f5 Guide To Economics

FIRST EDITION
ECONOMICS
ADVANCED
LEVEL
FOR CAMBRIDGE AND ZIMSEC
ADBEL MUSENDO
Tinofamba nevanofamba
UNDERSTANDING ECONOMICS Page 1

CONTENTS PAGE
TOPIC PAGE
Introduction to new learners 3
Economic Resources 7
Tools for economic analysis 46
Demand Theory 62
Supply Theory 85
Theory of Firm 109
Theory of Distribution 138
Government Intervention in the economy 163
International Trade 174
Measurement of Economic Perfomance 205
Money and Price Level 225
Macro-economic Problems and Policies 236

WHAT IS ECONOMICS?
• Economics is a social science that examines how people choose among the alternatives
available to them.
• Is the study of efficient allocation of scarce resources to satisfy unlimited human wants
and needs.
• It is based on assumptions that is Ceteris paribus.
Ceteris paribus
Means other things held constant or not changing. It is used to isolate the effects of one variable
on another variable by assuming other variables are held constant or have no effect.
ECONOMICS IS DIVIDED INTO MICROECONOMICS AND MACROECONOMICS
Microeconomics
• Micro means small.
• Is concerned with the study of the market system on a small scale.
• It looks at the individual markets that make up the market system.
• Is concerned with the choices made by small economic units such as individual
consumers, individual firms, or individual government agencies.
Macroeconomics
• Macro means large.
• Is concerned with the study of the market system on a large scale.
• It considers the aggregate performance of all markets in the market system.
• Is concerned with the choices made by the large subsectors of the economy.
• For example the household sector, which includes all consumers; the business sector,
which includes all firms; and the government sector, which includes all government
agencies.

ECONOMICS DEALS WITH TWO STATEMENTS
a. Positive statements.
• It deals with objective statements or facts that can be tested by looking at the
available evidence and the testing and rejection of theories.
• For example:
 If the government raises the tax on beer, this will lead to a fall in profits of
the brewers.
b. Normative Statements.
• It deals with subjective statements or people’s opinions (value judgments)

which can not be tested and rejected by looking available evidence.
• For example:
 The retirement age should be raised to 70 to combat the effects of our

ageing population.

1. In economics a statement is positive if it
A. Examines the desirability of government economic policy
B. Assumes current economic conditions remain unchanged
C. Concerns factual outcomes of an economic action
D. Is based upon the opinion of an economic advisor
2. Which of the following is a positive statement
A. The government should be worried about unemployment in the economy
B. The best level of taxation is zero percent because people keep everything they earn
C. A decrease in university tuition fees will cause more students to apply for university
entry
D. An equitable distribution of income and wealth should lead to economic growth in an

economy
3. Which of the following is a normative statement
A. Large scale farming increases productivity as compared to small scale farming
B. Productivity can be enhanced by employing capital widening and capital deepening
C. Inflation rate in Zimbabwe is higher than in South Africa
D. Zimbabwe has a deficit on her balance of payments
4. Which of the following is not a positive statement
A. There is deficit on the balance of trade
B. Unemployment is currently above 50%
C. Inflation rate has fallen to a single digit
D. Controlling inflation is more important than economic growth

5. Which of the following is not a normative statement
A. The government should be more worried about unemployment in the economy
B. The inflation rate in Zimbabwe in November 2005 was above 400%
C. Equitable distribution of income and wealth should lead to economic growth in an

economy
D. The government should increase the interest rate in order to reduce the problem of
inflation
6. Which one of the following statements in normative rather than positive
A. Smoking can seriously damage your health
B. Taxes on cigarettes are regressive
C. Cigarette machines should be available only on premises to which children do not

have ready access
D. The prevalence of smoking is much higher among manual workers than among non
manual workers
7. Which of the following is a positive statement
A. Wealth should be distributed equally
B. The best level of taxation is zero percent because people keep everything they earn
C. An increase in college tuition fees will cause fewer students to apply for college
D. The government must lower the price of bread so that more customers can afford it

ECONOMIC RESOURCES
Factors of production
In economics, the factors of production are the resources or inputs that are used in the production
of goods and services.
• Land
This refers to all natural resources used in production, including land itself, as well as any
minerals, water, forests, or other resources that are found in or on the land. Land is often
considered a fixed factor because its supply is generally limited.
• Labour
Labour includes the physical and mental effort exerted by individuals in the production
process. It encompasses the skills, abilities, and time contributed by workers. Labour is a
variable factor as it can be increased or decreased based on the needs of production.
• Capital
Capital refers to the physical assets or man-made resources used in production. It includes
machinery, equipment, tools, buildings, infrastructure, and any other tangible goods that are
employed to produce other goods and services. Capital can be classified as either physical
capital or financial capital.
• Entrepreneurship
Entrepreneurship refers to the ability and willingness to organize, coordinate, and take risks
in the production process. Entrepreneurs play a crucial role in identifying business
opportunities, assembling and allocating resources, making strategic decisions, and assuming
the uncertainties and risks associated with starting and managing a business.
In conclusion, these four factors—land, labor, capital, and entrepreneurship—combine together

to facilitate the production of goods and services. They are complementary to each other,
meaning that all factors are typically needed in combination to achieve efficient production. The
relative availability, quality, and combination of these factors of production influence the level of
economic output and the distribution of income in an economy.

RESOURCES
Resources refer to all the materials present in our environment which are used by living beings.
Resources are considered to be very useful raw materials found in the environment. These are
known as materials that are found in nature. They are beneficial to every individual in a variety
of ways.
Natural Resources
Humans require many useful things available in nature to live on this planet. These are referred
to as natural resources.
Air, water, woods, animals, and minerals are some examples. When humans use natural things to
make a new thing that increases its value, it is known as a man-made resource.
Types of Natural Resources
Natural resources are important for living beings. There are many ways of classifying natural
resources. The most general category is the amount of resources available for human
consumption. There are two types of energy resources: renewable and non-renewable energy
resources.
RENEWABLE RESOURCES
Renewable resources are those that cannot be depleted. They are always available and thus could
be reused. The various types of Renewable resources are given below:
Renewable Resources : Examples

Sun - The energy obtained from sunlight is solar energy. The sun is the ultimate natural resource
for all living beings on the earth. Plants utilise solar energy and make their own food through
photosynthesis.
Wind - It is an important renewable resource required for the survival of living organisms. Air is
important to carry out photosynthesis (the process by which green plants turn carbon dioxide and
water into food using energy from sunlight) and respiration (the inhaling of oxygen and the
exhaling of carbon dioxide) in plants and animals, respectively. The energy that is obtained from
wind is termed as wind energy.

NON-RENEWABLE RESOURCE
Natural resources that are limited in quantity are referred to as non-renewable resources. These
resources cannot be supplied or regenerated in a short duration of time. These resources cannot
be reused. The various types of non renewable resources are as follows.
Non-renewable Resources : Examples
Fossil Fuels- Fossil fuels are non-renewable energy sources. This means that they will ultimately
be finished, which is why energy prices are rising. Fossil fuels consist of coal, natural gas and
petroleum.
Coal- Coal is used as a fuel, to generate electricity, and in factories and steam engines.
Natural gas- Natural gas, often known as compressed natural gas, is an excellent alternative to
petrol and diesel. It burns quickly and generates a large amount of heat. It's an excellent source
of hydrogen.

Scarcity, Choice and Opportunity Cost
All choices mean that one alternative is selected over another. Selecting among alternatives
involves three ideas central to economics: scarcity, choice, and opportunity cost.
Scarcity in Economics
Scarcity refers to resources being finite and limited. Scarcity means we have to decide how and
what to produce from these limited resources. It means there is a constant opportunity cost
involved in making economic decisions. Scarcity is one of the fundamental issues in economics.
In other words scarcity is the basic economic problem.
Examples of scarcity
Land – a shortage of fertile land for populations to grow food. For example, the desertification of
the Sahara is causing a decline in land useful for farming in Sub-Saharan African countries.
Water scarcity – Global warming and changing weather, has caused some parts of the world to
become drier and rivers to dry up. This has led to a shortage of drinking water for both humans
and animals.
Health care shortages
In any health care system, there are limits on the available supply of doctors and hospital beds.
This causes waiting lists for certain operations.

CHOICE
• Because of scarcity, choices must be made by consumers, businesses and governments.
• Most people can not have all the goods and services they want, they have to makes
choices.
• With no rise in income (wages), if someone wants to buy a car, they may have to spend
less on education.
• All societies have make choices, whether they be individuals, groups or government.
• Choice is related to basic economic questions of what, how and for whom to produce.
• It is illustrated by the many possible combinations that an economy can produce given its
available resources as shown along the PPC/PPF.
OPPORTUNITY COSTS
Because of the problem of scarcity it follows that choices have to be made. Consumers
must choose what to buy out of their limited incomes. Produ cers must choose what to
produce with their limited resources. Governments must choose what services to provide
out of their limited tax revenues.
Every choice involves a sacrifice and this sacrifice is called opportunity cost.
Opportunity cost is the sacrifice of the next best alternative choice. For a consumer the
opportunity cost of choosing a product is the next item on his/her scale of preference. For
a producer the opportunity cost of producing a good is the next most profitable product
which could have been produced with the resources used. For a government the
opportunity cost of providing a service is the next best service which it could have
provided with the resources used.
In economics we assume that people are rational, i.e. when faced with a choice they will
always choose the alternative that will give them the greatest satisfaction. This involves
weighing up all the alternatives and then choosing the one that has the lowest opportunity
cost.

PRODUCTION POSSIBILITY FRONTIER AND OPPORTUNITY COST
Is a curve or a boundary which shows the combinations of two or more goods and services that
can be produced whilst using all of the available factor resources efficiently.
A production possibility frontier shows the maximum combination of factors that can be
produced.
• Moving from Point A to B will lead to an increase in services (21-27). But, the
opportunity cost is that output of goods falls from 22 to 18.
• Therefore, the opportunity cost of increasing consumption of services is the 4 goods

foregone.
At point D, the economy is inefficient. We can increase both goods and services without any
opportunity cost. C is currently impossible.
A shift in the PPC outward indicate economic growth, which achieved through an increase in
factor resources, an increase in the efficiency (productivity) of factor resources and an
improvement in technology.
• A shift inwards indicated economic decline.
• The slope of the PPC is the opportunity costs.

OVERVIEW OF THE PRODUCTION POSSIBILITY CURVE
Production possibility curve is the curve that show the combination of two item or services that
can be produce in the market in a certain amount of time provided that all other eternal factor
that can effect the curve are kept constant such as, labour, technology land and capital. The curve
shows the production between two item and how much can we produce with the current
resources or technology. As the title says ‘possibility’ which also means that with this much of
resources, how much of item can it produce or achieve.
There are 3 types of production possibility curve which are straight-line sloping down, concave
and convex curve.
The first type of curve has a constant negative gradient or constant ratio which also means that as
one item/good decreases by one, the other item/good will increase by one, and it will always be
constant. Which also means that its opportunity cost will be always constant. But this type of
curve is not realistic because it cannot represent the market/economy.
The second type of curve is known as concave curve, it has increasing ratio as moving on the
curve which also means that we need to decrease more of a item/good to produce more of the
good and the decreasing number will keep increase as a sacrifice for another item/good. Which
also means that the opportunity cost will keep increasing. Thus this graph is also knows as
increasing opportunity curve. This type of curve is more realistic and it represent the whole
market or economy.
The last type of curve is known as convex curve, it has decreasing ratio as moving on the curve
which is also means that we need to decrease less of a item/good to produce more of a good and
the decreasing number will keep decrease as moving along the curve. Which is also means that
the opportunity cost will keep decreasing. Thus the graph is also known as decreasing
opportunity curve. This type of curve does not really exist in the real life economy, some says
that in agriculture, this type of curve does exist but mostly it is not.

Key ideas to note in a PPF:
1. There is always a tradeoff along the PPF. (Opportunity Cost).
2. Points outside the curve are unattainable.
3. We achieve production efficiency when the point is on the curve that is pareto efficiency.
4. When a point is inside the curve, this is product inefficient, that is pareto inefficient.
Opportunity Cost: is the benefit, profit, or value of something that must be given up to acquire
something else.

THE THREE BASIC ECONOMIC QUESTIONS
1) What to produce?
In economics, what to produce is usually determined by the demand for goods and services by
consumers.
Therefore, what consumers demand is what is usually produced. The decision as to what to
produce is also influenced by the type of economy; whether the economy is a planned or
command economy, a free economy or whether the economy is a mixed economy. In a planned
or command economy, what to produce is determined by a central economic authority
established by the government. In a true free market, what to produce is determined by choices
of consumers. However, most nations fall somewhere between a true command economy and a
true free market system and production is determined by both the demand by buyers and by some
level of government intervention.
2) How to produce?
Many different ways and methods are available to firms in determining how goods and services
can be produced. A firm can employ a few skilled or a great deal of unskilled workers. The firm
can also be more capital intensive with high technological methods of production. The firm can
also produce locally or overseas. In addition, firms can use new or recycled raw materials to
make their products. These are some of the issues that can confront firms in the economy
regarding how to produce society’s goods and services.
3) For whom to produce?
If a good or service is produced, a decision must be made as to who will consume it.
Decisions to have one person or group receive a good or service usually means it will not be
available to others or less will be available to others. Usually those persons or groups in society
who and which have access to financial capital will usually have quicker access to the goods and
services produced by society. Therefore, the question as to whom to produce for is usually
geared to those persons in society who have the financial capacity and can afford to purchase
these goods and services that are produced.

ECONOMIC SYSTEMS
The way in which a society answers the three fundamental economic questions is called an
economic system. More formally, an economic system is a process or mechanism for answering
the three fundamental questions.
An economic system can be classified by any two characteristics: who owns the resources? And
who answers the fundamental questions?
There are three main types of economic systems: command, market and mixed.
1) COMMAND ECONOMY
A command or planned economy occurs when the government controls all major aspects of the
economy and economic production. In a command economy, it is the government that decides
what to produce, how to produce goods and how to distribute goods and services within the
economy.
A command economy works in contrast to a free market economy. In a free market economy,
goods and services are produced by private enterprise with distribution occurring according to
market forces.
How a command economy works
• Government ownership of the means of production. In command economies,

governments will own some or all of the industries producing goods and services.
• Government pricing and production decisions. In a command economy, production is

decided by government agencies, who decide the most socially efficient goods to produce.
Government agencies may also set prices or give consumers rations directly.
• Government macro-economic objectives. In a command economy, the government will

have over-riding macroeconomic objectives such as employment rates and what to
produce.
• Some centrally planned economies may consist of not just state-owned enterprises, but
some privately owned firms who are closely directed by state management.

Advantages of command economies
• Supporters of command economies argue that it enables the government to overcome

market failure, inequality and create a society that maximises social welfare rather than
maximises profit.
• Command economies can prevent abuse of monopoly power.
• Command economies can prevent mass unemployment, often a feature of capitalist

economies.
• Command economies could produce goods which benefit society and ensure everyone
has access to basic necessities.
Disadvantages of command economies
• Government agencies usually have poor information about what to produce.

Centralisation means that decisions are taken by people who may have no access to what
is actually happening. Command economies, like the Soviet Union, often produced goods
that weren’t used.
• Unable to respond to consumer preferences.
• Inefficient firms are protected and kept going; making it hard for resources to move to
dynamic and efficient firms.
• Threat to democracy and liberty. A command economy creates a very powerful

government which limits individuals rights to pursue economic objectives. This
invariably creates a climate where governments can extend their control into other areas
of people’s lives.
• Bureaucratic. Command economies tend to be very bureaucratic with decisions held up

by planning and committees.
• Price controls invariably lead to shortages and surpluses.

2) MARKET ECONONY
In a market economic system, or a “free-market system,” communities, firms and proprietors act
in self-interest to decide how to allocate and distribute resources, what to produce and who to
sell to. Governments in market systems typically have little intervention on how businesses
operate and generate income, however, can regulate factors like fair trade, policy development
and honest business operations.
While market economic systems can benefit emerging businesses and sole proprietorships, there
are some potential disadvantages to using a free-market economic system.
Advantages may include the following
• Provides incentive for innovative entrepreneurship
• Gives consumers a choice in goods, services and purchase prices
• Creates market competition for resources, resulting in quality offerings and efficient use
of resources to produce goods
• Inspires research, development and advances in goods and production of goods
Some disadvantages could be
• Highly competitive markets can cause a scarcity in resources for disadvantaged

individuals
• Potential for monopolizing of industries and niches, such as technology, health care and
pharmaceuticals
• Can increase income disparity by placing focus on economic needs over societal,
community and human needs.

3) MIXED ECONONY
Mixed economic systems combine two or more economic practices to form one central system.
Traditionally, a mixed economy consists of a market and command economy combined to form
an economic system where the market is generally free from government or national ownership.
However, the government can still have control over essential industries and sectors like
transportation and defense.
Additionally, the governing entities in mixed economic systems usually have a predominant
oversight over the regulation of private corporations and businesses. While mixed economies are
fairly common around the world and offer many benefits, they also can have some weaknesses:
A mixed economic system often has these advantages:
• Allows for private companies to operate more efficiently and reduce operational costs
because of less government oversight
• Creates an outlet for market failures through allowing certain government intervention
• Enables governments to create net programs like social security, health care and food and
nutrition programs
• Gives governments power to redistribute income through tax policies, reducing income
disparities
Some potential disadvantages include
• Government intervention can be too frequent or not frequent enough, creating an

imbalance
• Creates potential for government subsidiaries within state-run industries
• Can cause subsidized government industries to go into debt with a lack of competition in
state-run industries.

THE PRICE MECHANISM
Refers to the system where the forces of demand and supply determine the prices of commodities
and the changes therein. It is the buyers and sellers who actually determine the price of a
commodity.
• The interaction of buyers and sellers in free markets enables goods, services, and
resources to be allocated prices.
• Relative prices, and changes in price, reflect the forces of demand and supply and help
solve the economic problem.
• Resources move towards where they are in the shortest supply, relative to demand, and
away from where they are least demanded.
The rationing function of the price mechanism
Whenever resources are particularly scarce, demand exceeds supply and prices are driven up.
The effect of such a price rise is to discourage demand, conserve resources, and spread out their
use over time. The greater the scarcity, the higher the price and the more the resource is rationed.
This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this
discourages demand and leads to more oil being conserved than at lower prices. The rationing
function of a price rise is associated with a contraction of demand along the demand curve.
The signalling function of the price mechanism
Price changes send contrasting messages to consumers and producers about whether to enter or
leave a market. Rising prices give a signal to consumers to reduce demand or withdraw from a
market completely, and they give a signal to potential producers to enter a market. Conversely,
falling prices give a positive message to consumers to enter a market while sending a negative
signal to producers to leave a market. For example, a rise in the market price of ‘smart’ phones
sends a signal to potential manufacturers to enter this market, and perhaps leave another one.
Similarly, the provision of ‘free’ healthcare may signal to ‘consumers’ that they can pay a visit to
their doctor for any minor ailment, while potential private healthcare providers will be deterred
from entering the market. In terms of the labour market, a rise in the wage rate, which is the price
of labour, provides a signal to the unemployed to join the labour market. The signalling function
is associated with shifts in demand and supply curves.

The incentive function of the price mechanism
An incentive is something that motivates a producer or consumer to follow a course of action or

to change behaviour. Higher prices provide an incentive to existing producers to supply more
because they provide the possibility or more revenue and increased profits. The incentive
function of a price rise is associated with an extension of supply along the existing supply curve.

REVISION QUESTIONS
1. Explain the factors of production. [10]
2. With the use a production possibility curve demonstrate scarcity, choice and
opportunity cost. [10]
3. a) How are the basic economic questions of what to produce, how to produce and for
whom to produce answered in
i) a market economy,
ii) a planned economy? [12]
b) Assess the view that resources are more efficiently allocated in the market economy
than in the planned economy. [13]
4. a) Explain how the basic economic questions are answered in a market economy. [10]
b) Discuss whether market economy best solves the basic economic problem. [15]
5. Evaluate the view that the mixed economy allocates resources efficiently. [25]
6. (a) What do economists mean by the basic economic problem of scarcity? [10]
(b) Is it beneficial for an economy to change from a command economy to a market

economy? [15]

ENTERPRISING
Enterprising is a person who is full of energy and ambition. An example of enterprising is

someone who starts their own business.
ENTREPRENEUR
An entrepreneur is an individual who creates a new business, bearing most of the risks and
enjoying most of the rewards. The entrepreneur is commonly seen as an innovator, a source of
new ideas, goods, services, and business/or procedures.
There’s no single personality profile that describes every successful entrepreneur; however,
certain characteristics are particularly important when it comes to starting and leading a venture.
CHARACTERISTICS OF A SUCCESSFUL ENTREPRENEURS
Curiosity
Successful entrepreneurs have a sense of curiosity that allows them to continuously seek new
opportunities. Rather than settling for what they think they know, curious entrepreneurs ask
challenging questions and explore different avenues.
Structured Experimentation
Along with curiosity comes the need for structured experimentation. With each new opportunity
that arises, an entrepreneur must run tests to determine if it’s worthwhile to pursue.
For example, if you have an idea for a new product or service that fulfills an underserved
demand, you’ll have to ensure customers are willing to pay for it. To do so, you’ll need to
conduct thorough market research and run meaningful tests to validate your idea and determine
whether it has potential.

Adaptability
The nature of business is ever-changing. Entrepreneurship is an iterative process, and new

challenges and opportunities present themselves at every turn. It’s nearly impossible to be
prepared for every scenario. Entrepreneurs need to evaluate situations and adapt so their business
can keep moving forward when unexpected changes occur.
Team Building
A great entrepreneur is aware of their strengths and weaknesses. Rather than letting
shortcomings hold them back, they build well-rounded teams that complement their abilities.
In many cases, it’s the entrepreneurial team, rather than an individual, that drives a venture
toward success. When starting your own business, it’s critical to surround yourself with
teammates who have complementary talents and contribute to a common goal.
Decisiveness
To be successful, an entrepreneur has to make difficult decisions and stand by them. As a leader,
they’re responsible for guiding the trajectory of their business, including every aspect from
funding and strategy to resource allocation.
Being decisive doesn’t always mean having all the answers. If you want to be an entrepreneur, it
means having the confidence to make challenging decisions and see them through. If the
outcome turns out to be less than favorable, the decision to take corrective action is just as
important.
Persistence
While many successful entrepreneurs are comfortable with the possibility of failing, it doesn’t
mean they give up easily. Rather, they see failures as opportunities to learn and grow.
Throughout the entrepreneurial process, many hypotheses turn out to be wrong, and some
ventures fail altogether. Part of what makes an entrepreneur successful is their willingness to
learn from mistakes, continue to ask questions, and persist until they reach their goal.

Comfortable with failure
In addition to managing risk and making calculated decisions, entrepreneurship requires a certain
level of comfort with failure.
Successful entrepreneurs prepare themselves for, and are comfortable with, failure. Rather than
let fear hold them back, the possibility of success propels them forward.
Risk Tolerance
Entrepreneurship is often associated with risk. While it’s true that launching a venture requires
an entrepreneur to take risks, they also need to take steps to minimize it. While many things can
go wrong when launching a new venture, many things can go right.
Successful entrepreneurs are comfortable with encountering some level of risk to reap the
rewards of their efforts; however, their risk tolerance is tightly related to their efforts to mitigate
it.
Innovation
Many ascribe to the idea that innovation goes hand-in-hand with entrepreneurship. This is often
true—some of the most successful startups have taken existing products or services and
drastically improved them to meet the changing needs of the market.
Innovation is a characteristic some, but not all, entrepreneurs possess. Fortunately, it’s a type of
strategic mindset that can be cultivated. By developing your strategic thinking skills, you can be
well-equipped to spot innovative opportunities and position your venture for success.
In conclusion
Entrepreneurship is both a challenge and a great opportunity, and it takes certain qualities to be
successful. There’s no right or wrong way to be an entrepreneur. Key characteristics and
behaviors like experimentation, persistence, and innovation can be developed with time,
experience, and training.

REQUIREMENTS FOR COMPANY REGISTRATION
1. Proposed company names
3-5 proposed company names.
There are a few requirements and restrictions – but generally, you have quite a lot of freedom
when it comes to naming your new company. However, digits and abbreviations are not allowed.
2. Company addresses and email
Every company must have a physical, a postal address and an email address. The company’s
physical addresses must be Zimbabwean addresses and not a P.O. BOX. Please ensure you
provide the full postal address.
3. Business activity
A business is required to provide the new company’s business activity. This can be a rough idea
of what business you want to venture in and we will perfect it according to the requirements of
the Companies Registry.
4. Directors details
• Full name(s) and surname as shown on their official government issued identity
documents (provide any former forenames and surnames if available).
• Full residential or business and postal address.
• National Identification number/passport number.
• Nationality.
Note directors should be above the legal age of 16 years and at least one director should be
ordinarily a Zimbabwean resident and should not be disqualified.

5.i. Shareholders’ Details
• (Where the Shareholder is a Person)
• Full name(s) as shown on their official government issued identity documents.
• Contact address (residential or other address).
• Nature of control that is, the share percentage of each shareholder.
5.ii. Shareholders’ Details
• (Where the Shareholder is a Company)
• Full name of the company as shown on the certificate of incorporation;
• Company Number;
• Company representative i.e. their name(s) and surname;
• Company address.
6. Company Secretarys’ Details
• Full name(s) and surname as shown on their official government issued identity
documents (provide any former forenames and surnames if available).
• Nationality.
• Full residential or business and postal address.
• National Identification number/passport number.
Note company secretary’s should be above the legal age of 16 years and at least one director
should be ordinarily a Zimbabwean resident and should not be disqualified.

SOURCES OF CAPITAL
In economics, capital can be defined as the physical or financial resources used to produce value
in an economy. These resources may be invested in tangible assets such as factories, businesses,
and equipment, or intangible assets such as intellectual property and technological innovations.
The purpose of capital is to provide a flow of goods and services that can be used in the
production process and generate income for its owners. Capital represents a key factor of
production in an economy and its efficient use is essential for economic growth.
Types of Capital
Below are types of capital that businesses focus on in more detail
Debt Capital
A business can acquire capital by borrowing. This is debt capital, and it can be obtained through
private or government sources. For established companies, this most often means borrowing
from banks and other financial institutions or issuing bonds. For small businesses starting on a
shoestring, sources of capital may include friends and family, online lenders, credit card
companies, and federal loan programs.
Like individuals, businesses must have an active credit history to obtain debt capital. Debt capital
requires regular repayment with interest. The interest rates vary depending on the type of capital
obtained and the borrower’s credit history.
Individuals quite rightly see debt as a burden, but businesses see it as an opportunity, at least if
the debt doesn't get out of hand. It is the only way that most businesses can obtain a large enough
lump sum to pay for a major investment in its future. But both businesses and their potential
investors need to keep an eye on the debt to capital ratio to avoid getting in too deep.
Equity Capital
Equity capital can come in several forms. Typically, distinctions are made between private
equity, public equity, and real estate equity.
Private and public equity will usually be structured in the form of shares of stock in the company.
The only distinction here is that public equity is raised by listing the company's shares on a stock
exchange while private equity is raised among a closed group of investors.
When an individual investor buys shares of stock, he or she is providing equity capital to a
company.

Sources of capital such as:
● loans
● shares
● leasing
● hire purchase
● personal savings
LOANS
Loans are amounts of money borrowed from banks or other financial institutions for large and
long-term business projects such as the development or expansion of the business. However
loans can be substituted by other alternative sources of finance which are more suitable.
Advantages
• Large amounts can be borrowed.
• Suitable for long-term investments.
• The lender has no say on how the money is spent.
• Need not be paid back for a fixed time period and banks do not withdraw at a short notice.
• Interest rates are lower than for bank overdrafts and are set in advance.
Disadvantages
• Collateral security is needed.
• The amount borrowed has to be repaid at the agreed date.
• Interest is charged.
• Loans will affect a company’s gearing ratio.

ORDINARY SHARE ISSUE
Ordinary shares also known as equity shares are a unit of investment in a company. Ordinary
shareholders have the privilege of receiving a part of company profits via dividends which is
based on the value of shares held by the shareholder and the profit made for the year by the
company. They also have the right to vote at general meetings of the company. Companies can
issue ordinary shares in order to raise finance for long-term financial needs.
Advantages
• The amount need not be paid back — it is a permanent source of capital.
• Able to raise large amounts of finance.
• If the company follows a rational dividend policy it can create huge reserves for its
development program.
• The dividends need to be paid only if the company makes a profit.
• No collateral is required for issuing shares.
• It will help reduce gearing ratio
Disadvantages
• Issuing shares is time consuming.
• It incurs issuing costs.
• There are legal and regulatory issues to comply with when issuing shares.
• Possible chances of takeover where an investor buys more than 50% of the total issued
shares value.
• Groups of equity shareholders holding majority of shares can manipulate the control and
management of the company.
• May result in over-capitalization where dividend per share falls.
• Once issued the shares may not be bought back and therefore the capital structure cannot
be changed.
LEASING
In a lease the leasing company buys the asset on behalf of the business and the asset is then
provided for the business to its use. Unlike a hire purchase the ownership of the asset remains
with the leasing company. The business pays a rent throughout the leasing period. The leasing
firm is known as the lessor and the customer as lessee. Leasing is of two types, namely Finance
lease and Operating lease.
Advantages
• The amount in full need not be paid in order to start using the asset.
• The total cost and the lease period is pre-determined and thus helps with budgeting cash
flow.
• In an operating lease, payments are made only for the usage duration of the asset.
• Lease is inflation friendly where the agreed rate is paid even after five years when other
costs increase due to inflation.
• It is easier to obtain a lease than a commercial loan.
Disadvantages
• The ownership of the asset remains with the lessor even after payments but however in a
finance lease the option is provided to buy the asset at a nominal value.
• In a finance lease the lessee ends up paying more than the value of the asset.
• Lease cannot be terminated whenever at lessee’s will.

HIRE PURCHASE
Hire purchase allows a business to use an asset without paying the full amount to purchase the
asset. The hire purchase firm buys the asset on behalf of the business and gives the business the
sole usage of the asset. The business on its part must pay monthly payments to the hire purchase
firm amounting to the total value of the asset and charges of the hire purchase firm. At the end
of the payment period the business has the option of purchasing the asset for a nominal value.
Advantages
• The business gains use of the asset before paying the asset’s value in full.
• The payment is made in affordable installments.
• Hire purchase installments are taxable expenditures.
• At the end of the payments ownership of the asset is transferred to the company.
• Payments can be made from the asset’s usage and return of the asset.
Disadvantages
• Ownership remains with the lender until the last payment is made.
• The asset will cost the company more than the original value.
• If payments are not made on time the lender has the right to repossess the asset.
• If the asset is required to be replaced due to breakdown or because it is out-dated in

which case the payment may still have to be made and the asset replaced.

PERSONAL SAVINGS
This is the amount of personal money an owner, partner or shareholder of a business has at his
disposal to do whatever he wants.When a business seeks to borrow the personal money of a
shareholder, partner or owner for a business’s financial needs the source of finance is known as
personal savings.
Advantages
• The owner would not want collateral to lend money to the business.
• There is no paperwork required.
• The money need not necessarily be paid back to the owner on time.
• Can be interest free or carry a lower rate of interest since the owner provides the loan.
Disadvantages
• Personal savings is not an option where very large amounts of funds are required.
• Since it is an informal agreement, if the owner demands the money back in a short notice
it might cause cash flow problems for the business.

BUSINESS ORGANISATIONS
●sole trader
●partnership
●cooperatives
●private & public limited
TYPES OF PRIVATE SECTOR ORGANISATIONS
1. SOLE TRADERS
A business in which one person provides the permanent finance and in return has full control of
the business and is able to keep all the profits.
The person usually trades under his own name.
They are common in industries such as farming, hairdressing, window cleaning and retailing.
Advantages of Sole Traders
• Easy to set up and no legal formalities required
• Owner has complete control, not answerable to anybody else.
• Owner keeps all profits.
• Able to choose times and patterns of work.
• Able to establish close personal relationship with staff and customers.
• Decisions are made quickly and not consultative.
• They are likely to receive assistance from the government.
• Pay little or no tax to the government.
• Can have flexible and convenient working hours.

Disadvantages of Sole Traders
• Unlimited liability – All of owner’s assets are potentially at risk.
• Often faces intense competition from bigger firms.
• It may be difficult to raise finance to expand the business.
• Since capital is obtained from personal savings, borrowing and ploughing back profits,
the firm has no access to larger capital markets.
• The business depends heavily upon the owner’s ability. He cannot be jack of all trades,
for example, he can be skilled in mechanics for all cars but finds it difficult to cope with
accounts.
• If the owner is ill, dies or not fit, the business lacks continuity.
• Sole traders often overwork themselves.
• Have no one to share ideas with and suffers all the losses.
2. PARTNERSHIPS
• A partnership is legally defined as two or more persons carrying on business in common

with a view of profit making.
• It can be defined as business formed by two or more people to carry on a business

together with shared capital investments and usually shared responsibilities.
• Partnerships have a legal maximum of 20 people, they require few documents.
• It is an unincorporated business and partners have unlimited liability.
• The partnership agreement does not create a separate unit; a partnership is just a group of
individuals formed to overcome some of the drawbacks of sole traders.
• Errors and decisions of each partner are considered to be the responsibility of them all.
A partnership deed is often drawn and likely covers matters such as:
✓ The amount of capital to be contributed by each partner.

✓ Proportions in which profit and losses will be shared.
✓ Management responsibilities of each partner.
✓ Maximum drawings of cash by each partner.
✓ Terms under which the partnership will be terminated.
✓ Voting rights.
Advantages of Partnerships
• Partners may specialize in different areas of business management.
• Shared decision making.
• Can raise more capital through each partner’s contribution.
• Partners share the losses.
• Greater privacy and fewer formalities than corporate organisations.
Disadvantages of Partnerships
• Unlimited liability for all partners (with exception of limited partnerships).
• Lack of continuity. The partnership will have to be reformed in the event of one partner’s
death.
• All partners are bound by decisions of any one of them.
• Cannot raise capital from selling shares.
• Loss of independence in decision making as in sole traders.
• They share profits.
• Conflicts may arise which may lead to dissolution.
• Decision making is consultative and is time consuming.

3. COOPERATIVES
A co-operative is a democratic organisation, owned and controlled by its members for a shared
benefit. It is a distinct legal entity from its members or officers.
Advantages of a co-operative include that:
• There are equal voting rights for members.
• This structure encourages member contribution and shared responsibility.
• Liability for members is limited.
• There is no limit on the number of members.
Disadvantages of a co-operative include that:
• Members have equal voting rights regardless of investment - which may not suit an
investor-driven business.
• Legal limits on payments of dividends on shares may not suit an investor-driven business

4. PRIVATE LIMITED COMPANIES
A small to medium sized business that is owned by shareholders who are often members of the
same family. This company cannot sell shares to the general public.
Limited companies are sometimes called joint stock companies because their stock or shares is
held jointly by a number of people.
Private limited companies have a restriction on the sale of shares.
It cannot advertise its shares for sale on the stock exchange.
Shareholders have limited liability and business accounts are not published.
Existing shareholders can only sell their shares with the agreement of the other shareholders.
Advantages of Private Limited Companies
• Shareholders have limited liability.
• Separate legal personalities.
• Continuity in the event of the death of a shareholder.
• Original owner is still often able to retain control.
• Able to raise capital from the sale of shares to family and friends.
• Greater status than an unincorporated organisation.
• Many private limited companies are large enough to obtain benefits of large scale
productions.
• There is no minimum authorized capital.
• Accounts are less complicated than those of public limited.
• It is possible to restrict transfer of shares, for example, preserve ownership by family and
accounts can remain private.

Disadvantages of Private Limited Companies
• There are complex legal formalities in establishing the business.
• Shares cannot be sold to the general public.
• It may be difficult for shareholders to sell their shares and get their investment back.
• End of year accounts must be sent to company available for public inspection.
5. PUBLIC LIMITED COMPANIES
Can be recognized by the use of PLC or Inc.
Often a large business with legal rights to sell shares to the general public, share prices are
quoted on the stock exchange.
They have all advantages of private limited companies plus the right to sell shares to the general
public on the stock exchange.
Existing shareholders may quickly sell their shares if they want to. This flexibility of selling
shares encourages the public to buy the shares.
Most PLC shareholders do not take part in the management of the firm which is run by a board
of directors elected by shareholders.
Advantages of Public Limited Companies
• Limited liability.
• Separate legal identity.
• Continuity.
• Easy buying and selling of shares for shareholders. This encourages investment.
• Access to substantial sources of finance due the ability to issue a prospectus to the public
and offer shares for sale.
• They benefit from economies of scale.

Disadvantages of Public Limited Companies
• As a large firm, the company may seem impersonal to customers and employees.
• They are vulnerable to takeovers.
• Because of their size, they make diseconomies of scale such as decisions taking a long
time to make.
• Legal formalities in formation.
• Costs of business consultants and financial advisors when creating such a company.
• Share prices subject to fluctuations.
• Directors influenced by short-term objectives of major investors.
• There is divorce between ownership and control.

BUSINESS ETHICS
Business ethics refers to moral principles and social values that business should adopt in its code
of conduct.
These are rules that businesses must accept and follow in its day to day operations for the
welfare of society and all its stakeholders.
Business is termed as social organ and therefore it should not indulge in any activity that is
harmful to the interest of all its stakeholders.
Importance of Business Ethics
Business ethics is the moral code of conduct that guides the actions and operations of an
organization and the employees working in it. Business ethics aims to promote moral and ethical
behavior in the activities of organizations.
Business ethics improve the organization’s reputation. The general public and society will fully
embrace the company if it adheres to all ethical standards. The business community and
businessmen that adhere to the required business ethics and refrain from unethical behavior are
always supported by society.
As was previously discussed, a company that practices business ethics benefits all of its
stakeholders, including its employees, shareholders, customers, dealers, and suppliers. Happy
stakeholders provide the company its full support, facilitating the efficient operation of
commercial operations.
Consumer satisfaction is the key to a successful business. Corporate firms can best meet
customer expectations by upholding business ethics.
Organizations in the business world are compelled by business ethics to put the needs of their
customers first. Only when a company operates according to moral standards does the level of
customer satisfaction rise.

Functions of Business Ethics
Protect consumer rights
Business ethics ensures that customers are treated fairly and provided with their full rights.
Organizations that implement ethics operates economically and provide better quality goods at
lower cost. They serve customers at a reasonable profit without exploiting them. Customers are
fully satisfied with services that makes them loyal to such businesses for a long term.
Enhance relations with society
Relationship with society is must for survival of every business organization. Ethics directs
business to consider the interest of society and work for their welfare. It should not focus only on
its growth at the cost of exploitation of society. Business should actively participate in corporate
social responsibility and should contribute towards infrastructural development programmes for
its society.
Safeguard interest of industry
Business ethics protects the small scale business from exploitation by large firms in an industry.
It provides them full rights to operate efficiently and establish their position in market. Following
of ethics in an industry ensures that all firms works fairly without the exploitation of other
players in market.
Improve business goodwill
Ethics play a key role in enhancing the overall image of business in market. It monitors all
operations of business and avoids any unethical activities. Practicing of ethics maintains the
legality of business thereby providing better service to customers. All unfair trade activities are
controlled and quality goods are delivered. Customers are happy with the services which leads to
create a positive image of company.
Assist in decision making
Supporting in decision making of organization is an important function played by business ethics.

Ethics provides rules and guidelines to be followed by business in its functioning. All decisions
are taken in light of moral and social values mentioned in these ethics. It guides in deciding what
is right or wrong for business organization. Every ethic need to be practiced properly and any
violation will lead to penalty.

Advantages of Business Ethics
Enhance business reputation
Business ethics helps in enhancing the reputation of the organization in the market. Practicing of
ethics ensures the legality of business and provide better service to customers. It controls all
unfair trade practices and operates all activities ethically.
Positive work environment
It helps in maintaining a positive work environment for business. Ethics clearly defines the code
of conduct for business and directs the limits within which it should operate. Employees are
trained to work efficiently in a team and develop better relationships with their co-workers.
Improves customer happiness
Ethics leads to improved customer satisfaction with the business. Companies follow ethical
principles operate at a reasonable profit and fulfill all needs of their customers at a lower cost.
Customers when treated fairly get committed to the business for the long term.
Retain Good Employees
Adopting of ethical principles enable business in retaining good employees for a longer period.
Employees want to work with such an organization that treats them fairly and recognizes their
talent. They need to be compensated for their work and wants appreciation based on their work
quality.
Builds investor loyalty
All investor wants to be associated with the ethical business for earning better return. They look
for reputation, ethics, and social responsibility of business before choosing the one to invest their
funds. Business working on ethical values are able to attract large number of investors.
Avoid legal problems
Controlling legal issues is another important advantage provided by business ethics.

Implementation of ethical principles ensures that organizations comply with all labor laws and
environmental regulations. Employees are provided safe working environment and good quality
materials for carrying out the operations.

Disadvantages of Business Ethics
Reduce profits
Business ethics reduces the profit earning ability of the organization by putting limits to its
operations. Companies working on ethical values can’t focus on profit maximization by
exploiting others. They need to give equal attention to the interest of its stakeholders like
customers, employees, society, creditors and government.
Time consuming
Implementation of ethics within the business practices is a time-consuming process. It is a long

process that requires large efforts on the part of the organization. Businessmen need to properly
learn about these ethics for their successful implementation.
Not ideal for small business
Ethical standards are not suitable for small scale business as it lower their profit. Small business
cannot afford to lose some profit for the sake of running their operations ethically. It can hamper
their growth and survival in today’s stiff competition. Following these principles brings extra
cost to the business which is not feasible for small companies.
Instability
Business ethics are not stable and are changed from time to time. Business owners revise them as
per the company needs and desires without considering whether they are ethical or not. It
becomes inconvenient to change these standards within the business practices many times.
Companies need to educate and guide its employees each time it brings changes to its standards.

REVISION QUESTIONS
1. Explain the characteristics of a successful entrepreneur. [10]
2. Explain the requirements for business formation. [10]
3. Evaluate any three sources of capital. [15]
4. Discuss the benefits of converting a Sole trader business to a Partnership business. [15]
5. Distinguish between Private Limited Companies and Public Limited Companies. [20]
6. Discuss the benefits of business ethics to businesses. [15]

TOOLS FOR ECONOMIC ANALYSIS
Just like it is for every field of study, economics often use simple and quick tools like tables,
charts and graphs to represent information than with endless written pages to ensure easier
understanding. Such visual aids or condensed ideas are more meaningful and comprehensible to
readers who may have difficulties in interpreting statistics from printed words or who have less
time to read volumes of books or papers just to get the same information. Visual comparison and
representation of data is not only important in economic analysis, it is now an acceptable mode
of modern writing.
Tables
In economics, a table is simply an orderly arrangement of information in boxes, showing the

relation between variables. Tables are very essential in economics because they help to make the
field of study even more beautiful and attractive to students. Basically, below are some of the
importance of a table in Economics:
1. Tables reveals information that is being conveyed to reader at a fast rate. This is probably
impossible if the same information is hand written.
2. They help in reading, writing and interpretation of information to readers.
3. Representing information in a tabular format help to economize writing materials and spaces.
4. It can be used for future forecast on the same study.

Tables, charts and graphs
Tables, charts and graphs are some of the most used tools in economic analysis. In fact, just as
lawyers are known for speaking legal maxims and Doctors for medical terms, that is how
Economists are known for using Tables, charts and graphs.
Often times, they serve as a shorthand for the presentation of facts. Instead of writing volumes of
written words, the same information is presented in a form of tables, graphs and diagrams which
can catch the eye quickly. Well, it is also important to note that Tables, charts and graphs are not
the same at all.
Charts
Unlike a table, charts are simply graphical presentation of data. Charts can either be called
(charts, diagrams and graphs). This three words (charts, diagrams and graphs) are often used
interchangeably to mean the same thing but they are obviously not the same thing.
First and foremost, A graph is a pictorial presentation of the relationship between variables.
Many types of graphs are employed in economics depending on the nature of the data involved
and the purpose for which the graph are intended.
Among these are bar graphs, pie graphs, pictographs and so on. Graphs are sometimes referred to
as “charts” or “diagram “. We may thus speak of bar chart and pie diagram as the same thing.
Nonetheless, there are actually some differences between the two.
A bar chart is a series of rectangles whose height are being represented as assessed. The height of
the bars should be drawn to scale to show the relative measurements. The width of the bar
rectangle could be of any convenient size, but all the bars must have the same with and they
should not overlap.
On the other hand, a pictograph is a picture drawn resembling the object we want to compare.
These pictures enable visual comparison of the totals of such objects. For example, if a farmer
produces rice, he can use bags of rice to present the quantities of annual rice production in
different years.
It should be noted also that there is a difference between a pictograph and a histogram. A
histogram is simply a graphical representation of frequent distribution. It usually consist of a set
of rectangles having their bases on the horizontal axis know as the “x-axis“. They also have their
centers on the class mark (mid-point) of each interval.
Measures of central tendency
A measure of central tendency is a single value that attempts to describe a set of data by
identifying the central position within that set of data.
There are three main measures of central tendency:
1. The arithmetic mean or arithmetic average
2. The mode
3. The Median
Arithmetic mean
Arithmetic mean (otherwise called mean) is the average of a series of figures or values. It is
obtained by dividing the sum of these figures by the total number of the figures or values.
• For example, if there are 10 graduates in a class and they obtained the following test = 60,
50, 45, 30, 80, 85, 65, 50, 55, 40
• The mean of the above will then be calculated by adding all the numbers.
• 60 + 50 + 45 + 30 + 80 + 85 + 65 + 50 + 55 + 40 = 560
• 560 / 10 = 56
• So the arithmetic mean is simply 56.

Median
Median is an average which is the middle, value when figures are arranged in order of magnitude.
So if for instance we have values like:
• 60, 40, 45, 30, 80, 65, 50, 55
• By rearranging the marks in order of magnitude, we get:
• 30, 40, 45, 50, *55* , 60, 65, 80, 85
• Now, counting from the left or right, we see that the 5th position gives the median value.
• Therefore, the median is 55.
Please note that if there are, e.g 10 numbers there will be 2 numbers in the middle, so you add
the 2 numbers then you divide the sum by 2 to get the median.
Mode
Mode is probably the simplest in the measures of central tendency. It simply means the value
that appear most in a series of value. So take for instance, if you have the following values:
• 1, 2, 5, 8, 5, 6, 3, 5, 8, 2
• The mode amongst all the values is “5”. And the reason is simply because 5 appears
more than every other value in that particular series of values.

PIE CHARTS
• It is a type of graph in which a circle is divided into sectors that each represent a
proportion of the whole.
• A pie chart or circle chart is a circular statistical chart graph, which is divided into slices
to illustrate numerical proportions
Advantages
• pie charts display relative proportions of multiple classes of data
• size of the circle can be made proportional to the total quantity it represents
• summarize a large data set in visual form
• be visually simpler than other types of graphs
• permit a visual check of the reasonableness or accuracy of calculations
• require minimal additional explanation
• be easily understood due to widespread use in business and the media
Disadvantages
• pie charts do not easily reveal exact values
• many pie charts may be needed to show changes over time
• fail to reveal key assumptions, causes, effects, or patterns
• pie charts can be easily manipulated to yield false impressions

BAR CHART
A bar chart (aka bar graph, column chart) plots numeric values for levels of a categorical feature
as bars. Levels are plotted on one chart axis, and values are plotted on the other axis. Each
categorical value claims one bar, and the length of each bar corresponds to the bar's value.
Advantages
• show each data category in a frequency distribution
• display relative numbers or proportions of multiple categories
• summarize a large data set in visual form
• clarify trends better than do tables
• estimate key values at a glance
• permit a visual check of the accuracy and reasonableness of calculations
• be easily understood due to widespread use in business and the media
Disadvantages
• require additional explanation
• be easily manipulated to yield false impressions
• fail to reveal key assumptions, causes, effects, or patterns

INTERVIEWS
Face-to-face interaction between the interviewer and the interviewee is called an interview. It is a
formatted conversation in which one person asks questions and the other responds to them. The
interviewer asks questions to the interviewee to decide whether the interviewee is suitable for the
position.
It is the most important part of the overall selection process. The interview determines whether a
candidate should be hired, move further with the interview process, or be discarded. It acts as the
main source for collecting more details about the candidate.
Advantages of interviews
Deciding which candidates are best for the job
The interview is an opportunity to evaluate a candidate's abilities and personality. An interview

is a two-way conversation where you can observe the candidate's responses in a relaxed
environment and compare candidates during interviews.
Detailed assessment
Interviews are one of the finest ways to determine how much applicants know about the industry.
Interviews are helpful for both the candidate and the employer. It helps an employer to evaluate
each applicant's abilities and knowledge to determine whether they are good for the company or
not.
Fantastic source of information
Interviews are the primary source for achieving significant and trustworthy information. It is
beneficial for the company because it offers valuable data that can enhance decision-making,
customer satisfaction, and client retention.
Increasing knowledge
Interviews are an excellent method to get to know someone, and the interviewee can also
discover more about themselves.

Extra information extraction
During an interview, the interviewer can look for information that helps to shortlist the
candidates. It is important, especially when numerous applicants have the same qualifications.
Additionally, it enables the applicant to know more about the business and decide whether they
enjoy working there or not.
Disadvantages of Interviews
Traditionally, data is collected from applicants at interviews as they respond to questions. The
expense of conducting interviews as well as the possibility of interviewer stress are two
disadvantages of it. Its other disadvantages are described below.
Personal bias
The interview process is not always pleasant. The candidate might think their evaluation isn't
being done fairly. Many interviews also involve some aspect of manipulation, so some people
might not want to reveal much more personal information out of concern that it might be used
against them.
Quick to judge
Interviews are frequently used to learn more about candidates and their skills, but it takes a lot of
time. Decisions are frequently taken in the first few minutes of the interview itself, and the
remaining time is usually utilized to confirm or justify the original decision. This approach is not
ineffective, but it may also be more difficult to evaluate candidates during interviews.
Developing stereotypes
An interviewer will make assumptions about a candidate's skills, aptitude, and personality based
on how they respond to questions.
Challenging to verify the truth
It is a fantastic technique to learn in-depth details about a company. It's essential to keep in mind
that not all of what is mentioned during an interview will be actually correct or true. Several
times, the statements are completely wrong.
Unpredicted result
Although interviews are not as accurate as exams, they can still be useful in some situations. For
example, while interviewing a new employee, you learn more about how the person and how he
or she will interact with others at work. If an interviewer has to lack predictive ability, then they
cannot be able to predict how a candidate's abilities will convert into professional success.

Disappointed
Applicants may be disappointed when the interviewer asks questions that are not related to the
field. Because of this, a talented applicant might be rejected.
Expensive
The interviewing process is typically costly.
QUESTIONNAIRES
According to Cambridge Dictionary (2023), a questionnaire is a list of questions that several

people are asked so that information can be collected about something.
According to Pew Research Center (2023) a questionnaire is like a conversation which should be
arranged by topic and progress in a logical order. By asking simple questions, researchers can
make it useful, comfortable, interesting, and engaging for the respondents.
Advantages of questionnaires
• A questionnaire is easy to conduct and surely, large amounts of information can be

obtained from a large number of respondents. Questionnaires are also cost-effective when
the researchers aim to target a large population.
• Broad coverage: Local, national, and international respondents can be easily reached by a
questionnaire. The Internet and particularly, social media have made it easy to reach out
to respondents afar.
• One of the main advantages of questionnaires is that the responses received are frank and
anonymous. Unlike interviews, questionnaires are good for sensitive & ego-related
questions.

• Carrying out research with questionnaires is less time consuming and respondents can fill
in questionnaires at a convenient time as well.
• Questionnaires are often used by researchers in quantitative research as they are

understood to be very useful to collect large amounts of data from a large sample of
people.
Disadvantages of questionnaires
However, questionnaires are not without some limitations. It is, therefore, important for
researchers to examine their advantages and disadvantages before deciding whether they should
use this instrument in their research or not.
• No clarification for ambiguous questions. Many experts argue that questionnaires are
inadequate to understand human behavior, attitude, feelings etc. Likewise, a
questionnaire may sometimes be too cluttered and too long.
• Questionnaires are more rigid than interviews. Unless the researcher leaves a space for
the interviewee to write the answers, the respondent can only select from the range of
answers the researcher has provided.
• Some questions may be poorly worded, while some others may be very direct. These
questions are not useful to obtain good information. Many researchers also argue that
questionnaires lack validity as they yield information without explanation.
• Low response rate as questionnaires may not simply be suitable for some respondents.
Likewise, if the researchers decide to use a postal questionnaire, many people may
decline to respond.
• Many questions may be interpreted by respondents in ways the researchers did not intend
resulting in irrelevant data. Likewise, it is also difficult for a researcher to say how
truthful the respondents were.

OBSERVATION
Observation is the active acquisition of information from a primary source. In living beings,
observation employs the senses. In science, observation can also involve the recording of data
via the use of instruments.
The purpose of observation techniques are
• To collect data directly.
• To collect substantial amount of data in short time span.
• To get eye witness first hand data in real like situation.
• To collect data in a natural setting.
Observation as a data collection tool has the following advantages.
• Data are collected directly.
• Substantial amount of data can be collected in a relatively short time span.
• Provides pre-recorded data and ready for analysis.
• In the observation reliability is high.
Disadvantages of observation as data collection tool in research
• Establishing validity is difficult.
• Subjectivity is also there.
• It is a slow and laborious process.
• It is costly both in terms of time and money.
• The data may be unmanageable.
• There is possibility of bias.

SURVEYS
Surveys are a method of gathering information from a group of individuals by asking them
questions. Surveys can be conducted through various mediums such as paper and pencil, online
forms, telephone, or face-to-face interviews.
The main goal of a survey is to collect data that is representative of the group being surveyed,
allowing researchers to make informed decisions or draw conclusions. To create a successful
survey, it’s essential to craft questions that are clear, concise, and unbiased, avoiding leading or
loaded questions that could influence the answers.
Online Surveys
An online survey is a set of structured questions that the respondent completes over the internet,
generally by filling out a form. It is a more natural way to reach out to the respondents.
It is less time-consuming than the traditional way of gathering information through one-to-one
interaction and is less expensive. The data is collected and stored in a database, which an expert
in the field later evaluates.
As an incentive for respondents to participate in such online research, businesses offer rewards
like gift cards, reward points they can redeem for goods or services, free airline miles, discounts
at gas stations, etc.
Research studies with rewards are a win-win situation for both businesses and respondents.
Companies or organizations get valuable data from a controlled environment for market research.
Advantages of Surveys
• Relatively easy to administer
• Can be developed in less time (compared to other data-collection methods)
• Cost-effective, but cost depends on survey mode
• Can be administered remotely via online, mobile devices, mail, email, kiosk, or telephone.
• Conducted remotely can reduce or prevent geographical dependence
• Capable of collecting data from a large number of respondents
• Numerous questions can be asked about a subject, giving extensive flexibility in data
analysis

Disadvantages of Surveys
• Respondents may not feel encouraged to provide accurate, honest answers.
• Respondents may not feel comfortable providing answers that present themselves in a
unfavorable manner.
• Respondents may not be fully aware of their reasons for any given answer because of
lack of memory on the subject, or even boredom.
• Surveys with closed-ended questions may have a lower validity rate than other question
types.
SAMPLING
Sampling is a process in statistical analysis where researchers take a predetermined number of

observations from a larger population.
A sample is a smaller set of data that a researcher chooses or selects from a larger population
using a pre-defined selection method.
Advantages of Sampling Method
Reduce Cost
It is cheaper to collect data from a part of the whole population and is economically in advance.
Greater Speed
Sampling gives more time to researcher for data collection, so it is quickly and has a lot of time
for collection of inflammation.
Detailed Information
Investigator during studying a small universe provides a detail and comprehensive information’s.
Practical Method
Sampling is the only practical method when the population is infinite.
Much Easier
It is much easier to collect information from many individuals in a universe.

Disadvantages of Sampling Method
• Careful sampling selection is difficult.
• Experts are required for careful study of the universe.
• If the information’s is required for each and every unit in the study, then it is difficult to
interview each and every person in sampling method.
EXPERIMENTAL RESEARCH
Experimental research is often the final form of a study conducted in the research process which
is considered to provide conclusive and specific results.
Advantages of experimental research
Control of the variables
This method allows you to isolate the variables you want to study and modify them depending on
the objective of the study. You can also combine variables to study how they interact with each
other.
Identification of the cause-effect relationship
By studying the variables in isolation, the direct relationship between an action incorporated by
the researcher and the results obtained can be easily established .
There are no study limits
Any subject can be approached through the experimental method , you just have to know how to
introduce it in the experimental design and extract the variables to analyze.
The results can be duplicated
By having control over the variables and the context in which the experiment is carried out, it
can be replicated and repeated as many times as desired.

In addition, another research group can perform the same experiment following the guidelines of
who originally did it and duplicate their results.
Can be combined with other research methods
To ensure that the results obtained are reliable, it is beneficial to combine experimental research
with other methods.
Disadvantages of experimental research
Non-operable aspects
Love, happiness and other abstract ideas are hard to study . That is, unlike variables such as
length, height, temperature and so on, emotions, for example, cannot be measured accurately.
Human error
Human beings are imperfect and, although the experimentation is rigorous, it may be the case
that the experimenter himself is wrong when measuring the variables. Although human error
does not have to be a very serious event, in the most serious cases it may mean having to
invalidate all the results and it is necessary to repeat the study.
The environment influences the participants
If the laboratory or any other place where the study is conducted has any distracting factor or that
can alter the mood of the participant, their responses will be affected.
Variable manipulation may not be objective.
It is possible that, whether due to a researcher’s bias or intentionally, the results are manipulated
and interpreted in a way that confirms the hypotheses to be verified in the study.

REVISION QUESTIONS
1 a) Explain the following methods of collecting data:
i. interviews,
ii. questionnaires,
iii. surveys,
iv. observations, [10]
b) Evaluate the usefulness of interviews when collecting data in economics. [15]
2. Explain the benefits of the following methods of presenting data:
a. pie-charts,
b. bar charts,
c. frequency polygons,
d. pictorial data,
e. line graphs [25]

DEMAND THEORY
Demand implies the desire for a good, supported by the ability and readiness to pay for it. On the
other hand, supply alludes to the total amount of a commodity ready for sale.
Definition of Demand
Demand is the customer’s desire for a particular product, at the given price, which he/she is
ready to buy in one market at different prices during a given period of time. So, there are two
aspects of demand:
• Willingness to buy : It is the customer’s desire for the good.
• Ability to pay : It is the customer’s purchasing power to pay the price for the goods.
The demand of the customers depend on their needs and wants. Further, to constitute an effective
demand, there must be :
• A desire
• Means to purchase and
• Willingness to use those means for the purchase.
For example, A beggarman also has a desire for food and clothes, but he does not have the
money to buy them, so it does not amount to an effective demand.

LAW OF DEMAND
When there is a rise in the price of the product, the customers demand less quantity, whereas
when the prices fall, the demand for the product will rise.
Here, you can see in the graph, wherein the vertical axis represents the price of a commodity, and
the horizontal axis indicates the quantity demanded. The demand curve is an indicator of the
inverse relationship between price and quantity demand.
Please note that the Demand function is denoted by Qd whilst the suupply function is
denoted by Qs:
Qd = Qs

CHANGE IN DEMAND
The demand curve can either shift rightward or leftward.
Reasons why demand curves can shift:
Price of substitute goods : If price of substitute good increases, demand for the original good
increases and vice versa.
Expected future prices : If the price of the good is expected to increase in the future, they will
buy more now, causing the demand to increase.
Income : People buy more normal goods if they have more income. This is the opposite for
inferior goods.
Expected future income : If income is expected to increase in the future, buyers will increase
the demand for the quantity now.
Population : the larger the population, the bigger the demand.
Preferences : People with the same income has different demands for the good.
SHIFTS IN THE DEMAND CURVE

DETERMINANTS OF DEMAND
When price changes, quantity demanded will change. That is a movement along the same
demand curve. When factors other than price changes, demand curve will shift. These are the
determinants of the demand curve.
1. Income : A rise in a person’s income will lead to an increase in demand (shift demand curve to
the right), a fall will lead to a decrease in demand for normal goods. Goods whose demand varies
inversely with income are called inferior goods (e.g. Hamburger Helper).
2. Consumer Preferences : Favorable change leads to an increase in demand, unfavorable change

lead to a decrease.
3. Number of Buyers : the more buyers lead to an increase in demand; fewer buyers lead to
decrease.
4. Price of related goods:
a. Substitute goods (those that can be used to replace each other): price of substitute and demand
for the other good are directly related.
Example: If the price of coffee rises, the demand for tea should increase.
b. Complement goods (those that can be used together): price of complement and demand for the
other good are inversely related.
Example: if the price of ice cream rises, the demand for ice-cream toppings will decrease.
5. Expectation of future :
a. Future price: consumers’ current demand will increase if they expect higher future prices; their
demand will decrease if they expect lower future prices.
b. Future income: consumers’ current demand will increase if they expect higher future income;
their demand will decrease if they expect lower future income.
In short
• A change in quantity demanded is caused by a change in its own price of the good.
• A change in demand is caused by a change in determinants.
Elastic Demand
The demand that changes, as the price for product increases or decreases, it is known as elastic
demand or price elasticity of demand. Such a demand is termed as price-sensitive demand.
It means a small change in the price of the product may lead to a greater change in the quantity
demanded by the consumers, i.e. if the price of a product is increased then the consumers will
stop purchasing the commodity or switch to the substitutes or buy less quantity of the product, or
they will wait for the prices to become normal. On the other hand, if the price drops then the
consumers will start buying some more quantity of the product, or it will attract some more
customers.
Inelastic Demand
The demand is said to be inelastic when the demand for the given product or service does not
change in response to the fluctuations in price. Such a demand is not much sensitive to price.
Items for need or necessities are the goods that have inelastic demand, i.e. water, salt, soap,
petrol, etc. or the items to which people are addicted, like liquor, cigarettes, etc. or the items that
have no close substitutes like medicines. When the demand for the given product is inelastic then
no matter what the price is, people will not stop buying it. In the same way, if the price falls,
there will not be much change in the quantity demanded by consumers.

Differences between elastic and inelastic demand.
The differences between elastic and inelastic demand can be drawn clearly on the following
grounds:
Elastic Demand is when a small change in the price of a good, cause a greater change in the
quantity demanded. Inelastic demand means a change in the price of a good, will not have a
significant effect on the quantity demanded.
The elasticity of demand can be calculated as a ratio of percent change in the price of the
commodity to the percent change in price, if the coefficient of elasticity of demand is greater
than, equal to 1, then the demand is elastic, but if it’s less than one the demand is said to be
inelastic.
When the demand is elastic, the curve is shallow. Conversely, if the demand is inelastic, the
slope will be steep.
In the case of elastic demand, the price and total revenue move in opposite direction, however,
with inelastic demand, the price and total revenue moves in the same direction.
Items of comforts and luxuries have elastic demand whereas items of necessity have an inelastic
demand.
Conclusion
Products with no or less close substitutes have an inelastic demand. As compared to the products
with a large number of substitutes, have an elastic demand because of the consumers switch to
different substitute, if there is a small change in their prices. Therefore, it is true to say that the
less the substitutes, the more the inelastic demand.

PRICE ELASTICITY OF DEMAND
Price Elasticity of Demand (PED) is defined as the responsiveness of quantity demanded to a

change in price. The demand for a product can be elastic or inelastic, depending on the rate of
change in the demand with respect to the change in the price.
What does Price Elasticity mean?
Price Elasticity of Demand is defined as the rate at which demand goes up or down when prices
change. The demand for a product can be elastic or inelastic, depending on how quickly that
product’s demand responds to changes in the price of that product.
Demand is said to be elastic when the change in demand is proportionally larger than the change
in price. In other words, demand is elastic when the demand changes significantly with smaller
price changes. Conversely, demand is inelastic when the change in demand is proportionally
smaller than the difference in price.
Price Elasticity of Demand is also the slope of the demand curve. We can calculate the slope as
“rise over run”. As the slope of the demand curve steepens, demand changes at a faster rate,
which represents a higher elasticity. Conversely, flattening the curve causes demand to change at
a slower rate, denoting relative inelasticity.
For example, if I increase the price of a phone from $300 to $500, then how much can I expect
my demand to fall? The answer to this question, depending on various factors mentioned below,
will help the firm calculate its price elasticity of demand.
Key Takeaways:
• Price Elasticity of Demand (PED) is a product’s change in quantity demanded divided by

change in price
• It is determined by various factors such as whether there are substitutes for that product,
whether or not the product is a necessity and others
• It can be used by policymakers in a variety of practical situations
• One of the most useful applications of PED is to determine the potential Total Revenue
of a product depending on price changes
• Perfect elasticity or inelasticity are theoretical concepts which represent infinitely

essential and perfectly competitive products, respectively

Determinants of Price Elasticity of Demand
Once a manufacturer or producer knows the price elasticity of demand for their product, it can
help them determine the change in Total Revenue if they have to change the price of the product.
Total Revenue is the number of goods a manufacturer sells multiplied by the price at which the
good is sold. The change in total revenue depends on elasticity. This is important because it helps
businesses determine which prices might maximize total revenue, and thus which prices would
maximize profits.
1. Substitutes
If there is a greater availability of substitutes for a product, then that product is likely to be more
elastic. For example, if the price of one soda brand increases, people can turn to other brands
instead. So, a small change in price for this product is likely to cause a greater fall in the quantity
demanded for these products.
2. Necessities
If a good is a necessity, then its demand tends to be inelastic. For example, if the price for
drinking water rises, then there is not likely to be a huge drop in the quantity demanded of that
product, since drinking water is a necessity.
3. Time
Over time, a good tends to become more elastic because consumers and businesses have more
time to find alternatives or substitutes. For example, if the price of gasoline increases, people will
eventually adjust to that change, i.e. they may drive less, use public transportation, or form
carpools.
4. Habit
The demand for addictive or habitual products is usually inelastic. This is because the consumer
has no choice but to pay whatever price the producer is demanding. For example, if the price for
a pack of cigarettes goes up, it will likely not have any effect on the product’s demand.

Uses of Price Elasticity of Demand
• Price elasticity of demand allows a firm or business to predict the change in total revenue
using a projected change in price.
• It provides a useful marker by which firms can find out whether or not any of the
determinants listed above are present, e.g. whether or not there are substitutes in the
market for a certain product.
• Firms can charge different prices in different markets if elasticities differ in income
groups. This practice is known as price discrimination.
For example, airlines have segmented airplane seats into different classes—
economy, business, and first-class, in order to charge the less price-sensitive
customer a higher price for premium seats.
• It allows a firm to decide how much tax to pass on to a consumer. If a product is inelastic,
then the firm can force the customer to pay the tax.
This is a common tactic used by cigarette manufacturers who pass on any health
tax directly to the consumer.
• It also enables the government to predict the impact of taxation policies, or the effect of
other policies that may decrease the demand of a certain product.
Price Elasticity of Demand Formula
(New Quantity Demand – Old Quantity Demand)

(Old Quantity Demand)
Over x 100%
(New Price – Old Price)

(Old Price)
The value of Price Elasticity of Demand (PED) is always negative, i.e. price and demand have an
inverse relationship. This is because the ratio of changes of the two variables is in opposite
directions, so if the price goes up, demand goes down and the change will end up negative.
PED which is greater than 1 is relatively elastic (using absolute value since the number is
negative).

Price Elasticity of Demand Example
Musendo Ltd decides to reduce the price of its product, Power from $100 to $75. The company
predicts that the sales of Power will increase from 10 000 units a month to 20 000 units a month.
To calculate the price elasticity of demand, first, we will need to calculate the percentage change
in quantity demanded and percentage change in price.
• % Change in Demand = (20,000-10,000)/(10,000) = +100%
• % Change in Price = ($75-$100)/($100)= -25%
• Therefore, the Price Elasticity of Demand = 100%/-25% = -4.
This means the demand is relatively elastic.
Types of Price Elasticity of Demand
1. Perfectly Inelastic Demand, (PED = 0)
Perfectly Inelastic Demand
With a perfectly inelastic demand, there is no change in the demand for a product with a change
in its price. This means that the demand remains constant for any value of price. The demand
curve is represented as a straight vertical line.
It is practically impossible to find a product that has a perfectly inelastic demand. The closest
thing could be essentials like water or certain food products.
This is the effect on total revenue with a change in price.
2. Relatively Inelastic Demand, (PED = 0 < x < 1)
Relatively inelastic demand occurs when the percentage change in demand is less than the
percentage change in the price of a product.
For example, if the price of a product increases by 15% and the demand for the product
decreases only by 7%, then the demand would be called relatively inelastic.
The demand curve of relatively inelastic demand is rapidly sloping.

3. Unit Elastic Demand, (PED = 1)
Demand is said to be unit elastic when the proportionate change in demand produces the same
change in the price. The quantity demanded changes by the same percentage as the change in
price.
4. Relatively Elastic Demand, (PED = 1 < x < ∞)
Relatively elastic demand is defined as the proportionate change produced in demand is greater
than the proportionate change in the price of a product. The quantity demanded changes by a
larger percentage than the change in price.
For example, if the price of a product increases by 10% and then the demand for the product
decreases by 15%, then the demand would be relatively elastic.
The demand curve of relatively elastic demand is gradually sloping. It is less steep than relatively
inelastic demand.
5. Perfectly Elastic Demand, (PED = ∞)
In Perfectly Elastic Demand, a small rise in price will result in a fall in demand to zero, while a
small fall in price will result in the demand to become infinite. Consumers will buy all available
at some price, but none at any other price. This is a theoretical concept because it requires perfect
competition where the slightest price increase results in zero demand.
In a perfectly elastic demand, the demand curve is represented as a horizontal straight line.

DIFFERENT TYPES OF ELASTICITIES

INCOME ELASTICITY OF DEMAND
Income Elasticity of Demand (YED) is defined as the responsiveness of demand when a
consumer’s income changes. It is defined as the ratio of the change in quantity demanded over
the change in income.
The higher the income elasticity, the more sensitive demand for a good is to changes in income.
This means that a very high-income elasticity of demand suggests that when a consumer’s
income goes up, consumers will buy a lot more of that good and, reciprocally, when income goes
down consumers will cut back their purchases of that good to an even higher degree. A very low
price elasticity implies that changes in a consumer’s income will have little effect on demand.
YED is useful for governments and firms to help them decide what goods to produce and how a
change in overall income in the economy affects the demand for their products, i.e., whether it’s
inelastic or elastic.
YED can be positive or negative. This depends on the type of good. A normal good has a
positive sign, while an inferior good has a negative sign.
For example, if a person experiences a 20% increase in income, the quantity demanded for a
good increased by 20%, then the income elasticity of demand would be 20%/20% = 1. This
would make it a normal good.
Income Elasticity of Demand Formula
The formula for calculating the Income Elasticity of Demand is defined as the ratio of the change
in quantity demand over the change in income.
(New Quantity Demand – Old Quantity Demand)

(Old Quantity Demand)
Over x 100%
(New Income – Old Income)

(Old Income)

Types of Income Elasticity of Demand
We can categorize income elasticity of demand into 5 different categories depending on the
value.
Normal goods have a positive income elasticity of demand so as consumers’ income increase,
there is an increase in quantity demand.
Necessities have an income elasticity of demand of between 0 and +1. For example, a staple like
rice or bread could be considered a necessity.
Inferior goods have a negative income elasticity of demand meaning that demand falls as income
rises.
1. Income Elasticity of Demand for a Normal Good
A normal good has an Income Elasticity of Demand > 0. This means the demand for a normal
good will increase as the consumer’s income increases.
2. Income Elasticity of Demand for an Inferior Good
An inferior good has an Income Elasticity of Demand < 0. This means the demand for an inferior
good will decrease as the consumer’s income decreases.
3. Income Elasticity of Demand for a Luxury Good
Luxury goods usually have Income Elasticity of Demand > 1, which means they are income
elastic. This implies that consumer demand is more responsive to a change in income. For
example, diamonds are a luxury good that is income elastic.
4. Relatively Inelastic Income Elasticity of Demand
0 < Income Elasticity of Demand < 1 are goods that are relatively inelastic. This means that
consumer demand rises less proportionately in response to an increase in income.
5. Income Elasticity of Demand is 0
Income Elasticity of Demand = 0 means that the demand for the good isn’t affected by a change
in income.

Income Elasticity of Demand Example
Let’s take an example of a shop that sells batteries. They estimate that when the average real
income of its customers falls from $60 000 to $40 000, the demand for its batteries falls from 5
000 to 4 000 units sold, with all other things remaining the same.
Using the income elasticity of demand formula,
YED = (New Quantity Demand – Old Quantity Demand)/(Old Quantity Demand) / (New
Income – Old Income)/(Old Income)
= (4 000 – 5 000)/(5 000) / (40 000 – 60 000)/(60 000)
= ~0.67
This produces an elasticity of 0.67, which indicates customers are not particularly sensitive to
changes in their income when it comes to buying these batteries. The demand does not fall
significantly with a fall in income.

CROSS ELASTICITY OF DEMAND
Cross Price Elasticity of Demand (XED) measures the responsiveness of demand for one good to
the change in the price of another good. It is the ratio of the percentage change in quantity
demanded of Good X to the percentage change in the price of Good Y.
For businesses, XED is an important strategic tool. This elasticity measure can help determine
whether or not it is a good move to increase or decrease selling prices, or to substitute one
product for another to generate greater revenues.
There are three types of cross-price elasticity of demand: substitute goods, complementary goods,
and unrelated products.
Types of Cross Elasticity of Demand
1. Cross Price Elasticity of Demand for Substitutes
When the cross-price elasticity of demand for product A relative to a change in the price of
product B is positive, it means that the quantity demanded of product A has increased in
response to a rise in the price of product B. Many consumers have switched from consuming
product B to consuming product A. This implies that most consumers perceive products A and B
as substitutes that satisfy similar preferences.
Substitutes will always have a positive Cross Price Elasticity or greater than zero.
2. Cross Price Elasticity of Demand for Complements
When the cross elasticity of demand for product A relative to a change in the price of product B
is negative, it means that the quantity demanded of A has decreased relative to a rise in the price
of product B. Even though the price of product A is unchanged, many consumers still decreased
their consumption of it because the price increase for product B made consuming these products
together more expensive. This implies that most consumers perceive products A and B as
complements that are more enjoyable consumed together than consumed separately.
Complements will always have a negative Cross Price Elasticity or less than zero.
3. Cross Elasticity of Demand for Unrelated
These are goods that show no relationship in consumer consumption patterns. Price changes in
one product don’t affect the quantity consumed of the other product.
Unrelated goods will always have a Cross Price Elasticity of 0

Uses of Cross Price Elasticity of Demand
Knowing a product’s cross price elasticity of demand for other related products allows a firm to
better understand the market that it is serving. This firm can better identify how many
competitors share the same product space in the eyes of consumers, as well as how sensitive
sales revenues are to changes in the marketing strategy of complementary products outside of its
own market. This kind of valuable information can reduce the firm’s exposure to financial risk.
Firms use this information to develop targeted strategies that optimally respond to the price
changes of both competing and complementary products.
How to Calculate Cross Price Elasticity
Cross Price Elasticity of Demand (XED) = Percentage Change in Quantity Demanded of Good x
/ Percentage Change in Price of Good y
(New Quantity Demanded of Good x – Old Quantity Demanded of Good x)

(Old Quantity Demanded of Good x)
Over x 100%
(New Price of Good y – Old Price of Good y)

(Old Price of Good y)
This can be calculated following these simple steps:
• Calculate any percent change by taking the difference between the new value and the old
value, and dividing this difference by the old value.
• For % change in Quantity (Qx) of Product X: (Q new – Q old)/Q old
• For % change in Price (Py) of Product Y: (P new – P old)/P old
• The ratio of % change in Qx to % change in Py yields the cross price elasticity.
Key points
• If XED > o, then the two goods are substitutes. For example: Coke and Pepsi
• If XED < o, then they are complements. For example: Bread and Butter
• If XED = 0, then they are unrelated. For example: Bread and Soda
IMPORTANCE OF PRICE ELASTICITY OF DEMAND
Determination of price policy: While fixing the price of the product, a businessman has to
consider the elasticity of demand for the product. He should consider whether a lowering of price
will stimulate demand for his product, and if so to what extent and whether his profits will also
increase a result thereof.
If the increase in his sales is more than proportionate, to the reduction in price his total revenue
will increase and his profits might be larger. On the other hand, if increase in demand is less than
proportionate to fall in price, his total revenue we will fall and his profits would be certainly less.
Therefore, knowledge of elasticity of demand may help the businessman to make a decision
whether to cut or increase the price of his product or to shift the burden of any additional cost of
production on to the consumers by charging high price.
In general, for items having inelastic demand, the producer will fix a higher price and items
whose demand is elastic the businessman will fix a lower price.
Price discrimination: Price discrimination refers to the act of selling the technically same
products at different prices to different section of consumers or in different sub-markets.
The policy of price-discrimination is profitable to the monopolist when elasticity of demand for
his product is different in different sub-markets. Those consumers whose demand is inelastic can
be charged a higher price than those with more elastic demand.
Shifting of tax burden: To what extent a producer can shift the burden of indirect tax to the
buyers by increasing price of his product depends upon the degree of elasticity of demand.
If the demand is inelastic the larger part of the indirect tax can be shifted upon buyers by
increasing price. On the other hand if the demand is elastic than the burden of tax will be more
on the producer.
Taxation and subsidy policy: The government can impose higher taxes and collect more
revenue if the demand for the commodity on which a tax is to be levied is inelastic.
On the other hand, in ease of a commodity with elastic demand high tax rates may fail to bring in
the required revenue for the government.
Government should provide subsidy on those goods whose demand is elastic and in the
production of the commodity the law of increasing returns operates.

Importance in international trade: The concept of elasticity of demand is of crucial
importance in many aspects of international trade.
The success of the policy of devaluation to correct the adverse balance of payment depends upon
the elasticity of demand for exports and imports of the country.
The policy of devaluation would be beneficial when demand for exports and imports is price-
elastic.
A country will benefit from international trade when: (i) it fixes lower price for exports items
whose demand is price elastic and high price for those exports whose demand is inelastic (ii) the
demand for imports should be inelastic for a fall in price and inelastic for arise in price.
The terms of trade between the two countries also depends upon the elasticity of demand of
exports and imports of two countries. If the demand is inelastic, the terms of trade will be in
favour of the seller country.
Importance in the determination of factors prices: Factor with an inelastic demand can
always command a higher price as compared to a factor with relatively elastic demand.
This helps the trade unions in knowing that where they can easily get the wage rate increased.
Bargaining capacity of trade unions depend upon elasticity of demand for workers services.
Determination of sale policy for supper markets: Super Markets is a market where in a variety
of goods are sold by a single organization. These items are generally of mass consumption.
Therefore, the organization is supposed to sell commodities at lower prices than charged by
shopkeepers in the other bazaars.
Thus, the policy adopted is to charge a slightly lower price for items whose demand is relatively
elastic and the costs are covered by increased sales.
Pricing of joint supply products: The goods that are produced by a single production process
are joint supply products. The cost of production of these goods is also joint.
Therefore, while determining the prices of these products their elasticity of demand is considered.
The price of a joint supply product is fixed high if its demand is inelastic and low price is fixed
for that joint supply product whose demand is elastic.

Effect of use of machines on employment: Ordinarily it is thought that use of machines
reduced the demand for labour. Therefore, trade unions often oppose the use of machines fearing
unemployment. But this fear is not always true because use of machines may not reduce demand
for labour. It depends on the price elasticity of demand for the products.
The use of machines may reduce the cost of production and price. If the demand of the product is
elastic then the fall in price will increase demand significantly. As a result of increased demand
the production will also increase and more workers will be employed.
In such cases concept of elasticity of demand help the management to pacify the trade unions.
But if the demand of the product is inelastic than use of more machines will cause
unemployment.
Public utilities: The nationalization of public utility services can also be justified with the help
of elasticity of demand. Demand for public utilities such as electricity, water supply, post and
telegraph, public transportation etc. is generally inelastic in nature.
If the operation of such utilities is left in the hand of private individuals, they may exploit the
consumers by charging high prices. Therefore, in the interest of general public, the government
owns and runs such services. The public utility enterprises decide their price policy on the basis
of elasticity of demand. A suitable price policy for public utility enterprises is to charge from
consumers according to their elasticity of demand for public utility.
Explanation of paradox of poverty: Exceptionally good harvest brings poverty to the farmers
and this situation is called ‘Paradox of Poverty’.
This paradox is easily explained by the inelastic nature of demand for most farm products. Since
the demand is inelastic, prices of farm products fall sharply as a result of large increase in their
supply in the year of bumper crops. Due to sharp fall in prices, the farmers get less income even
by selling larger quantity. This paradox of poverty is the basis of regulation and control of farm
products prices. Government fixes the minimum prices of farm products because the demand for
farm products is inelastic. Thus, the concept of elasticity of demand helps the government in
determining its agricultural policies.
Output decisions: The elasticity of demand helps the businessman to decide about production.
A businessman chooses the optimum product- mix on the basis of elasticity of demand for
various products. The products having more elastic demand are preferred by the businessmen.
The sale of such products can be increased with a little reduction in their prices.
From the above discussion it is amply clear that price elasticity of demand is of great
significance in making business decisions.

REVISION QUESTIONS
1. Explain the following terms:
a. Elastic demand
b. Inelastic demand [10]
2. Analyse the causes of movements along the demand curve and shifts of the
demand curve. [10]
3. Distinguish between movement along and shift of demand curve. [10]
4. a) Explain
i) Price elasticity of demand,

ii) Income elasticity of demand,
iii) Cross elasticity of demand. [12]
b) Discuss the usefulness of the elasticity of demand concepts to small-scale miners

in Zimbabwe. [13]
5. a) Analyse the factors influencing price elasticity of demand for cement in your
country. [10]
b) To what extent are elasticity of demand concepts useful to the housing

construction industry ? [15]

SUPPLY THEORY
Supply implies the quantity (how much) of a product or service which are offered by the
manufacturer for sale at various prices to the customers, during a given period of time. So, there
are two determinants of supply:
Willingness : The quantity of the product which the producers want or are prepared to sell at
various prices.
Ability to supply : How much of a product is available with the producers to sell at a time.
It should be noted that supply is anything that the firm has offered for sale in the market.
LAW OF SUPPLY
When there is an increase in the price of the commodity, the quantity of the products produced
and available for sale will also increase, and when the prices drop, the supply also decreases. this
is due to the fact that the higher the price, the higher will be the profit margin.
Here in the graph, the vertical axis represents the price of a commodity, and the horizontal axis
indicates the quantity supplied. Supply curve represents a direct relationship between price and
quantity supplied.

CHANGE IN SUPPLY
The supply curve can either shift rightward or leftward.
Reasons why supply curves can shift:
Prices of Factors of Production : if the prices for factors of production increases, then it
becomes more costly, causing producers to produce less of the supply at the price. This shifts the
supply curve to the left.
Prices of related goods produced : prices of related goods which firms make influence supply.
Substitutes : Suppose good x and y are substitutes. If the firm is producing good x, and the price
of good y increases, then the firm switches to good y, causing the supply of good x to decrease.
Complements : Suppose good x and y are complements. Then increasing the price of good x
will increase the supply of good y.
Expected future prices : If the price of a good is expected to rise in the future, then the supply
of the good today decreases. This causes the supply curve to shift leftward.
Number of Suppliers : The more supplies there are, the greater the supply of products.
SHIFTS IN SUPPLY CURVE

DETERMINANTS OF SUPPLY
When price changes, quantity supplied will change. That is a movement along the same supply
curve. When factors other than price changes, supply curve will shift. Here are some
determinants of the supply curve.
1. Production cost:
Since most private companies’ goal is profit maximization. Higher production cost will lower
profit, thus hinder supply. Factors affecting production cost are: input prices, wage rate,
government regulation and taxes, etc.
2. Technology:
Technological improvements help reduce production cost and increase profit, thus stimulate
higher supply.
3. Number of sellers:
More sellers in the market increase the market supply.
4. Expectation for future prices:
If producers expect future price to be higher, they will try to hold on to their inventories and
offer the products to the buyers in the future, thus they can capture the higher price.
In short
• A change in quantity supplied is caused by a change in its own price of the good.
• A change in supply is caused by a change in determinants.

MARKET EQUILIBRIUM
An equilibrium is when two opposing forces balance each other. In this case, the quantity
demanded and the quantity supply equal to one another.
Equilibrium Price: the price at which the quantity demanded is equal to the quantity supplied
Equilibrium Quantity: the quality that is bought and sold at the equilibrium price.
In the equilibrium, there is no excess or shortage in the product, and no tendency for the market
price to change.

PRODUCER AND CONSUMER SURPLUS
Producer Surplus
Producer surplus is defined as the difference between the amount the producer is willing to
supply goods for and the actual amount received by him when he makes the trade. Producer
surplus is a measure of producer welfare. It is shown graphically as the area above the supply
curve and below the equilibrium price.
A producer always tries to increase his producer surplus by trying to sell more and more at
higher prices. However, it is simply not possible to increase the producer surplus indefinitely
since at higher prices there might be very little or no demand for goods.
Example of producer surplus
• This is the difference between the price a firm receives and the price it would be willing
to sell it at.
• If a firm would sell a good at $4, but the market price is $7, the producer surplus is $3.
Consumer Surplus
Consumer surplus is defined as the difference between the consumers' willingness to pay for a
commodity and the actual price paid by them, or the equilibrium price.
Total social surplus is composed of consumer surplus and producer surplus. It is a measure of
consumer satisfaction in terms of utility.
Graphically, it can be determined as the area below the demand curve (which represents the
consumer's willingness to pay for a good at different prices) and above the price line. It reflects
the benefit gained from the transaction based on the value the consumer places on the good. It is
positive when what the consumer is willing to pay for the commodity is greater than the actual
price.
Consumer surplus is infinite when the demand curve is inelastic and zero in case of a perfectly
elastic demand curve.
Example of Consumer Surplus
• This is the difference between what the consumer pays and what he would have been
willing to pay.
• If you would be willing to pay $5 for a ticket to see the Chibuku Super Cup final, but you
can buy a ticket for $4. In this case, your consumer surplus is $1.
PRICE ELASTICITY OF SUPPLY
Price Elasticity of Supply is defined as the responsiveness of quantity supplied when the price of
the good changes. It is the ratio of the percentage change in quantity supplied to the percentage
change in price.
The Price Elasticity of Supply is always positive because the Law of Supply says that quantity
supplied increases with an increase in price. This means:
• If the supply is elastic, producers can increase output without a rise in cost or a time delay
• If the supply is inelastic, firms find it hard to change production in a given time period.
Price Elasticity of Supply Formula
To calculate the price elasticity of supply, use the following formula:
Price Elasticity of Supply (PES) = Percentage Change in Quantity Supply divided by the
Percentage Change in Price
(New Quantity Supplied – Old Quantity Supplied)

(Old Quantity Supplied)
Over x 100%
(New Income – Old Income)

(Old Income)

Price Elasticity of Supply Example
Given the following data for the supply and demand of movie tickets, calculate the price
elasticity of supply when the price changes from $9.00 to $10.00.
We know that the original price is $9 and the new price is $10, so we have Price (Old) =$9 and
Price (New) = $10. From the chart, we see that the quantity supplied when the price is $9 is 75
and when the price is $10 is 105.
So we have:
• Price (Old) = $9
• Price (New) = $10
• Quantity Supplied (Old) = 75
• Quantity Supplied (New) = 105
To calculate the price elasticity of supply for movie tickets, we need to know what the
percentage change in quantity supplied is and what the percentage change in price is.
[105 – 75] / 75 = (30/75) = 0.4
So we note that % Change in Quantity Supplied = 0.4
Now we need to calculate the percentage change in price.
Calculating the Percentage Change in Price
The formula used to calculate the percentage change in price is:
[Price (New) – Price (Old)] /Price (Old))
By filling in the values we wrote down, we get:
[10 – 9] / 9 = (1/9) = 0.1111

We have both the percentage change in quantity supplied and the percentage change in price so
that we can calculate the price elasticity of supply.
The Final Step
PES = (% Change in Quantity Supplied)/(% Change in Price)
We now fill in the two percentages in this equation using the figures we calculated.
PES = (0.4)/(0.1111) = 3.6
We get the price elasticity of supply when the price increases from $9 to $10 is 3.6. So for movie
tickets, the price is elastic and thus supply is very sensitive to price changes.

Determinants of Price Elasticity of Supply
1. Marginal Cost
If the cost of producing one more unit keeps rising as output rises or Marginal Costs (which is
the increase in cost by producing just one more unit) rises rapidly with an increase in output, then
the rate of output production will be limited, i.e., Price Elasticity of Supply will be inelastic,
which basically means that the percentage of quantity supplied changes less than the change in
price. If Marginal Cost rises slowly, then supply will be elastic.
2. Time
Over time price elasticity of supply tends to become more elastic, which means that producers
would increase the quantity supplied by a larger percentage than an increase in price.
3. Number of Firms
The larger the number of firms, the more likely the supply is elastic. This is because other firms
can jump in to fill in the void in supply.
4. The Mobility of Factors of Production
If factors of production are mobile, then the price elasticity of supply tends to be more elastic.
This means labor and other manufacturing inputs can be brought in from other location to
increase capacity quickly.
5. Capacity
If firms have spare capacity, the price elasticity of supply is elastic. The firm can increase output
without experiencing an increase in costs, and quickly with a change in price.

Five types of Price Elasticity of Supply
These are the five ranges of Price Elasticity of Supply.
Perfectly Inelastic Supply
(PES = 0), The Quantity Supplied doesn’t change as the price changes.
Perfectly Inelastic Supply
Relatively Inelastic Supply
(0 < PES < 1), Quantity Supplied changes by a lower percentage than a percentage change in
price.
Relatively Inelastic Supply
Unit Elastic Supply
(PES = 1), Quantity Supplied changes by the same percentage as the change in price.
Unit Elastic Supply
Relatively Elastic Supply
(1 < PES < ∞), The Quantity Supplied changes by a larger percentage than the percentage
change in price.

SUMMARY OF DIAGRAMS
Diagrammatic representations of elasticity of supply

PRODUCTION COSTS
• TC = TFC + TVC
• AFC = TFC / Q
• AVC = TVC / Q
• ATC = TC / Q
• TC = TOTAL COSTS
• TFC = TOTAL FIXED COSTS
• TVC = TOTAL VARIABLE COSTS
• AVC = AVERAGE VARIABLE COSTS
• ATC = AVERAGE TOTAL COSTS
• Q = QUANTITY
Example 1
The information relates to a firm’s costs.

$
Average total costs 1 000
Total variable costs 72 000
Average fixed costs 200
What is the firms’s output is
ATC = AFC+ATC
AVC=ATC-AFC
800=1 000-200
AVC = TVC/OUTPUT
800=72 000/OUTUT
90

Example 2
A firm’s total cost of production is $300. Output produced 100 units and total variable cost $230.
What is the average fixed cost of production?
TC = TFC+TVC
$300 = TFC+ $230
TFC = $70
AFC = TFC/OUTPUT
AFC = $70/100
$0.70
AFC = AVERAGE FIXED COST
ATC= AVERAGE TOTAL COST
AVC= AVERAGE VARIABLE COST

LAW OF RETURNS TO SCALE
The law of returns are often confused with the law of returns to scale. The law of returns
operates in the short period. It explains the production behavior of the firm with one factor
variable while other factors are kept constant. Whereas the law of returns to scale operates in the
long period. It explains the production behavior of the firm with all variable factors.
There is no fixed factor of production in the long run. The law of returns to scale describes the
relationship between variable inputs and output when all the inputs, or factors are increased in
the same proportion. The law of returns to scale analysis the effects of scale on the level of
output. Here we find out in what proportions the output changes when there is proportionate
change in the quantities of all inputs. The answer to this question helps a firm to determine its
scale or size in the long run.
It has been observed that when there is a proportionate change in the amounts of inputs, the
behavior of output varies. The output may increase by a great proportion, by in the same
proportion or in a smaller proportion to its inputs. This behavior of output with the increase in
scale of operation is termed as increasing returns to scale, constant returns to scale and
diminishing returns to scale. These three laws of returns to scale are now explained, in brief,
under separate heads.
(1) Increasing Returns to Scale:
If the output of a firm increases more than in proportion to an equal percentage increase in all
inputs, the production is said to exhibit increasing returns to scale.
For example, if the amount of inputs are doubled and the output increases by more than double,
it is said to be an increasing returns to scale. When there is an increase in the scale of production,
it leads to lower average cost per unit produced as the firm enjoys economies of scale.
(2) Constant Returns to Scale:
When all inputs are increased by a certain percentage, the output increases by the same
percentage, the production function is said to exhibit constant returns to scale.
For example, if a firm doubles inputs, it doubles output. In case, it triples output. The constant
scale of production has no effect on average cost per unit produced.

(3) Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs.
For example, if a firm increases inputs by 100% but the output decreases by less than 100%, the
firm is said to exhibit decreasing returns to scale. In case of decreasing returns to scale, the firm
faces diseconomies of scale. The firm's scale of production leads to higher average cost per unit
produced.
Graph/Diagram:
The three laws of returns to scale are now explained with the help of a graph below:

ECONOMIES OF SCALE
Economies of scale are defined as the cost advantages that an organization can achieve by
expanding its production in the long run.
In other words, these are the advantages of large scale production of the organization. The cost
advantages are achieved in the form of lower average costs per unit.
It is a long term concept. Economies of scale are achieved when there is an increase in the sales
of an organization. As a result, the savings of the organization increases, which further enables
the organization to obtain raw materials in bulk. This helps the organization to enjoy discounts.
These benefits are called as economies of scale.

TYPES OF ECONOMIES OF SCALE
The Economies of scale are of two types:
1) Internal Economies
2) External Economies
INTERNAL ECONOMIES
Internal economies of production arise when the benefits or advantages of a firm’s expansion are
enjoyed by the firm itself.
Thus, internal economies accrue only to the individual firm by its own organizational ability and
effort. These internal advantages reaped by a firm enable it to lower its average cost of
production as its scale of production increases. These are called internal because the scale
economies are within the control of the firm.
Internal economies result from various factors. These are:
●Technological economies
●Marketing (trading) economies
●Financial economies
●Managerial economies
●Risk-distribution economies
EXTERNAL ECONOMIES
External economies arise when an increase in a firm’s expansion produces favourable effects on
other firms. In other words, benefits of increased production spread on other firms in the industry
or in the region.
Such economies arise because the development of an industry leads to the development of
ancillary services or benefit to all firms. Thus, external economies are available to all firms in the
industry irrespective of their sizes. These are called external because the scale economies are
outside the control of the firm.

TYPES OF EXTERNAL ECONOMIES
External economies can also be grouped into three:
●Economies of concentration or localization
●Economies of information
●Economies of disintegration.
Summary on Economies of Scale
Economies of scale refer to the cost advantage experienced by a firm when it increases its level
of output. The advantage arises due to the inverse relationship between the per-unit fixed cost
and the quantity produced. The greater the quantity of output produced, the lower the per-unit
fixed cost.
Economies of scale also result in a fall in average variable costs (average non-fixed costs) with
an increase in output. This is brought about by operational efficiencies and synergies as a result
of an increase in the scale of production.
Economies of scale can be realized by a firm at any stage of the production process. In this case,
production refers to the economic concept of production and involves all activities related to the
commodity, not involving the final buyer.
DISECONOMIES OF SCALE
Diseconomies of scale occur when average unit costs begin to increase, often as a result of
business growth. This is one of the main risks that an expanding business may face.
Causes diseconomies of scale
Diseconomies of scale can be caused by problems with communication as the firm expands
possibly into different locations or internationally. Decisions take longer to reach all employees
because communication is more difficult.

Diseconomies of scale can also be caused by coordination issues as managers are in charge of
increasing numbers of employees. These can lead to reduced staff motivation and lower
productivity, which increases unit costs.
TYPES OF DISECONOMIES OF SCALE
The Diseconomies of scale are of two types:
1) Internal Diseconomies
2) External Diseconomies
INTERNAL DISECONOMIES OF SCALE
Internal diseconomies implies to all those factors which raise the cost of production of a
particular firm when its output increases beyond the certain limit. These factors may be of the
following two types:
(a) Inefficient Management:
The main cause of the internal diseconomies is the lack of efficient or skilled management.
When a firm expands beyond a certain limit, it becomes difficult for the manager to manage it
efficiently or to co-ordinate the process of production. Moreover, it becomes very difficult to
supervise the work spread all over, which adversely affects the operational efficiency.
(b) Technical Difficulties:
Another major reason for the onset of internal diseconomies is the emergence of technical
difficulties. In every firm, there is an optimum point of technical economies. If a firm operates
beyond these limits technical diseconomies will emerge out. For instance, if an electricity
generating plant has the optimum capacity of 1 million Kilowatts of power; it will have lowest
cost per unit when it produces 1 million Kilowatts. Beyond, this optimum point, technical
economies will stop and technical diseconomies will result.
(c) Production Diseconomies:
The diseconomies of production manifest themselves when the expansion of a firm’s production
leads to rise in the cost per unit of output. It may be due to the use of inferior or less efficient
factors as the efficient factors are in scarcity. It happens when the size of the firm surpasses the
optimum size.
(d) Marketing Diseconomies:
After an optimum scale, the further rise in the scale of production is accompanied by selling
diseconomies. It is due to many reasons. Firstly, the advertisement expenditure is bound to
increase more than proportionately with scale. Secondly, the overheads of marketing increase
more than proportionately with the scale.
(e) Financial Diseconomies:
If the scale of production increases beyond the optimum scale, the cost of financial capital rises.
It may be due to relatively more dependence on external finances. To conclude, diseconomies
emerge beyond an optimum scale. The internal diseconomies lead to rise in the average cost of
production in contrast to the internal economies which lower the average cost of production.
(d) Marketing Diseconomies:
After an optimum scale, the further rise in the scale of production is accompanied by selling
diseconomies. It is due to many reasons. Firstly, the advertisement expenditure is bound to
increase more than proportionately with scale. Secondly, the overheads of marketing increase
more than proportionately with the scale.
(e) Financial Diseconomies:
If the scale of production increases beyond the optimum scale, the cost of financial capital rises.
It may be due to relatively more dependence on external finances. To conclude, diseconomies
emerge beyond an optimum scale. The internal diseconomies lead to rise in the average cost of
production in contrast to the internal economies which lower the average cost of production.

EXTERNAL DISECONOMIES OF SCALE
External diseconomies are not suffered by a single firm but by the firms operating in a given
industry. These diseconomies arise due to much concentration and localization of industries
beyond a certain stage. Localization leads to increased demand for transport and, therefore,
transport costs rise. Similarly, as the industry expands, there is competition among firms for the
factors of production and the raw-materials. This raises the prices of raw-materials and other
factors of production. As a result of all these factors, external diseconomies become more
powerful.
(a). Diseconomies of Pollution:
The localization of an industry in a particular place or region pollutes the environment. The
polluted environment acts as health hazard for the labourers. Thus, the social cost of production
rises.
(b). Diseconomies of Strains on Infrastructure:
The localisation of an industry puts excessive pressure on transportation facilities in the region.
As a result of this, the transportation of raw materials and finished goods gets delayed. The
communication system in the region is also overtaxed. As a result of the strains on infrastructure,
monetary as well as the real costs of production rise.
(c). Diseconomies of High Factor Prices:
The excessive concentration of an industry in a particular industrial area leads to keener

competition among the firms for the factors of production. As a result of this, the prices of the
factors of production go up. Hence, the expansion and growth of an industry would lead to rise in
costs of production.

REVISION QUESTIONS
1. Explain the determinants of supply. [10]
2. Distinguish between movements along and shifts of the supply curve. [10]
3. Distinguish between consumer surplus and producer surplus. [10]
4. Explain short run and long run periods. [10]
5. a) Explain the following terms:
i) Economies of scale
ii) Diseconomies of scale [10]
6. Distinguish between internal and external economies and diseconomies of scale. [10]
7. (a) Explain
(i) constant returns to scale,

(ii) diminishing returns to scale. [10]
(b) As firms grow bigger, they enjoy economies of scale. Does this mean that firms
should continue to grow? [15]
8. a) Explain the following terms:
i) law of variable proportions

ii) increasing returns
iii) external diseconomies of scale [12]
9. a) Analyse the factors influence price elasticity of supply of a product. [12]

b) Assess the relevance of price elasticity of supply to a maize farmer in Zimbabwe. [13]

6. THEORY OF THE FIRM
ECONOMIC OBJECTIVES OF FIRMS
The main objectives of firms are:
● Profit maximisation
● Sales maximisation
● Increased market share/market dominance
● Social/environmental concerns
Sometimes there is an overlap of objectives. For example, seeking to increase market share, may
lead to lower profits in the short-term, but enable profit maximisation in the long run.
Profit maximisation
Usually, in economics, we assume firms are concerned with maximising profit. Higher profit
means:
• Higher dividends for shareholders.
• More profit can be used to finance research and development.
• Higher profit makes the firm less vulnerable to takeover.
• Higher profit enables higher salaries for workers
Sales maximisation
Firms often seek to increase their market share – even if it means less profit. This could occur for
various reasons:
• Increased market share increases monopoly power and may enable the firm to put up
prices and make more profit in the long run.

• Managers prefer to work for bigger companies as it leads to greater prestige and higher
salaries.
• Increasing market share may force rivals out of business. E.g. the growth of supermarkets
have lead to the demise of many local shops. Some firms may actually engage in
predatory pricing which involves making a loss to force a rival out of business.
Growth maximisation
This is similar to sales maximisation and may involve mergers and takeovers. With this objective,
the firm may be willing to make lower levels of profit in order to increase in size and gain more
market share. More market share increases its monopoly power and ability to be a price setter.
Long run profit maximisation
In some cases, firms may sacrifice profits in the short term to increase profits in the long run. For
example, by investing heavily in new capacity, firms may make a loss in the short run but enable
higher profits in the future.
Social/environmental concerns
A firm may incur extra expense to choose products which don’t harm the environment or
products not tested on animals. Alternatively, firms may be concerned about local community /
charitable concerns.
● Some firms may adopt social/environmental concerns as part of their branding. This can
ultimately help profitability as the brand becomes more attractive to consumers.
● Some firms may adopt social/environmental concerns on principal alone – even if it does little
to improve sales/brand image.

DIAGRAM SHOWING DIFFERENT OBJECTIVES OF FIRMS
Q1 = Profit maximisation (MR=MC).
Q2 = Revenue Maximisation (MR=0).
Q3 = Marginal cost pricing (P=MC) – allocative efficiency.
Q4 = Sales maximisation – maximum sales while still making normal profit (AR=ATC)

MARGINAL COST
Marginal cost is how much money it costs your company to produce one additional unit of your
product or merchandise. As a growing company, you don’t want to run the risk of an inventory
shortage but you also don’t want to overproduce and not see the return on your investment. To
avoid these risks, you need to look at your 2 types of business costs: fixed costs and variable
costs.
Fixed costs, as you may have already guessed, are the costs that are pretty much set in stone and
they don’t change with production—like employee salary cost, for example. Variable costs are
more flexible and change depending on the production output, like operating costs.
Why is marginal cost important?
Marginal cost is important because if you’re looking to maximize profits, you’ll want to plan
production so that your marginal costs are equal to your marginal revenue. It’s the blueprint
needed to find the sweet spot of effective output and can yield several other benefits, such as:
• Preventing your company from losing money through loss of sales or overproduction
• Determining how many products are needed to satisfy customer demand
• Providing your company with important metrics for profit planning
• If you're producing at a quantity where marginal costs exceed marginal revenue, that
negatively impacts your profitability.
For example, let’s say a company produces 5 000 watches in 1 production run at $100 apiece.
The manufacturer will want to analyze the cost of another multiunit run to determine the
marginal cost. The average cost of producing a watch in the first run is $100, but the marginal
cost is the additional cost to produce one more unit. Using the marginal cost formula, we can
determine how an additional production run will impact profitability.
Marginal cost formula
The marginal cost formula is change in cost divided by change in quantity. In the example above,
the cost to produce 5 000 watches at $100 per unit is $500 000. If the business were to consider
producing another 5 000 units, they’d need to know the marginal cost projection first.
The business finds the marginal cost to produce one more watch is $90. If the business has a
lower marginal cost, it can see higher profits. If the business charges $150 per watch, they will

earn a $50 profit per watch on the first production run, and they’d earn a $60 profit on the
additional watch.
To calculate the marginal cost, divide the change in cost by the change in quantity or the number
of additional units. See the formula below:
Marginal cost = change in cost / change in quantity
The total cost of the second batch of 5 000 watches is $450 000. Dividing the change in cost by
the change in quantity produces a marginal cost of $90 per additional unit of output.
How to calculate marginal cost
Calculating marginal cost is a fairly simple process. As we learned above, the marginal cost
formula consists of dividing the change in cost by the change in quantity. Now we’re going to
look at those steps individually to make sure we have the process covered.
1. Calculate the change in cost
Change in cost is a simple formula that tells you the increase or decrease in cost over time.
Here’s the formula:
Change = new cost - original cost
2. Calculate the change in quantity
Change in quantity for marginal cost is not much different. We’re looking at the increase or
decrease in quantity over time, so the same setup applies:
Change = new quantity – original quantity
3. Divide cost by quantity
Taking it back to our original formula, this is what the final equation will look like:
Marginal cost = change in cost / change in quantity

Marginal cost example
To fully understand marginal cost, we’re going to cover a simplified example below:
Say you own a hat company and you want to see what the marginal cost will be to produce
additional hats.
It currently costs your company $100 to produce 10 hats and we want to see what the marginal
cost will be to produce an additional 10 hats at $150.
Step 1: Calculate the change in cost
$150 - $100 = $50
Step 2: Calculate the change in quantity
20 hats - 10 hats = 10 hats
Step 3: Divide the change in cost by the change in quantity
50 ÷ 10 = $5
Based on the math above, your company is looking at a marginal cost of $5 per additional hat.
Since it costs you less money to produce more hats, it makes sense for your company to produce
the additional units and seize the opportunity to make additional profits.
Additional factors to keep in mind
Now that you’ve been introduced to the basics, there are a few nuances you should be aware of
to maximize your marginal cost experience.
How production costs affect marginal costs
Marginal costs are a direct reflection of production quantity and costs, according to our equation
above. And since production is a product of cost and quantity, your output directly affects
marginal costs. As production increases or decreases, marginal costs can rise and fall.
Marginal costs vs. variable costs

It’s easy to get confused when comparing marginal costs and variable costs, since marginal costs
are made up of both variable and fixed costs. Let’s simplify each one:
Marginal cost is the cost to produce 1 more unit of merchandise. For example, the marginal cost
to produce more hats in our last equation was $5.
Variable cost is the changing costs associated with production. For instance, in that same hat
example, variable costs would be the cost of supplies to produce those additional hats. As the
output increases, so does the variable cost.
The bottom line is that variable cost is part of marginal cost, with the other part being fixed cost.
If you need to buy or lease another facility to increase output, for example, this variable cost
influences your marginal cost.
Marginal cost versus marginal product
Earlier we uncovered that marginal cost is the cost to produce additional units. Marginal product
is simply the change in output as a result of the change in input from those additional units
Going back to the hat example, since the additional hats were only going to cost $50 instead of
$100 as the originals had, there was incentive to produce more hats. Those additional 10 hats are
what is known as the marginal product.
Understanding the marginal cost curve
The marginal cost curve is presented in a graph. Production quantity is on the x-axis and price is
on the y-axis. On the graph, the marginal cost curves down before increasing. The U-shaped
curve represents the initial decrease in marginal cost when additional units are produced. The
marginal cost rises as production increases.
The curve represents diminishing marginal returns. At some point, your business will incur
greater variable costs as your output increases. The point where the curve begins to slope upward
is the point where operations become less efficient and profitability decreases.

MARGINAL REVENUE
In addition to marginal cost, another important metric to consider is marginal revenue. Marginal
revenue is the revenue or income to be gained from producing additional units.
Why is marginal revenue important?
Marginal revenue is an important business metric because it is a measure of revenue increases

from increases in sales. When marginal costs exceed marginal revenue, a business isn’t making a
profit and may need to scale back production.
Marginal revenue formula
This formula is similar to the marginal cost calculation. It divides the change in revenue by the
change in quantity, or number of units sold. The formula is as follows:
How to find marginal revenue
Similar to finding marginal cost, finding marginal revenue follows the same 3-step process.
1. Calculate the change in revenue
Calculating the change in revenue is performed the exact same way we calculated change in cost
and change in quantity in the steps above. To find a change in anything, you simply subtract the
old amount from the new amount.
Change in revenue = new revenue – old revenue
2. Calculate the change in quantity
Plug in these numbers in the same way as above.
Change in quantity = new quantity – old quantity
3. Divide the revenue by the quantity
This brings us back to the original formula for marginal revenue:
Marginal revenue = change in revenue / change in quantity

Diagnosing your marginal revenue
To determine which pricing strategy works best for your business, you’ll need to understand how
to analyze marginal revenue. The key to sustaining sales growth and maximizing profits is
finding a price that doesn’t dampen demand. When it comes to setting prices by unit cost, you
have 2 options.
You can increase sales volume by producing more items, charging a lower price, and realizing a
boost in revenue. Or you can produce fewer items, charge a higher price, and realize a higher
profit margin.
But be careful—relying on one strategy may only work if you have the market cornered and
expect adequate sales numbers regardless of price point. Ultimately, you’ll need to strike a
balance between production quantity and profit.
Factors that lead to decreases
The major cause of a decrease in marginal revenue is simply the rise in marginal cost. As we
touched on before, that sweet spot is anything that results in marginal cost being equal to
marginal revenue. Otherwise, the company is either underproducing or overproducing, and either
way that creates a loss of money.
A good example of this would be marginal cost of production costing more than original
production. For instance, in the hat example—if the first batch of hats cost $100 to make but the
second batch cost $200 to make, the company is now in a tough spot. It has to either decide on
finding a more efficient way to produce the product or raise the prices to see a profit.
Factors that lead to increases
Let's put that last concept in reverse—what causes marginal revenue to increase? Simply put,
less production costs. The less money the company is using to produce more products, the more
profits it can retain.
What is the relationship between marginal cost and marginal revenue?
The maximum profitability of a company results when marginal cost equals marginal revenue.
Anything swaying on one side or the other may result in a loss of profits for the company.

What happens if the marginal cost is less than marginal revenue?
A company ultimately wants to aim for marginal cost equalling marginal revenue for the
maximum profitability. If your marginal cost is less than marginal revenue, the result is
underproduction.
What happens if the marginal revenue is less than the marginal cost?
Again, a company ultimately wants to aim for marginal cost equalling marginal revenue for the
maximum profitability. If your marginal cost is more than marginal revenue, the result is
overproduction.

MARKET STRUCTURES
What is a Market?
One can define the market as a place where two or more parties meet for economic exchange. It
facilitates the exchange of goods and services, and it can be a physical place like a retail store
where people meet face-to-face or a virtual one, i.e., online e-commerce websites. There are
buyers and sellers in a market which determines the size of the market.
Market structure refers to how different industries are classified and differentiated based on their
degree and nature of competition for services and goods. The five popular types of market
structures include perfect competition, oligopoly market, monopoly market, contestable market
and monopolistic competition.
Types of Market Structures
According to economic theory, market structure describes how firms are differentiated and
categorized by the types of products they sell and how those items influence their operations. A
market structure helps us to understand what differentiates markets from one another.
MONOPOLISTIC COMPETITION
Monopolistic competition is a type of market structure where many companies are present in an
industry, and they produce similar but differentiated products. None of the companies enjoy a
monopoly, and each company operates independently without regard to the actions of other
companies. The market structure is a form of imperfect competition.
Monopolistic Markets Characteristics
Monopolistically competitive markets have the following characteristics:
• There are many producers and many consumers in the market, and no business has total
control over the market price.
• Consumers perceive that there are non-price differences among the competitors' products.
• There are few barriers to entry and exit.

• Producers have a degree of control over price.
• The long-run characteristics of a monopolistically competitive market are almost the
same as a perfectly competitive market. Two differences between the two are that
monopolistic competition produces heterogeneous products and that monopolistic
competition involves a great deal of non-price competition, which is based on subtle
product differentiation. A firm making profits in the short run will nonetheless only break
even in the long run because demand will decrease and average total cost will increase.
This means in the long run, a monopolistically competitive firm will make zero economic
profit. This illustrates the amount of influence the firm has over the market; because of
brand loyalty, it can raise its prices without losing all of its customers. This means that an
individual firm's demand curve is downward sloping, in contrast to perfect competition,
which has a perfectly elastic demand schedule.
Industries exhibiting features of Monopolistic Competition
• Clothing and apparel
• Sportswear products
• Restaurants
• Hairdressers
• PC manufacturers
• Television services

DIAGRAM OF MONOPOLISTIC COMPETITION IN THE SHORT RUN
In the short run, the diagram for monopolistic competition is the same as for a monopoly.
The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to
supernormal profit
DIAGRAM OF MONOPOLISTIC COMPETITION IN THE SHORT RUN
Demand curve shifts to the left due to new firms entering the market.
In the long-run, supernormal profit encourages new firms to enter. This reduces demand for
existing firms and leads to normal profit.

OLIGOPOLY
An oligopoly is a market characterized by a small number of firms who realize they are
interdependent in their pricing and output policies. The number of firms is small enough to give
each firm some market power.
When all firms are of (roughly) equal size, the oligopoly is said to be symmetric.
In an oligopoly market structure there are a small number of firms, none of which can keep the
others from having significant influence.
There is no precise upper limit to the number of firms in an oligopoly, but the number must be
low enough that the actions of one firm significantly influence the others.
Oligopoly Characteristics
1. Few sellers.
There are just several sellers who control all or most of the sales in the industry.
2. Barriers to entry.
It is difficult to enter an oligopoly industry and compete as a small start-up company. Oligopoly
firms are large and benefit from economies of scale. It takes considerable know-how and capital
to compete in this industry.
3. Interdependence.
Oligopoly firms are large relative to the market in which they operate. If one oligopoly firm
changes its price or its marketing strategy, it will significantly impact the rival firm(s). For
instance, if Pepsi lowers its price by 20 cents per bottle, Coke will be affected. If Coke does not
respond, it will lose significant market share. Therefore, Coke will most likely lower its price,
too.
4. Prevalent advertising.
Oligopoly firms frequently advertise on a national scale.
5. Ability to set price
Oligopolies are price setters rather than price takers.

6. Long run profits
Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms
from entering the market to capture excess profits.
7. Product differentiation
Product may be homogeneous (steel) or differentiated (automobiles).
8. Perfect knowledge
Assumptions about perfect knowledge vary but the knowledge of various economic factors can
be generally described as selective. Oligopolies have perfect knowledge of their own cost and
demand functions but their inter-firm information may be incomplete. Buyers have only
imperfect knowledge as to price, cost and product quality.
In the kinked demand curve model, the firm maximises profits at Q1, P1 where MR=MC. Thus a
change in MC, may not change the market price. It suggests prices will be quite stable.

The kinked demand curve makes certain assumptions
• Firms are profit maximisers.
• If one firm increases the price, other firms won’t follow suit. Therefore, for a price
increase, demand is price elastic.
• If one firm cuts price, other firms will follow suit because they don’t want to lose market
share. Therefore, for a price cut, demand is price inelastic.
• This is how we get the ‘kinked demand curve
However, the kinked demand curve has limitations
• It doesn’t explain how the price was arrived at in the first place.
• Firms may engage in price competition.
Collusion
Collusion occurs when rival firms agree to work together – e.g. setting higher prices in order to
make greater profits. Collusion is a way for firms to make higher profits at the expense of
consumers and reduces the competitiveness of the market.
Types of collusion
Formal collusion
When firms make formal agreement to stick to high prices. This can involve the creation of a
cartel. The most famous cartel is OPEC – an organisation concerned with setting prices for oil.
Tacit collusion
Where firms make informal agreements or collude without actually speaking to their rivals. This
may be to avoid detection by government regulators.
Price leadership
It is possible firms may try to unofficially collude by following the prices set by a market leader.
This enables them to keep prices high, without ever meeting with rival firms. This kind of
collusion is hard to prove whether it is unfair competition or just the natural operation of markets.

Problems of collusion
Collusion is seen as bad for consumers and economic welfare, and therefore collusion is mostly
regulated by governments. Collusion can lead to:
High prices for consumers. This leads to a decline in consumer surplus and allocative
inefficiency (Price pushed up above marginal cost).
New firms can be discouraged from entering the market by types of collusion which act as a
barrier to entry.
Easy profits from collusion can make firms lazy and avoid innovation and efforts to increase
productivity.
Industry gets the disadvantages of monopoly (higher price) but none of the advantages (e.g.
economies of scale)
Justification for collusion
In times of unprofitable business conditions, collusion may be a way to try and save the industry
and prevent firms from going out of business, which wouldn’t be in the long-term consumer
interest. Dairy suppliers tried to use this justification in 2002/03 after problems from foot and
mouth disease led to a decline in farm incomes.
Research and development. Profits from collusion could, in theory, be used to invest in research
and development.
Collusive Oligopoly
Sometimes, firms may try to remove uncertainty related to acting independently and enter into
price agreements with each other. This is collusion. Collusion is either formal or informal. It can
take the form of cartel or price leadership.
A cartel is an association of independent firms within the same industry which follow the
common policies relating to price, output, sale, profit maximization, and the distribution of
products.

Price leadership is based on informed collusion. Under price leadership, one firm is a large or
dominant firm and acts as the price leader who fixes the price for the products while the other
firms allow it.
Firms behaviour under Oligopoly
Based on the objectives of the firms, the magnitude of barriers to entry and the nature of
government regulation, there are different possible outcomes in relation to a firm’s behavior
under Oligopoly.
These are:
1. Stable prices
2. Price wars
3. Collusion for higher prices
Further, Oligopoly can either be collusive or non-collusive. Collusive oligopoly is a market

situation wherein the firms cooperate with each other in determining price or output or both. A
non-collusive oligopoly refers to a market situation where the firms compete with each other
rather than cooperating.
Cartel
A cartel occurs when two or more firms enter into agreements to restrict the supply or fix the
price of a good in a particular industry.
A cartel is a formal type of collusion.
Cartels are considered to be against the public interest. This is because cartels aim to:
• Increase price.
• Distort normal workings of a competitive market.
• Redistribute income in society from consumers to powerful vested interests.
• Successful cartels become an ‘easy’ way to make profit, therefore it may discourage
innovation and efficiency gains.
MONOPOLY
A monopoly market is a form of market where the whole supply of a product is controlled by a
single seller. There are three essential conditions to be met to categorize a market as a monopoly
market.
Pure monopoly
A pure monopoly is a market structure where one company is the single source for a product and
there are no close substitutes for the product available. Pure monopolies are relatively rare. In
order for a provider to maintain a pure monopoly, there must be barriers preventing competitors
from entering the market.
Natural Monopoly
A natural monopoly occurs when the most efficient number of firms in the industry is one. A
natural monopoly will typically have very high fixed costs meaning that it is impractical to have
more than one firm producing the good.
An example of a natural monopoly is tap water. It makes sense to have just one company
providing a network of water pipes and sewers because there are very high capital costs involved
in setting up a national network of pipes and sewage systems. To have two different companies
offering water wouldn’t make sense as the average cost would be very high compared to just one
firm and one network. There would also be the inconvenience of having two firms dig up the
road to lay a duplicate set of water pipes.
Characteristics of a Monopoly
A monopoly can be recognized by certain characteristics that set it aside from the other market
structures:
Profit maximizer
A monopoly maximizes profits. Due to the lack of competition a firm can charge a set price
above what would be charged in a competitive market, thereby maximizing its revenue.

Price maker
The monopoly decides the price of the good or product being sold. The price is set by
determining the quantity in order to demand the price desired by the firm (maximizes revenue).
High barriers to entry
Other sellers are unable to enter the market of the monopoly.
Single seller
In a monopoly one seller produces all of the output for a good or service. The entire market is
served by a single firm. For practical purposes the firm is the same as the industry.
Price discrimination
In a monopoly the firm can change the price and quantity of the good or service. In an elastic
market the firm will sell a high quantity of the good if the price is less. If the price is high, the
firm will sell a reduced quantity in an elastic market.
Reasons for the Existence of Monopoly Market
• Monopolies arise in the market due to the following three reasons.
• The firm owns a key resource, for example, Debeers and Diamonds.
• The firm receives exclusive rights by the government to produce a particular product.
Like patents on new drugs, the copyright for books or software, etc.
• One producer can be more efficient than others due to the cost of production. This gives
rise to increasing returns on sale. Few examples are American electric power, Columbia
Gas.

Monopoly Power
The individual control of the market in a monopoly market structure is due to the following
sources of power.
• Legal barriers
• Economies of sale
• Technological superiority
• Control of natural resources
• Network externalities
• Deliberate actions
• Capital requirements
• No suitable substitute

A competitive market produces at Qc and Pc
A monopoly produces less (Qm) and charges higher price (Pm)
Inefficiency of monopoly
• Monopolies set the price of Pm – which is higher than Pc (allocative inefficiency)
• Monopolies produce at Qm (which is productive inefficient – not the lowest point on AC

curve)
• Monopolies lead to deadweight welfare loss of blue triangle

PERFECT COMPETITION
Perfect competition, a theoretical market structure that features no barriers to entry, an unlimited
number of producers and consumers, and a perfectly elastic demand curve.

Perfectly Competitive Market Characteristics
Infinite buyers and sellers – An infinite number of consumers with the willingness and ability to
buy the product at a certain price, and infinite producers with the willingness and ability to
supply the product at a certain price.
Zero entry and exit barriers – A lack of entry and exit barriers makes it extremely easy to enter or
exit a perfectly competitive market.
Perfect factor mobility – In the long run factors of production are perfectly mobile, allowing free
long term adjustments to changing market conditions.
Perfect information - All consumers and producers are assumed to have perfect knowledge of
price, utility, quality and production methods of products.
Zero transaction costs - Buyers and sellers do not incur costs in making an exchange of goods in
a perfectly competitive market.
Profit maximizing - Firms are assumed to sell where marginal costs meet marginal revenue,
where the most profit is generated.
Homogenous products - The qualities and characteristics of a market good or service do not vary
between different suppliers.
Non-increasing returns to scale - The lack of increasing returns to scale (or economies of scale)
ensures that there will always be a sufficient number of firms in the industry.
Property rights - Well defined property rights determine what may be sold, as well as what rights
are conferred on the buyer.

• The market price is set by the supply and demand of the industry (diagram on right)
• This sets the market equilibrium price of P1.
• Individual firms (on the left) are price takers. Their demand curve is perfectly elastic.
• A firm maximises profit at Q1 where MC = MR
• At this price firms make normal profits – because average revenue (AR) = average cost
(AC)
1. Market demand rises from D1 to D2 causing the price to rise from P1 to P2.
2. Due to the rise in price to P2, profits are now maximised at Q2.
3. A firms marginal cost (MC) curve is effectively its supply curve
4. At Q2, (AR is greater than price) and therefore the firm now makes supernormal profit.
• However, the supernormal profit encourages more firms to enter the market.
• New firms enter (supply increases from S1 to S2) until the price falls to P1.
• With price at P1, profits are maximised at Q1 and normal profits are made once again
(AR=AC).

CONTESTABLE MARKET
A contestable market is one that is open to actual & potential competition. A market is
contestable where an entrant has access to all production techniques available to existing
businesses and when entry decisions can be reversed without cost i.e. there are no sunk costs.
A contestable Market is a market where enterprises can enter and exit without encountering
obstacles. They are typically uncommon in the actual world, either because of government
restrictions on the entry of new businesses or a natural monopoly forming in an industry.
A contestable market allows the free entry and exit of firms. Potential entrants need to recognize
a fleeting profit opportunity because they can enter, pocket their profits before prices change, and
leave without incurring any costs if the environment turns hostile. Its susceptibility to hit-and-run
entry is the essential characteristic of a contestable market.
The firms or businesses here need not be small in size, numerous, autonomous in their judgment,
or able to create uniform goods. On the contrary, it’s the only characteristic of perfect
competition that contestable markets may share. In other words, a completely competitive market
is also necessary for being a perfectly contestable market.
The market will have close-to-average prices or similar prices across the firms. This is because
entrants will enter the market if incumbents raise prices since there are no obstacles to entry. As
a result, they will be able to produce just as effectively as incumbents as they have equal access
to technology.
Additionally, if prices drop due to the emergence of new entries, the newcomer will be able to
leave the market quickly and cheaply due to no existing barriers. This entry type is often called a
“hit and run.” The contestable market theory goes like this- monopoly or oligopoly market
enterprises would have conducted similarly as in perfect competition if there was an easy entry
and exit option.
Characteristics of contestable market
A contestable market typically satisfies the following conditions:-
Entry and exit
In a perfectly contestable market, firms are free to enter or exit at any time. They do not have any
barriers and are, therefore, competitive.

Equal access to technology
All firms in the marketplace, whether old or newcomer, are provided access to the same
technology for production purposes. Hence one firm does not have an unfair advantage over
accessibility.
Availability of information
Contestable market economics is transparent. Information on prices is available to all consumers

and firms across the markets.
Low or no sunk costs
Sunk costs are costs that one cannot recover after they have spent them. Such costs arise due to
activities requiring specialized assets that cannot be used for other purposes. And hence the
opportunities for selling them are few. They are fixed costs and firm-specific. When sunk costs
are present, firms find it difficult to exit and enter. It becomes a costly affair. This factor makes a
contestable market and significantly contributes to the fact that existing firms do not aggressively
react to the new entry of firms. The other one is economies of scale.

REVISION QUESTIONS
1. a) Explain the objectives of firms. [10]

b) Analyse the factors that influence the pricing and output decisions of the firm. [15]
2. a) Describe briefly the main forms of imperfect competition. [10]

b) Discuss the means by which the government of your country may control the
power of monopolies. [15]
3. a) Explain the differences between oligopoly and monopoly. [10]

b) Discuss the view that oligopoly is a more beneficial marketstructure to society
than a monopoly. [15]
4. a) Explain the market structure in which supermarkets are found in your country. [10]
b) Assess whether society would benefit more if the supermarkets were taken over
by one big firm. [15]
5. Compare and contrast the main characteristics of monopolistic competition

and oligopoly. [25]
6. a) Compare and contrast firms under oligopoly and monopolistic competition. [12]
b) Discuss whether society benefits more from an oligopolistic firm than a
monopolistic firm. [13]
7. Evaluate the advantages of monopolies to society. [15]
8. Discuss the benefits of changing from perfect competition to monopolistic

competition. [15]
9. a) Contrast a monopoly and a perfectly competitive firm. [10]

b) Assess the benefits of monopoly firms to society. [15]

7. THEORY OF DISTRIBUTION
Factors of production
In economics, the factors of production are the resources or inputs that are used in the production
• Land
This refers to all natural resources used in production, including land itself, as well as any
minerals, water, forests, or other resources that are found in or on the land. Land is often
considered a fixed factor because its supply is generally limited.
• Labour
Labour includes the physical and mental effort exerted by individuals in the production
process. It encompasses the skills, abilities, and time contributed by workers. Labour is a
variable factor as it can be increased or decreased based on the needs of production.
• Capital
Capital refers to the physical assets or man-made resources used in production. It includes
machinery, equipment, tools, buildings, infrastructure, and any other tangible goods that are
employed to produce other goods and services. Capital can be classified as either physical
capital or financial capital.
• Entrepreneurship
Entrepreneurship refers to the ability and willingness to organize, coordinate, and take risks
in the production process. Entrepreneurs play a crucial role in identifying business
opportunities, assembling and allocating resources, making strategic decisions, and assuming
the uncertainties and risks associated with starting and managing a business.
In conclusion, these four factors—land, labor, capital, and entrepreneurship—combine together

to facilitate the production of goods and services. They are complementary to each other,
meaning that all factors are typically needed in combination to achieve efficient production. The
relative availability, quality, and combination of these factors of production influence the level of
economic output and the distribution of income in an economy.

Rewards for factors of production
Suppliers of factors of production are rewarded or compensated, which varies depending on what
factors they supply. If we add up, we know the compensation as a factor income. If it is
calculated for all economic actors in an economy, it is national income.
Rent
Rent is a reward for land. Landlords can lease their land to producers throughout the economy.
In the perspective of economics, land does not only include agricultural, plantation, or industrial
areas. But, it also includes the natural resources contained in it, such as various metallic minerals,
petroleum, and coal. They can be renewable resources, abundantly available in nature, and non-
renewable resources, which can be exhausted if we over-exploit them.
Wages
Compensation to workers takes many forms. It can be wages, salaries, and benefits such as
insurance and pensions. Wages usually refer to compensation to manual workers, for which they
are paid hourly. Meanwhile, salary refers to compensation in a fixed amount, usually paid per
month. If the wages received by workers depend on their total hours worked, it is not on salary.
But, in economics, we specifically refer to them all as wages, i.e., compensation for workers’
mental and physical effort used in the production process.
Interest
Interest is compensation for capital. Capital represents a man-made tool to help process inputs
into outputs. They include machinery, buildings, equipment, and vehicles. Sometimes, we also
refer to them as capital goods.
Economists exclude financial capital such as cash, bonds, and stocks from the capital category.
This is because we cannot use them directly to produce goods and services, but rather, we use
them indirectly, namely as payment intermediaries to buy capital goods.
Profit
Profit is the reward for entrepreneurship. Entrepreneurs earn it for their willingness to take risks
to commercialize a business idea, start and run a business. Profit is the revenue remaining after
all production costs have been paid, including payments to suppliers of the other three resources.

TRANSFER EARNINGS
• Transfer earnings are the minimum income a worker needs in order to supply their labour.
• Transfer earnings are defined as the minimum payment necessary to prevent a factor of
production moving to a different use.
Example of Transfer Earnings for Labour
A worker may have a transfer earning of $150 a week. If he was paid less, he wouldn’t want to
work in that occupation. For example, a worker may feel he is better off claiming unemployment
benefits that working for less than $150 a week.
ECONOMIC RENT
• Economic rent is the extra income a worker receives – above the minimum level they
need in order to work. In other words economic rent refers to income earned from a
factor of production which is greater than the minimum necessary to bring the factor of
production into operation.
Example of Economic Rent – Labour.
Suppose a football player would be willing to work for $200 a week. If the football player got
paid $1 000 a week. His economic rent is $800 a week.
Economic rent is the area between the supply curve and the wage rate. The supply curve
indicates the minimum wage people are prepared to work at.
The elasticity of demand and supply will determine the relative size of economic rent. If we take
a footballer, demand is quite wage inelastic (not many alternatives to best players. Therefore,
economic rent is relatively large.
Low-skilled jobs – lower economic rent

For low skilled jobs, both supply and demand are more wage elastic.
With many workers qualified to work as a cleaner, supply is elastic. Most cleaners get paid only
slightly above their transfer earings, therefore economic rent is relatively low.

Example of Economic Rent – Property
Suppose a landlord has a property and he would be willing to rent it out for a minimum of $400 a
month. If the landlord was able to rent the property for $950 a month, then his economic rent is
$550.
Difference between rent and quasi-rent and rent
Rent can be referred to as any payment periodically made to a landlord by a tenant in return for
the use of property, land, office, building, or even an apartment. It is the periodic return made by
an occupant or a tenant of a property to the owner for the use or possession of the property.
Quasi rent is defined as the income earned resulting from the opportunity cost after an
investment. Quasi rent, sometimes also referred to as the economic rent is said to be the
difference between the obtained income from a given factor of production and the cost of the
factor that is applied in bringing the production in a given use while rent is an agreed sum that a
tenant or user of the property pays to the owner in well-agreed intervals.
Rent is earned by leasing property to tenants and periodically collecting income from them at
intervals while quasi rent is earned the amount earned after individuals lose the cost of
investment and have their payment sunk.
Rent is an unearned income while quasi rent is an essential payment. Rent is permanent while
quasi rent is temporary. Rent is gained from land and other gifts of nature while quasi rent is
gained from man-made capital equipment. Rent arises from both long and short-periods while
quasi rent arises in short periods only.
QUASI RENT
Quasi rent is the earning of capital equipments such as machineries, buildings etc., which are
inelastic in supply, in short run. According to Marshall, it is only a temporary surplus, which is
enjoyed by the owner of the capital equipments in the short run. This is due to the increase in its
demand and it will disappear in the long run, if supply of the capital equipment is increased in
response to the increased demand. It is also defined as the excess of total revenue earned in the
short run over and above the total variable costs. Thus, Quasi Rent = Total Revenue Earned
minus Total Variable Costs.
Ricardian rent is a payment made for the use of land whereas quasi-rent is a payment for man
made factors such as buildings, machineries, etc. Ricardian rent Wage Fund Rate of Wages =
Number of Workers exists both in short run and long run because supply of land is fixed in long
run. But it is only a temporary earning due to increased demand.

In the figure, P represents price. The firm maximises profit while it produces ON unit of output
with 0PEN amount of total revenue. Now, the firm pays 0NBA amount of variable cost to the
variable factor. This means that the residual of the total income, i.e., ABEP is the quasi-rent
which goes to the fixed factor.
It is to be noted that the theory assumes that the firm operates under perfect competition. The
quassi-rent can be divided into two parts. This has been shown with the help of Figure. In the
figure, the area ABCD represents the total fixed cost, while PECD represents the excess (or pure)
profit.
Thus,
Quasi-rent = TFC + Excess Profit. Or,
Excess profit = Quasi-rent – TFC.

In the long run, as supply increases, Quasi-rent becomes zero and the firm is in equilibrium,
earning just normal profit.
DETERMINATION OF REWARDS OF FACTORS
OF PRODUCTION
MARGINAL REVENUE PRODUCTIVITY THEORY
What is marginal revenue product of labor?
The marginal revenue product of labor (MRPL) is the additional amount of revenue a firm can
generate by hiring one additional employee. It is found by multiplying the marginal product of
labor by the price of output. Firms will demand labor until the MRPL equals the wage rate.
Another factor that determines pay is the demand for the good. For example, the best football
players get paid much more than the best hockey players because there is much more demand for
watching football games, there is more money in the sport, so clubs are willing and able to pay
much higher salaries to get the service of the best players.
Example
If we take wages for strawberry pickers.The worker who picks much faster and fills his basket of
strawberries should get paid a higher salary than a lazy worker who falls asleep. For jobs such as
strawberry picking, firms can pay piecemeal and link pay to productivity.
What factors determine the wage that someone receives?
Basic economic theory suggests that wages depend on a worker’s marginal revenue product
MRP. (this is basically the value that they add to the firm which employs them.)
MRP is determined by two factors:
• MPP – Marginal physical product – the productivity of a worker.
• MR – Marginal revenue of last good sold – Effectively the price and demand for the good.

Monopsony
The theory of monopsony suggests employers will have market power in determining wages and
therefore are able to pay workers less than their MRP.
A traditional monopsony would be a single employer of workers in a town, e.g. Government.

With no other choice of work, workers have to accept the conditions and wages of the
monopsony employer.
In a modern economy, these single employers are quite rare, but arguably many firms have
significant monopsony power and have market power in setting wages.
Sources of monopsony power and wage inequality
Unemployment
When unemployment is high, arguably firms gain more monopsony power. Someone who has
unsuccessfully applied for many jobs is more willing to accept lower wages to get a job.
Lack of information
The theory of competitive labour markets assumes that workers have access to different job wage
rates and potential sources of employment. But, in practice, it is difficult to have all the relevant
information. It takes time to find information.
Geographical immobility
Often work is chosen on grounds of geographical proximity or other non-wage factors (rather
than wage rates). Therefore, even if higher paid work may be available elsewhere, it is not worth
the extra commute.
Difficulties in moving jobs
Workers often have a great reluctance to leave work. You can’t just change jobs like deciding to
buy a different type of petrol. A worker will lose on the job training, and firms are reluctant to
employ workers who have a habit of moving frequently to get slightly higher pay. Workers can
also gain loyalty to a particular place of work, e.g. become friends with co-workers.

Marginal Productivity Theory of Wages: Statement and Limitations of the Theory
The marginal productivity theory states that, under conditions of perfect competition, every
worker of same skill and efficiency in a given category will receive a wage equal to the value of
the marginal product of that type of labour.
The marginal product of labour in any industry is the amount by which the output would be
increased if one more man was employed while the quantities of other factors of production
employed in the industry remained constant.
In short, it is the output of a single worker unaccompanied by any change in other factors of
production.
The value of the marginal product of labour is the price at which the marginal product can be
sold in the market. Under conditions of perfect competition, an employer will go on employing
more and more workers until the value of the product of the last man he employs is equal to the
marginal or additional cost of employing the last man.
Further, the condition of perfect competition implies that the marginal cost of labour is always
equal to the wage rate, irrespective of the number of men the employer may engage. Every
industry being ultimately subject to law of diminishing returns, this marginal product must start
declining sooner or later. Wages remaining the same, the employer stops employing more
workers at that point where the value of the product of a worker is equal to the wage rate.
So far we have assumed that the quantities of other factors remain constant while that of labour
alone increases. This, however, is not realistic, because quantities of other factors too can be
increased, though this may not be true in the short run.
To allow for this fact, the economists make use of the term “marginal net product of labour”
instead of “marginal product of labour”. The value of marginal net product of labour may be
defined as being the value of the amount by which output would be increased by employing one
more man with the appropriate addition of other factors of production, less the addition to the
cost of the other factors caused by increasing the quantities of other factors.
The theory may thus finally be re-stated as follows:
Under conditions of perfect competition in the labour market and in the market for the products
of the industry, and irrespective of the number employed, every worker will receive a wage equal
to the value of marginal net product of his labour.

Limitations of the Theory:
We have already studied in detail the various limitations and criticisms of the Marginal
Productivity Theory as a general principle of distribution. With reference to its application to
wages, we may repeat that the theory is true only under certain assumptions such as perfect
competition, perfect mobility of labour from employment to employment, homogeneous
character of all labour, constant rates of interest and rent and given prices of the product. It is a
static theory.
The actual world is dynamic. All the factors assumed to be constant are in fact constantly
changing, competition is never perfect; mobility of labour is restricted for various reasons; all
labour is not of the same grade, remuneration to other factors of production does not remain
constant; and the prices of the products of labour vary. All these changes modify the theory when
applied to actual conditions. The theory, however, as an assertion of a tendency is true and is
valuable in understanding the basic forces that determine wage rates.
In the actual world, owing to the absence of the above assumptions, there is no single rate of
wages that may be applicable to all labour of a particular type. Wages differ from place to place,
from person to person and from employment to employment.
The following limitations or points of criticism of the marginal productivity theory may now be
noted:
Firstly, this theory has little applicability to reality:
The labour is not perfectly mobile. Workers of the same skill and efficiency may not receive the
same wages at two different places.
Secondly:
Though the condition of a large number of independent sellers is fulfilled for a few industries of
all countries and for most industries of some countries, the employers usually combine to the
disadvantage of the workers. It is a case of monophony, i.e., one buyer (i.e., the employer) and
many sellers (i.e., workers). The employers succeed in pulling down the wages below the value
of the marginal net product of labour.

If employees are also collectively organized, the wage rates may or may not be equal to the
values of marginal net product of labour in the occupations or industries concerned. The wages
are determined by the relative bargaining strength of the two parties, but will not for a long time
exceed the value of the marginal net product of labour.
Thirdly:
The market for goods is in general characterised by imperfect competition. This also upsets the
theory.
Fourthly:
The productivity of workers is also dependent on factors such as the quality of capital and
efficiency of management. These factors are beyond the control of workers.
Fifthly:
Productivity is also dependent on wages. Low productivity may be the cause of low wages,
which may tell on the efficiency of the worker, lower his standard of living, and ultimately check
the supply of labour. The theory takes the supply of labour for granted.
In short, the marginal productivity theory ignores the effect of wage changes on the supply of
labour, bargaining strength and monopoly conditions, etc.
Conclusion:
In spite of these limitations, it may be said that the marginal productivity theory is more
satisfactory than the earlier theories. It furnishes a more satisfactory explanation of difference in
wages in different countries or at different times in the same country.

LIQUIDITY PREFERENCE THEORY
Liquidity Preference Theory is a theory that suggests that investors demand higher interest rates
or additional premiums for medium or long-term maturities and investments. According to this
theory, risk increases with maturity, and in such a situation, investors should aim for higher
interest rates. Because short-term investments are more liquid than medium or long-term
investments. Simply put, interest rates directly indicate the price of the money. Therefore, other
things remaining constant demand and supply of money determine the interest rate.
The Liquidity Preference Theory was developed by John Maynard Keynes in 1936. And this
theory gives immense importance to the liquidity factor of investment. According to this theory,
short-term investments give a lower interest rate because they provide liquidity to investors.
Moreover, medium and long-term investments lead to higher interest rates because of their
illiquid nature. Short-term investments mature from or within a year of the deposit by providing
liquidity, in contrast to medium and long-term investments that mature after 3-10 years and are
illiquid in nature.
According to John Maynard Keynes, the demand and supply of money determine interest rates.
Individuals prefer to hold liquid cash in their hands rather than invest it by preferring liquid cash.
Thus, according to Keynes, interest rates are a reward for not having liquidity in their hands, and
the consideration goes hand in hand with the ideology that cash is the most liquid asset.
Demand for Money (Motives)
Liquidity Preference Theory measures liquidity in relation to demand for money or other liquid
instruments. And according to Keynes, there are three main reasons (motives) for demand for
money. These motives are as follows:
1. Transactions Motive
This is a fundamental motive for the individual’s demand for money. Here, in order to satisfy all
daily needs, the individual requires money with a transaction motive. By transaction motive, the
individual requires money to buy food and maintain the standard of living. Moreover, higher
spending with a transaction motive leads to an increase in the standard of living. Thus, to
maintain the standard of living, individuals need sufficient cash in hand. Most people with higher
earning capacity require more money to satisfy daily needs. According to John Maynard Keynes,
demand through transaction motive is inelastic to interest rates and elastic to income level.

2. Precautionary Motive
According to John Maynard Keynes, this is the second motive for the demand for money.
Individuals demand money with a precautionary motive in order to protect themselves from an
uncertain future. Because the future is uncertain and there could be sudden natural or man-made
disasters. In such a situation in order to protect themselves, individuals demand money with
precautionary intentions. And money held under precautionary motive is known as ‘Idle
Balance’. These uncertain situations demand cash outflow and so individuals demand money for
the same. According to John Maynard Keynes, precautionary demand is inelastic to the interest
rate and elastic with regard to income levels, like the transaction motive.
3. Speculative Motive
A speculative motive is the third motive for the demand for money. Under this motive,
individuals demand money by taking into account fluctuations in interest rates or bond prices. If
interest rates are lower or bond prices are lower, there is a high demand for money with
speculative motives and vice versa. If interest rates are lower, these individuals hold / hoard their
money and invest later when interest rates are higher. As a result, under speculative demand for
money, there is an inverse relationship between interest rates and demand for money.
Total Demand
The aggregate demand for money or the function of liquidity preference would be the sum of all
three motives transaction, precautionary and speculative).
TD = T + P + S
Supply for Money
According to John Maynard Keynes, the supply of money is largely fixed and determined by the
country’s central bank. Therefore, according to the theory of liquidity preference, the supply is
perfectly inelastic and graphically represents a straight vertical line.

Determination of Rate of Interest
The interest rate is determined at the point where the demand for money is equal to the supply of
money. And, in the graph of the determination of the interest rate, the TD curve is downward
sloping from left to right. This is due to the opposite link between the demand for money and the
interest rate. Whereas the Supply (SP) curve is perfectly inelastic and represents a vertical
straight line. Let’s understand this with a graphical representation:-
Interpretation
As shown in the figure above, the X axis measures the amount of money and the Y axis the
interest rate. In the figure, TD is the demand curve of money and SP is the supply curve of
money. And the point at which the demand of money equals the supply of money is denoted by
E. At point E, both curves intersect each other and determine the interest rate R, and the interest
rate R is the equilibrium interest rate.
At point E1, the supply of money is higher than the demand for money, and so individuals buy
more securities. In such situations, the interest rate begins to fall back to the point-R (equilibrium
level). Similarly, at point E2, the demand for money is higher than the supply of money, and
therefore individuals will begin to sell securities. As a result, the interest rate will rise to
equilibrium level R.
If we look at the figure above, there is a liquidity trap, and the range between R-Min and R-Max
is known as a liquidity trap, so the interest rate only fluctuates under this trap.

Limitations of Liquidity Preference Theory
• One of the biggest limitations of the liquidity preference theory is that it assumes that the
employment rate is constant. In reality, the employment rate is not constant and it is
constantly changing.
• The second criticism is that this theory assumes a certain level of income.
• The third criticism is that this theory claims that it is either cash or an investment in
bonds. In today’s scenario, many people have cash at their disposal for liquidity purposes
and investments in bonds. This theory completely ignores the scenario of receiving
interest benefits for some funds and receiving liquidity benefits for remaining funds.
• The fourth criticism is that different interest rates exist in different markets at the same
time, which the liquidity preference theory completely ignores.
• According to the experts, the liquidity preference is not the only criterion for interest
rates. This theory also does not take into account so many real elements. This ignorance
is the fifth criticism.
• The savings done by individuals is not considered under this theory.
Conclusion of the liquidity preference theory
Notwithstanding many criticisms of Liquidity Preference Theory, it is useful for identifying the
effect of demand and the supply of money on interest rates. It shows the relationship between the
motives of people with income and interest rates. It also asserts that monetary policy is not
effective in the economy because of a liquidity trap during the depression in the economy. At the
same time, however, we need to understand and assess that liquidity is not the only factor that
drives the money supply or interest rates. There are so many other factors to consider before
making a decision.

LOANABLE FUNDS THEORY
The loanable funds theory is a fundamental concept in economics that explains how the supply
and demand for loanable funds affect interest rates in an economy.
The loanable funds theory was formulated in the 1930s by British economist Dennis Robertson
and Swedish economist Bertil Ohlin. However, Ohlin credited the origin of the theory to Knut
Wicksell, a Swedish economist, and the Stockholm school, which included economists like Erik
Lindahl and Gunnar Myrdal.
INTEREST RATE AND ITS TYPES
Loanable funds theory is used to determine the interest rate in the money market of a country.
Interest Rate
The cost of borrowing money, expressed as a percentage of the amount of the loan, is called the
interest rate. In other words, the interest rate is the amount paid by the borrower to the lender for
the use of the borrowed money, expressed as a percentage of the principal amount.
Types of Interest Rates
Nominal Interest Rate
The interest rate measured at current year prices, which includes inflation, is called the nominal
interest rate.
Real Interest Rate
The interest rate measured at base year prices and adjusted for inflation is called the "real interest
rate."
Real Interest Rate = Nominal Interest Rate - Rate of Inflation

ASSUMPTIONS OF THE LOANABLE FUNDS THEORY
Perfect competition
The loanable funds theory assumes that there is perfect competition in the financial markets. This
means that there are many buyers and sellers in the market, and no single entity has the power to
influence the market price.
Rationality
The theory assumes that borrowers and lenders are rational and make decisions based on their
self-interest.
No Risk
The loanable funds theory assumes that there is no risk associated with lending or borrowing
money.
Homogeneity
The theory assumes that all loanable funds are identical. In reality, however, different loans and
investments have different characteristics and risks.
No Transaction Cost
The theory assumes that there is no transaction cost associated with borrowing or lending money.
In reality, however, there are always transaction costs, such as fees and commissions.
UNDERSTANDING THE LOANABLE FUNDS THEORY
The loanable funds model explains the determination of interest rates through the relationship
between supply and demand for loanable funds in an economy. In this model, the supply of funds
comes from savings, while the demand for funds comes from investment opportunities.
In essence, the loanable funds theory explains how lenders and borrowers interact to determine
the equilibrium interest rate, which is the rate at which the quantity of funds supplied equals the
quantity of funds demanded.

According to Loanable Funds Theory, the interest rate in an economy is determined by
1. Demand for Loanable Funds
2. Supply of Loanable Funds
LOANABLE FUNDS
The funds available with banks for lending and borrowing are called "loanable funds."
1. Demand for Loanable Funds
The willingness and ability of borrowers to get loans is called the demand for loanable funds.
Households, firms, and the government demand loanable funds.
• Households demand loanable funds for expensive purchases, e.g., houses, cars, etc. This
demand for loanable funds is interest-elastic.
• Firms demand loanable funds for investment. This demand for loanable funds is also
interest-elastic.
• The government demands loanable funds to finance its budget deficit. This demand for
loanable funds is interest-inelastic.
There is a negative or inverse relationship between the quantity demanded of loanable funds and
the interest rate as shown in the following graph of the demand curve.

A graph illustrating the downward sloping demand curve of loanable funds.
Factors affecting the Demand for Loanable Funds
The demand for loanable funds is affected by various factors, including the level of economic
growth, the state of consumer confidence, and the availability of alternative sources of financing,
such as equity markets.
2. Supply of Loanable Funds
The willingness and ability of banks (lenders) to give loans is called the supply of loanable funds.
Banks supply loanable funds from the amounts deposited by households and firms.
• As savers, the households save money in banks.
• Firms keep their excessive profits and capital in banks.
There is a positive, or direct, relationship between the quantity supplied of loanable funds and
interest rate as shown in the following graph of the supply curve.

A graph illustrating the upward sloping supply curve of loanable funds.
Factors affecting the Supply of Loanable Funds
The supply of loanable funds is primarily influenced by two key factors: the willingness of
households to save and the level of government borrowing. When households are more willing to
save, the supply of loanable funds increases, and interest rates decrease. Conversely, when the
government borrows more money, the supply of loanable funds decreases, and interest rates
increase.
Equilibrium Interest Rate
It is an interest rate for which: Demand for Loanable Funds = Supply of Loanable Funds.
In other words, the interaction between the supply and demand for loanable funds determines the
equilibrium interest rate, which is the rate at which the quantity of loanable funds supplied equals
the quantity of loanable funds demanded.
When there is a surplus of loanable funds, interest rates decrease, making it cheaper for
businesses and individuals to borrow money. Conversely, when there is a shortage of loanable
funds, interest rates increase, making it more expensive to borrow.

The equilibirum interest rate (r0) is shown by the following correctly labeled graph of the
loanable funds market showing the interaction between the demand and supply curves.
A graph illustrating the equilibirum interest rate according to loanable funds theory.
The quantity of loanable funds is taken on the horizontal axis, and the interest rate is taken on the
vertical axis. The supply and demand curves intersect at the equilibrium point E0. Q0 is the
equilibirum quantity of loanable funds and r0 is the equilibirum interest rate.
Changes in Equilibrium Interest Rate
Changes in equilibrium interest rate can be due to:
• The rightward or leftward shift in the demand for loanable funds
• The rightward or leftward shift in the supply of loanable funds
• The simultaneous shifts in the demand for loanable funds and the supply of loanable
funds

APPLICATION OF THE LOANABLE FUNDS THEORY
The loanable funds theory has numerous real-world applications, including the role of central
banks in setting interest rates. Central banks, such as the Federal Reserve in the United States,
adjust interest rates to influence the supply and demand for loanable funds in the economy, in
order to maintain stable economic growth and low inflation.
The theory also has implications for government borrowing and spending. When governments
borrow more money, they increase the demand for loanable funds, which can lead to higher
interest rates and reduced private investment.
Limitations of the Loanable Funds Theory
Liquidity Preference
The theory does not take into account the fact that investors may prefer to hold liquid assets,
such as cash or short-term securities, instead of investing in long-term projects.
Imperfect information
The theory assumes that borrowers and lenders have perfect information about the market and
each other. In reality, however, there is always some degree of information asymmetry, which
can affect the lending and borrowing decisions.
Behavioral Factors
The theory does not take into account the role of behavioral factors, such as emotions, social
norms, and cognitive biases, which can influence the lending and borrowing decisions.
Government Intervention
The theory assumes that there is no government intervention in the financial markets. In reality,
however, governments often regulate and influence the financial markets through policies such
as taxes, subsidies, and interest rate controls.

International Capital Flows
The theory focuses on the domestic market for loanable funds and does not take into account the
role of international capital inflows, which can affect the interest rates and allocation of credit in
an economy.
Money Supply
This theory ignores the total money supply in the economy and considers only the supply of
loanable funds.
Conclusion
In conclusion, the loanable funds theory is a crucial concept in economics that explains how the
supply and demand for funds affect interest rates and the allocation of credit in an economy. By
understanding the key components of this theory, we can better understand how economic agents
interact and how monetary policy and the working of the central bank can influence the overall
health of an economy.

WAGE DIFFERENTIALS
A wage differential refers to the difference in wages between people with similar skills within
differing localities or industries. It can also refer to the difference in wages between employees
who have dissimilar skills within the same industry. It is generally referenced when discussing
the given risk of a certain job. For example, if a certain line of work requires someone to work
around hazardous chemicals, then that job may be due a higher wage when compared to other
jobs in that industry that do not necessitate coming into contact with dangerous chemicals. There
are also geographical wage differentials where people with the same job may be paid different
amounts based on where exactly they live and the attractiveness of the area.
Causes of Wage Differentials
1. Occupational Differences
2. Inter-firm Differentials
3. Regional Differences
4. Inter-Industry Differences
5. Personal Wage Differences.
As there are individual differences, so are wage differentials also. An organisation offers
different jobs, thus, differentials in wages for different jobs are inevitable. Wage differentials are
also known as inter-industry, inter-firm, inter-area or geographical differentials.
1. Occcupational Wage Differentials
Obviously, certain occupations pay more than others. Surgeons make more than teachers, who
make more than retail salespeople. Most of these wage differentials are the result of educational
and training requirements, often called human capital. Surgeons require more than a decade of
education and training after high school before they can earn a living as surgeons, while retail
salespeople can get a job right of high school, or even while they are still in school.

Education and training limit the supply of labor in that they take a minimum time to complete
and require a certain level of skill. Many people who attend college or training school do not
have the time to work a full-time job. Therefore, they also incur an opportunity cost equal to the
amount of money they could have earned had it not been for the educational or training
requirement.
2. Inter-firm Differentials
There are wage differentials of workers in different plants in the same area and occupation.
Factors like differences in quality of labour employed by different firms, imper-fections in the
labour market and differences in the efficiency of equipment’s and supervision result in inter-
firm wage differentials. Added to these are differences in technological advance, managerial
efficiency, financial capability, firm’s age and size, availability of raw material, power and
transport facilities also account for differences in wages among firms.
3. Regional Differences
Not only wages differ among occupations, but these also differ in case of workers working in the
same occupation at different geographical regions. These differences are the result of working
conditions prevalent in different regions of the country For example Teachers serving in the
remote areas in Zimnabwe are paid additional remuneration in the form of Rural Allowance.
Sometimes, such wage differentials are used to attract people to serve in particular regions.
4. Inter-Industry Differences
These differences in wages surface in case of workers working in the same occupation and the
same area but in different industries. These differences are the result of varying skill
requirements, level of unionisation, nature of product market, ability to pay, the stage of
development of an industry, etc.
5. Personal Wage Differences
These differences arise because of the differences in the personal characteristics (age or sex) of
workers working in the same unit and occupation. Though provision of ‘equal pay for equal
work’ is certainly there, but it is still not the reality. Instances are there when woman worker is
paid less than her male counterpart for doing the same job. Of course, there are other reasons
also which cause wage differentials between male and female workers.

REVISION QUESTIONS
1. Explain the rewards for the factors of production. [10]
2. Distinguish between economic rent and transfer earnings. [10]
3. With the aid of a diagram explain quasi rent. [10]
4. a) Explain the marginal revenue productivity theory of demand for labour. [10]
b) To what extent does the marginal revenue productivity theory explain wage
differentials in your country.? [15]
5. a) Explain the concept of wage differentials. [10]

b) Justify the existence of wage differentials. [15]
6. Justify the existence of wage differentials between and within occupations. [25]
7. To what extent does economic theory, adequately explain wage differentials in your
country.? [25]
8. Discuss whether wage differentials are determined by workers' level of education

in your country. [13]
9. Discuss the applicability of the marginal revenue productivity (MRP) theory in

explaining wage differentials in your country. [25]
10. Discuss whether the level of workers' wages depends on the strength of their trade
union. [13]
11. Should there be wage differentials in your country.? [25]

8. GOVERNMENT INTERVENTION IN
THE ECONOMY
MARKET FAILURE
Market failure refers to the inefficient distribution of goods and services in the free market. In a
typical free market, the prices of goods and services are determined by the forces of supply and
demand, and any change in one of the forces results in a price change and a corresponding
change in the other force. The changes lead to a price equilibrium.
In other words market failure occurs when there is a state of disequilibrium in the market due to
market distortion. It takes place when the quantity of goods or services supplied is not equal to
the quantity of goods or services demanded. Some of the distortions that may affect the free
market may include monopoly power, price limits, minimum wage requirements,
and government regulations.
Causes of Market Failures
Market failure may occur in the market for several reasons, including:
1. Externality
An externality refers to a cost or benefit resulting from a transaction that affects a third party that
did not decide to be associated with the benefit or cost. It can be positive or negative. A positive
externality provides a positive effect on the third party. For example, providing good public
education mainly benefits the students, but the benefits of this public good will spill over to the
whole society.
On the other hand, a negative externality is a negative effect resulting from the consumption of a
product, and that results in a negative impact on a third party. For example, even though cigarette
smoking is primarily harmful to a smoker, it also causes a negative health impact on people
around the smoker.

2. Public goods
Public goods are goods that are consumed by a large number of the population, and their cost
does not increase with the increase in the number of consumers. Public goods are both non-
rivalrous as well as non-excludable.
Non-rivalrous consumption means that the goods are allocated efficiently to the whole
population if provided at zero cost, while non-excludable consumption means that the public
goods cannot exclude non-payers from its consumption.
Public goods create market failures if a section of the population that consumes the goods fails to
pay but continues using the good as actual payers. For example, police service is a public good
that every citizen is entitled to enjoy, regardless of whether or not they pay taxes to the
government.
3. Market control
Market control occurs when either the buyer or the seller possesses the power to determine the
price of goods or services in a market. The power prevents the natural forces of demand and
supply from setting the prices of goods in the market.
On the supply side, the sellers may control the prices of goods and services if there are only a
few large sellers (oligopoly) or a single large seller (monopoly). The sellers may collude to set
higher prices to maximize their returns. The sellers may also control the quantity of goods
produced in the market and may collude to create scarcity and increase the prices of commodities.
On the demand side, the buyers possess the power to control the prices of goods if the market
only comprises a single large buyer (monopsony) or a few large buyers (oligopsony). If there is
only a single or a handful of large buyers, the buyers may exercise their dominance by colluding
to set the price at which they are willing to buy the products from the producers. The practice
prevents the market from equating the supply of goods and services to their demand.
4. Asymmetric or Imperfect information in the market
Market failure may also result from the lack of appropriate information among the buyers or
sellers. This means that the price of demand or supply does not reflect all the benefits or
opportunity cost of a good. The lack of information on the buyer’s side may mean that the buyer
may be willing to pay a higher or lower price for the product because they don’t know its actual
benefits.On the other hand, inadequate information on the seller’s side may mean that they may
be willing to accept a higher or lower price for the product than the actual opportunity cost of
producing it.
UNDERSTANDING EXTERNALITIES
Positive externalities
An externality describes an effect on a third party, incurred when they use a good or service.
That externality is a positive gain when the effects benefit society. For example, investing in a
robust and affordable education system directly and primarily benefits students, but creates a
more intelligent and skilled workforce. Another example is that the provision of health care can
lead to a healthier and stronger population. When externalities are positive, the social benefits
usually exceed the private benefits.
Negative externalities
A negative externality is an undesirable effect on a third party when someone else uses or creates
a product or service. Both consumers and producers can fail to adequately consider the effects
that their actions have on third parties when in pursuit of their own self-interest. Under these
circumstances, the social cost usually exceeds the private cost. For example, someone smoking
primarily impacts their own health, but the effects of secondhand smoking can affect the health
of those around them.
NEGATIVE PRODUCTION EXTERNALITIES
Negative production externalities occur when the production process results in a harmful effect
on unrelated third parties. For example, manufacturing plants cause noise and atmospheric
pollution during the manufacturing process.
Some examples of negative production externalities include:
1. Air pollution
Air pollution may be caused by factories, which release harmful gases to the atmosphere. Some
of the gases include carbon monoxide and carbon dioxide. The destructive gases cause damage
to crops, buildings, and human health.
The high concentration of greenhouse gases in the atmosphere affects the global climate and
brings about extreme heat waves, rising sea levels, intense hurricanes, graded air quality, and
droughts. The release of toxic gases into the atmosphere adversely affects vulnerable populations
such as children, the elderly, and patients suffering from asthma and heart diseases.

2. Water pollution
When industrial wastes are released into public waterways it pollutes and makes it harmful to
humans, animals, and the plants that depend on it. Factory wastes often contain toxic chemicals
that cause death to aquatic animals living in the water, and it denies fishermen a source of
income.
The contaminated water also affects plants that rely on clean water to survive. On the side of
humans, drinking water that is contaminated with industrial wastes poses a threat to human life
and can cause life-threatening diseases and even death.
3. Farm animal production
Raising farm animals may also cause harmful effects on third parties who reside near the farm.
For example, the misuse of antibiotics can create a large pool of antibiotic-resistant bacteria that
spreads outside the farm and causes diseases to other animals.
Also, accumulated animal wastes can leak and cause contamination of rivers and streams and
render the water unsafe for human use and consumption.
NEGATIVE EXTERNALITIES
Negative externalities occur when the product and/or consumption of a good or service exerts a
negative effect on a third party independent of the transaction. An ordinary transaction involves
two parties, i.e., a consumer and the producer, who are referred to as the first and second parties
in the transaction. Any other party that is not related to the transaction is referred to as a third
party.
NEGATIVE CONSUMPTION EXTERNALITIES
Negative consumption externalities arise during consumption and result in a situation where the
social cost of consuming the good or service is more than the private benefit. Private benefits
refer to the positive factors rewarded to the producer or the consumer involved in a transaction.
Social costs are negative factors impacting third parties. For example, when a person consumes
alcohol and becomes drunk, he/she causes social disorder, disturbing the peace of non-drinkers.

Some examples of negative consumption externalities include:
1. Passive smoking
Passive smoking refers to the inhalation of smoke exhaled by an active smoker. Inhaling other
people’s smoke, also known as second-hand smoke, can cause diseases in the non-smoking
population.
Some of the smoking-related health complications include stroke, lung cancer, heart disease, and
chronic obstructive pulmonary disease. High-risk populations such as children and the elderly
are at a higher risk of respiratory infections such as asthma and bacterial meningitis.
2. Traffic congestion
When too many drivers use a road, it causes delays and slower commuting times for all motorists.
It also creates increased smog from higher idling times and increases the likelihood of accidents.
3. Noise pollution
Noise pollution caused by loud music from a casino or nightclub may also affect third parties
who are not part of the revelers dancing to the music. Loud music may be mentally and
psychologically disruptive, especially to children who are yet to adapt to the surrounding
environment. Also, noise pollution may cause sleep deprivation and affect the productivity of
nearby residents and businesses.
REMEDIES FOR NEGATIVE EXTERNALITIES
One of the solutions to negative externalities is to impose taxes to change people’s behavior. The
taxes can be imposed to reduce the harmful effects of certain externalities such as air pollution,
smoking, and drinking alcohol. An effective tax will equal the cost of the externality, and it is
imposed with the goal of discouraging activities that cause such harmful effects.
Also, since most negative externalities result from the lack of property risks, governments can
introduce property rights that will help internalize the costs and benefits. Putting property rights
in place will create fear among would-be offenders since they will be wary of possible legal
action against them.

SOLUTIONS FOR MARKET FAILURE
Government legislation
When market failure occurs, governments can enact certain laws to help ease certain issues. For
example, they might ban indoor smoking or create legislation that limits practices that harm the
environment.
Price mechanism
This strategy describes the manipulation of product prices to change consumer buying behaviors,
especially for to dissuade them from using goods that harm themselves or the market. For
example, governments might raise the price of alcohol or cigarettes to discourage their purchase.
Private collection actions
This is a solution to market failure that describes entities privately agreeing to limit how much
they consume a good or service. They might then enforce self-imposed rules among themselves
to combat the effects of market failure.
Direct provision for public and merit goods
Government entities usually have direct control over the resources, goods and services that
provide positive externalities. This can include items like better educational access, public parks,
hospitals and libraries.
Taxation
Similar to price mechanism, governments might raise taxes to certain goods and services to
discourage people from using them. By placing a tax on a product, they subsequently increase
the cost to buy it, which some people may decide not to pay.
Subsidies
If there is a good that provides positive benefits to a person or society, then governments might
reduce the price of those goods, encouraging more people to buy and use them. For example,
lowering the cost of college tuition can benefit society by creating a more educated workforce.

Property rights extensions
Property rights can extend to create privatization for specific non-private goods, usually those
that are natural like beaches, lakes and rivers. This creates a market for pollution, which allows
individuals to take legal action if corporations pollute those areas.
Tradable permits
Permits give companies the ability to produce a specific quantity of something, like air pollution.
Companies can trade their permits among themselves to alter what they can produce, lowering
their negative externalities with a production cap or limit.
International government cooperation
For certain types of market issues, governments from different countries sometimes come
together to work on a specific problem. For example, many governments combine their efforts to
protect the environment and ease the effects of climate change.
Advertising
Depending on the type of market failure that's occurring, advertisements can help resolve those
issues. A successful advertising campaign can discourage people from using goods and services
that generate negative externalities.
The Bottom Line
A market failure is any interruption in the efficient distribution of goods and services that would
otherwise reach equilibrium through the laws of supply and demand.
When a market failure occurs, there are many methods to correct it, primarily through the
introduction of government activities, such as regulations, tax adjustments, and subsidies.
However, many economists do not propose interfering in market failures, as they believe that
free markets will correct themselves eventually over time.

HOW GOVERNMENTS ATTEMPT TO CORRECT MARKET FAILURE
When the forces of market fail to allocate resources efficiently, the government may attempt to
intervene to correct the market failure. There are several ways in which government can
intervene in the market:
Type of Intervention How it works Strengths Weaknesses
Taxation Works through the Easy to Can be expensive to

price mechanism. understand. collect. Difficult to know
Reduces supply and the correct level of tax to
therefore increases
set, as it should equal the
price, to discourage
production external costs (= difficult
/consumption of a to measure). Ineffective if
good that has negative PED is inelastic, as tax
externalities. will have to be very high
to reduce equilibrium
quantity. Can be
regressive.
Subsidy Works through the Easy to Expensive for government

price mechanism. understand. — incurs an opportunity
Increases supply and cost. Difficult to know
therefore reduces
correct subsidy to provide
price, to encourage
production as it should equal external
/consumption of a benefits. Producers may
good with positive pocket the money and not
externalities. increase supply.
Regulation Aims to tackle Easy to Expensive to

negative externalities. understand and monitor/police. Firms may
Government imposes
rules regarding the often easy to ignore fines if they are not
production, sale or use monitor/police. large enough. Can be anti
of a good/service, and competitive. Often
backs this up legally difficult to ‘pin the blame’
by fines/ prison on the appropriate person,
sentences etc. therefore unfair.

State Provision Increases fairness of Ensures fair Storage is expensive,

access to services income for Transport to and from
Government directly such as healthcare and producers and fair storage is expensive it
provides a good or
education, which have prices for works only if goods are
service, funded
through tax revenue, many positive consumers. non-perishable it is nearly
in order to provide externalities attached. impossible to ensure that
goods which have Without Government the amount kept in storage
positive externalities provision, public will equal the amount
or are public goods. goods wouldn’t be required for release in the
provided. Trustworthy future to lower prices
provided with
common standards.
Buffer Stocks
Government
purchases
commodities if a floor
price is reached and
sells commodities if a
ceiling price is
reached.
Regulation Aims to tackle Easy to Expensive to

negative externalities. understand and monitor/police. Firms may
Government imposes often easy to ignore fines if they are not
rules regarding the monitor/police.
large enough. Can be anti
production, sale or use
of a good/service, and competitive. Often
backs this up legally difficult to ‘pin the blame’
by fines/ prison on the appropriate person,
sentences etc. therefore unfair.

Pollution Permits Aims to tackle Uses the market Difficult to set correct
negative externalities. mechanism, amount of pollution and
An efficient amount therefore therefore right number of
of pollution is agreed,
efficiency. permits.
and a corresponding
number of permits Requires little
released — these can Government
be traded amongst intervention,
firms so that low therefore cheap to
polluters can sell to run.
high polluters and
make a profit.
Pollution Permits Aims to tackle Uses the market Difficult to set correct
negative externalities. mechanism, amount of pollution and
An efficient amount therefore efficie therefore right number of
of pollution is agreed, Requires little
permits.
and a corresponding Government
number of permits intervention,
released — these can therefore cheap to
be traded amongst run. nt.
firms so that low
polluters can sell to
high polluters and
make a profit.
Extended Property Aims to identify who The economist Once property rights are
Rights is responsible for Ronald Coase allocated, no more
paying for external argued that it Government intervention
costs, therefore didn’t matter needed in theory, therefore
reducing negative whether the cheap. Difficult to allocate
externalities. producer or the property rights when they
consumer took have never existed before.
responsibility — Some property rights
either would be cannot be allocated, eg
an efficient carbon emissions cause
outcome. global warming, but no-
one ‘owns’ the world and
it would be politically
undesirable for this to
happen.

REVISION QUESTIONS
1. a) Explain the sources of market failure. [10]

b) Evaluate the possible solutions to market failure. [15]
2. a) Explain what is meant by externalities in production. [10]

b) Discuss how government may deal with externalities in production in a country. [15]
3. Explain the reasons for government intervention in the market. [10]
4. Explain methods by which governments intervene in markets. [10]
5. a) With examples, explain market failure. [10]

b) Assess the effectiveness of policies used by the government to correct market
failure. [15]

9. INTERNATIONAL TRADE
COMPARATIVE ADVANTAGE AND ABSOLUTE ADVANTAGE
There is a difference between being better at doing something and benefiting more from doing
something. This is the simplest way to distinguish between absolute advantage and comparative
advantage. One country may be faster than another country at producing the same product.
However, the faster country may still buy that product from the slower country. This is because,
in international trade, the focus is on benefits. So, if the faster country benefits more from buying
the product than producing it, then it will buy rather produce that product.
While we compare comparative advantage and absolute advantage in economics, it is important

to note that the two concepts do not necessarily go against each other. Absolute advantage
focuses on efficiency, whereas comparative advantage focuses on opportunity cost. Let's explain
each one.
First, we will look at the absolute advantage. Absolute advantage is essentially about being better
at producing a given product. In economics terms, if one country is more efficient at producing a
certain good, we say that country has an absolute advantage.
ABSOLUTE ADVANTAGE
Absolute advantage is the ability of an economy to produce a certain good more efficiently than
another economy can.
Note that efficiency is what gives the advantage here.
Absolute advantage means that one country can produce more of a good compared to another
country using the same quantity of resources.
Example
Consider two countries that only need labor to make coffee bags, Country A and Country B.
Country A has a workforce of 50 and produces 50 bags of coffee every day. On the other hand,
Country B has a workforce of 50, yet it produces 40 bags of coffee every day.
The example above shows that Country A has an absolute advantage over Country B in coffee
production. This is because even though they both have the same number of workers, they
produce more bags of coffee within the same duration when compared to Country B. This
describes the economics of absolute advantage.

COMPARATIVE ADVANTAGE
Comparative advantage is all about opportunity cost. What does the economy have to forgo to
produce a given product? In economics terms, the country that forgoes the least benefits to
produce a certain product has the comparative advantage over other countries that forgo more
benefits. For this reason, economists prefer comparative advantage to absolute advantage.
Comparative advantage is the ability of an economy to produce a given product at a lower

opportunity cost than other economies would incur in producing the same product.
Note that a lower opportunity cost is what gives the advantage here.
In other words, are you benefiting more than others by producing this particular product? If yes,
then you have a comparative advantage. If not, then you need to focus on a product that gives
you the most benefits or costs you the least. Time for an example!
Example
Let's consider two countries, Country A and Country B. Both countries can produce coffee and
rice and sell both at the same price. When country A produces 50 bags of coffee, it forgoes 30
bags of rice. On the other hand, when Country B produces 50 bags of coffee, it forgoes 50 bags
of rice.
From the example above, we can see that Country A has a comparative advantage in coffee
production. This is because, for every 50 bags of coffee produced, Country A gives up 30 bags of
rice, which is a lower opportunity cost than the 50 bags of rice Country B has to give up.
Calculation of Absolute Advantage and Comparative Advantage
The calculation of absolute advantage and comparative advantage is different, with the
comparative advantage being slightly more complex. For absolute advantage, we simply need to
compare the quantities of output, and the country with the larger quantity wins the absolute
advantage. However, comparative advantage is calculated by finding the opportunity cost for
each country, and the country with the lower opportunity cost wins the comparative advantage.
The following formula is used to find the opportunity cost of producing a good in terms of
another good.

The good whose opportunity cost you want to find goes under.
Let's say the two goods are Good A and Good B:
Opportunity Cost of Good A = Quantity ogf Good B

Quantity ogf Good A
Remember, for absolute advantage, you look for the higher quantity of output, whereas for
comparative advantage, you calculate and find the lower opportunity cost.
Comparative Advantage and Absolute Advantage Analysis
Let's perform an analysis of comparative advantage and absolute advantage using an example.
We will do this with two countries: Country A and Country B. These countries can produce
different combinations of coffee and rice, as shown in Table 1 below.
Country A Country B
Coffee 5 000 500
Rice 1 000 4 000
First, we can see that Country A has the absolute advantage in coffee production since it can
produce up to 5 000 bags against Country B's 500 bags. On the other hand, Country B has the
absolute advantage in rice production since it can produce up to 4 000 bags against Country A's 1
000 bags.
Next is comparative advantage. Here, we will calculate opportunity cost using the formula:
Opportunity Cost of Good A = Quantity ogf Good B

Quantity ogf Good A
We will now calculate the opportunity cost for both countries by assuming they will focus on the
production of only one product. Let's calculate it for coffee first!

Example
If Country A only produces coffee, then it forgoes the ability to produce 1 000 bags of rice.
The calculation is as follows:
1 000 = 0.2 rice / coffee
5 000
On the other hand, if Country B produces only coffee, then it will forgo the ability to produce 4
000 bags of rice.
4 000 = 8 rice / coffee
500
From the analysis above, Country A has a comparative advantage in the production of coffee
since it has a lower opportunity cost of 0.2 when compared to the opportunity cost of Country B,
which is 8.
This time, we will find the opportunity costs of producing rice.
Example
If Country A only produces rice, then it forgoes the ability to produce 5 000 bags of coffee.
5 000 = 5 coffee / rice

1 000
On the other hand, if Country B produces only rice, then it will forgo the ability to produce 500
bags of coffee.
500 = 0.125 coffee / rice
1 000
The analysis above shows that Country B has a comparative advantage in the production of rice
since it has a lower opportunity cost of 0.125 when compared to the opportunity cost of Country
A, which is 5.
All in all, we can see that country A has the absolute advantage and comparative advantage in
producing coffee, whereas Country B has the absolute advantage and comparative advantage in
producing rice.
Difference between absolute advantage and comparative advantage.
Absolute advantage is the ability to produce a good or a service at a lower production cost than
competitors. Comparative advantage is the ability to produce a good or service at a lower
opportunity cost than competitors.
Absolute advantage is the ability to produce a good or a service at a lower opportunity cost than
competitors. Comparative advantage is the ability to produce a good or service at a lower
production cost than competitors.
Absolute advantage is the ability to sell a good or a service at a lower price than competitors.
Comparative advantage is the ability to sell a good or service at a higher price than competitors.
Absolute advantage is the ability to sell a good or a service at a higher price than competitors.
Comparative advantage is the ability to sell a good or service at a lower price than competitors.
In short
• Absolute advantage is the ability of an economy to produce a certain good more

efficiently than another economy can.
• Comparative advantage is the ability of an economy to produce a given product at a

lower opportunity cost than other economies would incur in producing the same product.
• We compare the quantities of output between countries, and the country with the larger
quantity wins the absolute advantage.
• Comparative advantage is determined by calculating to find the lower opportunity cost.

FREE TRADE
Is a trade policy that does not restrict imports or exports.
ADVANTAGES OF FREE TRADE
• There are no tariffs and quotas among member countries.
• There is free movement of goods and services among member countries.
• There is free movement of people among member countries.
• Workers can be hired from any member country without any restrictions.
• There is free movement of money and capital.
• There is better relationship among member countries.
DISADVANTAGES OF FREE TRADE
• Home industries get affected.
• Infant industries get affected.
• Loss of revenue for the Government when foreign currency goes out.
• It sometimes causes unemployment.
• It causes imbalance of power among member countries.
• There is sometimes a drain of wealth.

PROTECTIONISM
Protectionism is the economic policy of restricting imports from other countries through methods
such as tariffs on imported goods, import quotas, and a variety of other government regulations.
Proponents argue that protectionist policies shield the producers, businesses, and workers of
the import-competing sector in the country from foreign competitors; however, they also
reduce trade and adversely affect consumers in general (by raising the cost of imported goods),
and harm the producers and workers in export sectors, both in the country implementing
protectionist policies and in the countries protected against.
Advantages of Protectionism
• More growth opportunities:

Protectionism provides local industries with growth opportunities until they can compete
against more experienced firms in the international market
• Lower imports:
Protectionist policies help reduce import levels and allow the country to increase its trade
balance.
• More jobs:
Higher employment rates result when domestic firms boost their workforce
• Higher GDP:
Protectionist policies tend to boost the economy’s GDP due to a rise in domestic
production
Disadvantages of Protectionism
• Stagnation of technological advancements:

As domestic producers don’t need to worry about foreign competition, they have no
incentive to innovate or spend resources on research and development (R&D) of new
products.
• Limited choices for consumers:

Consumers have access to fewer goods in the market as a result of limitations on foreign
goods.

• Increase in prices (due to lack of competition):
Consumers will need to pay more without seeing any significant improvement in the
product.
• Economic isolation:
It often leads to political and cultural isolation, which, in turn, leads to even more
economic isolation.
METHODS OF PROTECTIONISM
1. TARIFF
A tariff is a tax imposed by one country on the goods and services imported from another
country.
Tariffs are used to restrict imports by increasing the price of goods and services purchased from
another country, making them less attractive to domestic consumers.
With an increase in tax, the price of the goods also increases, which further leads to a fall in the
purchasing power of the customers. This reduces the demand for imported goods and services.
A key point to understand is that the tariff imposed affects the exporting country indirectly as the
domestic consumer might shy away from their product due to the increase in price. If the
domestic consumer still chooses the imported product then the tariff has essentially raised the
cost for the domestic consumer.
There are two types of tariffs, which are:
A specific tariff is levied as a fixed fee based on the type of item, such as a $1 000 tariff on a car.
An ad-valorem tariff is levied based on the item's value, such as 10% of the value of the vehicle.
What are the main reasons for imposing a tariff?
• Tariffs are generally imposed for a number of reasons:
• To protect newly established domestic industries from foreign competition.
• To protect aging and inefficient domestic industries from foreign competition.
• To protect domestic producers from “dumping” by foreign companies or governments.
• To raise revenue.

Positive effects of tariffs
• Tariffs mainly benefit the importing countries, as they are the ones setting the policy and
receiving the money.
• The primary benefit is that tariffs produce revenue on goods and services brought into the
country.
• Tariffs can also serve as an opening point for negotiations between two countries.
Negative effects of tariffs
• Tariffs make imported goods more expensive, which obviously makes consumers
unhappy if those costs result in higher prices.
• Domestic companies that may rely on imported materials to produce their goods could
see tariffs reducing their profits and raise prices to make up the difference, which also
hurts consumers.
• One of the disadvantages of tariffs is that it implements high tax on imports, leading to
the decrease in competition of foreign products, consequently leading to higher prices on
imports.
• Next, it would hinder free trade and spark trade wars among producers and importers,
leading to possible economic decline.
EXAMPLE 1
Diagram showing effects of tariffs, on next page

Without trade, the domestic price and quantity are P & Q. If a country opens up to world supply,
price falls to P1, and output increases from Q to Q2. As a result, domestic producers’ share falls
to Q1 and imports now dominate, with the quantity imported Q1 to Q2.
The imposition of a tariff shifts up the world supply curve to World Supply + Tariff.
The price rises to P2, and the new output is at Q3. Domestic producers share of the market rise to
Q4, and imports fall to Q4 to Q3. The result is that domestic producers have been protected from
cheaper imports from the rest of the World.
Given that domestic consumers face higher prices, they also suffer a loss of consumer surplus. In
contrast, domestic producers increase their producer surplus as they receive a higher price than
they would have without the tariff.
Increased market share also means that jobs will be protected in the domestic economy

EXAMPLE 2
Diagram showing effects of tariffs
• In this case, the tariff is P1-P2.
• The tariff leads to a decline in imports. Imports were Q4-Q1. After the tariff, imports fall
to Q3-Q2.
• Consumer surplus falls by 1+2+3+4
• Government raises tariff revenue of area 3
• Domestic suppliers gain an increase in producer surplus of area 1
• The net welfare loss is (1+2+3+4) – (1+3) = 2+4

Effect of tariffs
• Without any trade, the equilibrium price is $1.80 and a quantity of 40 million
• With a tariff of $0.40, the price of imports will be $1.60.
• The quantity of imports at $1.60 is (50-30) = 20 million.
• With free trade (no tariffs) the price would be $1.20 and quantity bought 60 million.
Government tariff revenue
Tariff revenue = tariff × q. of imports ($0.40 × 20 million) = $8 million

2. EXCHANGE CONTROLS
Exchange control means the interference by the state, central bank or any other agency with the
free play of market forces that determine foreign exchange rate. Exchange rates, under exchange
control system, are fixed arbitrarily by the government and are not determined freely by the
forces of demand and supply. In other words, exchange control system represents government
domination of the foreign exchange market.
Each international transaction requiring payment in foreign currencies is sanctioned by the

government and all foreign exchange receipts from international transactions are surrendered to
the government. The main object of exchange control is to secure stability of fixed exchange rate
and to ensure balance of payments equilibrium.
Exchange control maybe complete or partial. Exchange control is complete when the
government has full control over the exchange market. In fact, under complete exchange control,
there exists no exchange market and disequilibrium in the balance of payments is impossibility.
The exchange control applies to all types of international transactions and the government
restricts the sale and purchase of all currencies. Exchange control is partial when the government
partially controls the exchange market. The exchange control applies only to certain types of
international transactions and the government restricts the sale and purchase of some selected
currencies.
3. IMPORT SUBSTITUTION
Import substitution policy is a set of measures aimed at stimulating production and

competitiveness of domestic goods, increasing of domestic demand optimization of demand for
imports. It is determined by the need to reduce the dependence of transitive economy on
economic leaders. The main objective of the policy of import substitution is to encourage
national production, to development the new products to stimulate demand and import
restrictions.
In other words import substitution is a strategy that emphasizes the replacement of imports with
domestically produced goods, rather than the production of goods for export, to encourage the
development of domestic industry.

4. QUOTAS
An import quota is a limit on the amount of imports that can be brought into a particular country.
For example, the government may limit the number of Japanese car imports to 1 000 per year.
Quotas will reduce imports and help domestic suppliers.
However, they will lead to higher prices for consumers, a decline in economic welfare and could
lead to retaliation with other countries placing tariffs on our exports.
Quotas will lead to lower sales for foreign companies, but it could push up prices and make sales
more profitable.
Effects of quotas
In this diagram, the quota is the difference between S(domestic) and S(domestic) + quota
Without quotas
• The market price is P world
• Quantity of imports is Q4-Q1
• World exporters make revenue of areas A+B+C

Imposing quotas of (Q3-Q2)
• This leads to a fall in imports to just Q3-Q2
• Domestic suppliers gain more revenue. The price rises to P quota and domestic suppliers,
supply more Q1 to Q2. It can create domestic jobs.
• Consumers pay a higher price and also total quantity falls from Q4 to Q3.
• Governments are not affected directly, as there is no income.
• There is a net welfare loss to society because the increase in producer surplus is
outweighed by the decline in consumer surplus.
• World exporters will make less revenue – unless demand is very inelastic, meaning
increase in price is greater than fall in quantity.

ECONOMIC INTERGRATION
Economic integration is an arrangement among nations that typically includes the reduction or
elimination of trade barriers and the coordination of monetary and fiscal policies.
• Economic integration aims to reduce costs for both consumers and producers and to
increase trade between the countries involved in the agreement.
• Economic integration can reduce the costs of trade, improve the availability of goods and
services, and increase consumer purchasing power in member nations.
Understanding Economic Integration
Economic integration, like the name implies, involves the integration of countries’ economies.
Another term to describe it is globalization, which simply refers to the inter-connectedness of
businesses and trading among countries. An economy is defined as a set of inter-related activities
that determine how limited resources are allocated. In the modern economy, all economies
feature a form of a market system. A market-based economy utilizes the economic forces of
demand and supply in order to distribute these limited resources.
Traditionally, economies were thought of as separate for each region or country, with each
country managing its own separate economy and largely unrelated to other countries. However,
globalization allows the movement of goods, services, capital between countries and blurred the
distinctions between economies.
Today, there is no economy that functions completely isolated from other economies. There is a
simple reason for such an occurrence – trade benefits all economies in most cases. It allows for
specializations of economies with comparative advantages and can trade with other economies
that possess alternative comparative advantages.
Stages of Economic Integration
Economic integration is expected to improve the outcomes for all economies by many
economists and policymakers. Within economics, there are many stages that lead to complete
economic integration:
• Free Trade Area
• Customs Union
• Economic Union

Benefits of Economic Integration
Economic integration is beneficial in many ways, as it allows countries to specialize and trade
without government interference, which can benefit all economies. It results in a reduction of
costs and ultimately an increase in overall wealth.
Trade costs are reduced, and goods and services are more widely available, which leads to a
more efficient economy. An efficient economy distributes capital, goods, and services into the
areas that demand them the most.
The movement of employees is liberalized under economic integration as well. Normally,

employees would need to deal with visas and immigration policies in order to work in another
country. However, with economic integration, employees can move freely, and it leads to greater
market expansion and technology sharing, which ultimately benefits all economies.
Lastly, political cooperation is encouraged, and there are fewer political conflicts. Political
conflicts usually end with economic losses stemming from trade wars or even military wars
breaking out, resulting in extreme costs for all combatants.
Drawbacks of Economic Integration
Nationalists, or people who believe that their country is superior to others, are critical of
economic integration. In order to appeal to nationalists, some countries employ forms of
protectionism, which leads to higher tariffs and less free trade between other countries.
The notable feature of economic integration is the loss of individual central banks who control
monetary policy. It leads to less national sovereignty, and the responsibilities of central banks are
delegated to an external body instead. The external control becomes troublesome in terms of
managing a cohesive fiscal and monetary policy among many different countries.
FREE TRADE AREA
A free trade area is a region in which a group of countries has signed a free trade agreement and
maintain little or no barriers to trade in the form of tariffs or quotas between each other. Free
trade areas facilitate international trade and the associated gains from trade along with the
international division of labor and specialization. However, free trade areas have been criticized
both for costs that are associated with increasing economic integration and for artificially
restraining free trade.

A free trade area is concerned with removing tariffs, and regulations that are applied to member
countries who trade with each other. Members establish a common set of policies that regulate
trade terms, tariffs, and quotas.
Another thing about a free trade area is that imports from outside the area do not confer the
benefit of the free trade agreement. For example, two countries that are members of a free trade
area, such as the U.S. and Mexico, refrain from imposing tariffs on each other. However, if a U.S.
company imports bananas from South America, they would be subject to tariffs.
Advantages of a Free Trade Area
A free trade area offers several advantages, including:
Increased efficiency
The good thing about a free trade area is that it encourages competition, which consequently
increases a country’s efficiency, in order to be on par with its competitors. Products and services
then become of better quality at a lower cost.
Specialization of countries
When there is intense competition, countries will tend to produce the products or goods that they
are most efficient at. Efficient use of resources means maximizing profit.
No monopoly
When there is free trade, and tariffs and quotas are eliminated, monopolies are also eliminated
because more players can come in and join the market.
Lowered prices
When there is competition, especially on a global level, prices will surely go down, allowing
consumers to enjoy a higher purchasing power.
Increased variety
With imports becoming available at a lower cost, consumers gain access to a variety of products
that are inexpensive.

Disadvantages of Free Trade Area
Despite all the benefits brought about by a free trade area, there are also some corresponding
disadvantages, including:
Threat to intellectual property
When imports are freely traded, domestic producers are often able to copy the products and sell
them as knock-offs without fear of any legal repercussions. Therefore, unless the FTA includes
provisions for intellectual property laws and enforcement there are no protections for exporting
companies.
Unhealthy working conditions
Outsourcing jobs in developing countries can become a trend with a free trade area. Because
many countries lack labor protection laws, workers may be forced to work in unhealthy and
substandard work environments.
Less tax revenue
Since member countries are no longer subject to import taxes, they need to think of ways to
compensate for the reduced tax revenue.
CUSTOMS UNION
A customs union is an agreement between two or more neighboring countries to remove barriers
to trade between them and to set uniform tariffs with non-member countries. It is the second
stage of regional economic integration.
Customs union features
The main features of a customs union are:
• Eliminate barriers to export-import of goods and services among member countries.
• Adopt a set of uniform external policies and tariffs for trade with non-members.
• A customs union is similar to a free trade area. However, the two differ in terms of trade
policies with non-member countries.
• Under a customs union, member countries have similar policies regarding trade with non-
members.

• On the other hand, free trade does not have a uniform policy on trade with non-members.
Each of them still has the right to determine their own policies.
• A customs union is stronger cooperation than free trade. It is the second stage in regional
integration, before the common market. Under the common market, not only goods and
services flow freely among members, but also factors of production such as labor and
capital.
Customs union purposes
• The primary purpose of a customs union is to increase trade in goods and services
between member countries.
• Eliminating trade barriers reduces the administrative and financial burdens borne by
businesses in member countries.
• The creation of a customs union is beneficial for the economy in the long run.
• Apart from increasing trade between member countries, the customs unions also increase
their position in negotiating trade agreements with non-member countries. The
uniformity of import duties makes each member have the same interest in achieving the
best agreement result.
• Furthermore, other purposes of a customs union usually also include:
• Build closer political and cultural relations between member countries.
• Increased economic efficiency through a free flow of production factors
Customs union advantages
In more detail, a number of the advantages of a customs union are:
• Increased competition should lead to improvements in competitiveness, innovation, and

efficiency. The free flow of goods and services leads the market more open to
competition between companies in member countries.
• Increased trade flows and economic integration
• Trade creation and diversion
• Reducing trade deflections

• Increased trade flows
• Eliminating trade barriers increases transactions between member countries. For

companies, the market becomes wider because they can sell easily to other member
countries.
That, in turn, leads to better economic integration and political cooperation among
members. Member countries may promote stronger cooperation through the creation of
common markets or even economic unions.
• Trade creation and diversion
We also can measure the effectiveness of a customs union through the effects of trade
creation and trade expansion.
Trade creation occurs when more efficient union members sell to less efficient members,
which leads to a better allocation of resources.
Meanwhile, trade diversion occurs when efficient non-member countries sell fewer goods
to member countries due to external tariffs. This allows less efficient member countries to
sell more goods within the union. Economically, it is, of course, detrimental.
Suppose the gains from trade creation exceed the losses from trade diversion. In that case,
it leads to an increase in economic well-being among members.
• Reducing trade deflections
The customs union solves the trade deflection problem. This is one reason why customs
unions are preferable over free trade agreements.
Trade deflection occurs when non-member countries take advantage of the non-uniformity of
external tariffs among member countries. They tend to export to members who apply lower
rates and then sell them to countries with higher rates.
In the free trade area agreement, member countries have a non-uniform tariff policy when
trading with non-member countries.
Say, Indonesia and Malaysia are involved in a free trade agreement. Both of them set a 0%
tariff for car products. In other words, the flow in and out between the two countries is tariff-
free.

Assume that Malaysia imposes a 10% import tariff on cars from non-Indonesians.
Meanwhile, Indonesia sets a 15% tariff on cars from non-Malaysians.
Non-member countries, such as Japan, can take advantage of these tariff differences. Due to
lower tariffs, Japanese automakers will export their production to Malaysia.
The company sends them from Malaysia (0% rate) instead of shipping them from Japan
directly to Indonesia to sell to Indonesia. That way, company car prices in Indonesia will
remain cheap. In this case, the company only bears a tariff of 10%.
The uniformity of tariffs within the customs union helps to avoid problems resulting from
such differences in tariffs. Say, Indonesia, and Malaysia both set a 10% tariff. There is no
better choice for the company.
Customs unions have the following disadvantages:
• Economic sovereignty was eroded. Member countries must reach a mutual agreement on
external tariffs. Individual member countries cannot place more importance on their own
economy in negotiating external tariffs with non-member countries.
• The co-tariff setting is often complicated. Each member often disagrees because he wants
to protect their business interests and the domestic economy.
• Competitive pressures threaten domestic businesses. Some domestic companies may

close because they are unable to compete with products from other member countries.
• Customs union members may still require non-uniform documents. Policies such as
security checks, invoices, and transportation documents are left to each member. So, even
though the tariff is zero, exporters have to deal with the complexity of importing
documents.
ECONOMIC UNION
An economic union is a form of regional economic integration in which goods, services, and
factors flow freely between member countries. Plus, members also integrate economic policy. It
is a more advanced form of the common market.
Economic union features
Some of the main features of economic unions are:

• Goods, services, and production factors (capital and labor) flow freely among member
countries.
• All members adopt a uniform set of policies when trading with non-members.
• Members establish the general institutions and economic policies for trade unions.
• Economic unions integrate monetary and fiscal policy. Member countries coordinate and
harmonize government policy, taxation, and spending.
Economic union goals
Economic unions aim to eliminate internal barriers while simultaneously adopting external
barriers to the movement of strategic resources.
Also, other objectives of economic unions usually include increasing economic efficiency by
expanding the market economy. Members seek to build closer political and cultural ties between
them.
Members also agree to harmonize economic policies. They then form a unified economic and
financial market.
Advantages of the economic union
• More investment flows in member countries. The capital flows freely between them.
Some companies may wish to expand their locations close to centers of raw materials or
labor.
• Taxes are uniform among member countries. It facilitates a greater flow of goods and
services among members.
• Workers are more flexible in choosing jobs in member countries.
• The integration of market economies, finance, and common economic policies allows
economic unions to become the world’s new economic powers.

• Several members have the opportunity to be in a rapidly growing economic and monetary
area. They can take advantage of more developed financial markets to develop the
economy.
• The unemployment rate decreases as workers find it easier to find work in other member
countries. In other words, economic unions increase the geographic mobility of workers.
Disadvantages of economic union
• Land and property prices soared. Investors are looking for cheap land and property
among member countries. They do so easily because of the free flow of capital.
• The issue of standardization of regulations is often complicated. Each member must

standardize according to common standards.
• Internal economic interest motives often result in unequal treatment among members.
Members with a broader economy are likely to be more dominant in making decisions
and policies.
• Independence and economic independence are lost. Economic policies in member

countries must conform to mutual agreement. And, it may not fit their economic
background.
• Regional brain drain. Those with higher education leave their home country to pursue
better opportunities in other member countries.
• International companies quickly expand the markets of member countries. That reduces
the chances of smaller domestic companies developing.
• A crisis in one member can quickly spread to other members. It could lead to an even
bigger crisis, shaking not only regional but international economies.

COMMODITY AGREEMENTS
Commodity agreements are arrangements between producing and consuming countries to
stabilise markets and raise average prices. Such agreements are common in many markets,
including the market for coffee, tea, and sugar.
Example – The International Cocoa Agreement
In 2003, an agreement was made between the seven main cocoa exporting countries, Cameroon,
Ivory Coast, Gabon, Ghana, Malaysia, Nigeria and Togo, and the main importing countries
including the EU members, Russia, and Switzerland. The main purpose of this agreement was to
promote the consumption and production of cocoa on a global basis as well as stabilise cocoa
prices, which had been falling steadily. The agreement was planned to continue until 2010, but in
that year it was decided to extend the agreement for a further two years, until 2012. In 2012 the
signatories decided on a further extension, until 2026.
Commodity agreements often involve intervention schemes, such as buffer stocks, and usually
only last for a few years, whereupon they are re-negotiated. They differ from cartels such as
OPEC, largely because discussions and negotiations involve both producer and consumer
countries, unlike cartels, which are established to protect the interest of producers only.
GATT (GENERAL AGREEMENT ON TARIFFS AND TRADE)
The full form of GATT is the General Agreement on Tariffs and Trade. History beckons that the
agreement was signed on 30th October 1947. Twenty-three countries came together post World
War 2 to sign the agreement.
The primary objective of the GATT agreement was to reduce trade restrictions by revising or
removing certain tariffs, subsidies, and quotas. This was done at a time when international trade
was affected by the ills of war.
The GATT aimed to improve existing international relations by making trade easier. It consisted
of a set of rules that defined the new trade restrictions that were much more relaxed as compared
to the ones that existed before. The agreement also established a system to resolve trade-related
disputes among nations.
It is important to note that the World Trade Organization was established because of GATT;
which is why, GATT and WTO go hand in hand. The World Trade Organization was established
on 1st January 1995, and the body was responsible for extending the application of GATT.
Why was the GATT Created?
The GATT agreement aimed at resolving a wide variety of issues. However, most of these issues
were related to trade and barriers to trade. Some of the major reasons why GATT came into
existence are:
• The primary motive of GATT was to establish a system to regulate the policies of the
pre-war protectionist period. The agreement aimed at restricting or removing quantitative
trade barriers like trade controls between two countries.
• The other important motive of the GATT agreement is to provide a system to resolve
commercial conflicts among nations. Therefore, a framework to resolve these conflicts
and conduct multilateral tariff reduction negotiations was added to the agreement.
• GATT established a set of trading standards, and hence, it served the purpose of aligning
the trade practices of different countries
The GATT agreement was a successful intervention as several trade reforms were brought about
post its implementation.
How does the GATT work?
The primary purpose of GATT was to eliminate different kinds of trade protectionism imposed
by nations worldwide. The GATT also contributed to reviving economies dealing with the after-
effects of World war 2.
Three Provisions of GATT
GATT works on three main provisions.

1. As per the first provision, all the member nations must give each other the status of the
most favoured nation. As per the status, the tariffs and other quantitative restrictions
would be the same for all nations. However, the special tariffs imposed on the British
Commonwealth countries and customs unions were not under the purview of GATT.
2. The second provision included the number of imports on which there will be no trade
restrictions. However, there were some exclusions to this provision:
• In case of a surplus of agricultural produce

• If the country was facing issues with its balance of payments due to a reduction in
the foreign exchange reserves
• Counties that were emerging and needed to protect their industries
• Issues involving national security

3. The third provision was added to the GATT agreement in 1965. According to the
provision, the developed countries must agree to remove import tariffs from developing
countries. The primary motive of this provision was to support developing countries.
Based on these three provisions, the GATT works.
What are the Principles of GATT?
A set of principles governs the GATT. These principles are discussed in detail below.
• The most crucial principle of GATT is trade without discrimination. The principal of the
most favoured nation was made a part of GATT, as non-discrimination was a primary
principle of the agreement. As per the principle, no country should try to take advantage
of another country’s economic condition.
• The second principle ensures that tariffs protect the domestic industries. Hence, GATT
promoted customs tariffs over any other form of trade restrictions.
• The promotion of fair competition is another important principle. Several countries

practised dumping goods, and the principle addressed the issue.
• The prohibition of quantitative trade restrictions is the driving principle of GATT. The
only exception to this principle could be exercised if the country faced issues related to
the balance of payments.
• The principle of possible emergency actions is another vital aspect of GATT. According
to this principle, a country can ask for release from a particular GATT obligation. The
country will have to follow the waiver procedures stated in the agreement. This principle
can be exercised only if the economic or trade circumstances of the country are bad.
• Another principle that is a part of GATT is regional trading agreements. Under this
policy, an exception to most favoured nations can be exercised. These exceptions will be
granted as a customs union or a free trade area.
• Settling trade disputes is another principle of GATT. As per the agreement, GATT
performs regular activities like consultation, dispute settlement, etc.
All the principles stated above are important aspects of GATT. All decisions made under GATT
are based on these principles.

Member Countries of GATT
The GATT had 23 members when it was established. These countries included Australia,
Belgium, Brazil, Burma, Canada, Czechoslovakia, Ceylon (now Sri Lanka), Chile, China,
Netherlands, Cuba, France, India, Lebanon, Luxembourg, Norway, New Zealand, Pakistan, Syria,
Southern Rhodesia, South Africa, the United Kingdom, and the United States.
The number of members increased from 23 to 128 in 1994 and more countries came under the
purview of GATT. Hence, the trade patterns could be standardised at a larger level.
Advantages and Disadvantages of the GATT
The implementation of GATT was a milestone in World History. However, GATT has its own
set of pros and cons. Let’s understand both aspects:
Advantages
Improves International Trade Relations
GATT eliminated several trade barriers and reduced tariffs. Hence, the countries became more
open to trading with each other. Also, they realised the advantages of participating in free trade,
and the number of signatories to GATT increased from 23 to 128.
Promotion of Harmony and Peace
Post World War 2, several countries came together for the first time to take a collective decision.
Hence, the agreement promoted world peace and collaboration. Also, the European countries
were struggling, and a war-like situation was built. However, GATT kept the situation in check
and helped reduce the possibility of war.
Better Communication among Nations
GATT incentivised nations to interact with each other and improve their trade relations. Hence,
the nations tried to understand the problems in other nations and used effective communication
to solve these problems.

Disadvantages
Impact on Domestic Industries
With the implementation of GATT, more countries started importing goods instead of promoting
their domestic industries. Therefore, the unemployment rates of different countries shot up.
GATT enabled rich countries to increase production and push the products to other nations.
Hence, the middle and low-income nations suffered a lot.
Exposure to Risk
The trade of services was not under the purview of GATT. Hence, services like finance,
technology, etc. expanded worldwide, and only a few nations dominated these industries. Hence,
an impact on any of these nations impacted the entire economy.
The Reduced role of the Government
Once a country signs an agreement like GATT, it must abide by all its principles. Hence, the
government loses control over its own country and its people.
Relationship between GATT and WTO
GATT and WTO are related to each other as GATT became a part of WTO post its incorporation.
GATT did not cover several aspects of world trade. Therefore, there was a need for a stronger
body to take care of the entire aspect of world trade. This led to the establishment of the World
Trade Organization.
WTO is a permanent body and GATT came under its umbrella. The WTO took over GATT and
came up with overarching principles that covered services and intellectual property apart from
goods.
Conclusion
The GATT shaped world trade as it was the first agreement that came into existence to reduce
trade barriers. The 23 countries that signed the GATT agreement wanted to promote free trade of
goods among nations. The GATT also lived up to its expectations as it conducted several
negotiations to improve world trade.
However, due to a lack of coherent structure, it was replaced by the World Trade Organisation.
The World Trade Organization has developed several policies that enforce different aspects of
GATT. Hence, the GATT still functions under the umbrella of WTO.

REVISION QUESTIONS
1. a) Explain absolute and comparative advantage theories. [10]
b) Is free trade beneficial to a developing country such as Zimbabwe. [15]
2. a)Analyse the effects of proteting trade to society of:
i) a tariff
ii) a quota [12]
b) Discuss the benefits to your economy of protecting trade. [13]
3. a) With the aid of examples, explain the difference between a free trade area and an
economic union. [10]
b) Discuss the effectiveness of tariffs and quotas in protecting trade. [15]
4. a) Describe the following types of protectionism
i) tariffs
ii) foreign exchange controls
iii) import substitution [12]
b) Evaluate the benefits of economic intergration to Zimbabwe. [13]
5. Assess the effectiveness of trade protectionist measures in your country. [25]
6. a) What is meant by free trade area and economic union.? [10]
b) Assess the benefits of free trade to a country. [15]

7a) Explain
i) free trade area
ii) customs union
iii) economic union. [12]
b) Discuss the benefits to a developing country of joining a trading bloc such as SADC. [13]

10. MEASUREMENT OF ECONOMIC
PERF0RMANCE
CIRCULAR FLOW OF INCOME

Circular flow of income is an economic model that describes how the money exchanged in the
process of production, distribution and consumption of goods and services flows in a circular
manner from producers to consumers and back to the producers.
Understanding Circular Flow
The circular flow of income is an integral concept in economics as it describes the foundation of
the transactions that build an economy. The basic model of the circular flow of income
considers only two sectors, the firms and the households, which is why it is called the two-sector
economy model.
Let understand the meaning of these terms as well as the whole concept in simple steps.
Firms are the producers of goods and services. Firms require various factors of production or
societal resources to produce goods and services.
The factors of production are land, labor, building, stock, stationery, etc.
Households provide the resources or factors of production. For example, a household provides
land and labor to carry out business operations in exchange for the money paid in the form of
rent, wages, etc.
So, the money flows from the firms to the household in the form of rent, wages, etc.
The households utilize the money from wages and rent to purchase certain goods and services to
full their needs and wants.
When the households pay for these goods and services, the money flows back to the firms,
completing the circular movement of money.

CIRCULAR FLOW OF INCOME IN 2 SECTOR ECONOMY
As have been said before, the two-sector economy is a fundamental model consisting of only
sectors firms and households. Other assumptions of this model are as follows.
There are no savings by the households. Whatever they earn, they spend in the form of consumer
expenditure.
There is no profit retained by firms and whatever they earn from selling goods and services; it is
given back to households in the form of wages, rent, etc.
There is no government to interfere in the money flow, i.e. there is no tax liability on the
households or regulations imposed on the movement.
It assumes that it is a closed economy without any external interference of foreign countries, i.e.
there is no trade foreign trade.
CIRCULAR FLOW OF INCOME IN A THREE-SECTOR ECONOMY
The three-sector economy model includes the role of government when determining the flow of
money. In this type of economy, government plays an essential part.
A three-sector economy model rectifies some of the drawbacks of the two-sector model by
introducing the following.

The government plays a pivotal role as it consumes a major portion of the money flow in the
form of taxes.
Hence, the flow of money follows from the firms and households to the government in the form
of taxes.
The government utilizes taxes to develop the infrastructure and many other services like
healthcare, education, etc. So, to the firms, the government pays back in terms of incentives and
by purchasing their goods.
The government pays to the households in terms of interest rates on government securities, pay
revisions, government jobs etc.
Thus together, it all completes the circular movement of money.
If the government’s income from the taxes is less than its expenditure, it is said to have a deficit
budget.
As such, the role of government cannot be ignored in any economy because of such a huge
control it possesses over the economic cycle.
Governmental interference affects the overall economic performance of a country.
A three-sector economy does not consider the role of foreign markets, which has become even
more prevalent in the current globalized world.
Understanding 3 Sector economy
The three-sector economy involves three sectors namely, households, business, and government.
The addition of the government in an economy results in bringing two variables in an economy.
These variables are government expenditure (act as injections to income) and taxation (act as
leakage or withdrawals from income).
In other words, the government expenditure increases the aggregate demand, while taxation
reduces the aggregate demand.

CIRCULAR FLOW OF INCOME IN A FOUR-SECTOR ECONOMY
Circular flow of income in a four-sector economy consists of households, firms, government and
foreign sector.
Household Sector
Households provide factor services to firms, government and foreign sector.
In return, it receives factor payments. Households also receive transfer payments from the
government and the foreign sector.
Households spend their income on:
(i) Payment for goods and services purchased from firms;
(ii) Tax payments to government;
(iii) Payments for imports.

Firms
Firms receive revenue from households, government and the foreign sector for sale of
their goods and services. Firms also receive subsidies from the government.
Firm makes payments for:
(i) Factor services to households;
(ii) Taxes to the government;
(iii) Imports to the foreign sector.
Government
Government receives revenue from firms, households and the foreign sector for sale of goods
and services, taxes, fees, etc. Government makes factor payments to households and also spends
money on transfer payments and subsidies.
Foreign Sector
Foreign sector receives revenue from firms, households and government for export of goods and
services. It makes payments for import of goods and services from firms and the government. It
also makes payment for the factor services to the households.
The savings of households, firms and the government sector get accumulated in the financial
market. Financial market invests money by lending out money to households, firms and the
government. The inflows of money in the financial market are equal to outflows of money. It
makes the circular flow of income complete and continuous.

Summary
The Circular flow of income diagram models what happens in a very basic economy.
In the very basic model, we have two principal components of the economy:
Firms. Companies who pay wages to workers and produce output.
Households. Individuals who consume goods and receive wages from firms.
This circular flow of income also shows the three different ways that National Income is
calculated.
National Output. The total value of output produced by firms.

National Income. (profit, dividends, income, wages, rent) This is the total income received by
people in the economy. For example, firms have to pay workers to produce the output. Therefore
income flows from firms to households.
National Expenditure. Total amount spent on goods and services. For example, with wages
from work, households can then buy goods produced by firms. Therefore, the spending goes
back to firms.
This represents a simple economic model; it is a closed economy without any government
intervention.
In the real world, it is more complicated. We also add two more components:
Government. The government taxes firms and consumers, and then spend money, e.g. health
care and education.
Foreign sector.We sell exports abroad and buy imports. Therefore, there is a flow of money
between one country and the rest of the world.
Withdrawals (W) into Circular Flow of Income
Withdrawals are items that take money out of the circular flow. This includes:
• Savings (S) (money not used to finance consumption, e.g. saved in a bank)
• Imports (M) (money sent abroad to buy foreign goods)
• Taxes (T) (money collected by government, e.g. income tax and VAT)
Injections (J) into Circular Flow of Income
Spending that puts money into the circular flow of income.
• Investment (I). Money invested by firms into purchasing capital stock.
• Exports (X) . Money coming from abroad to buy domestically produced goods.
• Government spending (G). Government welfare benefits, spending on infrastructure.

Closed Economy
A closed economy is a type of economy where the import and export of goods and services don’t
happen, which implies that the economy is self-sufficient and has no trading activity from
outside economics. The sole purpose of such an economy is to meet all the domestic consumers’
needs within the country’s border.
In practice, there are no countries with closed economies at present. Brazil has the closest to the
closed economy. It has the least import of goods compared to the countries from the rest of the
world. It is impossible to meet all the goods and service demands within the domestic boundary.
With globalization and technology dependency building and maintaining such economies can be
a herculean task. It can be considered that India was a closed economy till 1991 and so were the
other countries across the globe. At present, it is not quite possible to run a closed economy.
The need for raw materials is important and plays a vital role in the final product, this makes the
closed economy inefficient. The government can shut down any particular sector from the
international competition through the use of quotas, subsidies, tariffs, and making it illegal in the
country. They have no or limited economic relationship with other economies.
Closed economy is an economy, which does not have any sort of economic relation with rest of
the world but is confined to itself only. A closed economy does not enter into any one of the
following activities.
• It neither exports goods and services to the foreign countries nor imports goods and
services from the foreign countries.
• It neither buys shares, debentures, bonds etc. from foreign countries nor sells shares,
debentures, bonds etc. to foreign countries.
• It neither borrows from the foreign countries nor lends to the foreign countries.
• It neither receives gifts from foreigners nor sends gifts to foreigners.
• Normal residents of a closed economy cannot go to other countries to work in their

domestic territory. No foreigner is allowed to work in the domestic territory of a closed
economy.
Due to all these seasons, Gross Domestic Product and Gross National Product are the same in a
closed economy.

Open Economy
An open economy is an economy in which there are economic activities between the domestic
community and outside. People and even businessescan trade in goods and services with other
people and businesses in the international community, and funds can flow as investments across
the border. Trade can take the form of managerial exchange, technology transfers, and all kinds
(However, certain exceptions exist that cannot be exchanged; the railway services of a country,
for example, cannot be traded with another country to avail the service.)
Open and Closed Economy National Income Formula
Income calculation in the closed and open economy.
Closed Economy
Y=C+I+G
Where,
Y – National income
C – Total consumption
I – Total investment
G – Total government expenditure
Open Economy
Y = Cd + Id + Gd + X
Where,
Y – National income
Cd – Total domestic consumption
Id – Total investment in domestic goods and services
Gd – Government purchases of domestic goods and services
X – Exports of domestic goods and services

NATIONAL INCOME
National income is the total value a country’s final output of all new goods and services
produced in one year.
The creation of national income

The simplest way to think about national income is to consider what happens when one product
is manufactured and sold. Typically, goods are produced in a number of ‘stages’, where raw
materials are converted by firms at one stage, then sold to firms at the next stage. Value is added
at each, intermediate, stage, and, at the final stage, the product is given a retail selling price. The
retail price reflects the value added in terms of all the resources used in all the previous stages of
production.
Final output
In accounting terms, only the value of final output is recorded. To avoid the problem of double
counting, only the value of the final stage, the retail price, is included, and not the value added in
all the intermediate stages – the costs of production, plus profits. In short, national income is the
value of all the final output of goods and services produced in one year.
Example
For example, consider the production of a motor car which has a retail price of $25 000. This
price includes $21 000 for all the costs of production ($6 000 for components, $10 000 for
assembly and $5 000 for marketing) plus $4 000 for profit. To avoid double-counting, the
national income accounts only record the value of the final stage, which in this case is the selling
price of $25 000.
When goods are bought second-hand, the transaction does not add new value and will not be
included in national output. If second-hand goods are included, double-counting will occur, and
this would falsely inflate the value of national income.
For example, if the car in question is sold in two year’s time for $15 000 it would provide the
owner with money, but the sale will not add to national income. If it were included in national
income, it would make the value of the car $35 000 – the initial $25 000 plus the second hand
value of $15 000. This is clearly not the case, so any future second-hand sales are not included
when valuing national income. Such second-hand transactions are called transfers.

Calculating national income
Any transaction which adds value involves three elements – expenditure by purchasers, income
received by sellers, and the value of the goods traded. For example, if a student purchases a
textbook for $30, spending = $30, income to the bookseller = $30, and the value of the book =
$30. All of the transactions in an economy can be looked at in this way, giving us three ways to
measure national income.
NATIONAL INCOME
National Income is total amount of goods and services produced within the nation during the
given period eg, one year. It is the total of factor income i.e. wages, interest, rent, profit, received
by factors of production i.e. labour, capital, land and entrepreneurship of a nation.
BASIC CONCEPTS OF NATIONAL INCOME
The following are some of the concepts used in measuring national income.
• GDP
• GNP
• NNP
• NNP at factor cost
• Personal Income
• Disposable Income
• Per capita Income
• GDP deflator

1. GROSS DOMESTIC PRODUCT (GDP)
GDP is the total market value of final goods and services produced within the country during a
year. This is calculated at market prices and is known as GDP at market prices.
GDP by expenditure method at market prices = C + I + G + (X – M)
Where C – consumption goods; I – Investment goods;
G – Government purchases;
X – Exports; M – Imports
(X – M) is net export which can be positive or negative.
2. GROSS NATIONAL PRODUCT (GNP)
GNP is the total measure of the flow of final goods and services at market value resulting from
current production in a country during a year, including net income from abroad. GNP includes
five types of final goods and services :
(1) value of final consumer goods and services produced in a year to satisfy the immediate wants
of the people which is referred to as consumption (C);
(2) gross private domestic investment in capital goods consisting of fixed capital formation,
residential construction and inventories of finished and unfinished goods which is called as gross
investment (I) ;
(3) goods and services produced or purchased by the government which is denoted by (G) ; and
(4) net exports of goods and services, i.e., the difference between value of exports and imports of
goods and services, known as (X-M) ; Net factor incomes from abroad which refers to the
difference between factor incomes (wage, interest, profits ) received from abroad by normal
residents of India and factor incomes paid to the foreign residents for factor services rendered by
them in the domestic territory in India (R-P);
(5) GNP at market prices means the gross value of final goods and services produced annually in
a country plus net factor income from abroad (C + I + G + (X-M) + (R-P)).
GNP at Market Prices = GDP at Market Prices + Net Factor income from Abroad.

3. NET NATIONAL PRODUCT (NNP) (AT MARKET PRICE)
Net National Product refers to the value of the net output of the economy during the year. NNP is
obtained by deducting the value of depreciation, or replacement allowance of the capital assets
from the GNP. It is expressed as,
NNP = GNP – depreciation allowance.
(depreciation is also called as Capital Consumption Allowance)
4. NNP AT FACTOR COST
NNP refers to the market value of output. Whereas NNP at factor cost is the total of income
payment made to factors of production. Thus from the money value of NNP at market price, we
deduct the amount of indirect taxes and add subsidies to arrive at the net national income at
factor cost.
NNP at factor cost = NNP at Market prices – Indirect taxes + Subsidies.
5. PERSONAL INCOME
Personal income is the total income received by the individuals of a country from all sources
before payment of direct taxes in a year. Personal income is never equal to the national income,
because the former includes the transfer payments whereas they are not included in national
income. Personal income is derived from national income by deducting undistributed corporate
profit, and employees’ contributions to social security schemes and adding transfer payment.
Personal Income = National Income – (Social Security Contribution and undistributed corporate
profits) + Transfer payments
6. DISPOSABLE INCOME
Disposable Income is also known as Disposable personal income. It is the individuals income
after the payment of income tax. This is the amount available for households for consumption.
Disposable Income = Personal income – Direct Tax.
As the entire disposable income is not spent on consumption,
Disposal income = consumption + saving.

7. PER CAPITA INCOME (PCI)
Is calculated by dividing the national income of the country by the total population of a country.
Thus, PCI=Total National Income/Total National Population

USEFULLNESS OF NATIONAL INCOME
National income is an indicator of success of planning in a country. National income data can be
used to describe the relative significance of primary, secondary and tertiary sectors of an
economy. National income data can be useful in measuring the equitableness of distribution of
income in the country.
Below is a list of importances on the national income statistics;
• Provides information on the country’s economic performance over a period of time.
• Provides information to be used for making economic policies or budgeting or planning.
• Provides information on the contribution of each sector of the economy to the national
income.
• Provides a breakdown on consumer expenditure and government expenditure.
• Provides information on the distribution of income.
• Provide information on the types of factor incomes in the economy.
• Provide statistics for measuring the economic growth of the country.
• Provides information that is used to measure the standard of living in the country.
• Provide information used for comparing economic performance of the country across two
or more years.

DIFFICULTIES FACED IN ESTIMATING NATIONAL INCOME
Six major difficulties faced in the measurement of national income are as follows:
All the countries face some special difficulties in estimating national income. Some of these
difficulties are given below:
1. Problems of Definition
This relates to what we include in the National Income?
Ideally we should include all goods and services produced in the course of the year, but there are
some services which are not calculated in terms of money, e.g., services of housewives.
2. Lack of Adequate Data
The lack of adequate statistical data makes the task of estimation of national income more acute
and difficult.
3. Non-availability of Reliable Information
The reason of illiteracy, most producers has no idea of the quantity and value of their output and
do not follow the practice of keeping regular accounts.
4. Choice of Method
The selection of method while calculating National Income is also an important task. The wrong
method leads to poor results.
5. Lack of Differentiation in Economic Functioning
In all the countries the occupational specialization is still incomplete so that there is a lack of
differentiation in economic functioning. An individual may receive income partly from farm
ownership and partly from manual work in industry in the slack season.
6. Double Counting
Double counting is also an important problem while calculating national income. If the value of
all goods and services totaled, the total will overtake the national output, because some goods are
currently consumed being used in the making of others. The best way to avoid this error is to
calculate only the value of those goods and services that enter into final consumption.

GDP DEFLATOR
GDP deflator is an index of price changes of goods and services included in GDP. It is a price
index which is calculated by dividing the nominal GDP in a given year by the real GDP for the
same year and multiplying it by 100.
GDP deflator = [Nominal GDP/Real GDP] x100
In simple words, the GDP deflator is used to convert nominal GDP, which is the GDP measured
at current prices, to real GDP, which is the GDP measured at base year prices or constant prices.
By doing so, the GDP deflator helps to eliminate the impact of inflation or deflation on the
economy's growth rate.
Explanation
The Gross Domestic Product (GDP) is a measure of the total value of all final goods and services
produced (total output) within the geographic boundaries of a country in one year. GDP is a key
measure of economic activity, but it can be affected by changes in prices over time. The GDP
deflator is an important tool that economists use to adjust for these price changes and accurately
measure the growth of an economy.
In simple words, the GDP deflator is used to convert nominal GDP, which is the GDP measured
at current prices, to real GDP, which is the GDP measured at base year prices. By doing so, the
GDP deflator helps to eliminate the impact of inflation or deflation on the economy's growth rate.
The GDP deflator measures the prices of finished goods produced, rather than consumed, in a
country. So it includes the prices of capital goods as well as consumer products and includes the
price of exports but excludes the price of imports.

GDP Deflator Calculation
Suppose that the nominal GDP of a country in 2022 is $10 trillion, and the real GDP for the same
year is $8 trillion. To calculate the GDP deflator for the country, we can use the formula
mentioned above:
• GDP Deflator = (Nominal GDP / Real GDP) x 100
• GDP Deflator = ($10 trillion / $8 trillion) x 100
• GDP Deflator = 125
Therefore, the GDP deflator for the country is 125.
Importance of the GDP Deflator
The GDP deflator is an essential tool in economics because it helps to measure the real growth of
an economy by eliminating the effects of inflation. For instance, if the nominal GDP of a country
increases by 5% in a year, it does not necessarily mean that the country's economy has grown by
5%. If the inflation rate for the same year is 3%, then the real GDP growth of the country is only
2%. The GDP deflator provides a more accurate picture of the economy's growth and helps
policymakers make informed decisions.
Limitations of the GDP Deflator
Like any economic indicator, the GDP deflator has its limitations. For example, it may not
accurately capture changes in the quality of goods and services over time. If the quality of goods
and services increases, the price may remain the same, resulting in a deflated measure of
economic growth. Additionally, the GDP deflator is a broad measure that does not differentiate
between different sectors of the economy, which may be growing at different rates.
GDP Deflator vs. Consumer Price Index (CPI)
The GDP price deflator and the Consumer Price Index (CPI) are both price indices that are used
to measure inflation, but they differ in a few ways.
The GDP deflator measures the change in prices of all goods and services produced within a
country, including those used for investment purposes. It is used to calculate real GDP, which is
GDP adjusted for inflation.

On the other hand, the CPI measures the change in prices of goods and services bought by
consumers. It is used to calculate the inflation rate that affects consumers directly, such as the
cost of living.
While both are useful indicators of inflation, the GDP deflator provides a more comprehensive
picture of price inflation throughout the entire economy, while the CPI is more focused on the
prices of goods and services consumed by households.
The GDP deflator isn't based on a fixed basket of goods and services. For example, changes in
consumption patterns, investment patterns, or the introduction of new goods and services are
automatically incorporated in the GDP deflator but not in the CPI. Hence, the GDP deflator is a
more comprehensive measure of inflation.
Conclusion
The GDP deflator is an important price index that helps to measure the real growth of an
economy by adjusting for changes in prices over time. The formula for calculating the GDP
deflator is simple, and the example provided above illustrates how it can be computed. Despite
its limitations, the GDP deflator remains an essential tool for policymakers and economists to
measure and understand economic growth.

REVISION QUESTIONS
1. Explain the circular flow of income in the following sectors:
a. 2 sector economy [5]

b. 3 sector economy [5]
c. 4 sector economy [5]
2. Explain the following terms:
a. Closed economy [5]

b. Open economy [5]
3. a) What is a country’s
(i) gross domestic product (GDP),

(ii) net national product (NNP) [10]
b) Discuss whether national income statistics accurately measure standards of living

in your country. [15]
4. a) Explain the challenges of measuring national income. [12]

b) Discuss the usefulness of National Income Statistics in your country. [13]
5. a) Explain the following methods of calculating Gross Domestic Product (GDP):

i. Expenditure method and
ii. Output method [10]
b) Discuss the usefulness of National Income Statistics in comparing the standard of
living in two countries. [15]

11. MONEY AND THE PRICE LEVEL
MONEY
Anything that is accepted in the settlement of a debt.
CHARACTERISTICS OF MONEY
For money to carry out the stated functions it must have good characteristics which are:
Acceptability
• Money can be anything as long as it is acceptable in settling payments
• People should be free to accept it
Divisibility
• It must be available in different denominations or divided into small units (for purchasing
small items or for change)
Durability
• Money must resist quick wear or deterioration
• Should maintain its state for a long time
Portability
• Must be of convenient sizes to carry or must be easy to carry around
Recognisability
• Notes and coins of different sizes must be easily identified
Uniformity and homogeneity

• Notes and coins of same value should be the same or identical in all aspects

Scarcity
• Must should be limited in supply
Stability in value
• It must have a fairly constant value over a time to avoid inflation
• It must be available in different denominations or divided into small units (for purchasing
small items or for change)
Durability
• Money must resist quick wear or deterioration
• Should maintain its state for a long time
Portability
• Must be of convenient sizes to carry or must be easy to carry around
Mnemomic of characteristics of money : ADDSUPS
Acceptable
Divisible
Durable
Stable
Uniformity
Portable
Scarcity

FUNCTIONS OF MONEY
A medium of exchange
It can be exchanged for goods and services e.g. dress for money or labour for money
A measure of value
Value of goods and services is expressed in monetary terms e.g. pair of shoes worth $80
A standard of comparing values, e.g.
50kg of maize worth $10 as compared to 50kg beans worth $50
A store of value
• Surplus goods can be sold and stored as money
• Money can be saved in savings, current or deposit account
A standard of deferred payments or future payments
Goods and services are valued and paid for later e.g. paying debts at some future date
Unit of account
All transactions are expressed in monetary values.

MONEY MARKET INSTITUTIONS
CENTAL BANK/ RESERVE BANK OF ZIMBABWE
It is the Government bank or the Central bank
Functions
• Issue notes and coins through commercial banks
• A banker’s banks i.e. it keeps minimum deposit for commercial banks
• A banker to the government i.e. revenue is paid into it and payments are met out of it
• Carries out the government’s monetary policy by controlling interest on debt and the
value of the Zimbabwean dollar
• A lender of last resort to commercial banks and discount houses
• Acts as a clearing house in settling interbank debts
• Rations foreign currency and controls the issue of foreign currency
• Acts as advisor to the government on economic issues and ways of controlling inflation
• Sells treasury bills on behalf of government
• Withdraws and replaces worn out notes and coins
• A custodian of the nation’s reserves of gold and foreign assets
• Acts as an agent for state to borrow funds from the public
• Controls and regulates the supply of money
• Manages the national debts
• Controls the lending rates.

COMMERCIAL BANKS
Examples include First Capital Bank and CBZ Bank
Functions
• Accept deposits in form of current, savings or fixed deposit accounts
• Receive or make payments through cheques, direct debit, credit transfer
• Provide finance through loans and overdrafts
• Provide foreign currency, travellers cheques and bank overdrafts
• Offer credit and ATM cards
• Provide automated teller machines (ATM)
• Safeguard valuables such as title deeds certificates
• Give financial advice
• Offer night safe facilities
• Accept and discount Bills of Exchange
• Provide tele-banking facilities
• Act as trustees and executors
• Offer interest on account balance
• Offer point-of-sale in supermarkets
• Issue letters of credit
• Act as underwriters

BUILDING SOCIETIES
Examples include Central Africa Building Society (CABS), FBC
Functions
• They keep safely the customer’s deposits through savings, deposits, and fixed share
accounts
• Provide mortgage finance or building loans
• Provide Automated Teller Machines (ATM)
• Provide purchase points e.g. in supermarkets
• Provide cash and switch cards
• Issues certified cheques on request
• Operate stop order for their clients
• Give advice on investment portfolios
• Give loans
• Facilitate automatic transmission of funds (on line Real time computer system)

MERCHANT BANKS
An example is the National Merchant Bank of Zimbabwe (NMBZ)
Functions
• Specialise in accepting and discounting bills of exchange
• Lends money on short term to large importers
• May raise long term capital by arranging the issue of new shares
• Act as underwriters when they purchase unsubscribed shares
• Source and keep foreign currency for business
• Export and import goods
• Confirm orders
• Arrange letters of credit
• Offer banking services

MONEY MULTIPLIER
The money multiplier is a mechanism in which the banking system turns a portion of deposits
into loans, which then become deposits for other banks, leading to a larger overall increase in the
money supply. It represents how a single dollar deposited in a bank can 'multiply' into a greater
amount in the economy through the lending process.
Concept of Money Multiplier
The money multiplier is a phenomenon of creating money in the economy in the form of credit
creation. The money is created in the market based on the fractional reserve banking system. It is
also sometimes called monetary multiplier or credit multiplier.
It is the maximum limit to which money supply can be affected by bringing changes in the
number of money deposits deposited by the people in the market. The effect of the money
multiplier can be seen in commercial banks of the economy. Commercial banks accept money or
deposits. They keep some amount as a reserve with them and lend other shares as loans to the
people.
The amount of money that is kept as reserves by these commercial banks for the withdrawal
purposes of the depositors at any time is known as the reserve ratio or the required reserve ratio
or cash reserve ratio.
Credit Creation
Credit creation refers to expanding the availability of money through the advancement of loans
and credit by banks and financial institutions. These institutions use their demand deposits to
provide loans to their customers, giving borrowers higher purchasing power and competitive
interest rates.
In the process of credit creation, banks keep some share of their deposits as minimum reserves to
meet the demand of their depositors. Thus, banks lend out the excess reserves for loans and
investment purposes, and the interest earned becomes income for the banks. Therefore, the
factors that drive the credit creation process are liquidity and profitability of the banks.

Money Multiplier Formula
The money multiplier formula requires the use of the reserve ratio. This is because of the major
impact the reserve ratio has on the amount of money banks are allowed to loan out.
The money multiplier effect can be calculated as follows:
Money Multiplier Effect = 1 / Reserve Ratio
Money Multiplier Example
Below is a money multiplier example that utilizes the formula above.
Say the reserve ratio is set at 8%. The money multiplier is simply the reciprocal of the reserve
ratio:
• Reserve Ratio = 8%
• Money Multiplier = 1 / 0.08 = 8
Another Example
A new deposit of $1 billion is placed in a bank. The cash ratio is 20%.
How much does the money supply increase by assuming that there are no leakages?
Working
20% is the same as 0.2
So 1/0.2 = 5
5 x $1 billion
Answer is $5 billion

Further practice
In a banking system, all banks maintain 10% of deposits as cash.
Customers withdraw $20 000 in cash.
Assuming no subsequent net change in notes and coins in circulation, by how much will the
banks have to reduce their net loans?
Working
• 1/0.1 = 10
• 10 x $20 000 = $200 000
• $200 000 - $20 000
Answer $180 000
We subtract because it is a withdrawal.

REVISION QUESTIONS
1. Explain characteristics of money. [10]
2. Examine the functions of money. [10]
3. Explain any four functions of a central bank. [10]
4. Outline the functions of commercial banks. [10]
5. Illustrate how banks create money [10]

12. MACRO-ECONOMIC PROBLEMS
AND POLICIES
UNEMPLOYMENT
Unemployment can be defined as the state where people are out of jobs due to a variety of
reasons.There are several different types of unemployment, including macroeconomic as well as
individual factors. Unemployment can cause severe negative effects, not only for individuals but
also for the overall economy.
TYPES OF UNEMPLOYMENT
Cyclical unemployment
Cyclical unemployment refers to a state where there are large swings in unemployment due to
adverse economic conditions like recessions. Although cyclical unemployment can have
significant short-term effects on the local economy, in the long-term, the economy is likely to
recover since cyclical unemployment often is just temporary.
Frictional unemployment
Frictional unemployment is the lack of employment due to factors like the search for a new job
or due to the entering of the workforce of students after finishing college. All this requires a
certain amount of time, which implies temporary frictional unemployment.
Structural unemployment
Structural unemployment can be regarded as long-term unemployment due to a mismatch of

demand and supply on the job market. For instance, this could mean that unemployed people
simple do not have the knowledge that is necessary to participate in the job market. In our
nowadays age, this could mean that people lack basic knowledge on how to use a computer,
which makes it almost impossible to find an office job.

Regional unemployment
Another form of unemployment is regional unemployment. It refers to a state where specific

regions are structurally weak and just do not have many jobs to offer. This may be due to an
unattractiveness for firms to open branches in those regions due to political instability or high
corporate tax rates. Thus, in those regions, unemployment rates are often quite high since there
are simply not enough jobs.
Seasonal unemployment
Seasonal unemployment refers to unemployment that is due to seasonal factors. For instance,
some businesses make the majority of their sales in only a few months. A good example is when
companies supply goods for Christmas. In the months before Christmas, sales usually skyrocket.
However, after Christmas, there are almost no sales at all. Thus, especially in those kinds of
businesses, seasonal unemployment is a big issue since companies simply do not need their
workers anymore once the busy season is over.
Voluntary unemployment
There is also a fraction of people who actually do not want to work at all and want to enjoy their
leisure time instead. Those people contribute to the phenomenon that is often described as
voluntary unemployment.

CAUSES OF UNEMPLOYMENT
1. Low level of education
2. Mental issues
3. Physical health problems
4. Gender discrimination
5. Financial crisis
6. Structurally weak regions
7. Lack of motivation

EFFECTS OF UNEMPLOYMENT
1. Mental health issues
2. Physical health issues
3. Lower life expectancy
4. Homelessness
5. Drug use
6. Poverty
7. Social isolation
8. Adverse effects on children
9. Illegal activities
10. Economic effects
SOLUTIONS FOR UNEMPLOYMENT
1. Better education
2. Motivation programs
3. Programs against drug addiction and homelessness
4. Fight discrimination
5. Support programs for mental issues
6. Subsidies for companies how are reintegrating unemployed persons
7. Fiscal and monetary measures in a financial crisis situation
8. Fight structural unemployment
9. Create jobs

EFFECTS OF UNEMPLOYMENT
Unemployment is a real concern in all areas of the world. The negative effects of unemployment
on society outweigh the positive effects.
Positive effects of unemployment
• The only positive effects of unemployment are individual effects.
• Avoiding morning commute: Many people despise rush hour traffic on their commute to
work. Being unemployed means no more getting up early to deal with heavy traffic.
• More time with family and friends: This is a strong positive effect of unemployment for
an individual. They can spend time with their children, family and friends. Without a job,
there is more time to participate in family or school events.
Negative Effects of Unemployment
• The negative effects far outweigh the positive effects when it comes to the impact
unemployment has on society and the individual as well.
• Not enough money: This is one of the adverse effects on the individual. Everything in the
world costs money. If there is no source of income, you're going to have to settle and go
without. If an unemployed individual has a family, it's difficult. Sure, there are
unemployment benefits, but they aren't going to pay for extra things to do with your
family and travel to new places.
• Health issues: This is another individual negative effect, but an important one. Being
unemployed can lead to depression, low self-esteem, anxiety and other mental health
issues, especially if an individual truly wants a job but can't find employment. Tension
can occur, causing stress and strain on the body.
• Economic Issues: During unemployment, there is no income, which leads to poverty. The
burden of debt will increase, leading to economic problems. When there is
unemployment, the state and the federal governments have to step in and pay
unemployment benefits. By needing to pay more of these benefits, the government must
borrow money to pay the benefits or reduce spending in other areas.
• Social Issues: Many crimes are committed by individuals who are unemployed and living
in poverty. When unemployment rates increase, crime rates tend to rise.

Negative effects of unemployment
-Reduced effective demand for the firms products
-It increases anti social behaviour such as robbery, whoring
-It reduces investor confidence
-It reduces government revenue since government would be having less workers to tax
-Under utilisation of scarce resources
-Brain drain
-It reduces GDP
-Living standards would decline
-It strains the government in paying unemployment benefits
-It hampers economic growth and development
Positive effects of unemployment
-High unemployment reduces inflation (Phillips Curve Analysis)
-It forces policy makers (government) to implement sound policies
-It forces people to be innovative
-Technologic unemployment improves efficiency and production and service delivery

Discuss the effectiveness of supply side policies to reduce the high rate of unemployment in
your counter.
Supply side polices are policies designed to increase innovation, productivity, efficiency and
eventually long run aggregate supply. There are at times known as full employment output.
These policies have been widely used by governments to control the level of unemployment,
however the effectiveness of supply side policies have been criticized by economists who do not
favour the classical and free market economist due to its shortcomings.
Economists argue that education and training is a supply side policy that aims at improving skill
that will in the long term reduce the unemployment poll by providing individuals with the correct
skill in the fast changing labour market. For instance Zimbabwe Ministry of Education recently
introduced the new curriculum so as to equip learners at an early age with the subjects that will
equip them for their career choices. Governments may also set up training institutes such as
Universities and Colleges, government can help fund education of individuals through
apprenticeship levies. The main aim is to equip people with the new skills preparing them for the
changing economy, when education and training increases this will therefore increase the
aggregate supply of skilled labour force, hence productivity will increase. However some may
criticize this policy as it only depends on whether government can provide funding to implement
new curriculum or not and it also depends on whether the government can provide the skill
needed by employers, some argue that there is no guarantee that government spending will be
able to solve the skills gap.
It is argued that the government can use deregulation to reduce unemployment in the economy.
Deregulation is allowing state owned entities or other public services to be provided by private
sector. Allowing private sector to provide services and run other state owned entities increase
efficiency and competition. If privatization simply involves the transfer of natural monopoly to
private sector, the door for increased competition is limited. However where there is genuine
scope for increased competition for example supply of electricity can be supplied by private
sector, this privatization can lead to increased efficiency, more consumer choice and lower prices
to choose from different suppliers. Alternatively deregulation can involve the introduction of
private services into the public sector. For instance private contractors can provide their services
to clean hospitals or refuse collection for local authorities. Private sector can compete with each
other for franchise thereby expanding their business and providing employment opportunities for
citizens. Hence this will reduce the unemployment poll.

Economists argue that tax cuts for business and other investment incentives are effective policies
that reduce the level of unemployment. These aim at encouraging investment and seek to reduce
the general level of taxation on profits there by giving greater tax relief to investor. A cut in
corporate tax will increase after tax profits. This will create more money for ploughing back into
investment and the higher after tax returns on investment will encourage more investment to take
place. Hence more investments means more employment creation therefore this will effectively
reduce unemployment.
Geographical supply side policies are effective as they aim to increase occupational mobility.
Unemployment is often geographical in scope with occupational immobilities preventing the
unemployed to move to areas with job opportunities. The government could provide more
affordable housing in cities of employment growth give more land to private builders to build
houses for rent. There by increasing labour mobility. However this policy has some limitations
that individuals may not be willing to leave their social life behind and move into new areas
where there are no families and friends. This may be difficult to the individuals who may fear for
starting over a new life in new areas.
It is postulated that the reduction of trade union power is effective to reduce the level of
unemployment because trade unions jobs is to protect it’s own workers and they may push up
wages just to their own interest. If there is reduction in trade union power many employers may
be willing to hire more people for less and more working hours which some economist argue that
half bread is better than nothing, this means it’s better to work for less money than to be
unemployed and have no income coming in, without employment benefits unemployed
individuals may have greater incentives to take available jobs there by reducing unemployment
poll. However this policy is not effective because employers might act into their self interest of
increasing output there by exploiting workers by less pay and more long working hours. A lower
level of trade union power may result to lower job security levels for workers as there are no
protection laws for employees this means employers may fire workers when ever they want to
and there may be unfair dismissal. The reduction of trade unions means there will be a reduction
in the standard of living for the workers on the minimum wage and the unemployed as some
unemployment benefits may be scrapped out by firms.
In a nutshell the supply side policies are at large effective in controlling the level of
unemployment in an economy as this evidence has been supported by many economists such as
the neo – classical, despite the critics from other economists that do not support the neo –
classical such that supply side policies may take time to implement fully and reduce the level of
unemployment, the budget for subsidies may take time and may only be issued on the next
government budget. However the supply side policies are still justified to control the level of
unemployment.
Policies for reducing unemployment
There are two main strategies for reducing unemployment:
• Demand side policies to reduce demand-deficient unemployment (unemployment caused

by recession)
• Supply side policies to reduce structural unemployment / (the natural rate of

unemployment )

Demand side policies
Demand side policies are critical when there is a recession and rise in cyclical unemployment.
(e.g. after 1991 recession and after 2008 recession)
1. Fiscal Policy
Fiscal policy can decrease unemployment by helping to increase aggregate demand and the rate
of economic growth. The government will need to pursue expansionary fiscal policy; this
involves cutting taxes and increasing government spending. Lower taxes increase disposable
income (e.g. VAT cut to 15% in 2008) and therefore help to increase consumption, leading to
higher aggregate demand (AD).
With an increase in AD, there will be an increase in Real GDP (as long as there is spare capacity
in the economy.) If firms produce more, there will be an increase in demand for workers and
therefore lower demand-deficient unemployment. Also, with higher aggregate demand and
strong economic growth, fewer firms will go bankrupt meaning fewer job losses.
Keynes was an active advocate of expansionary fiscal policy during a prolonged recession. He
argues that in a recession, resources (both capital and labour) are idle. Therefore the government
should intervene and create additional demand to reduce unemployment.
Impact of Higher AD on Economy
This shows an increase in AD causing higher real GDP. The increase in output leads to firms
needing more workers.

However,
1. It depends on other components of AD. e.g. if confidence is low, cutting taxes may not
increase consumer spending because people prefer to save. Also, people may not spend tax cuts,
if they will soon be reversed.
2. Fiscal policy may have time lags. E.g., a decision to increase government spending may take a
long time to affect aggregated demand (AD).
3. If the economy is close to full capacity, an increase in AD will only cause inflation.
Expansionary fiscal policy will only reduce unemployment if there is an output gap.
4. Expansionary fiscal policy will require higher government borrowing – this may not be
possible for countries with high levels of debt, and rising bond yields.
5. In the long run, expansionary fiscal policy may cause crowding out, i.e. the government
increase spending but because they borrow from the private sector, they have less to spend, and
therefore AD doesn’t increase. However, Keynesians argue crowding out will not occur in a
liquidity trap .
2. Monetary policy
Monetary policy would involve cutting interest rates. Lower rates decrease the cost of borrowing
and encourage people to spend and invest. This increases AD and should also help to increase
GDP and reduce demand deficient unemployment.
Also, lower interest rates will reduce exchange rate and make exports more competitive.
In some cases, lower interest rates may be ineffective in boosting demand. In this case, Central
Banks may resort to Quantitative easing. This is an attempt to increase the money supply and
boost aggregate demand.
Evaluation
• Similar problems to fiscal policy. e.g. it depends on other components of AD.
• Lower interest rates may not help boost spending if banks are still reluctant to lend.
• Demand side policies can contribute to reducing demand deficient unemployment e.g. in
a recession. However, they cannot reduce supply side unemployment. Therefore, their
effectiveness depends on the type of unemployment that occurs.

Supply side policies for reducing unemployment
Supply side policies deal with more micro-economic issues. They don’t aim to boost overall
aggregate demand but seek to overcome imperfections in the labour market and reduce
unemployment caused by supply side factors. Supply side unemployment includes:
• Frictional
• Structural
• Classical (real wage)
Policies to reduce supply side unemployment
1. Education and training. The aim is to give the long-term unemployed new skills which enable
them to find jobs in developing industries, e.g. retrain unemployed steel workers to have basic
I.T. skills which help them find work in the service sector. – However, despite providing
education and training schemes, the unemployed may be unable or unwilling to learn new skills.
At best it will take several years to reduce unemployment.
2. Reduce the power of trades unions. If unions can bargain for wages above the market clearing
level, they will cause real wage unemployment. In this case reducing the influence of trades
unions (or reducing Minimum wages) will help solve this real wage unemployment.
3. Employment subsidies. Firms could be given tax breaks or subsidies for taking on long-term
unemployed. This helps give them new confidence and on the job training. However, it will be
quite expensive, and it may encourage firms to just replace current workers with the long-term
unemployment to benefit from the tax breaks.
4. Improve labour market flexibility. It is argued that higher structural rates of unemployment in
Europe is due to restrictive labour markets which discourage firms from employing workers in
the first place. For example, abolishing maximum working weeks and making it easier to hire
and fire workers may encourage more job creation. However, increased labour market flexibility
could cause a rise in temporary employment and greater job insecurity.
5. Stricter benefit requirements. Governments could take a more pro-active role in making the
unemployed accept a job or risk losing benefits. After a certain period, the government could
guarantee a public sector job (e.g. cleaning streets). This could significantly reduce
unemployment. However, it may mean the government end up employing thousands of people in
unproductive tasks which is very expensive. Also, if you make it difficult to claim benefits, you
may reduce the claimant count, but not the International Labour force survey. See: measures of
unemployment

6. Improved geographical mobility. Often unemployed is more concentrated in certain regions.
To overcome this geographical unemployment, the government could give tax breaks to firms
who set up in depressed areas. Alternatively, they can provide financial assistance to
unemployed workers who move to areas with high employment. (e.g. help with renting in
London)
7. Maximum working week. It has been suggested a maximum working week of (for example 35
hours) would lead to firms needing to hire more workers and reduce unemployment.
However, a maximum working week may increase a firms costs and therefore they are not
willing to hire more. Also, there is no certainty a firm will respond to a cut in hours by
employing more – they may try to increase productivity. Those with wrong skills will still face
same problem.

INFLATION
COST-PUSH INFLATION
Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of
wages and raw materials. Higher costs of production can decrease the aggregate supply (the
amount of total production) in the economy. Since the demand for goods hasn't changed, the
price increases from production are passed onto consumers creating cost-push inflation.
The most common cause of cost-push inflation starts with an increase in the cost of production,
which may be expected or unexpected. For example, the cost of raw materials or inventory used
in production might increase, leading to higher costs.
Inflation is a measure of the rate of price increases in an economy for a basket of selected goods
and services. Inflation can erode a consumer's purchasing power if wages haven't increased
enough or kept up with rising prices. If a company's production costs rise, the company's
executive management might try to pass the additional costs onto consumers by raising the prices
for their products. If the company doesn't raise prices, while production costs increase, the
company's profits will decrease.
For cost-push inflation to take place, demand for the affected product must remain constant
during the time the production cost changes are occurring. To compensate for the increased cost
of production, producers raise the price to the consumer to maintain profit levels while keeping
pace with expected demand.
Causes of Cost-Push Inflation
As stated earlier, an increase in the cost of input goods used in manufacturing, such as raw
materials. For example, if companies use copper in the manufacturing process and the price of
the metal suddenly rises, companies might pass those increase on to their customers.
Increased labor costs can create cost-push inflation such as when mandatory wage increases for
production employees due to an increase in minimum the wage per worker. A worker strike due
to stalled to contract negotiations might lead to a decline in production and as a result, higher
prices ensue for the scare product.
Unexpected causes of cost-push inflation are often natural disasters, which can include floods,
earthquakes, fires, or tornadoes. If a large disaster causes unexpected damage to a production
facility and results in a shutdown or partial disruption of the production chain, higher production
costs are likely to follow. A company might have no choice but to increase prices to help recoup

some of the losses from a disaster. Although not all natural disasters result in higher production
costs and therefore, wouldn't lead to cost-push inflation.
Other events might qualify if they lead to higher production costs, such as a sudden change in
government that affects the country’s ability to maintain its previous output. However,
government-induced increases in production costs are more often seen in developing nations.
Government regulations and changes in current laws, although usually anticipated, may cause
costs to rise for businesses because they have no way to compensate for the increased costs
associated with them. For example, the government might mandate that healthcare be provided,
driving up the cost of employees or labor.

DEMAND-PULL INFLATION
Demand-pull inflation is the upward pressure on prices that follows a shortage in supply.
Economists describe it as "too many dollars chasing too few goods."
Demand-pull inflation is a tenet of Keynesian economics that describes the effects of an

imbalance in aggregate supply and demand. When the aggregate demand in an economy strongly
outweighs the aggregate supply, prices go up. This is the most common cause of inflation.
The term demand-pull inflation usually describes a widespread phenomenon. That is, when
consumer demand outpaces the available supply of many types of consumer goods, demand-pull
inflation sets in, forcing an overall increase in the cost of living.
In Keynesian economic theory, an increase in employment leads to an increase in aggregate

demand for consumer goods. In response to the demand, companies hire more people so that
they can increase their output. The more people firms hire, the more employment increases.
Eventually, the demand for consumer goods outpaces the ability of manufacturers to supply them.

There are five causes for demand-pull inflation:
• A growing economy. When consumers feel confident, they spend more and take on more
debt. This leads to a steady increase in demand, which means higher prices.
• Asset inflation. A sudden rise in exports forces an undervaluation of the currencies

involved.
• Government spending. When the government spends more freely, prices go up.
• Inflation expectations. Companies may increase their prices in expectation of inflation in

the near future.
• More money in the system. An expansion of the money supply with too few goods to buy
makes prices increase.

CAUSES OF INFLATION
Inflation means there is a sustained increase in the price level. The main causes of inflation are
either excess aggregate demand (AD) (economic growth too fast) or cost push factors (supply-
side factors).
Methods to Control Inflation
Inflation is generally controlled by the Central Bank and/or the government. The main policy
used is monetary policy (changing interest rates). However, in theory, there are a variety of tools
to control inflation including:
1. Monetary policy – Higher interest rates reduce demand in the economy, leading to lower
economic growth and lower inflation.
2. Control of money supply – Monetarists argue there is a close link between the money supply
and inflation, therefore controlling money supply can control inflation.

3. Supply-side policies – policies to increase the competitiveness and efficiency of the economy,
putting downward pressure on long-term costs.
4. Fiscal policy – a higher rate of income tax could reduce spending, demand and inflationary
pressures.
5. Wage controls – trying to control wages could, in theory, help to reduce inflationary pressures.
Effects of Inflation
1. Effects on Distribution of Income and Wealth:
The impact of inflation is felt unevenly by the different groups of individuals within the national
economy—some groups of people gain by making big fortune and some others lose.
We may now explain in detail the effects of inflation on different groups of people:
(a) Creditors and debtors:
During inflation creditors lose because they receive in effect less in goods and services than if
they had received the repayments during a period of low prices. Debtors, on other hand, as a
group gain during inflation, since they repay their debts in currency that has lost its value (i.e.,
the same currency unit will now buy less goods and services).
(b) Producers and workers:
Producers gain because they get higher prices and thus more profits from the sale of their
products. As the rise in prices is usually higher than the increase in costs, producers can earn
more during inflation. But, workers lose as they find a fall in their real wages as their money
wages do not usually rise proportionately with the increase in prices. They, as a class, however,
gain because they get more employment during inflation.
(c) Fixed income-earners:
Fixed income-earners like the salaried people, rent-earners, landlords, pensioners, etc., suffer
greatly because inflation reduces the value of their earnings.

(d) Investors:
The investors in equity shares gain as they get dividends at higher rates because of larger
corporate profits and as they find the value of their shareholdings appreciated. But the
bondholders lose as they get a fixed interest the real value of which has already fallen.
(e) Traders, speculators, businesspeople and black-marketers:
They gain because they make more profits from the persistent rise in prices.
(f) Farmers:
Farmers also gain because the rise in the prices of agricultural products is usually higher than the
increase in the prices of other goods.
Thus, inflation brings a shift in the pattern of distribution of income and wealth in the country,
usually making the rich richer and the poor poorer. Thus during inflation there is more and more
inequality in the distribution of income.
2. Effects on Production:
The rising prices stimulate the production of all goods—both of consumption and of capital
goods. As producers get more and more profit, they try to produce more and more by utilising all
the available resources at their disposal.
But, after the stage of full employment the production cannot increase as all the resources are
fully employed. Moreover, the producers and the farmers would increase their stock in the
expectation of a further rise in prices. As a result hoarding and cornering of commodities will
increase.
But such favourable effects of inflation upon production are not always found. Sometimes,
production may come to a standstill position despite rising prices, as was found in recent years in
developing countries like India, Thailand and Bangladesh. This situation is described as
stagflation.

3. Effects on Income and Employment:
Inflation tends to increase the aggregate money income (i.e., national income) of the community
as a whole on account of larger spending and greater production. Similarly, the volume of
employment increases under the impact of increased production. But the real income of the
people fails to increase proportionately due to a fall in the purchasing power of money.
4. Effects on Business and Trade:
The aggregate volume of internal trade tends to increase during inflation due to higher incomes,
greater production and larger spending. But the export trade is likely to suffer on account of a
rise in the prices of domestic goods. However, the business firms expand their businesses to
make larger profits.
During most inflation since costs do not rise as fast as prices profits soar. But wages do not
increase proportionate with prices, causing hardships to workers and making more and more
inequality. As the old saying goes, during inflation prices move in escalator and wages in stairs.
5. Effects on the Government Finance:
During inflation, the government revenue increases as it gets more revenue from income tax,
sales tax, excise duties, etc. Similarly, public expenditure increases as the government is required
to spend more and more for administrative and other purposes. But the rising prices reduce the
real burden of public debt because a fix sum has to be paid in instalment per period.
6. Effects on Growth:
A mild inflation promotes economic growth, but a runaway inflation obstructs economic growth
as it raises cost of development projects. Although a mild dose of inflation is inevitable and
desirable in a developing economy, a high rate of inflation tends to lower the growth rate by
slowing down the rate of capital formation and creating uncertainty.

EFFECTS OF INFLATION ON AN ECONOMY
The impact of inflation is felt unevenly by the different groups of individuals within the national
economy. As a macro economic woe, inflation have some devastating effects on an economy
although there are some positive effects associated it.
Negatives
- Closure of companies
- Rise in the rate of unemployment
- Loss of value of the domestic currency
- Leads to a decadence in peoples living standards
- Planning becomes very difficult
- Brain drain
- Loss making by many firms
- Can promote black marketing
- A rise in cost of production e.g. rise in bank rates, wages
- Shortage of basics on the market
- Can lead to the eruption of anti social behaviour
- Fall in investor confidence
- Wage price spiral, as wages are increased prices also increase
- Erosion of peoples purchasing power
- Erosion of profits
- Corruption becomes rampant (order of the day)
- General macro economic and political instability
Positive effects
- It leads to redistribution of income i.e. borrowers would gain whilst lenders will lose,
income redistributed from the rich (lenders) to the poor (borrowers)
- Inflation unites conflicting parties
- It forces policy makers to be wide awake and implement sound policies
- Profiteering by firms

Problems in Measuring Inflation
Inflation is a measure of changes in the cost of living. It is calculated by using statistics such as
Consumer Price index [CPI], Retail price index [RPI]. The process for measuring inflation is
broadly because it requires creating a weighted basket of goods – depending on frequently goods
are bought, measuring monthly changes in prices and creating an index from the price change
multiplied by the weighting of the good.
Difficulties in measuring inflation include
1. Changes in the quality of goods. Changes in the quality of goods mean that price rises may not
reflect inflation, but just the fact it is an improved good. For example, computers have many
more features than 10 years ago, so it is difficult to compare prices because they are effectively
different goods.
2. Shrinkflation. It is also possible goods can deteriorate in quality and size. For example, the
price of vegetables may stay the same, but if the size decreases, the price per gram effectively
rises. Shrinkflation has often been a response to rising cost-push inflation – firms reduce the size
of chocolate bars rather than increase the price. Inflation measures may not pick up on this
marginal decrease in size.
3. One-off shocks may give a misleading impression . For example, a rise in oil prices will lead
to higher inflation. But, this rise in prices may just be temporary. Tax changes have a similar
effect.
4. Which measure to use? – There are numerous different measures of inflation which include
different items in the inflation index. Measures of inflation include CPI, CPIH, RPI or RPIX.
CPI excludes mortgage interest payments. CPIH includes them.
In 2009, with falling interest rates, RPI gave a negative inflation rate, whilst CPI was positive.
There is often a difference between the two measures. A rise in interest rates causes RPI to rise
but not CPI. Therefore, it is important which measure is used. The government’s preferred
measure is currently CPI.

5. Different groups can have different inflation rates. Rising electricity and gas prices may affect
old people more than young people. Therefore, old people could have a higher inflation rate than
the national average. This is important if pensions are index linked because their cost of living
may rise more than prices causing a decrease in living standards.
6. Basket of goods can become outdated. In a fast-changing economy, goods people are buying is
frequently changing. Trends may cause people to be buying new technology or in different
places – and the traditional basket of goods can fail to keep up. For example, if there is a rise in
internet shopping, inflation measures should give a higher weighting to online prices, but it takes
time to update the basket of goods and which prices should be counted.
The consumer price index or CPI is a more direct measure than per capita GDP of the standard of
living in a country. It is based on the overall cost of a fixed basket of goods and services bought
by a typical consumer, relative to price of the same basket in some base year. By including a
broad range of thousands of goods and services with the fixed basket, the CPI can obtain an
accurate estimate of the cost of living. It is important to remember that the CPI is not a dollar
value like GDP, but instead an index number or a percentage change from the base year.

Constructing the CPI
Each month, the Bureau of Labor Statistics publishes an updated CPI. While in practice this is a
rather daunting task that requires the consideration of thousands of items and prices, in theory
computing the CPI is simple.
The CPI is computed through a four-step process.
1. The fixed basket of goods and services is defined. This requires figuring out where the typical
consumer spends his or her money. The Bureau of Labor Statistics surveys consumers to gather
this information.
2. The prices for every item in the fixed basket are found. Since the same basket of goods and
services is used across a number of time periods to determine changes in the CPI, the price for
every item in the fixed basket must be found for every point in time.
3. The cost of the fixed basket of goods and services must be calculated for each time period.
Like computing GDP, the cost of the fixed basket of goods and services is found by multiplying
the quantity of each item times its price.
4. A base year is chosen and the index is computed. The price of the fixed basket of goods and
services for each comparison year is then divided by the price of the fixed basket of goods in the
base year. The result is multiplied by 100 to give the relative level of the cost of living between
the base year and the comparison years.

Limitations of the Consumer Price Index (CPI)
The consumer price index (CPI) is a measure of the overall price level of goods and services
bought by a typical consumer in a particular economy. Its goal is to measure the cost of living
and show the effects of inflation on individual consumers. However, like most indicators, the
CPI has its shortcomings. Specifically, there are four limitations of the consumer price index
which are: (1) the substitution bias, (2) the representation of novelty, (3) the effects of quality
changes, and (4) the possible lack of individual relevance. In the following paragraphs, the
limitations will be explained in more detail.
1) Substitution Bias
The substitution bias causes certain increases in price to be overstated because it ignores the
presence of substitutes. More specifically, the reason for this is that not all prices change
proportionately. While some prices may rise from one year to the next, others may fall, and some
of them won’t move at all. Now, consumers respond to these changes by buying more of the
goods that become relatively cheaper and less of those that become relatively more expensive.
That is, they substitute some of the more expensive goods for cheaper alternatives. However,
because the CPI is calculated with a fixed basket of goods, it cannot include this effect (i.e., it
just assumes that people continue to buy the more expensive goods instead of switching to
cheaper ones). Hence, an increase in the price of a good in the index may be overstated.
For example, let’s say burgers are included in the CPI while hot dogs aren’t. When the price of
burgers increases, people will eat more hot dogs instead (because they become relatively
cheaper). However, because the index is based on a fixed basket of goods, it does not take this
into account. Instead, it simply assumes that people will continue to eat burgers and pay the
higher price. As a result, the increase in the cost of living reported by the index is higher than the
actual increase, because it ignores the fact that consumers may switch to cheaper hot dogs
instead.
2) Representation of Novelty
The representation of novelty in the CPI results in a temporary distortion of the actual cost of
living after the introduction of new products. The reason for this is that people have a wider
variety of goods or services to choose from, whenever new products are introduced. However,
for products to be included in the CPI, they need to be bought consistently and in significant
quantities (usually for several years). Therefore it may take multiple years before new products
or innovations are included in the basket and thereby represented in the CPI. Other indicators,
such as the GDP deflator represent these changes more quickly and accurately.

To give an example, let’s assume Toyota releases an affordable flying car next year. Flying cars
are obviously much faster than regular cars, so many consumers abandon road traffic within a
few weeks. However, the new flying cars will not be included in the CPI at this point. It will take
several months or years of consistent consumer purchases before they will become part of the
fixed basket.
3) Effects of Quality Changes
The effects of quality changes cannot always be accurately represented because the quality is
extremely hard to measure. If the quality of a good deteriorates from one year to the next, the
value of this good decreases even if its price remains the same. This essentially has the same
effect as an increase in price (i.e., consumers receive less value per dollar). The CPI does not
take these changes into account by default. However, the US Bureau of Labor Statistics (BLS)
updates the basket regularly to reflect changes in quality. However, despite sophisticated
measures and scientific methods (e.g., hedonic quality adjustment), it is extremely difficult to
measure and include quality changes in the basket accurately.
For example, the quality of computers constantly increases due to technological progress.
Therefore, the consumer price index has to be adjusted on a regular basis to reflect these changes.
However, there is no bulletproof method to measure the increase in quality (or its value), which
makes it difficult to include the value increase in the consumer price index accurately.
4) Lack of Individual Relevance

The consumer price index may not accurately report the level of inflation experienced by an
individual because it measures the price level and inflation based on a typical consumer. Simply
put, if the spending patterns of an individual are different from those of an average consumer, the
numbers reported by the CPI may not be particularly relevant for that individual.
For example, let’s say you own a house and a car. You will probably have to spend a significant
amount of your income on mortgage and fuel. So if the prices of mortgages and gas increase, you
will personally experience a disproportionate increase in the level of inflation (as compared to
the CPI). Meanwhile, someone who neither owns a car nor a house will experience no inflation
at all.
In a nutshell, the goal of the consumer price index (CPI) is to measure the cost of living and
show the effects of inflation on individual consumers. However, CPI has four important
limitations the substitution bias causes certain increases in price to be overstated because it
ignores the presence of substitutes, the representation of novelty results in a temporary distortion
of the actual cost of living after the introduction of new products, the effects of quality changes
cannot always be represented accurately because the quality is extremely hard to measure and
finally, the CPI may not accurately report the level of inflation experienced by an individual,
because it measures the price level and inflation based on a typical consumer.

INFLATIONARY AND DEFLATIONARY GAPS
In a two sector economy where there are firms and personals doing certain kind of economic
transaction between each other the equilibrium occurs where C + I equals S + C or aggregate
demand of the economy equals the aggregate supply of the economy and if this happens to be at
a level of income which represents full employment in the economy, it can only be regarded as
blessing because it the best situation which can exist in the economy at any time. Still, it is not
necessary that equilibrium level of income always represents full employment level of output
and ser vices. It can either be above it or can be below it. Then these situations are termed as
gaps in the economy.
What is an Inflationary Gap?
Inflationary gap is an output gap, that signifies the difference between the actual GDP and the
anticipated GDP at an assumption of full employment in any given economy.
Inflationary Gap = Real or Actual GDP – Anticipated GDP
There are two types of GDP gaps or output gaps. While the inflationary gap is one, the
recessionary gap is the other. An inflationary gap can be understood as the measure of excess
aggregate demand over aggregate potential demand during full employment. A recessionary gap
is an economic state where the real GDP is out-weighted by the potential GDP under full
employment.
Components of the inflationary gap
It is composed of two factors viz, real gross domestic product and anticipated gross domestic
product.
If X is the real GDP and Y is the GDP with full employment, then X – Y denotes the inflationary
gap. In order to determine the real GDP of an economy, the following factors are taken into
account with short descriptions on their usage:
a. Government Expenditure: It includes social benefit transfers, all public consumption,

income transfers, etc.
b. Consumption Expenditure: It includes household licenses, permits, the output of

unincorporated enterprises, etc.
c. Net exports (exports – imports): Trade surplus if exports exceed imports, trade deficit if
imports exceed exports.
d. Investments: Commercial Expenses (incl. equipment), excludes exchange of assets,

purchase of financial assets.
Example of the inflationary gap
The real gross domestic product (GDP) of an economy in Africa is $100 billion. The anticipated
GDP is $92 billion. Determine the nature and magnitude of the output gap.
Solution
The real GDP exceeded the anticipated GDP; hence it is an inflationary gap. Also, this gap can
be calculated by subtracting anticipated GDP from the real GDP of the economy.
$100 billion – $92 billion = $8 billion
Thus, an Inflationary gap of $8 billion can be seen to exist in the economy.
The x-axis represents national income whereas the y-axis signifies the expenditure.

As apparent, the blue lines intersect demand curves at different points corresponding to the
national incomes. Notice the red line sitting on top of the blue line (at $92 billion). This is the
line of full employment. When the aggregate demand (in terms of national income) exceeds the
demand under full employment condition, the inflationary gap is caused; in this case $8 billion.
Note that aggregate demand is the total demand for all final goods and services produced in an
economy.
Advantages of the inflationary gap
• It is a good measure to layout economic policies. It is also useful in the critical analysis of
these economic policies (fiscal and monetary).
• If the resources of an economy are fully deployed in contribution to GDP, any signaling
price rise is due to excess demand in the economy.
• It tells that inflation can be controlled by checking aggregate demand.
Disadvantages of the inflationary gap
• The excess gap between the current income, current expenditure and current consumption
is taken whereas corresponding factors already produced in the economy are ignored in
the analysis.
• Inflation is not a static process. It keeps on changing with improbable and varying
degrees. However, the study of the inflationary gap is founded on static nature basis.
• The negligence of factor market in affecting the inflationary gap is a weakness of the
concept.

What is a Deflationary Gap?
A deflationary gap occurs when the actual real GDP is below its potential output. In this situation,
some economic resources are underutilized, which in turn, creating a downward pressure on
price level. This term is synonymous with the recessionary gap or the Okun gap.
How do deflationary gaps occur?

Aggregate demand and short-run aggregate supply fluctuate in the short-run. Such fluctuation
causes actual real GDP to deviate from potential GDP.
Economists call the deviation of real GDP from its potential as the output gap. The output gap
can be positive or negative. The positive output gap occurs when aggregate demand and short-
run aggregate supply intersects (short-run equilibrium) above its potential output. This situation
refers to the inflationary gap (positive output gap).

However, when short-run equilibrium is below its potential output, it is a deflationary gap
(negative output gap).
Causes of deflationary gap
A deflationary gap could occur when aggregate demand declines. For example, the global
recession reduces foreign demand for domestic products. Exports decline, so do with aggregate
demand.
High-interest rate environment also contributes to lower aggregate demand. In this case, new
loans become more costly. Households reduce their spending on durable goods, and companies
postpone their investment spending.
Other factors that reduce aggregate demand are higher taxes, more pessimistic consumers and
businesses, and lower equity and housing prices.
A decrease in aggregate demand results in lower real GDP and lower prices levels. The economy
operates below its potential output.
Implications on the economy
When the economy experiences a deflationary gap, economic growth and inflation rate are lower
(or even negative). When a decrease in aggregate demand bring the economy into a recession,
real GDP and the price level fall (deflation).
Companies face excess capacity. Prices and wages put on the downward pressure. Their profit
margins shrink and force them to reduce labor, causing a higher unemployment rate.
Households become more pessimistic on their future job and income prospects. As a result, they
spend less on goods and services.
For the government, a decline in economic activity causes tax revenues to fall.
In financial markets, investors will usually reduce investment in cyclical companies and
commodity-based companies. They began to reallocate investment more on defensive companies
as they have a more stable performance during an economic slowdown.
Explain the meaning of inflationary gap and deflationery gap. Explain any one measure by
which these gaps can be reduced.
Excess demand or inflationary gap is the excess of aggregate demand over and above its level
required to maintain full employment equilibrium in the economy.

Deficient demand or deflationary gap refers to the situation when aggregate demand is short of
aggregate supply corresponding.
One measure of correcting inflationary and deflationary gaps is:
Margin requirement refers to the difference between the current value of security offered for loan
and the value of loan granted. During deficient demand or deflation, the central bank decreases
the margin in order to increase the credit creation capacity of the commercial bank and as a result,
the money supply in an economy gets increased and the deficient demand or deflationary gap is
combated. Whereas, during inflationary gap the margin requirement is increased by the central
bank.

Difference between Inflationary Gap and Deflationary Gap.
Inflationary Gap Deflationary Gap
When the economy is operating at a level When the national income is below the full
which is greater than full employment it is employment level it means the investment
called inflationary gap and counter part of this opportunities are not enough to utilize all the
case is known as deflationary gap. saving that will be available if N.Y is to be
maintained at full employment in such a case
there exists a situation known as deflationary
gap also known as recessionary gap.
Deflationary gap is measured by the excess of An inflationary gap rises when saving falls
saving over investment or by the difference of short of the total investment of the economy or
income levels at equilibrium and at full the excess of equilibrium level of income over
employment. the full employment level of income, after full
employment is reached the physical output
cannot be increased so whatever may be the
increase in income it is an increase in the
financial value of the existing products.

DEFLATION
Deflation is generally the decline in the prices for goods and services that occur when the rate of
inflation falls below 0%. Deflation will take place naturally, if and when the money supply of an
economy is limited. Deflation in an economy indicates deteriorating conditions.
Deflation is normally linked with significant unemployment and low productivity levels of goods
and services. The term “Deflation” is often mistaken with “disinflation.” While deflation refers
to a decrease in the prices of goods and services in an economy, disinflation is when inflation
increases at a slower rate.
Causes of Deflation
Deflation can be caused by multiple factors:
• Structural changes in capital markets
When different companies selling similar goods or services compete, there is a tendency
to lower prices to have an edge over the competition.
• Increased productivity
Innovation and technology enable increased production efficiency which leads to lower
prices of goods and services. Some innovations affect the productivity of certain
industries and impact the entire economy.
• Decrease in the supply of currency
The decrease in the supply of currency will decrease the prices of goods and services to
make them affordable to people.
Effects of Deflation
Deflation may have the following impacts on an economy:
• Reduction in Business Revenues
In an economy faced with deflation, businesses must drastically reduce the prices of their
products or services to stay profitable. As reductions in prices take place, revenues begin
to drop.

• Lowered Wages and Layoffs
When revenues begin to drop, businesses need to find means to reduce their expenses to
meet objectives. One way is by reducing wages and cutting jobs. This adversely affects
the economy as consumers would now have less to spend.
Effect of deflation on the economy of the country
Just like inflation, deflation can be a continuous cycle. When prices continue to fall over time,
consumers can withhold spending money in the long term which means demands continue to fall,
leading to further deflation. A fall in sales is not good for company profits. As a result,
companies too withhold investing in new projects. All this leads to a slowdown in the economy.
Countries often struggle to get out of the deflation cycle.
How consumers benefit from deflation.
Consumers will benefit from deflation in the short term as the prices of goods will reduce. When
the prices of goods reduce it increases the purchasing power of the consumers and also helps the
consumers to save more.

PRICE CONTROLS
Price controls can take the form of maximum and minimum prices. They are a way to regulate
prices and set either above or below the market equilibrium:
Maximum prices can reduce the price of food to make it more affordable, but the drawback is a
maximum price may lead to lower supply and a shortage.
Minimum prices can increase the price producers receive. They have been used in agriculture to
increase farmers income. However, minimum prices lead to over-supply and mean the
government have to buy surplus.
Maximum prices
A maximum price means firms are not allowed to set prices above a certain level. The aim is to
reduce prices below the market equilibrium price.
Advantages of maximum prices
• The advantage is that they will lead to lower prices for consumers.
• This may be important if the supplier has monopoly power to exploit consumers. For
example, a landlord who owns all the property in an area can charge excessive prices.
Maximum prices are a method to bring prices closer to a ‘fair’ and ‘competitive
equilibrium.
• Maximum prices are usually reserved for socially important goods, such as food and
renting.
The equilibrium price is Pe. A maximum price leads to demand of Q2, but a fall in supply to Q1.

The disadvantage of max prices
• The disadvantage is that it will lead to lower supply. If firms get a lower price, there may
be less incentive to supply the good, and the number of properties on the market declines.
• A maximum price will also lead to a shortage – where demand will exceed supply; this
leads to waiting lists. In housing it could lead to a rise in homelessness.
• A maximum price can lead to the emergence of black markets as people try to overcome
the shortage of the good and pay well above the market price.
Examples of maximum prices
1. Food. During the second world war, the price of goods was fixed and goods rationed.
However, this encouraged people to sell on the black market through inflated prices.
2. Football games. Tickets for football games and concerts are often set at a maximum price.
(e.g. if left to the market, equilibrium prices would be much higher). e.g. at current prices,
Chubuku Super Cup final pitting Dynamos and Ngezi Platinum could sell many more
tickets than 20 000. The advantage of setting this maximum prices is that it keeps football
affordable for the average football supporter. It is argued that if prices were set solely by
market forces, it would be just the wealthy who could afford to go to games. The
disadvantage is that it means some who want to go to the game can’t because there is a
shortage of tickets.
3. Housing. The government may set a maximum price for renting to keep housing
affordable.
• However, a maximum price may reduce the supply of housing leading to

homelessness.
• However, if landlords have monopoly power and supply is very inelastic. In

this case, a maximum price can make renting cheaper without reducing supply

Minimum Prices
Minimum prices are used to give producers a higher income. For example, they are used to
increase the income of farmers producing food.
Diagram Minimum Prices
The equilibrium price is Pe. A minimum price leads to an increase in supply to Q2, but fall in
demand to Q1.
The Disadvantage of Minimum Prices
• Higher prices for consumers. We had to pay more for food.
• Minimum prices encourage oversupply and are inefficient.
Conclusion
Generally, price controls distort the working of the market and lead to oversupply or shortage.
They can exacerbate problems rather than solve them. Nevertheless, there may be occasions
when price controls can help for example, with highly volatile agricultural prices.
• A better solution to maximum prices may be to increase the supply of housing.
• A better solution to minimum prices may be to offer subsidies to farmers who promote
some environmental benefit to society – rather than through prices.

BALANCE OF PAYMENTS
The balance of payments , also known as balance of international payments and abbreviated
B.O.P. of a country is the record of all economic transactions between the residents of the
country and the rest of the world in a particular period of time (e.g., a quarter of a year). These
transactions are made by individuals, firms and government bodies. Thus the balance of
payments includes all external visible and non-visible transactions of a country.
First, the balance of payment provides detailed information concerning the demand and supply of
a country's currency. For example, if Zimbabwe imports more than it exports, then this means
that it may suffer from a BOP defit.
Second, a country's balance of payments data may signal its potential as a business partner for
the rest of the world. If a country is grappling with a major balance of payments difficulty, it may
not be able to expand imports from the outside world. Instead, the country may be tempted to
impose measures to restrict imports and discourage capital outflows in order to improve the
balance of payments situation. On the other hand, a country with a significant balance of
payments surplus would be more likely to expand imports, offering marketing opportunities for
foreign enterprises, and less likely to impose foreign exchange restrictions.
Third, balance of payments data can be used to evaluate the performance of the country in
international economic competition. Suppose a country is experiencing trade deficits year after
year. This trade data may then signal that the country's domestic industries lack international
competitiveness.
To interpret balance of payments data properly, it is necessary to understand how the balance of
payments account is constructed. These transactions include payments for the country's exports
and imports of goods, services, financial capital and financial transfers . It is prepared in a single
currency, typically the domestic currency for the country concerned. The balance of payments
accounts keep systematic records of all the economic transactions (visible and non-visible) of a
country with all other countries in the given time period. In the BoP accounts, all the receipts
from abroad are recorded as credit and all the payments to abroad are debits. Since the accounts
are maintained by double entry bookkeeping, they show the balance of payments accounts are
always balanced. Sources of funds for a nation, such as exports or the receipts of loans and
investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to
invest in foreign countries, are recorded as negative or deficit items.

When all components of the BOP accounts are included they must sum to zero with no overall
surplus or deficit. For example, if a country is importing more than it exports, its trade balance
will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by
funds earned from its foreign investments, by running down currency reserves or by receiving
loans from other countries.
While the overall BOP accounts will always balance when all types of payments are included,
imbalances are possible on individual elements of the BOP, such as the current account, the
capital account excluding the central bank's reserve account, or the sum of the two. Imbalances
in the latter sum can result in surplus countries accumulating wealth, while deficit nations
become increasingly indebted. The term "balance of payments" often refers to this sum: a
country's balance of payments is said to be in surplus (equivalently, the balance of payments is
positive) by a specific amount if sources of funds (such as export goods sold and bonds sold)
exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased)
by that amount. There is said to be a balance of payments deficit (the balance of payments is said
to be negative) if the former are less than the latter. A BOP surplus (or deficit) is accompanied
by an accumulation (or decumulation) of foreign exchange reserves by the central bank.
Under a fixed exchange rate system, the central bank accommodates those flows by buying up
any net inflow of funds into the country or by providing foreign currency funds to the foreign
exchange market to match any international outflow of funds, thus preventing the funds flows
from affecting the exchange rate between the country's currency and other currencies. Then the
net change per year in the central bank's foreign exchange reserves is sometimes called the
balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a
managed float where some changes of exchange rates are allowed, or at the other extreme a
purely floating exchange rate (also known as a purely flexible exchange rate). With a pure float
the central bank does not intervene at all to protect or devalue its currency , allowing the rate to
be set by the market , the central bank's foreign exchange reserves do not change, and the
balance of payments is always zero.

FOREIGN EXCHANGE RATE
A medium of exchange for goods and services is called currency. In a nutshell, it is money
issued by governments and accepted for payment in the country. It comes in the form of coins
and paper. Every nation has a currency that is widely accepted within its boundaries. For
example, the Pound (£) in England,and the Dollar ($) in the United States of America.
However, a country’s currency cannot be used in another country; For example, the Indian rupee
(₹) can not be directly acceptable in the USA. In today’s world, countries have economic
relations with each other. Thus, there is an increase in interdependence among the countries.
Therefore, in the case of international payments, it has to be first converted into the other
country’s currency after this, it can be used in economic transactions. If an Indian resident wants
to visit the USA, then he/she has to pay in Dollars ($) to stay there, or if an Indian resident wants
to purchase a certain thing from abroad, then he/she has to pay in their respective currency to
purchase that thing.
Thus, for this purpose, the currency of one country is converted into the currency of another
country and the rate at which one currency is exchanged for another is called the Foreign
Exchange Rate or Foreign Rate of Exchange. In simple words, it is the price paid in domestic
currency for buying a unit in foreign currency. For example, If 60 rands are to be paid to get one
dollar, then the exchange rate, in that case, is $1 = 60 rands
Devaluation and Revaluation
Devaluation includes a reduction in the value of the domestic currency in terms of foreign
currencies by the government. Under a fixed exchange rate system, the government undertakes
devaluation when the exchange rate is increased.
Revaluation refers to an increase in the value of the domestic currency by the government.

TYPES OF FOREIGN EXCHANGE RATES
There are three types of exchange rates; namely, Fixed Exchange Rate, Flexible Exchange Rate,
and Managed Floating Exchange Rate.
FIXED EXCHANGE RATE
Under this system, the exchange rate for the currency is fixed by the government. Thus, the
government is responsible to maintain the stability of the exchange rate. Each country maintains
the value of its currency in terms of some ‘external standard’ like gold, silver, another precious
metal, or another country’s currency.
The main purpose of a fixed exchange rate is to maintain stability in the country’s foreign trade
and capital flows.
The central bank or government purchases foreign exchange when the rate of foreign currency
rises and sells foreign exchange when the rates fall to maintain the stability of the exchange rate.
Thus, government has to maintain large reserves of foreign currencies to maintain a fixed
exchange rate.
When the value of one currency(domestic) is tied to another currency then this process is known
as pegging and that’s why the fixed exchange rate system is also referred to as the Pegged
Exchange Rate System.
When the value of one currency (domestic) is fixed in terms of another currency or in terms of
gold, then it is called the Parity Value of currency.
Merits of Fixed Exchange Rate System:
• It ensures stability in the exchange rate. Thus it helps in promoting foreign trade.
• It helps the government to control inflation in the economy.
• It stops speculating in the foreign exchange market.
• It promotes capital movements in the domestic country as there are no uncertainties about
foreign rates.
• It helps in preventing capital outflow.

Demerits of Fixed Exchange Rate System:
• It requires high reserves of gold. Thus it hinders the movement of capital or foreign
exchange.
• It may result in the undervaluation or overvaluation of the currency.
• It discourages the objective of having free markets.
• The country which follows this system may find it difficult to tackle depression or
recession.
FLEXIBLE EXCHANGE RATE SYSTEM
Under this system, the exchange rate for the currency is fixed by the forces of demand and
supply of different currencies in the foreign exchange market. This system is also called the
Floating Rate of Exchange or Free Exchange Rate. It is so because it is determined by the free
play of supply and demand forces in the international money market.
Under the Flexible Exchange Rate system, there is no intervention by the government.
It is called flexible because the rate changes with the change in the market forces.
The exchange rate is determined through interactions of banks, firms, and other institutions that
want to buy and sell foreign exchange in the foreign exchange market.
The rate at which the demand for foreign currency is equal to its supply is called the Par Rate of
Exchange, Normal Rate, or Equilibrium Rate of Foreign Exchange.
Merits of Flexible Exchange Rate System
• With the flexible exchange rate system, there is no need for the government to hold any
reserve.
• It eliminates the problem of overvaluation or undervaluation of the currency.
• It encourages venture capital in the form of foreign exchange.
• It also enhances efficiency in the allocation of resources.

Demerits of the Flexible Exchange Rate System
• It encourages speculation in the economy.
• There is no stability in the economy as the exchange rate keeps on fluctuating as per
demand and supply.
• Under this, coordination of macro policies becomes inconvenient.
• There is uncertainty in the economy that discourages international trade.
MANAGED FLOATING EXCHANGE RATE
Managed floating is a type of flexible exchange rate system where the central bank or the
government intervenes in the foreign exchange market to direct the currency value to a certain
direction. It refers to the system in which the foreign exchange rate is determined by the market
forces and the central bank stabilizes the exchange rate in case of appreciation or depreciation of
the domestic currency.
Under this system, the central bank acts as a bulk buyer or seller of foreign exchange to control
the fluctuation in the exchange rate. The central bank sells foreign exchange when the exchange
rate is high to bring it down and vice versa. It is done for the protection of the interest of
importers and exporters.
For this purpose, the central bank maintains the reserves of foreign exchange so that the
exchange rate stays within a targeted value.
If a country manipulates the exchange rate by not following the rules and regulations, then it is
known as Dirty Floating.
However, the central bank follows the necessary rules and regulations to influence the exchange
rate.
Advantages of Managed Floating Exchange Rate
Flexibility: Allows currency to adjust based on market forces.
Economic Stability: Mitigates extreme fluctuations, reducing risks.

Monetary Autonomy: Permits independent monetary policies.
Trade Competitiveness: Enhances exports and trade growth.
Foreign Reserves Management: Helps stabilize exchange rates efficiently.
Market-Based Price Discovery: Reflects supply and demand dynamics.
Risk Diversification: Reduces risks for international investors.
Adaptability to Globalization: Navigates complexities of the global economy.
Economic Policy Coordination: Enables coordinated economic policies.
Reduced Speculative Activities: Deters short-term currency speculation.
Demerits of the Managed Floating Exchange Rates
Exchange Rate Uncertainty: Interventions create uncertainty for businesses and investors.
Policy Ineffectiveness: Interventions may not always achieve desired outcomes.
Speculative Pressures: Intervention possibilities attract speculation.
Political Interference: Susceptible to political pressures.
Currency Manipulation: Can be used for unfair trade advantages.
Competitive Devaluation: This may trigger currency wars and tensions.
Market Distortions: Frequent interventions hinder market efficiency.
Inflationary Pressures: Interventions can influence domestic inflation.
Time and Resource Intensive: Requires significant time and effort.
Coordination Challenges: Complex to coordinate with other countries.

ECONOMIC GROWTH AND ECONOMIC
DEVELOPMENT
To understand the two terms economic growth and economic development, we will take an
example of a human being. The term growth of human beings simply means the increase in their
height and weight which is purely physical. But if you talk about human development, it will
take into account both the physical and abstract aspects like maturity level, attitudes, habits,
behaviour, feelings, intelligence and so on.
In the like manner, growth of an economy can be measured through the increase in its size in the
current year in comparison to previous years, but economic development includes not only
physical but also non-physical aspects that can only be experienced like improvement in the
lifestyle of the inhabitants, increase in individual income, improvement in technology and
infrastructure, etc.
Economic Growth
• Economic Growth refers to the increment in amount of goods and services produced by
an economy.
• Economic growth means an increase in real national income / national output.
• It refers to an increase over time in a country’s real output of goods and services (GNP)
or real output per capita income.
• Economic growth is single dimensional in nature as it only focuses on income of the

people.
• Earlier, economic growth was only measured in terms of Gross Domestic Product (GDP).
• At present, it is measured in terms of GDP, Gross National Income (GNI) and Per Capita
Income.
• Economic Growth is the precursor and prerequisite for economic development.
• Indicators of economic growth are GDP, GNI and per capita income.

• Economic growth relates a gradual increase in one of the components of GDP;
consumption, government spending, investment or net exports.
• It is also considered as a traditional measure of development which indicates the
quantitative rise of economy.
• Economic growth only looks at the quantitative aspect. It brings quantitative changes in
the economy.
• Economic growth is concerned with increase in economy’s output.
• It focuses on production of goods and services.
• Economic growth is more relevant metric for assessing progress in developed countries.
• Economic growth is relatively narrow concept as compared to economic development.
• It is for short term/short period.
• It is a material/physical concept.
• Economic growth is measured in certain time frame/period.
Economic Development
• Economic development refers to the reduction and elimination of poverty, unemployment

and inequality with the context of growing economy.
• Economic development is the quantitative and qualitative change in an economy.
• Economic development includes process and policies by which a country improves the
social, economic and political well-being of its people.
• Economic development is multi-dimensional in nature as it focuses on both income and

improvement of living standards of the people.

• Economic development is concerned with the happiness of public life.
• Economic development comes after economic growth. It is a positive impact of economic

growth.
• Economic development also refers to:
1. Provision of sufficient and effective physical and social infrastructures
2. Equal access to resources
3. Participation of all in economic activities
4. Equitable distribution of dividends of economy.
Economic development= Economic growth + standard of living
It refers to increase in productivity.
Indicators of economic development are:
1. Human Development Index (HDI)
2. Human Poverty Index (HPI)
3. Gender Development Index (GDI)
3. Physical Quality of Life Index (PQLI)
Economic development is the end of development.
Achieving economic development is linked with end of poverty and inequality.
It is more abstract concept.
Economic development focuses on distribution of resources.

Differences between Economic Growth and Economic Development
Economic growth Economic development
Economic Development is defined as the

Economic Growth refers to the rise in the value process of increase volume of production along
of everything produced in the economy. It with the improvement in technology, a rise in
implies the yearly increase in the country’s the level of living, institutional changes, etc. In
GDP or GNP, in percentage terms. It alludes to short, it is the progress in the socio-economic
considerable rise in per-capita national product, structure of the economy.
over a period, i.e. the growth rate of increase in
total output, must be greater than the
population growth rate.
Economic Growth is the increase in the real Economic Development is the increase in the
output of the country in a particular span of level of production in an economy along
time. enrichment of living standards and the
advancement of technology.
Economic growth does not consider the Economic Development takes consideration of
Income from the Informal Economy. The all activities, whether formal or informal and
Informal economy is unrecorded economic eases people with low standards of living a
activity.
suitable shelter and with proper employment.
Economic Growth does not reflect the Economic Development is concerned with
depletion of natural resources. Depletion of sustainability, which means meeting the needs
resources such as pollution, congestion & of the present without compromising.
disease. Governments are under pressure due
to the environmental issues, majorly the
problem is due to Global warming.
Economic Growth is basically related to the Economic Development is related to

developed countries. underdeveloped or developing countries of the
world.
Economic growth indicates the expansion of Economic Development refers to the increase
the Gross Domestic Product (GDP) of the of the Real National Income of the economic
country. and socio-economic structure of any country
over a long period of time.
Economic Growth can be measured through an Economic Development can be measured

increase in the GDP, per capita income, etc.
through Improvement in the life expectancy
rate, infant mortality rate, literacy rate, and
poverty rates.
Economic growth is the subset of economic Economic Development is a broader concept

development. than the Economic Growth.
Economic growth is the positive change in the Economic Development involves a rise in the
real output of the country in a particular span level of production in an economy along with
of time economy. the advancement of technology, improvement
in living standards and so on.
Economic growth is an automatic process. Economic development, which is the outcome

of planned and result-oriented activities.
Economic growth enables an increase in the On the other hand, economic development
indicators like GDP, per capita income, etc. enables improvement in the life expectancy
rate, infant mortality rate, literacy rate and
poverty rates.
Economic growth can be measured when there Economic development can be seen when there
is a positive change in the national income. is an increase in real national income.
Economic growth is a short-term process Economic development it is a long term

which takes into account yearly growth of the process.
economy.
Economic Growth applies to developed Economic development applies to developing

economies to gauge the quality of life, but as it countries to measure progress.
is an essential condition for the development, it
applies to developing countries also.
Economic growth can be measured in a Economic development is a continuous process

particular period. so that it can be seen in the long run.
Economic Growth results in quantitative Economic development brings both

changes. quantitative and qualitative changes.
Conclusion

After the above differences, we can say that economic development is a much bigger concept
than economic growth. In other words, the economic development includes economic growth. As
the former uses various indicators to judge the progress in an economy as a whole, the latter uses
only specific indicators like gross domestic product, individual income etc.
Factors affecting economic growth in developing countries
• Levels of infrastructure – e.g. transport and communication.
• Levels of corruption, e.g what percentage of tax rates are actually collected and spent on
public services.
• Educational standards and labour productivity. Basic levels of literacy and education can
determine the productivity of the workforce.
• Levels of inward investment. For example, China has invested in many African countries
to help export raw materials, that its economy needs.
• Labour mobility. Is labour able to move from relatively unproductive agriculture to more
productive manufacturing?
• The flow of foreign aid and investment. Targeted aid, can help improve infrastructure and
living standards.
• Level of savings and investment. Higher savings can fund more investment, helping
economic growth.
Factors limiting Economic Growth

1. Poor Health & Low Levels of Education
People who don’t have access to healthcare or education have lower levels of productivity. This
lack of access means the labor force is not as productive as it could be. Therefore, the economy
does not reach the productivity it could otherwise.
2. Lack of Necessary Infrastructure
Developing nations often suffer from inadequate infrastructures such as roads, schools, and
hospitals. This lack of infrastructure makes transportation more expensive and slows the overall
efficiency of the country.
3. Flight of Capital
If the country is not delivering the returns expected from investors, then investors will pull out
their money. Money often flows out of the country to seek higher rates of returns.
4. Political Instability
Similarly, political instability in the government scares investors and hinders investment. For
example, historically, Zimbabwe had been plagued with political uncertainty and laws favoring
indigenous ownership. This instability has scared off many investors who prefer smaller but
surer returns elsewhere.
5. Institutional Framework
Often local laws don’t adequately protect rights. Lack of an institutional framework can severely
impact progress and investment.
6. The World Trade Organization
Many economists claim that the World Trade Organization (WTO) and other trading systems are
biased against developing nations. Many developed nations adopt protectionist strategies which
don’t help liberalize trade.
Main barriers to economic growth and development

• Poor infrastructure
• Human capital inadequacies
• Primary product dependency
• Declining terms of trade
• Savings gap; inadequate capital accumulation
• Foreign currency gap and capital flight
• Corruption, poor governance, impact of civil war
• Population issues
Advantages of Economic Growth.
Standard of living of the people will increase.
Economic growth is an important point to bring better living standards and lower rates of poverty.
The average income of people can said that increases and indirectly people able to consume
more and motivate the economic growth increasing.
Rising Employment
Economic growth stimulates employment. The economic growth produces more vacancies for
job and bring better standard of living to them.
Increased capital investment.
Economic growth can used to increase capital investment.
Benefit to Government

Economic growth brings advanced tax incomes for the government, Because of this, the
government spends less unemployment benefits.
Superior public services.
Due to government got government income as economy growth, it can spend more on public
services like education for contributing in superior public services.
Enhanced business confidence
Economic growth creates positive effect as encourage people running their businesses. As profits
of small firms and business increase with economic growth, their business confidence and will to
grow up to meet more challenges.
Disadvantages of Economic Growth.
Inflation
Potential High and rising inflation will occur due to demand grows faster than long run
productive. It may destabilizing for an economy as interest rate may increase and can cause a
loss of competitiveness in international markets.
Regional disparities
Although average living standards may be rising, there is a gap between rich and poor. It can
widen the issues of poverty and make a wide gap between different regions.
Pollution
Economic growth can never be separated from environmental issues. Rapid growth of production
and consumption may create environment pollution such as sound and air pollution and road
congestion. Environmental damage may bring negative effects on our quality of life. For the
example, road congestion will produce more Co2 in a high density area. The health of residents
in that area will been affected.
DEVELOPING COUNTRIES

Developing countries are countries with economies that have a low gross domestic product (GDP)
per capita and rely heavily on agriculture as the primary industry. When it comes to regions of
the world, developing countries have not quite reached economic maturity, although there's a
wide array of different definitions.
Characteristics of Developing Countries
Even though developing nations have very different backgrounds in terms of resources, history,
demography, religion and politics, they still share a few common characteristics. Today,l will go
over common characteristics of developing economies.
Low Per Capita Real Income
Low per capita real income is one of the most defining characteristics of developing economies.
They suffer from low per capita real income level, which results in low savings and low
investments.
It means the average person doesn’t earn enough money to invest or save money. They spend
whatever they make. Thus, it creates a cycle of poverty that most of the population struggles to
escape. The percentage of people in absolute poverty (the minimum income level) is high in
developing countries.
High Population Growth Rate
Another common characteristic of developing countries is that they either have high population
growth rates or large populations. Often, this is because of a lack of family planning options,
lack of sex education and the belief that more children could result in a higher labor force for the
family to earn income. This increase in recent decades could be because of higher birth rates and
reduced death rates through improved health care.
High Rates of Unemployment
In rural areas, unemployment suffers from large seasonal variations. However, unemployment is
a more complex problem requiring policies beyond traditional fixes.
Dependence on Primary Sector

Almost 75% of the population of low-income countries is rurally based. As income levels rise,
the structure of demand changes, which leads to a rise in the manufacturing sector and then the
services sector.
Dependence on Exports of Primary Commodities

Since a significant portion of output originates from the primary sector, a large portion of exports
is also from the primary sector. For example, copper accounts for two-thirds of Zambia’s
High Dependence on Agriculture

Agriculture is the main occupation in developing countries. More than 70 percent of active labor
force is engaged in this primary sector. Population increases and the increased labor stick to
agriculture thereby over burdening the firm size. There is low output per head.
Underutilized Natural Resources

Most of the developing countries are rich in natural resources. However, their exploration and
exploitation is limited. Sometimes, foreign companies control them. Generally, raw products are
exported at low prices.
Lack of Industries and Enterprises
The industrial sector in developing countries is at the primary stage of development. Its
contribution to GDP is less than 10% employing 2 to 4% of the labor force. Industrial growth is
very slow.
Lack of Capital and Technology
Capital deficiency is another common problem of developing countries. Because the countries
are poor, they save less which results in low capital formation. They possess less investment
capital. In addition their existing technology is old and unproductive.
Lack of Basic Infrastructures
The factors that help for development are called infrastructures. Good road system, highways,
telephone, services, big dams and canals, banks and financial services are some examples of the
necessary infrastructures.
Dualistic Economy
All the sectors of economy have not been developed in developing countries. Employment
opportunities or activities exists in urban areas whereas traditional production method is used in
rural areas.

DEVELOPED COUNTRIES
Developed countries are countries that already have high technology and an evenly distributed
economic level. While developing countries are countries where the level of welfare of the
population is still in the middle of developing level.
Characteristics of Developed Countries
Has a high income per capita

Developed countries have high per capita incomes each year. By having a high income per capita,
the country’s economic value will be boosted. Therefore, the amount of poverty can be overcome.
Security Is Guaranteed
The level of security of developed countries is more secure compared to developing countries.
This is also a side effect of sophisticated technology in developed countries. With sophisticated
technology, security facilities and weapons technology also develop for the better.
Guaranteed Health
In addition to ensuring security, health in a developed country is also guaranteed. This is
characterized by a variety of adequate health facilities, such as hospitals and medical staff who
are trained and reliable. Therefore, mortality rates in developed countries can be suppressed and
the life expectancy of the population can be high. In addition, with adequate health facilities,
population development in developed countries can also be controlled.
Low unemployment rate
In developed countries, the unemployment rate is relatively small because every citizen can get a
job.
Mastering Science and Technology.
The inhabitants of developed countries tend to have mastered science and technology from
which new useful products such as the industrial pendant lights were introduced to the market.
Therefore, in their daily lives, they have also used sophisticated technology and modern tools to
facilitate their daily lives.
The level of exports is higher than imports
The level of exports in developed countries is higher than the level of imports because of the
superior human resources and technology possessed.
Examples of developed countries include the United States, Germany, and Japan.

Differences between developing and developed countries.
The following are the major differences between developed countries and developing countries
Developed countries Developing countries

The countries which are independent and The countries which are facing the beginning
prosperous are known as Developed of industrialization are called Developing
Countries. Countries.
Developed Countries have a high per capita Developing Countries have a low per capita
income and GDP as compared to Developing income and GDP as compared to Developed
Countries. Countries.
In Developed Countries the literacy rate is In Developing Countries illiteracy rate is
high. high
Developed Countries have good Developing Countries have bad infrastructure
infrastructure and a better environment in and environment in terms of health and
terms of health and safety, which are absent safety.
in Developing Countries.
Developed Countries generate revenue from Developing Countries generate revenue from
the industrial sector. the service sector.
In developed countries, the standard of living In developing countries, the standard of
of people is high. living of people is generally low./
Resources are effectively and efficiently Resources are not effectively and efficiently
utilized in developed countries. utilized in developed countries.
In developed countries, the birth rate and In developing countries, the birth rate and
death rate are low. death rate are high.

REVISION QUESTIONS
1. a) What are the causes of unemployment in your country? [10]

b) Discuss how the unemployment in your country could be reduced. [15]
Governments, the world over, are worried about a high rate of unemployment.
2. a) Why should governments be worried by a high rate of unemployment? [12]

b) Discuss how unemployment in your country could be solved. [13]
3. Explain the types of unemployment existing in your country. [10]
4. Analyse the effects of unemployment in an economy. [10]
5. Assess the causes and solutions to unemployment in your country. [25]
6. a) Explain the causes of inflation in your country. [10]

b) Should government be concerned with controlling inflation in a country. [15]
7. a) Analyse the effects of inflation on the functions of money. [12]

b) Assess the effectiveness of price controls and supply side policies to counter a
high rate of inflation. [13]
8. a) Explain
i) Demand-pull inflation.
ii) Cost-push inflation. [12]
b) Comment on the effectiveness of price controls and fiscal policy to counter a high
rate of inflation in your country. [13]

9. Discuss the effects of inflation to an economy. [15]
10. Evaluate the effectiveness of policies that can be used by the government of your
country to solve deflation. [25]
11a) Explain,
i. Fixed exchange rate,
ii. Floating exchange rate. [10]
b) Discuss the benefits of using a fixed exchange rate to your economy. [15]
12. a) Explain the term economic growth. [10]
b) Is it really worthwhile for a developing country such as Zimbabwe to pursue

economic growth. [15]
13. Analyse factors influencing economic growth in your country. [10]
14. Explain the differences between economic growth and economic development. [10]
15. Explain the characteristics of a developing country. [10]
16. Distinguish between developing and developed countries. [10]
MUSENDO POWER – TINOFAMBA NEVANOFAMBA
0771-075849 [WHATSAPP] 0774-453126 [CALLS]

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FIRST EDITION

UNDERSTANDING ECONOMICS Page 1

Introduction to new learners 3

Tools for economic analysis 46

Theory of Firm 109

Theory of Distribution 138

Government Intervention in the economy 163

International Trade 174

Measurement of Economic Perfomance 205

Money and Price Level 225

Macro-economic Problems and Policies 236

UNDERSTANDING ECONOMICS Page 2

• It is based on assumptions that is Ceteris paribus.

ECONOMICS IS DIVIDED INTO MICROECONOMICS AND MACROECONOMICS

• Micro means small.

• Is concerned with the study of the market system on a small scale.

• It looks at the individual markets that make up the market system.

• Macro means large.

• Is concerned with the study of the market system on a large scale.

• It considers the aggregate performance of all markets in the market system.

UNDERSTANDING ECONOMICS Page 3

• It deals with subjective statements or people’s opinions (value judgments)

 The retirement age should be raised to 70 to combat the effects of our

UNDERSTANDING ECONOMICS Page 4

A. Examines the desirability of government economic policy

B. Assumes current economic conditions remain unchanged

C. Concerns factual outcomes of an economic action

D. Is based upon the opinion of an economic advisor

2. Which of the following is a positive statement

A. The government should be worried about unemployment in the economy

D. An equitable distribution of income and wealth should lead to economic growth in an

3. Which of the following is a normative statement

A. Large scale farming increases productivity as compared to small scale farming

B. Productivity can be enhanced by employing capital widening and capital deepening

C. Inflation rate in Zimbabwe is higher than in South Africa

D. Zimbabwe has a deficit on her balance of payments

4. Which of the following is not a positive statement

A. There is deficit on the balance of trade

B. Unemployment is currently above 50%

C. Inflation rate has fallen to a single digit

D. Controlling inflation is more important than economic growth

UNDERSTANDING ECONOMICS Page 5

A. The government should be more worried about unemployment in the economy

B. The inflation rate in Zimbabwe in November 2005 was above 400%

C. Equitable distribution of income and wealth should lead to economic growth in an

6. Which one of the following statements in normative rather than positive

A. Smoking can seriously damage your health

B. Taxes on cigarettes are regressive

C. Cigarette machines should be available only on premises to which children do not

7. Which of the following is a positive statement

A. Wealth should be distributed equally

UNDERSTANDING ECONOMICS Page 6

In conclusion, these four factors—land, labor, capital, and entrepreneurship—combine together

UNDERSTANDING ECONOMICS Page 7

Types of Natural Resources

Renewable Resources : Examples

UNDERSTANDING ECONOMICS Page 8

Non-renewable Resources : Examples

UNDERSTANDING ECONOMICS Page 9

Health care shortages

UNDERSTANDING ECONOMICS Page 10

• Because of scarcity, choices must be made by consumers, businesses and governments.

UNDERSTANDING ECONOMICS Page 11