-based financial system has better-developed NBFIs than a bank-
based system, which is conducive for economic growth.
b) Stability: A multi-faceted financial system that includes non-bank financial institutions can
protect economies from financial shocks and enable speedy recovery when these shocks
happen. NBFIs provide multiple alternatives to transform an economy's savings into capital
investment, which serve as backup facilities should the primary form of intermediation fail.
However, in the absence of effective financial regulations, non-bank financial institutions can
actually exacerbate the fragility of the financial system.
On the other hand, since not all NBFIs are heavily regulated, the shadow banking system
constituted by these institutions could wreak potential instability. In addition, Due to
increased competition, established lenders are often reluctant to include NBFIs into existing
credit-information sharing arrangements. NBFIs often lack the technological capabilities
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necessary to participate in information sharing networks thus they contribute less information
to credit-reporting agencies than do banks.
11.3 Role of Central Bank in the Economy

Central Banks are usually owned and operated by governments and their functions are:
i. Government‟s banker: Government‘s need to hold their funds in an account into which they
can make deposits and against which they can draw cheques. Such accounts are usually held
by the Central Bank
ii. Banker‟s Bank: Commercial banks need a place to deposit their funds; they need to be able
to transfer their funds among themselves; and they need to be able to borrow money when
they are short of cash. The Central Bank accepts deposits from the commercial banks and will
on order transfer these deposits among the commercial banks. Thus the central bank acts as
the Clearing House of commercial banks.
iii. Issue of notes and coins: In most countries the central bank has the sole power to issue and
control notes and coins. This is a function it took over from the commercial banks for
effective control and to ensure maintenance of confidence in the banking system.
iv. Lender of last resort: Commercial banks often have sudden needs for cash and one way of
getting it is to borrow from the central bank. If all other sources failed, the central bank would
lend money to commercial banks in temporary need of cash. To discourage banks from over-
lending, the central bank will normally lend to the commercial banks at a high rate of interest
which the commercial bank passes on to the borrowers at an even higher rate. For this reason,
commercial banks borrow from the central bank as the lender of the last resort.
v. Managing national debt: It is responsible for the sale of Government Securities or Treasury
Bills, the payment of interests on them and their redeeming when they mature.
vi. Banking supervision: In liberalized economy, central banks usually have a major role to play
in policing the economy.
vii. Operating monetary policy: Monetary policy is the regulation of the economy through the
control of the quantity of money available and through the price of money i.e. the rate of
interest borrowers will have to pay. Expanding the quantity of money and lowering the rate
of interest should stimulate spending in the economy and is thus expansionary, or
inflationary. Conversely, restricting the quantity of money and raising the rate of interest
should have a restraining, or deflationary effect upon the economy.

1. State five functions of commercial banks in a developing economy
2. Explain three reasons that led to the emergence of Non-banking financial institutions in Kenya
3. Outline the role of the central bank in an economy
4. State six functions of the money market in a developing economy
5. Describe the history of the development of money
TOPIC 12
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12.0 PUBLIC FINANCE
Meaning of Public Finance
Public finance is a branch of economics that studies the financing of public activities and the impact
of the various ways of raising government revenue and expenditure on a country‘s economy,
individual sectors of the economy and individuals.
Principles of Public Finance

The principles and nature of public finance depends according to the traditional definition of the
subject, that is, branch of Economics which deals with the income and expenditure of a government.
In the words of Adam Smith, the investment into the nature and principles of state expenditure and
state revenue is called classical view of public finance administration. The earlier economists were
perfectly justified in giving this definition of the science of public finance because the functions of
the public authorities in those days were simply to raise revenue by imposing taxes for covering the
cost of administration and defense.
The scope of the science of public finance now-a-days has widened too much. It is due to the fact
that modern states have to perform multifarious functions to promote the welfare of its citizens. In
addition to maintaining law and order within the country and provision of security from external
aggression, it has to perform many economic and commercial functions. Due to the increased
activities of the state, there has taken place a vast increase in the expenditure of the public
authorities. The sources of revenue have also increased. Taxes are levied not for raising the revenue
alone but are used as an important instrument of economic policy. Public finance now includes the
study of, financial administration and control as well. Public finance is therefore defined e as that
branch of economics which ‗deals with income and expenditure of public authorities or the state
and their mutual relation as also with the financial administration and control (the term public
authorities includes all bodies which help in carrying on the administration of the state). The study
of public finance is split up into four parts namely: Public Expenditure, Public Revenue, Public
Debt and Budgeting etc
12.1 Sources of Government Revenue

Public revenue is all the amounts which are received by the government from different sources. The
main sources of public revenue are:
(a) Taxes
Taxes are the most important source of public revenue. Any tax can be defined as an involuntary
payment by a tax payer without involving a direct repayment of goods and services (as a "quid
pro quo") in return. In other words, there are no direct goods or services given to a tax payer in
return for the tax paid. The tax payer can, however enjoy goods or services provided by the
government like any other citizen without any preference or discrimination.
In addition to the above some tax experts define tax as;
i. A compulsory contribution to a public authority, irrespective of the exact amount of service
rendered to the tax payer in return.
ii. A compulsory contribution from a person to the government to defray the expenses
incurred in the common interest of all.
iii.A compulsory contribution of wealth by a person or body of persons for the service of the
public. There is a portion of the produce of the land and labour of country that is placed at
the disposal of the government for the common good of all.
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(b) Land rent and rates
These are levies imposed on property. Rent is paid to the Central Government on some land
leases while rates are paid to the Local Authority based on the value of property
(c) Fees
Fees is an amount which is received for any direct services rendered by the Central or Local
Authority e.g. television and radio fees, national park fees, airport departure fee, airport landing
and parking fee, port fee by ships, university fee, etc.
(d) Prices
Prices are those amounts which are received by the central or local authority for commercial
services e.g. railway fare, postage and revenue stamps, telephone charges, radio and television
advertisement etc.
(e) External borrowing
This is done from foreign governments and international financial institutions such as World
Bank and International Monetary Fund (IMF).
(f) Fines and Penalties
If individuals and firms do not obey the laws of the country, fines and penalties are imposed on
them. Such fines and penalties are also the income of the government.
(f) State Property
Some land, forests, mines, national parks, etc. are government property. The income that arises
from such property is also another source of public revenue. The income will arise from
payment of rents, royalties, or sale of produce.
Public Debt/Borrowing
Public debt also known as Government debt is the debt owed by a central government or provincial
government, municipal or local government. Public debt is one method of financing government
operations, but it is not the only method. Public debt management is the process of establishing and
executing a strategy for managing a governments' debt in order to raise the required amount of
funding, achieve its risk and cost objectives and to meet any other debt management goals that a
government may have set, such as developing and maintaining an efficient market for government
securities.
Governments usually borrow by issuing securities, government bonds and bills. Less creditworthy
countries sometimes borrow directly from international organizations (e.g. the World Bank) or
international financial institutions. As the government draws its income from much of the
population, public debt is an indirect debt of the taxpayers. Government debt can be categorized as
internal debt (owed to lenders within the country) and external debt (owed to foreign lenders).
Debt servicing refers to payment of public debt and interest earned by the debts i.e. the cash that is
required for a particular time period to cover the repayment of interest and principal on a debt. Debt
service is often calculated on a yearly basis. Debt service for a country often includes such financial
obligations as a payment of internal and external debts which may include repayments for
outstanding loans or outstanding interest on bonds or the principal of maturing bonds that count
towards the government‘s debt service.
Among challenges in managing public finance are intra-organisational reforms and accountability.
Many public sector management interventions have been directed at civil service reform through
downsizing, cost containment, and improvements in management skills and knowledge through
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training. The latter has been a traditional area of activity for bilateral donors in particular. However,
the primacy of training is being challenged by hitherto relatively neglected avenues of
organisational reform. Some of these, like institution building and strategic management, have a
more comprehensive view of factors that influence organisational performance. This notion of
accountability is applicable to all levels of government, public enterprises, individuals, and groups.
Methods of ensuring accountability will naturally differ between the micro- and macro-levels of
government. At all levels, however, public accountability is intended to ensure close correlation
between stated intentions, or goals, and actions and services rendered to the public, as well as the
efficient and effective use of public resources.
12.2 Government Expenditure

Broadly speaking, government spending is for the purposes of macroeconomic goals. The spending
can be expansionary, that is aimed at growing the economy and increasing employment, or
contractionary (aimed at slowing the growth of the economy). Expansionary policy features
increased government spending and/or decreases in the tax rates, while contractionary policy is the
opposite (lower government spending and/or higher tax rates).
When governments increase their spending, crowding out can occur i.e. government spending
reduces available funds and increases the cost of capital, leading many businesses to abandon
expansion projects. Likewise, when a government spends in excess of receipts (a deficit) and must
borrow funds to finance that deficit, crowding out can occur.
From a macroeconomic perspective, government debt can be thought of as future spending brought
forth into present time. Governments incur debt when their spending desires exceed their receipts
from taxes and other income sources, and that debt is ultimately repaid through a levy of taxes in
excess of current spending.
Classification of Public Expenditure

Classification of Public expenditure refers to the systematic arrangement of different items on
which the government incurs expenditure. Different economists have looked at public expenditure
from different point of view. The following classification is a based on these different views.
a. Functional Classification
Some economists classify public expenditure on the basis of functions for which they are
incurred. The government performs various functions like defence, social welfare, agriculture,
infrastructure and industrial development. The expenditure incurred on such functions fall
under this classification. These functions are further divided into subsidiary functions. This
kind of classification provides a clear idea about how the public funds are spent.
b. Revenue and Capital Expenditure
Revenue expenditure are current or consumption expenditures incurred on civil administration,
defence forces, public health and education, maintenance of government machinery. This type
of expenditure is of recurring type which is incurred year after year. On the other hand, capital
expenditures are incurred on building durable assets, like highways, multipurpose dams,
irrigation projects, buying machinery and equipment. They are non recurring type of
expenditures in the form of capital investments. Such expenditures are expected to improve the
productive capacity of the economy.
c. Transfer and Non-Transfer Expenditure
A.C. Pigou, the British economist has classified public expenditure as Transfer expenditure and
Non-transfer expenditure. Transfer expenditure relates to the expenditure against which there is
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no corresponding return. Such expenditure includes public expenditure on National Old Age
Pension Schemes, Interest payments, Subsidies, Unemployment allowances, Welfare benefits
to weaker sections, etc. By incurring such expenditure, the government does not get anything
in return, but it adds to the welfare of the people, especially belong to the weaker sections of
the society. Such expenditure basically results in redistribution of money incomes within the
society.
The non-transfer expenditure relates to expenditure which results in creation of income or

output. The non-transfer expenditure includes development as well as non-development
expenditure that results in creation of output directly or indirectly. By incurring such
expenditure, the government creates a healthy conditions or environment for economic
activities. Due to economic growth, the government may be able to generate income in form of
duties and taxes.
d. Productive and Unproductive Expenditure
This classification was made by Classical economists on the basis of creation of productive
capacity. Productive Expenditure is Expenditure on infrastructure development, public
enterprises or development of agriculture increase productive capacity in the economy and
bring income to the government. Unproductive Expenditure is Expenditures in the nature of
consumption such as defence, interest payments, expenditure on law and order, public
administration which do not create any productive asset which can bring income or returns to
the government.
e. Grants and Purchase Price
This classification has been suggested by economist Hugh Dalton. Grants are those payments
made by a public authority for which there may not be any quid-pro-quo, i.e., there will be no
receipt of goods or services. For example, old age pension, unemployment benefits, subsidies,
social insurance, etc. Grants are transfer expenditures. Purchase prices are expenditures for
which the government receives goods and services in return. For example, salaries and wages
to government employees and purchase of consumption and capital goods
Hugh Dalton further classified public expenditure as follows:-

i. Expenditures on political executives: i.e. maintenance of ceremonial heads of state,
like the president.
ii. Administrative expenditure: to maintain the general administration of the country, like
government departments and offices.
iii. Security expenditure: to maintain armed forces and the police forces.
iv. Expenditure on administration of justice: include maintenance of courts, judges,
public prosecutors.
v. Developmental expenditures: to promote growth and development of the economy,
like expenditure on infrastructure, irrigation, etc.
vi. Social expenditures: on public health, community welfare, social security, etc.
vii. Public debt charges: include payment of interest and repayment of principle
amount. f. Classification According to Benefits
Public expenditure can be classified on the basis of benefits they confer on different groups of
people as follows;
i. Common benefits to all: Expenditures that confer common benefits on all the people.
E.g. expenditure on education; public health; transport; defence; law and order;
general administration etc
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ii .Special benefits to all : Expenditures that confer special benefits on all. For example,
administration of justice, social security measures, community welfare.
iii. Special benefits to some: Expenditures that confer direct special benefits on certain
people and also add to general welfare. For example, old age pension, subsidies to
weaker section, unemployment benefits.
Reasons for Public Expenditure

a) To supply goods and services that the private sector would fail to do, such as public goods,
including defence, roads and bridges; merit goods, such as hospitals and schools; and welfare
payments and benefits, including unemployment and disability benefit.
b) To achieve supply-side improvements in the macro-economy, such as spending on education and
training to improve labour productivity.
c)To reduce the negative effects of externalities, such as pollution controls.
d)To subsidize industries which may need financial support, and which is not available from the
private sector. For example, transport infrastructure projects are unlikely to attract private
finance, unless the public sector provides some of the high-risk Agriculture is also an industry
which receives large government subsidies.
e) To help redistribute income and achieve more equity.
f) To inject extra spending into the macro-economy, to help achieve increases in aggregate demand
and economic activity. Such a stimulus is part of discretionary fiscal policy.
National Budget
A national budget is a detailed plan outlining the acquisition and use of financial and other
resources over some period of time in the future or an estimation of the revenue and expenses over a
specified future period of time in a country. A budget can also be made for a person, family, group
of people, business, government, multinational organization or just about anything else that makes
and spends money. A budget is a microeconomic concept that shows the tradeoff made when one
good is exchanged for another.
Role of budgeting in public

finance a. Coordination
The budgetary process requires that visible detailed budgets are developed to cover each sector,
department or function in the country. This is only possible when the effort of one sector /
department‘s budget is related to the budget of another sector/ department. In this way,
coordination of activities, function and department is achieved.
b. Communication
The full budgeting process involves liaison and discussion among all levels in government. Both
vertical and horizontal communication is necessary to ensure proper coordination of activities.
The budget itself may also act as a tool of communication of what is expected of the government.
High standards set calls for hard work and more input in terms of labour, time and other
resources.
c. Control
This is the process for comparing actual results with the budgeted results and reporting upon
variances. Budgets set a control gauge, which assists to accomplish the plans set within agreed
expenditure limits. The approach followed in the control process has five basic steps:
(i) Preparation of budgets based on the predetermined data on performance and prices.
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(ii) Measurement of actual performance and recording the data.
(iii) Comparing the budget with the actual performance and recording the difference.
(iv) Ascertaining reasons for the differences through, including others, variance analysis.
(v) Taking corrective actions through administering of proper strategies and measures.
d. Motivation
Budgets may be seen as a bargaining process in which ministries compete with each other for
scarce resources. Budgets set targets, which have to be achieved. Where budgetary targets are
tightly set, some individuals will be positively motivated towards achieving them. Involvement of
citizens in the preparation of budgets motivates them towards achieving the goals they have set
themselves. However, imposing budgets on citizens will be discouraging as they may perceive
the targets as unattainable.
e. Clarification of Responsibility and Authority
Budgetary process necessitates the organization of a ministries / Sectors into responsibility and
budget centers with clear lines of responsibilities of each manager. This reduces duplication of
efforts. Each manager manages those items directly under his or her control. To facilitate
effective responsibility accounting, authority and responsibility relationship must be balanced.
f. Planning
It is by Budgetary Planning that long-term plans are put into action. Planning involves
determination of objectives to be attained at a future predetermined time. When monetary values
are attached to plans they become budgets. Good planning without effective control is time
wasted. Unless plans are laid down in advance, there are no objectives towards which control can
be affected.
12.3 Purpose of Taxation

Taxation is the process of imposing compulsory contribution on the private sector to meet the
expenses which are incurred for a common good.
Purpose of Taxation
The raising of revenue is not the only purpose for which taxes are levied. The taxes are levied for
various purposes as follows:
a. Raising Revenue
The main purpose of imposing taxes is to raise government income or revenue. Taxes are the
major sources of government revenue. The government needs such revenue to maintain the
peace and security in a country, to increase social welfare, to complete development projects
like roads, schools, hospitals, power stations, etc.
b. Economic Stability
Taxes are also imposed to maintain economic stability in a country. In theory, during inflation,
the government imposes more taxes in order to discourage the unnecessary expenditure of the
individuals. On the other hand, during deflation, the taxes are reduced in order to encourage
individuals to spend more money on goods and services. The increase and decrease in taxes
helps to check the big fluctuations in the prices of goods and services and thus maintain the
economic stability.
c. Protection Policy
Where a government has a policy of protecting some industries or commodities produced in a
country, taxes may be imposed to implement such a policy. Heavy taxes are therefore imposed
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on commodities imported from other countries which compete with local commodities thus
making them expensive. The consumers are therefore encouraged to buy the locally produced
and low priced goods and services.
d. Social Welfare
Some commodities such as wines, spirits, beer, cigarettes, etc. are harmful to human health.
To discourage wide consumption of these harmful commodities, taxes are imposed to make
the commodities more expensive and therefore out of reach of as many people as possible.
e. Fair Distribution of Income
In any country, some people will be rich and others will be poor due to limited opportunities
and numerous hindrances to becoming wealthy. Taxes can be imposed which aim to achieve
equality in the distribution of national income. The rich are taxed at a higher rate and the
amounts obtained are spent on increasing the welfare of the poor. That way, the taxes help to
achieve a fair distribution of income in a country.
f. Allocation of Resources
Taxes can be used to achieve reasonable allocation of resources in a country for optimum
utilization of those resources. The amounts collected from taxes are used to subsidise or
finance more productive projects ignored by private investors. The government may also
remove taxes on some industries or impose low rates of taxes to encourage allocation of
resources in that direction
g. Increase In Employment Funds collected from taxes can be used on public works programmes
like roads, drainage, and other public buildings. If manual labour is used to complete these
programmes, more employment opportunities are created.
Principles of Taxation
These are the principles of an optimal tax system, also known as Canons of taxation, some of which
were laid down by Adam Smith.
a. Simplicity: A tax system should be simple enough to enable a tax payer to understand it and be
able to compute his/her tax liability. A complex and difficult to understand tax system may
produce a low yield as it may discourage the tax payer's willingness to declare income. It may
also create administrative difficulties leading to inefficiency. The most simple tax system is
where there is a single tax. However, this may not be equitable as some people will not pay
tax.
b. Certainty: The tax should be formulated so that tax payers are certain of how much they have
to pay and when. The tax should not be arbitrary. The government should have reasonable
certainty about the attainment of the objective(s) of that tax, the yield and the extent to which
it can be evaded. There should be readily available information if tax payers need it. Certainty
is essential in tax planning. This involves appraising different business or investment
opportunities on the basis of the possible tax implications. It is also important in designing
remuneration packages. Employers seek to offer the most tax efficient remuneration packages
which would not be possible if uncertainty exists.
c. Convenience
The method and frequency of payment should be convenient to the tax payer e.g. PAYE. This
may discourage tax evasion. For example, it may be difficult for many tax payers to make a
lumpsum payment of tax at the year-end. For such taxes, the evasion ratio is quite high.
d. Economic/Administrative Efficiency
A good tax system should be capable of being administered efficiently. The system should
produce the highest possible yield at the lowest possible cost both to the tax authorities and
the
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tax payer. The tax system should ensure that the greatest possible proportion of taxes collected
accrue to the government as revenue.
e. Taxable Capacity
This refers to the maximum tax which may be collected from a tax payer without producing
undesirable effects on him. A good tax system ensures that people pay taxes to the extent they
can afford it. There are two aspects of taxable capacity.
i) Absolute taxable capacity
ii) Relative taxable capacity
Absolute taxable capacity is measured in relation to the general economic conditions and
individual position e.g. the region, or industry to which the tax payer belongs. If an individual,
having regard to his circumstances and the prevailing economic conditions pays more tax than
he should, his taxable capacity would have been exceeded in the absolute sense. Relative
taxable capacity is measured by comparing the absolute taxable capacities of different
individuals or communities.
f. Neutrality
Neutrality is the measure of the extent to which a tax avoids distorting the workings of the
market mechanism. It should produce the minimum substitution effects. The allocation of
goods and services in a free market economy is achieved through the price mechanism. A
neutral tax system should not affect the tax payer's choice of goods or services to be
consumed.
g. Productivity
A tax should be productive in the sense that it should bring in large revenue which should be
adequate for the government. This does not mean overtaxing by the government. A single tax
which brings in large revenues is better than many taxes that bring in little revenue. For
example Value Added Tax was introduced since it would provide more revenue than Sales
Tax
h. Elasticity or Buoyancy
By elasticity we mean that the government should be capable of varying (increasing or
reducing) rates of taxation in accordance to the circumstances in the economy, e.g. if
government requires additional revenue, it should be able to increase the rates of taxation.
Excise duty, for instance, is imposed on a number of commodities locally manufactured and
their rates can be increased in order to raise more revenue. However, care must be taken not to
charge increased rate of excise duty from year to year because they might exert inflational
pressures on the economy.
i. Flexibility
It means that there should be no rigidity in taxation i.e. the tax system can be changed to meet
the revenue requirement of the state; both the rate and structure of taxes should be capable of
change or being changed to reflect the state‘s requirements. Such that certain old taxes are
discouraged while new ones are introduced. The entire tax structure should be capable of
change.
j. Diversity
It means that there should be variety or diversity in taxation. That the tax base should be wide
enough so as to raise adequate revenue and also the tax burden is evenly distributed among the
tax payers. A single tax or a few taxes may not meet revenue requirements of the state. There
should be both direct and indirect taxes.
k. Equity
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A good tax system should be based on the ability to pay. Equity is about how the burden of
taxation is distributed. The tax system should be arranged so as to result in the minimum
possible sacrifice. Through progressive taxation, those with high incomes pay a large amount
of tax as well as a regular proportion of their income as tax. Equity means people in similar
circumstances should be given similar treatment (horizontal equity) and dissimilar treatment
for people in dissimilar circumstances (vertical equity). There are three alternative principles
that may be applied in the equitable distribution of the tax burden which are; The benefit
principle, The ability to pay principle and The cost of service principle
Types of Taxes
Taxes can be classified on the basis
of: a. Impact and incidence of the
taxes
Impact of tax means on whom the tax is imposed. On the other hand, incidence of the tax
refers to who had to bear the burden of the tax i.e. who finally pays the tax. In this case the
taxes may be: Direct or Indirect
b. Rates of tax
The rate of tax is the percentage of the tax base to be taken in each situation. In this case the
taxes may be: progressive or proportional or regressive or digestive
i) Direct taxes
A direct tax is one where the impact and incidence of the Tax is on the same person e.g. Income
Tax, death or estate duty, corporation taxes and capital gains taxes. It can also be defined as the tax
paid by the person on whom it is legally imposed.
Merits of direct taxes

a. They satisfy the principle of equity as they are easily matched to the tax payers capacity to pay
once assessed.
b.They satisfy the principles of certainty and convenience to tax payers as they know the time and
manner of payment, and the amount to be paid in the case of these taxes. Similarly, the
government is also certain as to the amount of money it shall receive from these taxes.
c. They satisfy the Canon Simplicity as they are easy to understand.
d.Because most of them are progressive, they tend to reduce income inequalities as the rich are
taxed heavily through income tax, wealth tax, expenditure tax, excess profit, gift tax, etc.
e. Because the public are paying taxes to the government, they take an interest in the activities of
the state as to whether the public expenditure is incurred on public welfare or not. Such civic
consciousness puts a check on the wastage of the public expenditure in a democratic country.
Demerits of direct taxes
a) Heavy direct taxation, especially when closely linked to current earnings, can act as a serious
check to productivity by encouraging absenteeism and making men disinclined to work.
b) Heavy direct taxation will clearly reduce people‘s ability to save since it leaves them with less
money to spend.
c) Direct taxes possess an element of arbitrariness in them. They leave much to the discretion of the
taxation authorities in fixing the rates and in interpreting them.
d) They are not imposed on all as incomes earned on subsistence and non legal activities are left
out.
e) Cost of collection is generally high.

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f) These taxes are easily evaded either by understating the source of income or by any other means.
Such taxes thus cultivate dishonesty and there is loss of revenue to the state.
ii) Indirect taxes

These are imposed on an individual mostly producers or traders but they can be passed on to be
borne by others usually the final consumers. They can also be defined as taxes where the incidence
is not on the person on whom it‘s legally imposed. They include excise duties, sales tax, Value
Added Tax and others.
Advantage of indirect taxes
a) They are less costly to administer because the producers and sellers themselves deposit them
with the government.
b)If levied on goods with inelastic demand with respect to price rises, it will result in high revenue
collection.
c)Indirect taxes reach the pockets of all income groups. Thus, they have a wide coverage, and
every consumer pays to the state exchequer according to his ability to pay.
d)They can check on the consumption of harmful goods like wine, cigarettes and other toxicants.
e) Can be used as a powerful tool for implementing economic policies by the government. e.g the
government wants to protect domestic industries from foreign competition, it can levy heavy
import duties which will help to develop domestic industries.
Disadvantages of indirect taxes
a) Most indirect taxes are regressive as they are based are not based on ability to pay. The rich
and the poor are required to pay the same amount of tax on such commodities as matches,
kerosene, toilet soap, washing soap, toothpaste, blades, shoes, etc
b) They may lead to inflation as their imposition tends to raise the prices of commodities, thereby
leading to higher costs, to higher wages, and again to higher prices. Thus a price-wage cost
spiral sets in the economy
c) They sometimes have adverse effects on production of commodities, and even employment.
When the price of a commodity increases with the levy of a tax, its demand falls. As a result,
its production falls, and so employment.
d) The revenue from indirect taxes is uncertain because it is not possible to accurately estimate
the effect of such taxes on the demand for products.
iii) Progressive tax

A progressive income tax system is one where the higher the income, the greater the proportion
paid in taxes. This is effected by dividing the taxpayers‘ incomes into bands (brackets) upon which
different rates of tax are paid – the rates being higher and the band of income. For example, in
Kenya, the tax bands are as follows with effect from 2005: First KShs. 121,968 @ 10%
Next KShs.114, 912 @ 15%
Next KShs.114, 912 @ 20%
Next KShs.114, 9120 @ 25%
Above KShs. 466,704 @ 30%.
Examples of Progressive taxes in Kenya are Income Tax, Estate Duty, Wealth Tax and Gift Tax.
Advantages of progressive tax
a) It is more equitable. The broader shoulders are asked to carry the heavier burden.
b) It satisfies the canon of productivity as it yields much more than it would under proportional
taxation.
c) It satisfies the canon of equity as it brings about an equality of sacrifice among the taxpayers.
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d) To some extent it reduces inequalities of wealth distribution.
Disadvantages of progressive tax
a) High progressive tax makes work and extra effort become less valuable.
b) The effect on the willingness to accept risk i.e. High marginal rates of tax are likely to make
entrepreneurs less willing to undertake risks.
c) Effects on mobility i.e. some financial inducement is usually required if people are to be asked
to change their location, or undergo training, or accept promotion. Progressive taxation by
reducing differentials is likely to have some effect on a person‘s willingness to any of the
above.
d) Encourages tax avoidance and evasion.
e) Outflow of high achievers to other countries with lower Marginal tax rates.
d) It can lead to fiscal-drag where wage and price inflation cause people to pay higher proportion
of income as tax.
iv) Proportional tax

Is where whatever the size of income, the same rate or same percentage is charged. Examples
are commodity taxes like customs, excise duties and sales tax. Its advantage is that it‘s much
simpler than progressive taxation.
v) Regressive tax
A tax is said to be regressive when its burden falls more heavily on the poor than on the rich. No
civilized government imposes a tax like this.
vi) Digressive tax
A tax is called digressive when the higher incomes do not make a due contribution or when the
burden imposed on them is relatively less. Another way in which digressive tax may occur is
when the highest percentage is set for that given type of income one which it is intended to exert
most pressure; and from this point onwards, the rate is applied proportionally on higher incomes
and decreasing on lower incomes, falling to zero on the lowest incomes.
Economic effects of taxation

a) A deterrent to work: Heavy direct taxation, especially when closely linked to current earnings,
can act as a serious check to production by encouraging absenteeism, and making men disinclined
to work. However, indirect taxation may actually increase the incentive to work, since the more
money is then required to satisfy the same wants, indirect taxes having made goods dearer than they
were before.
b. A deterrent to saving: Taxation will clearly reduce people‘s ability to save since it leaves them
with less money to spend. Taxation may, therefore, act as a deterrent to saving. However, this
will not always be the case, as it will depend on the purpose for which people are saving.
c. A deterrent to enterprise: It is argued that entrepreneurs will embark upon risky undertakings
only when there is a possibility of earning large profits if they are successful. Heavy taxation of
profits, robs them of their possible reward without providing any compensation in the case of
failure. As a result, production is checked and economic progress hindered
d) Taxation may encourage inflation: Under full employment increased indirect taxation will lead to
demand for higher wages, thereby encouraging inflation. A general increase in purchase taxes
pushes up the Index of Retail Prices, and so brings in its train demands for wage increase.
e) Diversion of economic resources: Taxation of commodities is similar in effect to an increase in
their cost of production. Thus, the influence of a change of supply has to be considered, effect
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depending on their elasticity of demand. In consequence of taxation, resources will move from
heavily taxed to more lightly taxed forms of production. This result may, of course, be desired on
Non-economic grounds.
Fiscal Policy
Fiscal policy has been defined in a number of ways. According to Samuelson, by fiscal policy we
mean the process of shaping taxation and public expenditure in order to (a) help dampen the swings
of the business cycle and (b) to contribute to the maintenance of a growing high employment
economy. In the words of Arthur Smith, fiscal policy means ―policy under which the government
uses its expenditure and revenue programmes to produce desirable effects and to avoid undesirable
effects on the national income, production and employment‖. Roger defines fiscal policy as,
―changes in taxes and expenditure which aim at short run goals of full employment and price level
stability‖.
Fiscal policy also called budgetary policy is a powerful instrument in the hands of the government
to intervene in the economy. Fiscal policy relates to a variety of measures which are broadly
classified. as (a) taxation (b) public expenditure and (c) public borrowing. Fiscal policy is
considered an essential method for achieving, the objectives of development both in developed and
underdeveloped countries of the world.
Importance of Fiscal Policy
The role of fiscal policy in less developed countries differs from that in developed countries. In the
developed countries, the role of fiscal policy is to promote fall employment without Inflation
through its spending and taxing powers. On the other hand, The LDC‘s or developing countries are
caught in a vicious circle of poverty. The vicious circle of low income, low consumption, low
savings, low rate of capital formation and therefore low income has to be broken by a suitable fiscal
policy. Fiscal policy in developing countries is thus used to achieve objectives which are different
from the advanced countries. The principal roles of fiscal policy in a developing economy are:
(i) To mobilize resources for financing development.
The moping up of surplus resources through taxation is an effective means of raising
resources for capital formation. A rise in tax rates causes a reduction in aggregate demand
for three reasons (1) it reduces consumption (2) It reduces investment and (3) it reduces net
exports. A fall in the tax rates has the opposite effect. Agriculture sector is another important
source. of revenue which can be tapped for capital formation. With the use of improved
methods of cultivation, the agricultural production has fairly increased. It is, therefore,
justified that this largest sector of the economy should be brought under progressive tax net.
The government will not only raise large amount of revenue but also remove the disparity
between agriculture income and non agriculture income for tax purpose.
(ii) To promote economic growth in the private sector.
In a mixed economy, private sector constitutes an important part of the economy. While
framing fiscal policy, the interests of the private sector should not be ignored. The private
sector should make significant contribution to the development of the economy. The fiscal
methods for stimulating private investment in developing countries are: exempting Tax on
national saving and other approved forms of saving from taxation, to encourage private
savings; raising the rates of return on voluntary contribution to provident fund, insurance
premium etc., as an incentive to save; offering preferential rates or exempting the retained
profits of the public companies from taxation to boost private investment; Private investment
can being stimulated by giving tax holidays or relief from tax for some specified
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period of time to certain selected industries as well as granting rebates and liberal
depreciation allowances can also be granted to encourage investment in the private sector.
(iii) To control inflationary pressure in the economy.
In developing countries there is a tendency of the general prices to go up due to
expenditure on development projects, pressure of wages on prices, long gestation period
between investment expenditure and production etc. Fiscal measures are used to counter act
the effect of inflationary pressure. Tax structure is devised in such a manner that it mops up
a major proportion of the rise in income. Government also tries to reduce its own spending
and achieve budgetary surplus. It helps in reducing inflationary pressure in the economy.
(iv)To promote economic stability with employment opportunities
The ultimate objective of economic development is to increase conditions of employment
and to provide rising standard of living.
(v) To ensure equitable distribution of income and wealth.
A wider measure of equality in income and wealth is an integral part of economic
development and social advance. The fiscal operations if carefully worked out can bring
about a redistribution of income in favor of the poorer sections of the society. The
government can reduce the high bracket incomes by imposing progressive direct taxes. For
raising the income of the poor above the poverty line and narrowing the gap between rich
and poor, the government can take direct investment on economic and social overheads.
12.4 Review questions

1. Explain four classes of public expenditure
2. Outline five negative effects of taxation
3. Explain the five basic steps of control process in budgeting
4. Distinguish between monetary policy and fiscal policy
6. Discuss five canons of taxation
7. Briefly discuss the role of budget in public finance
TOPIC 13
13.0 UNEMPLOYMENT
13.1 Meaning of Unemployment
Employment refers to engagement in any type of income generating activity. A country can be said
to have attained full employment if all the people who are willing and able to work are employed.
Unemployment generally refers to a state / situation where factors of production (resources) are
readily available and capable of being utilized at the ruling market returns/rewards but they are
either underemployed or completely unengaged. Labour unemployment is considered to be a
situation where there are people ready, willing and able to work at the going market wage rate but
they cannot get jobs. This definition focuses only on those who are involuntarily not employed. All
countries suffer unemployment but most developing countries experience it at relatively higher
degree. Employment can be divided into informal and formal. Formal employment is government
regulated, and workers are assured a wage and certain rights. Informal employment takes place in
small, unregistered enterprises and employs the majority of the employees in Kenya. Self-
employment is also mostly informal
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Unemployment rate shows the number of people unemployed expressed as a percentage of total
labour force at a point in time i.e.
Number of people unemployed x100

Total workforce
13.2 Types of Unemployment

a) Open involuntary unemployment: This occurs when a person is willing to work at the ruling
wage rate but is not able to secure a job. This concept is particularly relevant in modern urban
sector where many young people aspire to get jobs and are unable to do so.
b) Disguised or „hidden‟ unemployment occurs when the work available to a given workforce is
insufficient of keep it fully employed so that some members of the workforce could be
withdrawn without loss of output. E.g. the civil service in many developing countries often
exceeds the required number, hence the marginal product of labour in these cases is zero and
does not contribute to any national output. Disguised unemployment is also common in rural
areas in developing countries where agriculture is practiced. Many such individuals working in
small plots of land are infact in disguised unemployment since they could be withdrawn without
a fall in output because their marginal product is zero or even negative.
c) General unemployment is that which is spread throughout the economy and not confined to a
particular region or categories of labour.
d) Structural unemployment, unlike general employment, is that which affects particular regions or
categories of labour and results from an imbalance between the supply of a particular group of
workers and the demand for their services. An example of how such an imbalance can occur is
where technological change makes the product on which a particular industry is based obsolete
or new methods of production render labour with particular skills redundant. On the demand
side, changes in consumer taste, competition from substitute products or new products in
different areas may be responsible.
e) Seasonal unemployment: Regular seasonal unemployment is caused by annual variations in
seasons, which affect economic activities in sectors such as agriculture, fisheries, construction
and tourism. During peak seasons in the season, demand for labour will be very high whereas
during the off-peak season, there will be a significant drop in this demand.
f) Frictional unemployment: this is unemployment which arises from immobility in the labour force
rather than from lack of demand for labour. It is essentially short term in nature and includes
unemployment which arises when people are changing jobs or because of lack of knowledge
about job opportunities. It usually takes time to match prospective employees with employers
and individuals will be unemployed during the search period.
g) Demand deficient or cyclical unemployment: This type of unemployment is associated with the
trade cycle. During the recovery and boom phases of the trade cycle, the demand for output and
labour is high and unemployment is low. On the other hand, during recession and depression,
the demand for output and labor falls and unemployment rises sharply. Demand deficient
unemployment can be relatively long term in nature, however it can be eradicated by demand
management policies.
13.3 Causes of Unemployment

It is obvious that the unemployment situation is grim indeed. It has, therefore, to be tackled with
appropriate measures and on an urgent basis. The major causes which have been responsible for the
wide spread unemployment can be spelt out as under.
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a) Rapid Population Growth:
It is the leading cause of unemployment. In many developing countries, particularly in rural
areas, the population is increasing rapidly. This has adversely affected the unemployment
situation largely in two ways. In the first place, the growth of population directly encourage the
unemployment by making large addition to labour force because the rate of job expansion could
never have been as high as population growth would have required. Increasing labour force
requires the creation of new job opportunities at an increasing rate. But in actual practice
employment expansion has not been sufficient to match the growth of the labor force.
Secondly; the rapid population growth indirectly affect unemployment situation by reducing the
resources for capital formation. It means large additional expenditure on their rearing up,
maintenance, and education. As a consequence, more resources get used up in private
consumption such as food, clothing, and shelter as well as on public consumption like drinking
water, electricity medical and educational facilities. This reduces the opportunities of diverting a
larger proportion of incomes to saving and investment.
b) Limited land:
Land is the gift of nature. It is always constant and cannot expand like population growth. Since,
population is increasing rapidly, the land is not sufficient for the growing population. As a
result, there is heavy pressure on the land. In rural areas, most of the people depend directly on
land for their livelihood. Land is very limited in comparison to population. It creates the
unemployment situation for a large number of persons who depend on agriculture in rural areas.
c) Seasonal Agriculture:
In Rural Society agriculture is the only means of employment. However, most of the rural people
are engaged directly as well as indirectly in agricultural operation. But, agriculture is basically a
seasonal affair that depends on rainfall. It provides employment facilities to the rural people
only in a particular season of the year. For example, during the sowing and harvesting period,
people are fully employed and the period between the post harvest and before the next sowing
they remain unemployed. It has adversely affected their standard of living.
d) Fragmentation of land:
In many developing countries, the heavy pressure on land of large population results to the
fragmentation of land. It creates a great obstacle in the part of agriculture. As land is fragmented
and agricultural work is being hindered the people who depend on agriculture remain
unemployed. This has an adverse effect on the employment situation. It also leads to the poverty
of villagers.
e) Backward Method of Agriculture:
The method of agriculture is very backward. Till now, the rural farmers follow the old farming
methods. As a result, the farmer cannot feed properly many people by the produce of his farm
and he is unable to provide his children with proper education or to engage them in any
profession. It leads to unemployment problem.
f) Decline of Cottage Industries:
Village or cottage industries are the only means of employment particularly of the landless people.
They depend directly on various cottage industries for their livelihood. But, now-a-days, these
are adversely affected by the industrialisation process. Actually, it is found that they cannot
compete with modern factories in matter or production. As a result of which the village
industries suffer a serious loss and gradually closing down. Owing to this, the people who work
in there remain unemployed and unable to maintain their livelihood.
g) Defective education:
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The day-to-day education is very defective and is confined within the class room only. Its main
aim is to acquire certificate only. The present educational system is not job oriented; it is degree
oriented. It is defective on the ground that is more general than the vocational. Thus, the people
who have getting general education are unable to do any work. They are to be called as good for
nothing in the ground that they cannot have any job here, they can find the ways of self
employment. It leads to unemployment as well as underemployment.
h) Lack of transport and communication:
In rural areas, there are no adequate facilities of transport and communication. Owing to this, the
village people who are not engaged in agricultural work remain unemployed because they are
unable to start any business for their livelihood and they are confined only within the limited
boundary of the village. It is noted that the modern means of transport and communication are
the only way to trade and commerce. Since there is lack of transport and communication in rural
areas, therefore, it leads to unemployment problem among the villagers.
i) Inadequate Employment Planning:
The employment planning of the government is not adequate in comparison to population growth.
The employment opportunities do not increase according to the proportionate rate of population
growth. As a consequence, a great difference is visible between the job opportunities and
population growth. On the other hand it is a very difficult task on the part of the Government to
provide adequate job facilities to all the people. Besides this, the government also does not take
adequate step in this direction. The faulty employment planning of the Government expedites
this problem to a great extent. As a result the problem of unemployment is increasing day by
day.
13.4Ways of Managing Unemployment

The measures appropriate as remedies for unemployment will clearly depend on the type and cause
of unemployment. Broadly they can be divided into: demand management or demand side policies
and supply side policies.
Demand management policies
These policies are intended to increase aggregate demand and, therefore the equilibrium level of
national income. They are sometimes called fiscal and monetary policies. The principal policy
instruments are:
 Supporting declining industries with public funds
 Instituting proper demand management policies that increase aggregate demand including
exploiting foreign and regional export markets. This can be done by increasing government
expenditure, cutting taxation or expanding the money supply.
 Promoting the location of new industries in rural areas which will require an improvement
of rural infrastructure.
Supply-side policies
Supply-side policies are intended to increase the economy‘s potential rate of output by increasing
the supply of factor inputs, such as labour inputs and capital inputs, and by increasing productivity.
They include:
 Increasing information dissemination on market opportunities.
 Reversing rural-urban migration by making rural areas more attractive and capable of
providing jobs. This particularly is the case in developing countries where rural-non-farm
opportunities offer the longest employment opportunities.
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 Changing attitude towards work i.e. eliminating the white-collar mentality and
creating positive attitudes towards agriculture and other technical vocational jobs.
 Provision of retraining schemes to keep workers who want to acquire new skills to
improve their mobility.
 Assistance with family relocation to reduce structural unemployment. This is done
by giving recreational facilities, schools, and the quality of life in general in other parts of
the country even the provision of financial help to cover moving costs and assist with home
purchase.
 Special employment assistance for teenagers many of them leave school without
having studied work-related subjects and with little or no work experience.
 Subsidies to firms which reduce working hours rather than the size of the workforce.
 Reducing welfare payments to the unemployed. There are many economists who
believe that welfare payments have artificially increased the level of unemployment.
 Reduction of employee and trade union rights.

1. Outline five supply related policies that can be used to reduce unemployment in a country
2. Briefly explain how a nation can solve its unemployment problems
3. Discuss five factors that may contribute to increase in unemployment in a country
KNEC Revision Papers
KNEC JULY 2011
1.a) Explain the factors that may affect price elasticity of demand for a commodity. [12marks]
b) One of the factors that can affect the supply of a commodity in a country is government policy.
Outline the ways in which such government policy may negatively affect supply. [8marks]
2.a) With the aid of a diagram, explain the effect of a positive shift in the demand curve of a
commodity, on equilibrium price and output of the commodity. [10 marks] b) Outline
the assumptions behind the application of the law of diminishing returns in production.
[10 marks]
3. a) Explain the reason that may account for the survival of the small firm despite the economies
that firm enjoy from large scale production. [10marks]
b) Describe the characteristics of a perfectly competitive market. [10 marks]
4. a) Highlight the factors that may account for the differences in wages paid to different categories
of labour in a country. [12marks] b) Explain the problems that
may be encountered in the measurement of national income using the
income approach. [8marks]
5. a) Outline the factors that can lead to demand – pull inflation in a country. [10 marks]
b) One of the stages in the evolution of money was the use of commodity money. Highlight the
reasons that may have led to the abandonment of the use of this form of money. [10marks]
6. a) Outline the functions of commercial banks in an economy. [8marks]

b) With the aid of a diagram, explain how a monopolist may earn abnormal profits. [12marks]
138

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7. a) The level of unemployment in country X is about 20% of the working population. Explain the
7. a) Explain the factors that may determine the supply of labour services in a
country. b) Describe the monetary measures that be used to control inflation in a

possible causes of such high level of unemployment. [12marks]
b) Highlight the sources of government revenue other than taxation. [8 marks]
KNEC NOVEMBER 2012

1. a) Highlight the services offered by merchant banks to corporate customers apart from taking
deposits and giving loans. [12marks] b) Outline the circumstances that may lead to a shift to the
left of the supply curve of a
commodity. [8 marks]
2. a) With the aid of a diagram, explain the effect of fixing the price of a commodity below the
equilibrium level [12 marks]
b) Outline the sources from which a firm would derive its monopoly power. [8marks]
3.a)With the aid of a diagram explain the relationship between fixed variable and total costs of a
firm. [12marks] b) One of the methods of
measuring the national income of a country is the expenditure approach. Describe the items of
expenditure that should be included in this approach. [8marks]
4. a) With the aid of a diagram, explain the concept of the kinked demand curve as it applies in an
oligopolistic market structure. [8marks]
b) Highlight the factors that determine the efficiency of labour as a factor of production.
[8 marks]
5. a) Outline the reasons that make it necessary for a country to measure its national income.
[10marks
]
b) Explain the different forms of unemployment that may be experienced in a country.

[10marks]
6. a) Describe the stages through which money has evolved upto the present form. [12marks]
b) Highlight the types of non –recurrent expenditures that may be incurred by a government.
[8marks
]
[12marks
]
[8marks]
139

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Economics Notes - 1

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TABLE OF CONTENTS

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1 INTRODUCTION TO -Meaning of the term economics

4 PRICE -Concept of price determination

5 PRODUCTION -Meaning of production

8 LABOUR MARKET -Meaning of demand and supply of labour

9 NATIONAL INCOME -Meaning of national income

10 INFLATION -Meaning of inflation

11 MONEY AND -Concept of money

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13 UNEMPLOYMENT -Meaning of unemployment

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1.1 The Meaning of Economics

Reasons for Studying Economics

1.2 The Scope of Economics

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1.3 Human wants

Types of Human wants

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Characteristics of Human Wants:

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1.4 Economic resources

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1.5 scarcity and choice

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1.7 Resource Allocation

Significance of resource allocation

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Economic Systems and Resource Allocation

The features of a free market system are:

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Resource allocation in a free enterprise

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Disadvantages of a Free Economy

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c)The Mixed Economy

Features of this system

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1.8 Review Questions

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2.1 Concept of Demand

Abnormal Demand Curves

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Different types of demand

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Shift and Movement along Demand

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b) Shifts in Demand Curve

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Factors That Cause Shifts in Demand Curve

2.2 Factors Determining Demand of a Product

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b)The Price of Related Goods

d) Changes in taste, fashion and preferences of consumers

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2.3 The Concept of Elasticity of Demand

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