Introduction To Advanced Level Economics: by Brian Ropi

Introduction to
Advanced
Level
Economics
By Brian Ropi
[email protected] | +263 772 230 130
Introduction to Advanced Level Economics
Contents
Tools of Economic Analysis ....................................................................... 1
Economic Resources .................................................................................. 1
Theory of Demand ..................................................................................... 1
Theory of Supply ....................................................................................... 1
The Theory of Consumer Behavior ........................................................... 1
Theory of the Firm .................................................................................... 1
Macroeconomics......................................................................................... 1
National Income ........................................................................................ 1
International Trade ................................................................................... 1
Money & Interest Rate .............................................................................. 1
Inflation ..................................................................................................... 1
Unemployment .......................................................................................... 1
Economic Growth ...................................................................................... 1
1 “Think like an Economist” - By Brian Ropi

Tools of Economic
Analysis
What is this chapter about?
 Introduction.
 Important elements in the definition.
 Economics is a social science.
 The scientific method.
 Positive and Normative statements.
 Microeconomics and Macroeconomics.
 Pitfalls to sound economic reasoning.

Introduction
Human needs and wants are unlimited meaning people will never reach a point of maximum satisfaction
even if they are to be given all the resources of the world. People by nature always demand more to less.
Resources of the world are not enough to satisfy human needs and wants. Economics is therefore
available to device different ways of allocating scarce resources to try to satisfy people needs and wants.
Economics is defined in different ways by different authors‘ but they all agree on the fact that economics
is all about finding ways of allocating scarce resources.
Economics is a social or human science that deals with the allocation of scarce resources among
the competing ends to satisfy human needs and wants.
Important elements in the definition
Scarcity - resources are scarce on the sense that they are not enough to fulfil everyone‘s needs and wants
to the point of satiety. The economists’ job is to evaluate the choices that exist from the use of these
resources.
Economics is a social science
A social science is the scientific study of human behaviour. Other examples of social sciences are
psychology, politics and sociology. It is different from a physical science, which involves the study of
the physical world. Examples of physical sciences are chemistry and physics.
The scientific method
Both physical and social sciences follow a scientific method of study. The method involves forming a
hypothesis, or idea, which can then be tested. In the physical sciences, the hypothesis can be tested
repeatedly in a laboratory until it is proved or disproved. It uses empirical data; that is, factual
information. A hypothesis in a social science can be tested through using methods such as a survey or
through observation. For example, if the idea to be tested is the favourite drink of students in this class
is Coke‘, I can test this by asking the students.
However, the result will not be as exact as a result in a physical test because it involves humans whose
behaviour is not always easy to measure. For example, they may not tell the truth and their answers may
change from day to day. Social sciences often use models help them study complex ideas in economics.
A model is a simplification of reality. It often means that parts of the problem being studied are kept the
same (held constant) while one part is changed. This would show that the result would be due solely to
the part that was changed. Parts that change are called variables, holding other things constant is called
“ceteris paribus”.

Two assumptions in economic model-building
 Ceteris paribus - is a Latin expression that means ‗other things equal‘. Another way of saying
this is that all other things are assumed to be constant or unchanging.
 Rational economic decision making - This means that individuals are assumed to act in their
best self-interest, trying to maximise (make as large as possible) the satisfaction they expect to
receive from their economic decisions. It is assumed that consumers spend their money on
purchases to maximise the satisfaction they get from buying different goods and services.
Similarly, it is assumed that firms (or producers) try to maximise the profits they make from their
businesses; workers try to secure the highest possible wage when they get a job; investors in the
stock market try to get the highest possible returns on their investments, and so on.
Positive and Normative statements
It is important to distinguish in the study of economics two types of statements representing the
methodology or approach in the scheme of analysis. These statements are positive and normative.
Positive Statements deal with facts which had already been experienced. They can be proved to be
correct or incorrect by looking at the facts. They can be tested empirically. Statistics are available to
help prove facts in Economics. For example, the inflation rate in a country. This data is available to
provide past facts and some information about the future; for example, when the next set of inflation
statistics will be available.
In addition, they are concerned about what is, was or will be. The evolution of life and the society is
dynamic and several experiences are encountered and it is ―positive statements‖ which would analyse
these experiences.
On the other hand, Normative Statements depend on our value judgements, i.e., what is good or bad
and how things should be. They cannot be tested empirically. For example the statement,
“unemployment is a worse problem than inflation” is both a matter of opinion and involves a value
judgment. A person‘s opinion cannot be proved to be right or wrong. The economist traditionally does
not make value judgments while analysing problems.
What we want to happen and what really happens are two different issues. What we want to happen is
normative and what really happens is positive. For example, “What policies will reduce
unemployment?” and ― “What policies will prevent inflation?” are positive ones, while the question
― “Ought we to be more concerned about unemployment than about inflation?” is a normative one.
The statement “A more equal distribution of income would increase national welfare” is a normative
statement, while “An increase in government spending will reduce unemployment and increase
inflation” is a positive one. In some cases normative statements normally contain the words: should,
ought to, might and positive include statistics or any form of measurement.

Microeconomics and Macroeconomics
Microeconomics - Economists develop economic principles and models at two levels. Micro economics
is the part of economics concerned with individual units such as a person, a household, a firm, or an
industry. At this level of analysis, the economist observes the details of an economic unit, or very small
segment of the economy, under a figurative micro-scope. In micro economics we look at decision
making by individual customers, workers, households, and business firms. We measure the price of a
specific product, the number of workers employed by a single firm, the revenue or income of a particular
firm or household, or the expenditures of a specific firm, government entity, or family. In
microeconomics, we examine the sand, rock, and shells, not the beach.
Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates, such
as the government, household, and business sectors. An aggregate is a collection of specific economic
units treated as if they were one unit. Therefore, we might lump together the millions of consumers in
the economy and treat them as if they were one huge unit called ―consumers. In using aggregates,
macroeconomics seeks to obtain an overview, or general outline, of the structure of the economy and
the relationships of its major aggregates.
Macroeconomics speaks of such economic measures as total output, total employment, total income,
aggregate expenditures, and the general level of prices in analysing various economic problems. No or
very little attention is given to specific units making up the various aggregates. Figuratively,
macroeconomics looks at the beach, not the pieces of sand, the rocks, and the shells. The micro–macro
distinction does not mean that economics is so highly compartmentalized that every topic can be readily
labelled as either micro or macro; many topics and subdivisions of economics are rooted in both.
Example: While the problem of unemployment is usually treated as a macroeconomic topic (because
unemployment relates to aggregate production), economists recognize that the decisions made by
individual workers on how long to search for jobs and the way specific labour markets encourage or
impede hiring are also critical in determining the unemployment rate.
Pitfalls to sound economic reasoning
Here are some common pitfalls to avoid in successfully applying the economic perspective.
 Biases - Most people bring a bundle of biases and preconceptions to the field of economics. For
example, some might think that corporate profits are excessive or that lending money is always
superior to borrowing money. Others might believe that government is necessarily less efficient
than businesses or that more government regulation is always better than less. Biases cloud
thinking and interfere with objective analysis. All of us must be willing to shed biases and
preconceptions that are not supported by facts.
 Loaded Terminology- The economic terminology used in newspapers and broadcast media is
sometimes emotionally biased, or loaded. The writer or spokesperson may have a cause to

promote and may slant comments accordingly. High profits may be labelled ― “obscene,” low
wages may be called ― “exploitive”, or self-interested behaviour may be ― “greed”.
Government workers may be referred to as ― “mindless bureaucrats” and those favouring
stronger government regulations may be called ― “socialists”. To objectively analyse economic
issues, you must be prepared to reject or discount such terminology.
 Fallacy of Composition- Another pitfall in economic thinking is the assumption that what is
true for one individual or part of a whole is necessarily true for a group of individuals or the
whole. This is a logical fallacy called the fallacy of composition: the assumption is not correct.
A statement that is valid for an individual or part is not necessarily valid for the larger group or whole.
You may see the action better if you leap to your feet to see an outstanding play at a Football game. But
if all the spectators leap to their feet at the same time, nobody—including you—will have a better view
than when all remained seated.
Here are two economic examples: An individual stockholder can sell shares of, say, Econet stock without
affecting the price of the stock. The individual‘s sale will not noticeably reduce the share price because
the sale is a negligible fraction of the total shares of Econet being bought and sold. But if all the Econet
shareholders decide to sell their shares the same day, the market will be flooded with shares and the
stock price will fall precipitously.
Similarly, a single cattle ranch can increase its revenue by expanding the size of its livestock herd. The
extra cattle will not affect the price of cattle when they are brought to market. But if all ranchers as a
group expand their herds, the total output of cattle will increase so much that the price of cattle will
decline when the cattle are sold. If the price reduction is relatively large, ranchers as a group might find
that their income has fallen despite their having sold a greater number of cattle because the fall in price
overwhelms the increase in quantity.
 Post Hoc Fallacy- You must think very carefully before concluding that because event A
precedes event B, A is the cause of B. This kind of faulty reasoning is known as the post hoc,
ergo propter hoc, or ― “after this, therefore because of this,” fallacy. Non-economic example:
“A professional football team hires a new coach and the team’s record improves. Is the new
coach the cause?” Maybe. Perhaps the presence of more experienced and talented players or an
easier schedule is the true cause. The rooster crows before dawn but does not cause the sunrise.
Economic example: Many people blamed the Great Depression of the 1930s on the stock market
crash of 1929. But the crash did not cause the Great Depression. The same severe weaknesses in
the economy that caused the crash caused the Great Depression. The depression would have
occurred even without the preceding stock market crash. Correlation but not Causation. Do not
confuse correlation, or connection, with causation. Correlation between two events or two sets
of data indicates only that they are associated in some systematic and dependable way. For
example, we may find that when variable X increases, Y also increases. But this correlation does
not necessarily mean that there is causation—that increases in X cause increases in Y. The

relationship could be purely coincidental or dependent on some other factor, Z, not included in
the analysis.
Here is an example: Economists have found a positive correlation between education and income. In
general, people with more education earn higher incomes than those with less education. Common sense
suggests education is the cause and higher incomes are the effect; more education implies a more
knowledgeable and productive worker, and such workers receive larger salaries. But might the
relationship be explainable in other ways? Are education and income correlated because the
characteristics required for succeeding in education—ability and motivation—are the same ones
required to be a productive and highly paid worker? If so, then people with those traits will probably
both obtain more education and earn higher incomes. But greater education will not be the sole cause of
the higher income.

Economic Resources
 Four factors of production
 Renewable & Non-Renewable Resources
 The basic Economic Problem
 Production Possibility Curves
 Shifts in the Production Possibility Curves
 Economic Systems

The four factors of production
Economists group factors of production under four broad categories:
Land - Includes all natural resources, including all agricultural and non-agricultural land, as well as
everything that is under or above the land, such as minerals, oil reserves, underground water, forests,
rivers and lakes. Natural resources are also called “gifts of nature”.
Labour - Includes the physical and mental effort that people contribute to the production of goods and
services. The efforts of a teacher, a construction worker, an economist, a doctor, a taxi driver or a
plumber all contribute to producing goods and services, and are all examples of labour.
Capital - Capital also known as physical capital, is a manmade factor of production (it is itself produced)
used to produce goods and services. Examples of physical capital include machinery, tools, factories,
buildings, road systems, airports, harbours, electricity generators and telephone supply lines. Physical
capital is also referred to as a capital good or investment good.
Entrepreneurship - Is a special human skill possessed people, involving the ability to innovate by
developing new ways of doing things, to take business risks and to seek new opportunities for opening
and running a business. Entrepreneurship organises the other three factors of production and takes on
the risks of success or failure of a business.
Renewable and Non-Renewable resources
Renewable - These are resources which are being continuously consumed by man but are renewed by
nature constantly. These resources are inexhaustible because they cannot be exhausted permanently.
Examples; Solar energy, Wind energy, Tidal energy, Hydro power, Geothermal energy, Biofuels
Non-Renewable - The Non-Renewable resources do not replenish and cannot be renewed. It took
thousands of years of time to form the non-renewable resources which exist inside the earth in the form
of coal, fossil fuels, Mineral Ores, Metal Ores, Crude Oil, and Nuclear Energy.

Differences between renewable and non-renewable:
Renewable Non-Renewable
 Replaced by nature itself in a very short  Cannot be replaced by nature during the
period time of human life span
 Are scarce and not available in an
 Are plenty and abundant in nature
abundant manner in nature
 Are obtained free of cost or at low cost  Are very costly and not easily available
 Do not affect environment of the earth
 Seriously affect the environment and
and do not cause any climate changes in
cause climate changes in the environment
the atmosphere
 Do not cause pollution in the  Pollute the earth by releasing various
environment and do not release pollutants types of pollutants into the air, water, soil,
into the environment etc when fossil fuel are burnt.
There is a limited supply of Non-Renewable resources on the Earth. We‘re using them much more
rapidly than they are being created. Eventually, they will run out and our future generations are left with
no crude oil and nuclear resources. We have a responsibility to transfer the resource to our future
generations, for that we have to use the non-renewable and renewable resources in a balanced way and
promote sustainability of resources.
The basic economic problem
The science of economics is based upon two basic facts: first, human material wants are virtually
unlimited, second, economic resources are scarce. As a result, the economic problem is a problem of
scarcity and can be described in terms of scarce resources in relation to unlimited wants.
Unlimited wants - Material wants refer to the desires of consumers to obtain and use various goods and
services which provide satisfaction.
Desire for material wants is insatiable. The ends of human beings are without end. The fulfilment of
some of the wants on the list seems to do little more than raise people's expectations of something even
better.
There are three reasons why wants are virtually unlimited
• Goods eventually wear out and need to be replaced.
• People get fed up with what they already own.
• New or improved products become available.

Scarce Resources
Resources are the things or services used to produce goods or services which can be used to satisfy
wants. Economic resources may be classified as property resources - land and capital - or as human
resources - labour and entrepreneurial ability. These resources are limited in supply and yet society
desires more of them than is available. Thus it can be said that resources are scarce because they are
limited in supply. However scarcity is a relative concept. It relates to the extent of the people's wants to
their ability to satisfy those wants.
Economics deals with the basic fact that scarcity exists in our everyday lives and in our economy.
Resources such as raw materials are in finite supply and must be allocated to their best use. Virtually all
resources are scarce, meaning that more of them are desired than is available. Economics is concerned
with the way people have to make choices in order to overcome the problems of scarcity.
Choice
Given the presence of scarcity, choices must be made as to how resources are allocated. Our lives are
filled with a wide range of choices regarding the use of limited personal funds. Advertisers constantly
inform consumers of their consumption possibilities and the choices available. The same principle
applies for the economy as a whole. We elect politicians who work with policy makers to allocate
government expenditures. Together they make difficult choices concerning how taxes will be spent.
Opportunity Cost
The relevant cost of any decision is its opportunity cost - the value of the next-best alternative that is
given up. This will mean that if we choose more of one thing, we will have to have less of something
else. Economists use the term opportunity cost to explain this behaviour. The opportunity cost of any
action is the value of the next best alternative forgone. By making choices in how we use our time and
spend our money we give something up. Instead of following the economics classes, what else could
you be doing? Your best alternatives may involve sports, leisure, work, entertainment, and more. Thus,
the concept of opportunity cost is your best alternative to the choice that is made. If you choose to go to
a restaurant this evening, the money that you spend on dinner will not be available for other uses, even
saving.
Businesses and governments also deal with opportunity costs. Businesses must choose what type of
goods to produce and the quantity. Given limited funds, the opportunity cost of producing one type of
good will arise from not being able to produce another.
Production occurs when we apply labour and capital to resources in order to increase the value of the
resources. Given a scarcity of resources, it is desired that society will allocate them to their best uses. In
many economies, the market performs most of the resource allocation role. Consumers indicate their
preferences by purchasing goods and services. Producers wish to satisfy the demands of consumers by
using scarce resources to produce those goods and services that consumers demand.

Three Basic Economic Questions

1. What to produce?
All economies must choose what particular goods and services and what quantities of these they
wish to produce.
2. How to produce?
All economies must make choices on how to use their resources in order to produce goods and
services. Goods and services can be produced by use of different combinations of factors of
production (for example, relatively more human labour with fewer machines, or relatively more
machines with less labour), by using different skill levels of labour, and by using different
technologies.
3. For whom to produce?

All economies must make choices about how the goods and services produced are to be distributed
among the population. Should everyone get an equal amount of these? Should some people get more
than others? Should some goods and services (such as education and health care services) be
distributed more equally?
The first two of these questions, what to produce and how to produce, are about resource allocation,
while the third, for whom to produce, is about the distribution of output and income.
Resource allocation refers to assigning available resources, or factors of production, to specific uses
chosen among many possible alternatives, and involves answering the “what to produce and how to
produce” questions. For example, if a “what to produce” choice involves choosing a certain amount of
food and a certain amount of weapons, this means a decision is made to allocate some resources to the
production of food and some to the production of weapons. At the same time, a choice must be made
about how to produce: which particular factors of production and in what quantities (for example, how
much labour, how many machines, what types of machines, etc.) should be assigned to produce food,
and which and how many to produce weapons.
If a decision is made to change the amounts of goods produced, such as more food and fewer weapons,
this involves a reallocation of resources. Sometimes, societies produce the “wrong” amounts of goods
and services relative to what is socially desirable. For example, if too many weapons are being produced,
we say there is an over allocation of resources in production of weapons. If too few socially desirable
goods or services are being produced, such as education or health care, we say there is an under
allocation of resources to the production of these.
An important part of economics is the study of how to allocate scarce resources, in other words how to
assign resources to answer the “What to produce?” and “How to produce?” questions, in order to meet
human needs and wants in the best possible way.

The third basic economic question, for whom to produce, involves the distribution of output and is
concerned with how much output different individuals or different groups in the population receive.
This question is also concerned with the distribution of income among individuals and groups in a
population, since the amount of output people can get depends on how much of it they can buy, which
in turn depends on the amount of income they have. When the distribution of income or output changes
so that different social groups now receive more, or less, income and output than previously, this is
referred to as redistribution of income.
Production Possibility Curve (PPC)
The Production Possibility Curve (PPC) is also called the Production Possibility Frontier (PPF) Curve
or Opportunity Cost Curve or Transformation Curve or Production Possibility Boundary.
Assumptions of the production possibility curve:
• Full employment-The economy is employing all its available resources.

• Fixed resources-The quantity and quality of the factors of production are fixed.
• Fixed technology-The state of technology (the methods used to produce output) is constant.
• Two goods-The economy is producing only two goods: manufactured goods and agricultural
products.
Characteristics of the PPC

1. Points along the frontier show the trade-off between two different goods for society; to get more
of one, we must give up some of the other.
2. Points outside the curve are unobtainable with given resources and technology.
3. Points inside the frontier are attainable, but do not utilize society's resources efficiently.
4. The production possibilities frontier illustrates concepts of:
a. Scarcity - resources are limited.
b. Choice - choices in the production of different goods need to be made.
c. Opportunity cost - to gain more of a good, something else must be given up.
Production Possibility Curve

All points inside the production possibility curve represent underutilisation of resources meaning there
are resources lying idle (points D and E). Points on the PPC show that there is full utilisation of
resources (points A, B and C) and all points outside the PPC are unattainable representing scarcity
(point F).

Output A, B & C – Are efficient

of Pizza output combinations lying on
the PPF
C
F D & E – Are inefficient
combinations – not all
A resources are fully utilised.
D
B F – is an output combination
that is not yet attainable
with the available resources.
E
Output of Sugar
The PPC, Scarcity, Choice and Opportunity cost

The production possibilities model is very useful for illustrating the concepts of scarcity, choice and
opportunity cost:
PPC – Scarcity, Choice & Opportunity Cost
A
40
B
35
30 G
Microwave Ovens
C
25
20
15 F D
10
E
0 5 10 15 20 25 30 35 40
Computers
 The condition of scarcity does not allow the economy to produce outside its PPC. With its
fixed quantity and quality of resources and technology, the economy cannot move to any point
outside the PPC, such as G, because it does not have enough resources (there is resource scarcity).

 The condition of scarcity forces the economy to make a choice about what particular
combination of goods it wishes to produce. Assuming it could achieve full employment and
productive efficiency, it must decide at which particular point on the PPC it wishes to produce. (In
the real world, the choice would involve a point inside the PPC.)
 The condition of scarcity means that choices involve opportunity costs. If the economy were
at any point on the curve, it would be impossible to increase the quantity produced of one good
without decreasing the quantity produced of the other good.
In other words, when an economy increases its production of one good, there must necessarily be a
sacrifice of some quantity of the other good; this sacrifice is the opportunity cost.
Say the economy is at point C, producing 25 microwave ovens and 21 computers. Suppose now that
consumers would like to have more computers. It is impossible to produce more computers without
sacrificing production of some microwave ovens. For example, a choice to produce 29 computers (a
move from C to D) involves a decrease in microwave oven production from 25 to 15 units, or a sacrifice
of 10 microwave ovens. The sacrifice of 10 microwave ovens is the opportunity cost of 8 extra
computers (increasing the number of computers from 21 to 29). Note that opportunity cost arises when
the economy is on the PPC (or more realistically, somewhere close to the PPC). If the economy is at a
point inside the curve, it can increase production of both goods with no sacrifice, hence no opportunity
cost, simply by making better use of its resources: reducing unemployment or increasing productive
efficiency.
Production Possibility Curve and Economic Efficiency

A production possibility frontier is used to illustrate the concepts of opportunity cost, trade-offs and also
show the effects of economic growth.
 Points within the curve show when a country‘s resources are not being fully utilized (productive
inefficiency). Combinations of the output of consumer and capital goods lying inside the PPF
happen when there are unemployed resources or when resources are used inefficiently. We could
increase total output by moving towards the PPF.
 Combinations that lie beyond the PPF are unattainable. A country would require an increase in
factor resources, an increase in the productivity or an improvement in technology to reach this
combination. Trade between countries allows nations to consume beyond their own PPF.
Producing more of both goods would represent an improvement in welfare and a gain in what is
called Allocative efficiency.

Good Y
20 P (10X , 20Y)
16 Q (20X , 16Y)
B
0 10 20 Good X
In an open economy, suppose a country produces at point P along the production possibility curve AB.
In other words, with the available amount of resources, it produces 10 units of X and 20 units of Y.
Combination Q cannot be produced due to scarcity of resources unless there is economic growth.
However, even without economic growth, consumption at point Q could be attained only through
exchange, that is, only if the country engages itself in international trade. To attain combination Q, the
country has to export 4Y and import 10X.
Production Efficiency
Efficiency refers to using resources in such a way as to maximize the production of goods and services.
Economy producing output levels on the production possibilities frontier is operating efficiently.
• Production efficiency is achieved if we cannot produce more of one good without producing less of
some other good.
• When production is efficient, we are at a point on the PPF.

Shape of Production Possibility Curve
Shape of the PPC - Concave
Good Y
A
P
B Good X
The slope of the production possibility curve is the Marginal Rate of Transformation (MRT) which
indicates the rate at which one good is being transformed into another, not physically, but by transferring
resources from one good to another good. As we move along the production possibility curve through
points P and Q downwards, slope or steepness of each tangent through these points increases. Thus, the
production possibility curve takes a concave shape, indicating increasing opportunity cost, that is, the
economy is willing to give up more Y for an additional unit of X. There is increasing opportunity cost
because of diminishing returns.
Note: slope of PPC = MRTYX = change in Y/ change in X = opportunity cost of producing an additional
unit of X in terms of Y.

Shape of the PPC - Convex
Good Y
A
Q
B
Good X
As we move downwards from P to Q, the steepness of each gradient falls, i.e., the gradient becomes
flatter. In other words, the slope of the production possibility curve diminishes as we move downwards.
This means that the MRTYX keeps falling, and thus, the opportunity cost is decreasing (increasing
returns). The economy is now willing to give up less units of Y for the same additional unit of X.
Shape of the PPC - Linear
Good Y
A
B
Good X
Here the slope of the production possibility curve remains constant. The MRTYX is constant or
unchanged as we moved downwards the curve from left to right. Thus, the production possibility curve

becomes linear or straight line. The opportunity cost also remains constant (constant returns). This
means that the economy is willing to give up the same amount of Y for the same additional unit of X.
Shifts of the production possibility curve
a) Parallel shifts
A country‘s production potential is constantly changing. If the capacity to produce goods and services
increases, the PPC will shift outwards to the right as shown i.e. parallel shift.
Parallel Shift of the PPC
Good Y
A1
A
C
A
B B1 Good X
If the economy‘s capacity to produce goods is increasing, the production possibility curve will be
moving outwards over time. This indicates that economic growth has taken place. Economic growth
shifts the boundary outward and makes it possible to produce more of all goods. Before growth points
A and B were on the production possibility curve and point c was unattainable. After growth, point C
is attainable.
Causes of an outward shift of the PPC

Outward shift of the PPC (economic growth) result from an increase in the resource base of a country
that is an improvement in land, labour, capital and enterprise. Following are the factors that cause an
improvement in factors of production.

1. The quantity of land may be increased through land reclamation and discovery of new natural
resources. The quality of the land can be improved by making better use of fertilisers.
2. The quantity of the labour force can also rise if:
a. There is a rise in the size of the population,
b. The retirement age is raised,
c. The school leaving age is reduced,
d. The size of the working age group is increased,
e. The proportion of males to females in the working age group is increased,
f. There is an increase in the number of hours worked and
g. There is a reduction in the number of holidays.
3. The quality of the labour force is also an important determinant of economic growth. This can be
improved through education and training. Education and training are described as ―investment in
people‖ there is no doubt that education and training help to improve the productivity of labour.
Equally important is the quality of capital equipment used by the workers.
4. Investment is another major factor that can bring economic growth. Investment is the act of
creating capital goods and represents additions to a country‘s stock of capital. With an
accumulation of capital goods it is possible to produce a greater output.
5. The quality of capital can be increased through research and development that brings technical
progress. Innovation and invention of new methods of production, development of new materials
and improvement in the design and performance of machinery fosters growth.
The PPC can also shift inwards to the left if the country’s production potential declines due to the
following reasons:
 Wars,
 Natural disasters which reduce the country‘s productive potential e.g. floods, droughts, cyclones,
hurricanes,
 Brain drain,
 Decrease in stock of capital goods,
 Outbreak of diseases e.g. HIV-AIDS, TB, malaria, typhoid, dysentery, cholera, swine flu,
 Technological decay, and
 Depletion of natural resources e.g. minerals.

Pivotal shifting of the Production Possibility Curve

A PPC pivot after a change in the level of resources which affect only one product, for example an
improvement in technology which only affects one good for example housing good only.
Pivotal Shift of the PPC
Education
B B1 Housing
Economic Systems
Economic systems are classified according to their method of resource allocation or according to
ownership of resources. The way in which a society organizes itself to decide What, How and For Whom
to produce is known as an economic system.
Economic systems are different ways or means in which we try to answer the 3 fundamental economic
questions: i.e. “What?”, “How?” And “For whom?”. This economic systems are;
1. The market mechanism (free market economy)

2. The planned economy (command economy)
3. The mixed economy
The Market Mechanism (Free Market Economy)
It‘s also called free enterprise or laissez faire or capitalist system. In a market economy resource
allocation is carried out by private individuals only. All factors of production are privately owned and

managed. There is no government intervention and everyone is free to operate according to his will and
desire. The framework of a market or capitalist system contains 6 essential features which are:
1. Private Property - Private ownership of means of production or factors of production. This means
individuals are free to own factors of production. Income from these factors of production goes to
the owners.
2. Consumers’ sovereignty exists, that is, consumer is a king because it directs the allocation of
resources to a large extent while satisfying its own needs. His basic aim is to maximise satisfaction.
The consumer‘s decision can dictate economic actions as what and how to produce.
3. Self Interest as the dominating motive. Each unit in the economy will do what is best for itself.
Firms aim to maximize profits. Owners of land aim to obtain highest possible rewards. Workers
move to occupations/jobs with the highest wages. Consumers spend incomes on goods and
supplies which yield maximum satisfaction/utility.
4. Competition - There are many sellers and buyers. Market forces of did and supplies determine
price as given and can‘t influence the price. There is survival of the fittest.
5. A reliance on the price system - Decisions of producers determine supply of a good. Decisions
of customers or buyers determine demand of a good. The interactions of demand and supply
determine prices. Changes in demand and supply cause changes in market prices and it is these
changes/movements in market prices which bring about changes in the ways in which society
allocates or uses economic resources. Prices act as a rationing device; prices give the value of
goods and supplies. Prices act as an allocation/ distribution device of goods and supplies.
6. A very limited role of government - government only intervenes to correct market failure.
Advantages of Market Economy

1. Optimal allocation of resources: Producers engage their resources only on those goods which
appear to yield maximum profits.
2. Greater output and higher income: There is increase in production and productivity leading to
increase in income, saving and investment.
3. Increase in efficiency: The presence of competition leads to a better use of resources to obtain
cost advantage.
4. Progress and prosperity: Intense competition promotes invention and innovation thereby
bringing economic growth and prosperity.

Disadvantages of Market Economy

i. Emergence of Monopoly: cut – throat competition may force small firms who could not cope to
shut down while the big firms may merge and monopolise the market charging exorbitant prices.
ii. Inequality problem is worsened: the rich who own resources and control production are favoured
while the poor become more impoverished.
iii. Inefficient production: more resources are allocated to the production of frivolous goods that are
desired by the rich who have the means while the basic necessities required by the poor are in short
supply.
iv. Economic depression and unemployment: excessive competition and unplanned production
leads to excess supply, low price level and cut in the number of workers employed.
Market failures / Imperfections

In theory the price mechanism can go a long way in efficiently and automatically solving the basic
economic problems. However, in practice it fails in many respects. There are many market failures such
that the price system cannot ensure the best use of scarce resources:
1. No provision for public goods or public utilities:

Public goods are goods produced on a non-profit maximisation basis because they (street lighting,
defence, roads) aim at maximising socio-economic welfare. Thus, they cannot be produced
through the market. There is no possibility of fixing a price for the product in question and hence
no possibility of making a profit.
2. Divergence between social cost and private cost:
Private cost refers to the cost which is incurred in the production of a certain commodity, for
example, labour cost or cost of raw materials. However, when production process takes place,
there are smokes which come from factory chimneys, and garbage or wastes thrown in rivers,
thereby, creating pollution. Economists evaluate these costs and name them as external costs or
negative externalities.
These external costs are never considered by a private producer in a market economy. This means
that nothing much is done to reduce pollution and any other destruction caused to nature.
3. Harmful products may be produced and consumed:
The absence of a government sector implies the absence of taxes and the free operation of the
market mechanism. Left to the price system, there will be overproduction of certain harmful

products such as drugs, alcoholic drinks and cigarettes. Their high prices initiate higher production
and greater infiltration of these harmful goods which greatly affect the peaceful life.
4. Luxuries in place of necessities:
Since allocation of resources depends greatly on those goods whose prices are high or are rising,
obviously, the private producers will produce more of these goods and less of other goods may be
essential products. Thus, a rise in the demand of cars may encourage producers to produce more
cars and less food which is but an irrational allocation of resources. The system broadly indicates
that only the rich people have the greater say through their expenditure patterns and the poor, on
the hand, remain poor.
5. Unequal wealth distribution / inequalities of income:
Indeed, the laissez-faire capitalism makes the rich richer and the poor poorer. Systematic
exploitation by the capitalists of the poor working class is obvious because they have to maximise
returns and minimise costs, essentially labour costs. The labour cost has to operate at low rates and
be very productive in the production process. In this case, the wealth distribution under this system
can never be reduced.
6. Persuasive advertising:
Owing to the fierce competition which exists among firms in a pure market system, huge expenses
are made annually on advertising. The advertising which is adopted is meant for product
differentiation. Such expenses are usually against customers’ interests because they are not only
misleading, but also wasteful. Resources used in advertising could have been used somewhere else
for more productive purposes.
7. Cyclical fluctuations:
Cyclical fluctuations are caused by the ever-changing demand and supply conditions.
Sometimes, when producers anticipate a rise in demand for certain goods, they raise investment to
produce more. But if demand actually does not rise, a general glut will occur, that is, stock
accumulation. Consequently, the affected producers will have to reduce investment, dismiss
workers to reduce costs. Both of these have an adverse effect in the economy as a whole. Less
investment means lower production while lower employment means less consumption, lower
prices and profits. These cumulative effects lead to a lower national income.
Policy Options that the government may use to correct market failure
1. Creating a framework of rules

2. Supplementing and modifying the price system i.e. price controls (maximum price, minimum
price, buffer stock).
3. Redistribution of income e.g. unemployment benefits, grants, transfer payments.
4. Provision of public goods and merit goods
5. Taxation.
6. Subsidising the production or sale of various goods and supplies.
7. Nationalisation of firms.
8. Providing information.
9. Encouraging long term planning – companies or businesses and a mission statement.
Note - If the government fails to correct market failure, this results in Government Failure.
It can be deduced that price mechanism determines allocation of resources as per what consumers want
more which initially sounds right. However, this system cannot be left to itself because of its various
imperfections which undoubtedly necessitate government intervention.
Functions of the price mechanism

The invisible hand – the workings of the price mechanism.
The price mechanism is simply the means by which the millions of decisions taken each day by
consumers and businesses interact to determine the allocation of scarce resources between competing
uses. This is the essence of economics; the price mechanism plays three important functions in any
market-based economy
The signalling function

Prices have a signalling function. Prices adjust to demonstrate where resources are required, and where
they are not. Prices rise and fall to reflect scarcities and surpluses. If market prices are rising because of
stronger demand from consumers, this is a signal to suppliers to expand output to meet the higher
demand. Consider the left hand diagram below. The demand for computer games increases. Producers
stand to earn higher revenues and profits from selling more games at a higher average price. So an
outward shift of demand leads to an expansion along the market supply curve (ceteris paribus)
In the second example on the right, an increase in supply causes a fall in the relative prices of digital
cameras and prompts an expansion along the market demand curve.

Effects of Demand & Supply Changes on Computer Games
Higher Demand signals to producers to An increase in Supply leads to lower market

step up production – if they are driven by prices – a signal to consumers that their real
the profit motive. income has increased and they can afford to
buy more.
Price Price
S
D2 S1
S2
D1
P2
P1
P1
P2
D
Q1 Q2 Quantity Q1 Q2 Quantity
The Transmission of preferences

Through the signalling function, consumers are able through their expression of preferences to send
information to producers about the changing nature of our needs and wants. When demand is strong,
higher market prices act as an incentive to raise output (production) because the supplier stands to make
a higher profit. When demand is weak market supply contracts.
The Rationing function

Prices serve to ration scarce resources in situations when demand in a market outstrips supply. When
there is a shortage of a product, the price is bid up – leaving only those with sufficient willingness and
ability to buy with the effective demand necessary to purchase the product. Be it the demand for cup
final tickets or the demand for a rare antique the market price acts a rationing device to equate demand
with supply. The growing popularity of auctions as a means of allocating resources is worth considering
as a means of allocating resources and clearing a market.
The planned economy (command economy)
It is also called the command economy or collectivism. Collectivism is the system whereby economic
decisions are taken collectively by planning committees and implemented through the direction of
collectively owned resources, either centrally or at local level.

A planned economy is the direct opposite of the market economy. Here all the resources are owned by
the government or the public sector which is the central body deciding upon the allocation of resources.
This allocation is however exerted on the following grounds:
 Maximising socio-economic welfare through creation of public utilities.

 Non-profit maximising strategy.
 Parliamentary decisions.
However, in real world, command economies seldom exist. Central planners may set the prices of
essential consumer goods, and allow factory managers to set prices of less essential goods.
In a command economy planning committees are appointed and they provide the answers to the three
fundamental economic questions that is resource allocation.
 What to produce? - Committees decide on what should be produced after gathering all the
relevant information. The decision on what should be produced considers the welfare of the
society and in some cases the government use the cost benefit analysis to make an effective
decision.
 How to produce? - It is solved by directing labour and other resources into certain areas of
production. Labour is used so as to help in reducing levels of unemployment in the economy.
 For whom to produce? - This problem is solved not by pricing but by allotting goods and
supplies on the grounds of social and political priorities. The try by all means to equally distribute
the scarce goods and services available. In some case rationing will be used so that equality
prevails.
Advantages of planned economies

1. Greater economic efficiency: the government ensures that resources are allocated to those
sectors where they can be used most productively. Therefore, production efficiency is greater
than under capitalism.
2. Absence of Wasteful Competition: Duplication of goods and services or use of resources on
extensive advertisement campaign is avoided.
3. Less Inequality of Income: Every member of the society is taken care of within the limits of
their relative capabilities and the overall resources of the state.
4. Exploitation of Private Monopoly if avoided: State monopoly exists only to promote overall
welfare of the people.
5. Can ensure stability because it does not coincide with business cycles

6. Serves people collectively instead of individuals; focus on equality
Problems of planned economies

1. Decisions are based on a parliamentary level: Since decisions are based on parliamentary level,
they are not readily implemented and in this way, several important decisions concerning socio-
economic activities may be delayed.
2. Inefficiency: A common feature against the public sector is inefficiency and lack of competence.
The sector is generally over-staffed and inefficient. The services are of ―Red-Tape‖ type because
of high level of bureaucracy. In addition, the attitude of a secured job in the government sector
makes workers idle and careless about the quality of services to be provided to the members of the
public.
3. Waste of resources: Very often there is wastage of resources especially when public sector
expenditure is analysed. There is a great abuse on the part of the workers concerning the use of
public sector resources and materials.
4. The absence of competition: The absence of competition in this economic system does not ensure
innovation and constant improvements in the quality and quantity of products. Owing to the
principle of ―No profit- No loss‖, huge losses have to be borne at times by the public sector.
Therefore, it is difficult to find out additional resources for innovations.
5. Restriction on consumers’ sovereignty: Since there is central allocation of resources, consumers
may demand what they wish but to a restricted extent. The production of luxuries is given as the
ultimate priority by the government because of the concept of the welfare state. Priority must be
given only to the production of the most essential products in the society.
The Mixed Economy
In a mixed economic system, resource allocation is influenced both by the private and public sectors. In
other words, in such an economic system, some economic decisions are taken by the market mechanism
and some by the government planning. It has been found that all modern economies are now, to varying
extent, mixed in nature. Many nations have fluttered from socialism in the course of time so much so
that they have embraced the term mixed economy.
In a mixed economy the price system allocates resources, but on account of market failures, there is the
need for government intervention. In fact, the government has to intervene in order to attain some
important micro and macro-economic objectives.
The Role of government planning in a mixed economy

1. In a modern mixed economy, the government has to intervene to change the wrong combination
of goods. If left to the price system, there will be over-production and over-consumption of demerit

goods like drugs, cigarettes and alcohol. Hence, the government has to discourage consumption of
these demerit goods through taxation.
2. The government has to provide public goods in a modern mixed economy since provisions of these
goods are difficult and unsuitable in the hands of private sectors. Defence, roads, street-lightning
are provided by the state in every modern mixed economy. Market system cannot compel payment
for public goods since there is no way to prevent a person who refuses to pay for the good from
receiving its services. Thus, the private firms will fail to produce these goods. The government, by
virtue of their power to tax, can provide the services and collect from everyone.
3. In a view to maximising profits, private firms consider only their private costs and private benefits.
They ignore any external costs and benefits incurred in the production process. Thus, firms tend
to produce more of those goods which cause external costs (pollution), but less of those goods
which cause external benefits. As a result, the government intervention is deemed necessary to
correct the externality by making rules and regulations. The government should subsidise activities
which cause external benefits, while impose taxation to reduce external costs.
4. Most government in modern mixed economy have policies designed to discourage firms to act as
monopoly. In many countries, important legislations are passed to regulate existing monopolies
and prevent informal agreements with the main aim of making profits by exploiting consumers.
5. Government may aim to promote the general economic welfare of the population by creating a
more equitable distribution of income and wealth. They may aim to achieve this by a system of
progressive taxation, subsidies and transfer payments.
6. Governments have a large number of macro-economic policy instruments which they use to
influence, for example, the level of spending, the amount of investment, level of employment, rate
of inflation and international trade position. Their aim is to ensure a steady rise in output and
improvements in living standards.
The role of private sector in a mixed economy

1. Greater competition in the private sector motivates innovations and improvements in the quality
of goods and services provided by the public sector.
2. Profits may be used as a guide to efficient allocation and this tends to raise competition and
encourage industrialisation.

Advantages of mixed economy

 Best allocation of resources. A mixed economy combines the good features of both capitalism
and socialism. Therefore, the resources of the economic are utilized in a way that ensures the
adequacy of all types of goods and services and production efficiency increases,
 General Balance. The competition and cooperation between the public sector and the private
sector favours the realization of a high rate of capital accumulation and economic growth.
 Welfare State. In a mixed economy, there is no exploitation either by the capitalists or by the
state. Government agencies are established to protect consumers’ interest, while legislative
measures are adopted to reduce poverty and inequalities of income and wealth.
Disadvantages of mixed economy

 Non-cooperation between the private and the public sector. In real – life, public – private sector
partnership to promote economic progress is hardly found. Most often, the private sector is
subjected to heavy taxes and restrictions that impact negatively on its performance, while the
public sector is given subsidies and preferences.
 Inefficient public sector. The public sector of a mixed economy works inefficiently due to
bureaucratic control, over-staffing of the personnel, corruption and nepotism. As a result, resources
are not properly utilised and the level of production is low.
 Economic fluctuations. Periods of economic prosperity and hardship alternating which are
characteristic features of a capitalist economy are equally experienced in a mixed economy. This
is a result of the improper mixture of the features of capitalism and socialism.
Functions of an Economic System
All economies perform the following functions
i. Allocation of Resources: Every economy has to decide what and how much good and services
to produce at any given time.
ii. Organisation of Production: Every economic system must decide what alternative techniques
of production are more suitable to its circumstances.
iii. Distribution of Goods and Services: How the goods are shared among people is determined in
every economic system.

iv. Economic Growth and Development: The mechanisms to grow the economy and raise average
living standard at determined in each economy.
v. Economic Stability: Every economic system had mechanisms designed to control fluctuations
in the level of economic activity e.g. using fiscal and monetary policies.
Enterprising
Entrepreneurship - Is the willingness of an entrepreneur to seek an opportunity and take the risks
involved in starting and managing a new Business with the aim of making a profit.
 It requires initiative and risk-taking in planning, organising, controlling and directing a new
Business venture.
An Entrepreneur - is the person who engages in entrepreneurship. Uses initiative and takes risk in
starting up a new business with the aim of making a profit.
Entrepreneurial Characteristics
1. Risk-taker: takes both financial and reputational risks in starting and managing a new business
venture. They assess the risk of failure however if they feel a project is worthwhile they go ahead
with it. Limited Liability of Companies helps reduce the financial risk.
2. Creative: ability to come up with new ways of doing things, to discover new ideas, develop new
products. ―Thinking outside the box‖.
3. Realistic: have an honest view of their own capabilities and assess their own limitations. They
seeking advice and help when and where required. When looking at the potential of the Business
and setting objectives they are realistic. They have good judgement.
4. Decisive: once situations/information have been assessed, action is taken quickly to achieve the best
results. Decisions are clear and entrepreneurs take responsibility for any decisions they make
irrespective of the outcome. They show an ability to make decisions quickly as situations change.
This is important as the Business needs to adapt and respond to change.
5. Ambitious/Self-Confident: Entrepreneurs believe in themselves, they see opportunities where
others see difficulties. Their self-confidence helps them solve problems greatly when issues arise,
i.e. problem solvers not finders.
6. Flexible: are adaptable as priorities change and objectives may need to be revised. Flexibility
enables entrepreneurs to change their approach to a situation if the original approach does not work
and to adopt others points of views where they see fit.

Entrepreneurial Skills
1. Self (Stress)-Management: being disciplined in Business, taking the initiative to make the most of
a situation and ensuring a work/life balance. One needs to manage stress from work and focus on
tasks at hand.
2. Problem Solver – ability to identify crucial issues and use experience knowledge and instinct to
solve them.
3. Time Management – ability to achieve your goals/objectives on time. Also includes judging best
time to introduce a new idea/product or start a new Business.
4. Interpersonal Skills: ability to manage people and build good working relationships which will
benefit the Business. One needs the ability to listen, communicate effectively, to persuade, to
motivate and to accept others views. 5. Decision Making: in the short term, looking at various options
and their benefits and drawbacks and deciding the best one to choose. Seizing opportunities in every
situation to potentially get high returns.
5. Setting Goals: ability to plan ahead for the future, set clear goals/ objectives and outline how they
are to be achieved

Theory of Demand
 Introduction.
 The Demand Curve
 Determinants of Demand
 Price Elasticity of Demand
 Income Elasticity of Demand
 Cross Elasticity of Demand

Introduction
Demand is the quantity of a commodity/ good which people are willing and able to buy at any given
price over some given period of time. This is effective demand. Demand is not the same as desire or
wish. Demand must be backed by an ability to pay.
Ex-ante demand is the quantity which buyers wish or intend to buy at the going price – ex-ante means
intended, desired or planned, expected before the event.
Ex-post demand is the quantity which buyers finally buy i.e. the quantity which they actually succeed
in buying.
Price and Value
 Price is the quantity of money which must be exchanged for a unit of good or service or price is
the cost of a good.
 Value is the worthiness of a good or service. Price is not the same thing as value.
The law of demand
The way consumers react to a change in the price of a commodity is so typical that economists state it
as a rule of law. This law states that the quantity demanded of a good is inversely (or opposite) related
to its price, when we hold constant other factors that influence consumer‘s consumption of a commodity.
An inverse relationship between quantity demanded and price means that quantity demanded will
increase if or when price falls and quantity demanded will decline if price rises, all things being equal.
The Demand Schedule

It is a table or a list of various prices of a commodity and the corresponding quantities that would be
purchased at a particular time period, when all other demand factors remain constant. Below is an
example of a demand schedule.
Price Quantity Demanded

($) (Per Week)
50 50
40 80
30 130
20 190

The Demand Curve
When the demand schedule is graphed, we obtain a demand curve of a consumer. Hence, the demand
curve is a graph (or a locus of points) showing the various quantities that will be bought at given prices
of a commodity for a given time period, when all other demand factors remain unchanged. A typical
demand curve has a negative slope. That is, it slopes downward from left to right depicting the law of
demand as illustrated below.
The Demand Curve

Price
D
P1
Q Q1 Quantity Demanded
The law of demand states that more of a good is demanded when its price falls
Hence there is an inverse relationship between the quantity of a good demanded and its price since as
price goes down the quantity demanded goes up.
The Demand Function/Equation - In defining demand, we said it is the quantity of goods or services
that consumers are willing and are able to buy at a given price within a specified period of time when
all other demand factors remain unchanged. The ―other factors‖ that influence demand are expected to
remain unchanged and thus include consumer income (Y), prices of related goods and services (PR),
consumer taste and preference which is in turn influenced by advertisement (A). The demand function
or demand equation is a mathematical expression that relates the quantity demanded of goods and
services to all demand factors including the own price of the good or service. Mathematically, the
general demand function is stated as follows:
𝑄𝐷 = 𝐹( 𝑃𝑂, 𝑌, 𝑃𝑅, 𝐴 )
Where
QD = Quantity Demanded;
PO = the own price of the commodity;

Y = Consumers’ incomes;
PR = prices of other commodities;
A = advertisement expenditure on good and service
This function or equation is read as, ― Quantity demanded is a function of (or depends on) the
commodity‘s own price, consumer income, prices pf other related commodities, and the advertisement
expenditure. The mathematical notation “f (…)” read “is a function of” and tells us what factors the
quantity demanded of a commodity is dependent on. When the other demand factors apart from the
commodity‘s own price are held constant the general demand function reduces to: Qd = f (Po )
Market Demand
The demand curves of all consumers in the market can be aggregated to obtain the market demand curve
showing the total amount of a good which consumers wish to buy at each price e.g.
Price Individual Individual Individual Total Market

($) A B C Demand
1 100 120 50 270
2 90 110 40 240
3 70 90 35 195
4 50 80 30 160
5 45 70 15 130
The market demand curve is the horizontal summation of individual demand arrives at given prices.
Why does the demand curve slope downwards form left to right?
1. Income Effect – when the price of a food falls consumers buy more because the purchasing power
of their money income has increased and vice versa. E.g. if a consumer has an income of $100.00
and the price of the good falls as shown in the table below.
Price ($) Quantity Demanded

100 1
50 2
25 4
20 5
10 10
5 20
4 25
2 50
1 100

If price is plotted against quantity demanded, we get a downward sloping demand curve.
3. The substitution effect – A fall in the price of a good makes it relatively cheaper when compared
with competing goods. There will probably be some switching goods of purchases away from the
now relatively dearer substitute towards the good which has fallen in price.
4. Marginal utility theory or marginal benefits.
What is the economic reasoning behind the relationship in the law of demand? Consumers buy goods
and services because these provide them with some benefit, or satisfaction, also known as utility.
The greater the quantity of a good consumed, the greater the benefit derived. However, the extra benefit
provided by each additional unit increases by smaller and smaller amounts. Imagine you buy a soft drink,
which provides you with a certain amount of benefit. You are still thirsty, so you buy a second soft
drink. Whereas you will enjoy this, you will most likely enjoy it less than you had enjoyed the first; the
second soft drink provides you with less benefit than the first. If you buy a third, you will get even less
benefit than from the second, and so on with each additional soft drink. The extra benefit that you get
from each additional unit of something you buy is called the marginal benefit or marginal utility
(marginal means extra or additional).
Since each successive unit of the good you consume produces less and less benefit, you will be willing
to buy each extra unit only if it has a lower and lower price.
Factors influencing demand (Determinants of Demand)
There are indeed several factors which affect the quantity demanded for a certain product. These factors
are grouped into two categories that is price and non-price determinants.
 Change in the price of the commodity itself:

Changes in the price of the commodity will lead to changes in quantity demanded. For instance, a
fall in the price of good X will lead to an increase in quantity demanded for good X. This is because
good X is now cheap and consumers buy more. An increase in price causes quantity demanded to
fall. This can be illustrated as follows:

Changes in price of the product itself

Price
D
P1 B
A
P
C
P2
Q1 Q Q2
Quantity Demanded
Changes in price of the product causes a movement on the demand curve not a shift in the demand
curve. If price rises from P to P1, quantity demanded will fall from Q to Q1, that is, a movement
from A to B along the demand curve. On the other hand, when price falls from P to P2, quantity
demanded will rise from Q to Q2, that is, a movement from A to C along the demand curve.
Non-Price Determinants of demand and shifts of the demand curve

The non-price determinants of demand are the variables other than price that can influence demand.
They are the variables assumed to be unchanging by use of the ceteris paribus assumption when the
relationship between price and quantity demanded was being examined. Changes in the determinants of
demand cause shifts in the demand curve: the entire demand curve moves to the right or to the left
as illustrated below.
Cross Elasticities of Demand

Price
Decrease in Increase in
Demand Demand
Q1 Q1 Q1 Quantity Demanded

The shifts of the demand curve are as a result of the following:

 Changes in consumer Income- A change in consumer income may bring about a change in the
demand for a good or service. However, the direction of change in demand will depend on the type
of commodity in question.
o For a normal good, demand might increase when consumer income increases and demand
might fall as consumer income falls, ceteris paribus.
o For an inferior good, demand might decrease when consumer income increases while
demand might fall as consumer income increases, ceteris paribus. Therefore, inferior goods
are those goods that we consume more when we are worse of financially and less when we
are better of. For instance, who would want to buy ―second hand‖ goods when he becomes
richer?
o For a necessity, a change in consumer income may not affect demand.
 Prices of Related Goods- Goods relate to each other in two ways. Goods are either compliments or
substitutes.
o Complimentary goods are goods with joint demand. They are needed jointly before a want
could be satisfied, e.g., camera and film. With complimentary goods, a steep rise in the price
of one will lead not to only to a fall in its consumption but also a decrease in demand for the
other good. A fall in the price of one good would lead to an increase in the demand of the
other.
o Substitute goods are goods that only one is needed to satisfy a want/need (not both). For
substitutes, a fall in the price of one leads to a decrease in demand for the other while an
increase in the price of one leads to an increase in the demand for the other, ceteris paribus.
For example, margarine and butter could be considered as examples of substitute goods. A
sharp increase in the price of margarine will let people consume more butter if the price of
butter does not change.
 Changes in consumer Tastes/Preferences - Any change in consumer taste or preference causes
demand to change. Increased taste or preference for a particular good causes demand to increase
whilst declining taste or preference causes demand to fall, ceteris paribus. Taste or preference for
goods and services are influenced by advertisement, fashion and sales promotions.
 Consumer Expectations - The decision to buy commodity today is influenced by the expected
future price of the commodity and expected change in consumer income. If a consumer anticipates

the price of a commodity to increase in future, today‘s demand for the commodity will increase but
if the consumer anticipates a fall in future price, then today‘s demand for the commodity will fall.
Similarly, an expected consumer income increase may cause current demand for a normal
commodity to increase and vice versa.
 Population changes of Consumers - Population and population changes may affect demand for a
commodity. Areas of high population may demand more of certain commodities than areas of low
populations. For example, Zimbabwe may demand more of certain goods and services than
Swaziland because Zimbabwe‘s population is higher than that of Swaziland. And even as the
population of a country increases, the demand for goods and services will increase. Also if the
composition or structure of population changes the demand of certain goods and services may also
change.
 Market Strategies - Marketing strategies such advertising, publicity and sales promotions (e.g.
raffles) are means used to get consumers to increase their purchases of commodity. They are
intended to inform and persuade existing consumers as well as new ones to buy more of the
commodity. Effective marketing strategy will lead to an increase in demand for the commodity, all
other things being equal.
 Natural Factors - Seasonal variations may affect the demand for a commodity at certain times of
the year. For example, during the raining season, demand for jackets, raincoats and umbrellas will
increase while during the dry season, demand for commodities such as fans and air conditioners will
rise.
 Availability of credit- When consumers are given credit facilities in the form of credit purchases,
hire purchases and the use of credit cards and cheques, they are encouraged to buy more goods.
Granting of credit facilities will increase demand for goods covered by these facilities, all things
being equal.
 Cost of borrowing (Interest rate) -If the cost of borrowing is low (lower interest rates) then people
can borrow and consume more of normal goods and services. If cost of borrowing is high then people
can borrow less and the investment reduces.
NB - Any change in price produces a change in quantity, shown as a movement on the demand
curve. Any change in a non-price determinant of demand leans to a change in demand, represented
by a shift of the entire demand curve.

Types of demand
a. Joint/Complementary Demand - Goods are said to be in joint/complementary demand when they
produce more consumer satisfaction when consumed together than when consumed separately.
Examples include bread and butter, camera and film, automobile and gasoline, and cassette player
and cassette.
b. Competitive Demand - Goods are said to be in competitive demand when they all compete for the
same consumer‘s income. Such goods are substitutes – i.e. goods that are alternative to one another
in consumption. Examples are peak milk and ideal milk; pork, beef and chicken, pork meat and cow
meat, etc.
c. Derived Demand - This is where the demand for a final product leads to the demand for a second
product which is used to produce this final product – i.e. if the demand of a product is not for its own
sake, but for the manufacturer of another product which is in demand. For example, the demand for
furniture derives the demand for wood, the demand for petrol derives the demand for crude oil.
Generally, demand for any factor of product is a derived demand.
d. Composite Demand - A commodity is said to have a composite demand when it is demanded for
alternative uses. For example, wood has composite demand because it is demanded for several
alternative uses such as the making of table, chairs, windows, doors, body of vehicles, and leather
for making shoes, belt, and briefcase and so on.
Elasticity of demand
Elasticity is concerned with the extent to which one variable, for example, demand, responds to a change
in another variable for example price, income and price of related goods.
There are three types of elasticity of demand which measure how the quantity demanded responds to
changes in the key influences on demand i.e. price, price of related products and income and therefore
we have:
1. Price elasticity of demand

2. Cross elasticity of demand
3. Income elasticity of demand
With elasticity of demand we will be concerned not only with the direction of change in demand but
also the size of the change (i.e. the magnitude of the change).

Price elasticity of demand (PED)
PED measures the responsiveness of demand for a product following a change in its own price. The
formula for calculating the co-efficient of elasticity of demand is:
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐃𝐞𝐦𝐚𝐧𝐝𝐞𝐝

𝐏𝐫𝐢𝐜𝐞 𝐄𝐥𝐚𝐬𝐭𝐢𝐜𝐢𝐭𝐲 𝐨𝐟 𝐃𝐞𝐦𝐚𝐧𝐝 =
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐏𝐫𝐢𝐜𝐞
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls
from 10 to 8 cones then your elasticity of demand would be calculated as:
(𝟏𝟎 − 𝟖)
× 𝟏𝟎𝟎 𝟐𝟎 %
𝟏𝟎 = =𝟐
(𝟐. 𝟐𝟎 − 𝟐. 𝟎𝟎) 𝟏𝟎 %
× 𝟏𝟎𝟎
𝟐. 𝟎𝟎
Since changes in price and quantity nearly always move in opposite directions, economists usually do not
bother to put in the minus sign. We are concerned with the co-efficient of elasticity of demand.
Computing the price elasticity of demand using the midpoint formula

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same
answer regardless of the direction of the change.
𝑸𝟐 − 𝑸𝟏
( 𝑸𝟐 + 𝑸𝟏 )/𝟐
𝑷𝒓𝒊𝒄𝒆 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝑫𝒆𝒎𝒂𝒏𝒅 =
𝑷𝟐 − 𝑷𝟏
(𝑷𝟐 + 𝑷𝟐 )/𝟐
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from
10 to 8 cones the your elasticity of demand, using themed point formula, would be calculated as:
𝟏𝟎 − 𝟖
(𝟏𝟎 + 𝟖)/𝟐 𝟐𝟐%
= = 𝟐. 𝟑𝟐
𝟐. 𝟐𝟎 − 𝟐. 𝟎𝟎 𝟗. 𝟓%
(𝟐. 𝟎𝟎 + 𝟐. 𝟐𝟎)/𝟐
Understanding values for price elasticity of demand

 If PED = 0 then demand is said to be perfectly inelastic. This means that demand does not change
at all when the price changes – the demand curve will be vertical. For example if prices increase
from $4 to $5 quantity demanded will remain at 100 units as illustrated below.

Perfectly Inelastic Demand

Price
D
An increase in price from

$4 to $5 leaves the
$5 Quantity Demanded
unchanged at 100
$4
100 Quantity Demanded
 If PED is between 0 and 1 (i.e. the percentage change in demand is smaller than the percentage
change in price), then demand is inelastic. Producers know that the change in demand will be
proportionately smaller than the percentage change in price. The amount consumed does not vary
very much with price, this can be illustrated as follows:
Inelastic Demand
Price D
P3
P3
Q2 Q1 Q3 Quantity Demanded
Examples of goods/services with Inelastic Demand

o Habit forming goods-e.g. drugs, cigarettes.

o Goods/services that are considered necessary- e.g. bread, potatoes, rice, electricity, cooking
oil.
o Products that are used in conjunction with other, more expensive goods. Complimentary
goods/service- e.g. petrol/car, spare parts for vehicles, driving licenses, motor vehicle
registration, car insurance.
o Goods/services that make-up a relatively small part of income e.g. matches, ballpoint pens.
o Agricultural goods, exports of LDCs. Most important.
 If PED = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in
price), then demand is said to unit elastic. Using a midpoint formula a 25% rise in price would lead
to a 25% contraction in demand leaving total spending by the same at each price level. A change in
price will lead to the same change in the amount demanded.
Unitary Elastic Demand

Price
D
A 25% increase in price from $4

to $5 leads to a proportionate
reduction in Quantity Demanded
$5 i.e. 25% from 100 to 75.
$4
75 100 Quantity Demanded
 If PED > 1, then demand responds more than proportionately to a change in price i.e. demand is
elastic. For example using midpoint formula a 22% increase in the price of a good might lead to a
67% drop in demand. The price elasticity of demand for this price change is –3. Even small changes
in prices lead to big changes in demand.

Elastic Demand
Price
A 25% increase in price from

D $4 to $5 leads to a reduction
in Quantity Demanded by
50% i.e. from 100 to 50.
$5
$4
50 100 Quantity Demanded
Examples of goods/services with Elastic Demand

o Goods/services having close substitutes which buyers find acceptable- e.g. butter/margarine.
o Goods/services that are durable - e.g. Televisions, cars & furniture.
o Goods/services that take-up a higher proportion of income - e.g. luxuries, holidays.
 Perfectly elastic demand — Exist when the quantity demanded changes by a very large percentage
in response to an almost zero percentage change in price as shown below.
Perfectly Elastic Demand
Price
At any price above $4,

quantity demanded is Zero
At exactly $4 consumers
$4 D will buy any quantity
At any price below $4,

quantity demanded is infinite
Quantity Demanded

Summary
If PED > 1 Elastic Demand
If PED < 1 Inelastic Demand
If PED = 1 Unitary Elastic Demand
If PED = 0 Perfectly Inelastic Demand
If PED = ∞ Perfectly Elastic Demand
What Determines Price Elasticity of Demand?

An example: Demand for transport services at peak times, the demand for public transport becomes
inelastic – and higher prices are charged by public transport companies who can then achieve higher
revenues and profits.
 Availability of close substitutes in the market, the more elastic is the demand for a product because
consumers can more easily switch their demand if the price of one product changes relative to others
in the market. People “have” to get to work for example, a latter bus is not a good substitute as you
get there late, so the demand is inelastic. The huge range of package holiday tours and destinations
make this a highly competitive market in terms of pricing – many holiday makers are price sensitive,
so demand is elastic. You can always go somewhere else on holiday!
 The cost of switching between different products – there may be significant transactions costs
involved in switching between different goods and services. In this case, from shifting from public
transport you would need to buy a car for example, find a parking space near work and so on,
therefore demand tends to be relatively inelastic.
 The degree of necessity or whether the good is a luxury or a necessity – goods and services
deemed by consumers to be necessities tend to have an inelastic demand whereas luxuries will tend
to have a more elastic demand because consumers can do without luxuries when their budgets are
stretched. I.e. in an economic recession we can cut back on discretionary items of spending. Again,
you “Have” to get to work so you “have” to pay the higher price. Transport companies know this
and so put the price up without affecting the levels of demand.
 The percentage of a consumer’s income allocated to spending on the good – goods and services
that take up a high proportion of a household‘s income will tend to have a more elastic demand than
products where large price changes makes little or no difference to someone‘s ability to purchase
the product.
 The time period allowed following a price change – demand tends to be more price elastic, the
longer that we allow consumers to respond to a price change by varying their purchasing decisions.
In the short run, the demand may be inelastic, because it takes time for consumers both to notice and

then to respond to price fluctuations. Back to the public transport example, it takes time to buy a car
and so on. Transport operators put their prices up and over time people would drift to cars away
from public transport.
 Whether the good is subject to habitual consumption – when this occurs, the consumer becomes
much less sensitive to the price of the good in question. Examples such as cigarettes and alcohol and
other drugs come into this category. This is also why firms spend vast amounts on building brand
images.
 Peak and off-peak demand - demand tends to be price inelastic at peak times – a feature that
suppliers can take advantage of when setting higher prices. Demand is more elastic at off-peak times,
leading to lower prices for consumers. Consider for example the charges made by car rental firms
during the course of a week, or the cheaper deals available at hotels at weekends and away from the
high-season. Bus fares are also high at peak times during the day
 The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for
petrol or meat, demand is often fairly inelastic. But specific brands of petrol or beef are likely to be
more elastic following a price change.
 The durability of goods - Goods which can be used more than once are called durable goods. They
are likely to have more elastic demand. Non-durable goods are likely to have inelastic demand.
Elasticity of demand and the gradient of the demand curve

Elasticity of demand is not measured by the slope or gradient of the whole demand curve. Normally on
any downward sloping demand curve, elasticity will be different at different prices. There are only 3
exceptions which are:
a. A perfectly elastic demand curve.

b. A perfectly inelastic demand curve.
c. A demand curve with unitary elasticity.
Price of Quantity Category of

Total
Commodity Demanded Price
Revenue
(£/kg) (kg/week) Elasticity
A 10 0 0
B 9 10 90
C 8 20 160 Elastic
D 7 30 210
E 6 40 240
F 5 50 250 Unitary
G 4 60 240
H 3 70 210
I 2 80 160 Inelastic
J 1 90 90
K 0 100 0

Adopted from Beardshaw
Elasticity of demand & The gradient of the curve
Price
D
$ 10
A Elastic Demand
Unitary Demand
$5
F
Inelastic Demand
K D
0 50 100 Quantity
Adopted from Beardshaw

The value of elasticity decreases from infinity at point A through unity at point F to zero at point K.

PED and Total Revenue

A firm‘s total revenue (TR) is the amount of money it makes from selling its goods – TR = P x Q. For
example a firm that sells 100 units of a good at $10 each will have a TR = 100 x $10 = $1000. The
effects of a change in good price on the total revenue of a firm depends on whether the demand for the
good is elastic or inelastic. When demand is elastic an increase in the price of a good will cause a
decrease in TR as illustrated below and a decrease in price will cause an increase in TR.
Elasticity of Demand and Total Revenue – Elastic Demand

Price Price $4 to $5 results in a
decrease in Total Revenue
from $200 to $100
D D
$5
$4
Revenue Revenue
$200 D $100 D
50
Quantity 20 Quantity
Demanded Demanded
When demand is inelastic e.g. necessities an increase in the price of a good will increase TR as illustrated
below and a decrease in price will decrease TR.
Elasticity of Demand and Total Revenue – Inelastic Demand
Price Price
$1 to $3 results in an
D D increase in Total Revenue
from $100 to $240
$3
Revenue
$1 $240
Revenue
$100 D D
100 Quantity 80 Quantity

Demanded Demanded

When a good has elasticity of demand which is unity, a decrease or increase in price of good leaves TR
unchanged. As the price of a good/service changes up or down, how TR will change depends on the PED of
the good/service. This can be summarized in the table below:
Price Increase Price Decrease

Elastic Good %∆QD↓ > %∆P↑ %∆QD↑ > %∆P↓
PED >1 TR↓ TR↑
Unit Elastic Good %∆QD↓ = %∆P↑ %∆QD↑ = %∆P↓
PED = 1 TR is Constant TR is Constant
Inelastic Good %∆QD↓ > %∆P↑ %∆QD↑ < %∆P↓
PED < 1 TR↑ TR↓
Why is the demand for primary products inelastic?

1. In the case of necessities i.e. goods which are required no matter what the price is (consumption
of such goods cannot be dispensed with). For example when the price of rice rises, the quantity
demanded will decrease slightly because rice is essential to the Asian diet. This is true for all
staple foods.
2. Most raw materials, except rubber have no close substitutes. So, despite changes in price the
demand for such goods will be inelastic. This is also generally true for food.
3. When a taste or preference becomes a force of habit, it becomes very difficult to change the habit.
For instance, a person who consume rice daily will find it difficult to switch to other types of
grain. Such forces of habit will bring about inelastic demand.
4. Most primary products are relatively cheap and consumers are not overly bothered by changes in
prices. Most vegetables, for example, do not cost more than US$5 per kilogram. Moreover, these
goods constitute only a minor portion of one’s total expenditure, such as salt and sugar.
5. The intake of food is limited. Hence, even though the prices of primary products may be cheap or
prices may have dropped considerably, consumers will not buy large quantities of such goods
(e.g. rice) because human intake of food is limited.
6. Most primary products are produced in bult and although the price may be cheap, consumers
would not buy in large quantities because they do not have the facilities to store such goods.
7. Associated with the problem of storage is the problem of perichability. Most primary products,
especially agricultural goods such as eggs and fresh fish, cannot be kept for long as they rot easily.
Adopted from tutor2u.com

Income Elasticity of Demand (YED or Ey)
YED is the relationship between the percentage changes in quantity demanded of a good due to a percentage
change in income. YED measures the degree of responsiveness of the quantity demanded of good to changes
in income.
For most goods, income and quantity demanded will move in the same direction i.e. an increase in Y will
lead to an increase in quantity demanded and vice versa. These goods are called normal goods – YED is
positive.
For some goods, income and quantity demanded will move in opposite directions. An increase in income
will lead to a decrease in quantity demanded and vice versa. YED is negative. These goods are called inferior
goods e.g. public transport, second hand clothing, cheap food stuffs etc.
When quantity demanded does not change as income changes YED = 0.
Types of income elasticity of demand

Change in Income
Change in Type of
Quantity Ratio Elasticity of
Income Product
Demanded Demand
A +10 +15 +1.5 Normal Positive
B +10 +10 +1.0 Normal Unity/ Unitary
C +10 +5 +0.5 Normal Positive
D +10 0 0 Zero
E +10 -5 - 0.5 Inferior Negative
A. Here the product is normal with the percentage increase in the quantity demanded outweighing the
percentage rise in income, so that a 10% rise in income results in a 15% increase in quantity
demanded, giving a YED of +1.5. This would suggest that the product could be a consumer durable
such as a CD player where the demand increases rapidly as income increases.
B. Here the 10% rise in income leads to exactly the same 10% increase in quantity demanded, giving a
YED of +1.
C. Here the percentage increase in the quantity demanded is smaller than the percentage rise in income,
so that a 10% rise in income results in a 5% increase in quantity demanded, giving a YED of +0.5.
Basic foodstuffs is a type of product which could result in this response since we would not expect
a substantial increase in the quantity of basic food purchased as income rises.
D. Here the 10% rise in income has no effect on the quantity demanded, giving a zero income elasticity
of demand.

E. Here the 10% rise in income leads to a 5% decrease in the quantity demanded, giving a YED of
−0.5. Clearly this is an inferior product or inferior good, with consumers switching away from this
product to a better quality alternative which they can now afford.
The relationship between the quantity demanded of a product and income can be understood further by
studying the diagram below:
Income Elasticity of Demand
Quantity
Demanded
Normal Good Zero Income Inferior Good

+ve Income Elasticity - ve Income
Elasticity of Demand Elasticity of Demand
Y1 Y2 Income
The figure illustrates three situations relating to income elasticity of demand. Up to an income level Y1
the quantity demanded of the product increases as income rises, indicating a positive income elasticity
of demand and thus a normal good. As income rises between Y1 and Y2 the quantity demanded of the
product remains unchanged; the income elasticity of demand is thus zero. Finally, as income rises above
Y2 the quantity demanded decreases, thus illustrating negative income elasticity of demand and an
inferior good.
Factors Affecting YED

1. Current standard of living
2. Type of good (normal, inferior)
3. Level of consumer‘s income
Cross Elasticity of Demand (XED/CED)
XED measures the degree of responsiveness of the quantity demanded of one good (A) to changes in the
price of another (B). This can be rewritten as:

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝒐𝒇 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 𝑨

𝑪𝑬𝑫 =
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 𝑩
This can be written as:

∆𝑸𝑨
𝑸𝑨 × 𝟏𝟎𝟎 ∆𝑸𝑨 𝑷𝑩
𝑪𝒓𝒐𝒔𝒔 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝒅𝒆𝒎𝒂𝒏𝒅 = = ×
∆𝑷𝑩 ∆𝑷𝑩 𝑸𝑨
𝑷𝑩 × 𝟏𝟎𝟎
Where:
𝑸𝑨 = the original quantity of product A
𝑷𝑩 = the original price of product B
∆𝑸𝑨 = the change in the quantity of product A
∆𝑷𝑩 = the change in the price of product B
Three possible outcomes are shown in the diagram below, with the sign of XED telling us something
about the relationship between the two products. The size (or magnitude) of XED tells us how close the
two products are, whether as substitutes or complements in consumption.
Cross Elasticities of Demand
Price of
Good B (3)
(1)
(2)
Quantity Demanded
of Good B
Line (1) illustrates a positive cross elasticity of demand with respect to a substitute in that as the price
of product B rises the demand for product A increases. Line (2) illustrates a negative cross elasticity of
demand with respect to a complement, in that as the price of product B rises the demand for product A
decreases. Finally, Line (3) illustrates a situation where the cross elasticity of demand is zero, in that
as the price of product B rises there is no effect on the demand for product A.

 In the case of substitute goods (i.e. goods which can be used in place of another), XED will be i.e.
an increase in the price of good A will lead to an increase in the quantity demanded of good B (and
vice versa) e.g. tea and coffee or beef and pork.
 In the case of complementary goods (i.e. goods which the use of one will require the use of
another). XED will be negative i.e. an increase in the price of good A will lead to a fall in the quantity
demanded of good B (and vice versa) e.g. cell phone and airtime, tea and sugar.
 If two (2) goods are very close substitutes XED will have a very high positive value.
 If CED is equal to zero – the goods are not related at all. They are independent goods e.g. televisions
and toilet paper & blankets and sweets.
Usefulness of PED to a firm/business

 To calculate a firm‘s revenue.
 For a firm to know pricing strategies to use/ embark on.
 For a firm to plan carefully its production levels or level of output to produce.
 For a firm to plan on which products to produce i.e. those which give maximum profits.
 For resource allocation.
Usefulness of YED
 For resource allocation.
 For production levels or level of output to produce.
Usefulness of CED
 For production levels or levels of output to produce.

 For planning on which products to produce i.e. those which yield maximum profits.

Practical Applications of the concepts of elasticity

1. Producers would be interested in the concepts of elasticity because their price policy will
be affected by the response expected.
2. For price elasticity of demand, the producer will push up prices if the demand for the
product is inelastic (in the case of necessities or goods with no close substitutes).
3. If demand for the product is elastic, then the producer will lower price in order to maximize
sales and revenue. This is the case of luxuries or goods with several substitutes.
4. For income elasticity of demand, the producer must first consider whether the production
is a normal good or an inferior good. If it is a normal good, then he will promote the good
when there is an increase in income example being bonus time. Promotions can be in the
form of some marketing gimmicks such as “buy one get one free”, or lucky draws or “buy
one and get the second one at a lower price”. The producer can also promote the good with
attractive display or perhaps demonstrations.
5. However, if the product is an inferior good, the producer would only promote the good in
times of falling income or when the economy is in a state or recession. For example, the
supermarket manager can promote instant noodles and canned food. In the case of an
inferior good, a falling income will lead to an increase in quantity demand.
6. For cross elasticity of demand where the two products are substitutes, with an increase in
the price of one good (e.g. chicken) the producer will promote the substitutes (e.g. pock,
mutton, fish, beef). This will increase sales and hence more revenue.
7. For negative cross elasticity of demand, the producer will promote complements. For
example, if the price of bread has fallen, the producer will promote spreads such as butter,
honey, peanut butter and jam. This will also boost sales.
8. There are also other uses of the concept of elasticity other than increasing sales. For
example, elasticity concepts will be useful to determine tax burden and to identify the
market structures that the business is in.
NOTE - Take note of the following terms:-
 Joint demand/ Complementary demand i.e. demand for complements

 Competitive demand i.e. demand for substitutes
 Composite demand - A good is said to be in composite demand if it is demanded for several
uses/different uses e.g. wool would be demanded by the textile industry, blanket manufacturers etc.
The demand for such goods are the aggregates of the demands of the various users.
 Joint supply – this means the production of one good automatically leads to the output of another
e.g. peanut butter and oil, beef and hides, mutton and wool, lead and zinc.

Practical Limitations of the concept of elasticity

In theory, the various measures of the elasticity of demand help managers to understand
the impact of changes in different variables on their sales. This is important to their
planning for example when estimating the required staffing and stock levels. However,
whilst a knowledge of the price, income and cross elasticities of demand would certainly
be useful, in reality using them can be difficult due to the following reasons:
 They do not show the actual cause and effect. For example, an increase in demand
may be accompanied by an increase in income. It could be that the higher
advertising has caused the increase in demand. However, it could be that with
more demand marketing managers feel they have the funds necessary to pay for
more advertising. The initial increase in demand may have been caused by
something entirely. It is not necessarily the increase in advertising that is causing
the increase in demand and so a high advertising elasticity of demand may be
misleading in terms of future decision making.
 Each of the equations for the elasticity of demand measures the relationship
between one specific factor and demand, for example the price elasticity of demand
analyses the impact of a change in price on the quantity demanded. In reality many
factors may be changing at the same time such as the spending on advertising,
competitors’ promotional strategies and consumers’ incomes, as well as the firm’s
price. It may therefore be difficult to know what specifically caused any changes in
the quantity demanded. Any change in the quantity demanded may not have been
due to a price change at all, and so the value of the price elasticity of demand may
be misleading.
To know the elasticity of demand managers must either look back at what happened in
the past when, for example, prices or income were changes (but the conditions are likely
to have altered since then) or estimate for themselves what the values are now (in which
case they may be wrong because it is an estimate). The value of elasticity is, therefore,
not actually known at any moment, it is merely estimated. This means that managers
should be careful about basing their decisions on their estimates of the elasticity as the
value will be changing at the time as demand conditions change.

Theory of Supply
 Introduction
 The law of Supply
 Determinants of Supply
 Market Equilibrium
 Functions of Price in a Market Economy
 Consumer Surplus & Producer Surplus
 Price Controls
 Elasticity of Supply

Introduction
Supply is the maximum quantity of a commodity that firms will offer for sale at a given market price within
a specified time period when all other supply factors remain unchanged. Simply put, it is a set of prices with
a corresponding set or quantities that firm would offer for sale at a given time and when all other supply
factors remain unchanged.
The law of supply
According to the law of supply, there is a positive causal relationship between the quantity of a good supplied
over a particular time period and its price, ceteris paribus: as the price of the good increases, the quantity of
the good supplied also increases; as the price falls, the quantity supplied also falls, ceteris paribus.
The supply schedule and supply curve show the relationship between market prices and quantities which
producer/suppliers/manufacturers are prepared to offer for sale at a given price over a given period of time.
Supply Schedule is a table showing the different quantities of a good that producers are willing and able to
supply at various prices over a given period of time.
Price Quantity Supplied (Per Week)

50 250
40 220
30 180
20 120
10 50

Supply Curve – A graph showing the relationship between the price of a good and the quantity of the good
supplied over a given period of time.
The Supply Curve

Price S
P1
Q Q1
Quantity Supplied
Why the supply curve is upward sloping?

What is the economic reasoning behind the law of supply? Higher prices generally mean that the firm‘s
profits increase, and so the firm faces an incentive to produce more output. Lower prices mean lower
profitability, and the incentive facing the firm is to produce less. Therefore, there results a positive
relationship between price and quantity supplied: the higher the price, the greater the quantity supplied.
The supply function

The supply function or equation is a mathematical expression showing a relationship between the quantity
supplied of a commodity and the supply factors with commodity‘s market price inclusive. If all the other
supply factors are held constant and allow quantity supplied to depend only on the market price of the
commodity then we have: 𝐐𝐒 = 𝐅(𝐏) Where QS is the quantity supplied and P is the market price.
Exceptional Supply Curves - Regressive Supply Curve
Supply curves usually slope upwards from left to right, sometimes however they change direction and are
said to become regressive e.g. an individual supply curve for labour where there may be a high leisure
preference. As wage rates increase workers have opted to work for shorter hours. This is because instead of
taking the increased wage rate in money workers take increased leisure and offer less hour of labour as shown
in the diagram below.

Regressive Supply Curve

Price
S
P1
Q1 Q
Quantity Supplied
Market Supply
Market supply indicates the total quantities of a good that firms are willing and able to supply in the market
at different possible prices, and is given by the sum of all individual supplies of that good. The supply curves
of all producers in the market can be aggregated to obtain the market supply curve showing the amount of a
good which producers are willing to supply at each price
Market Supply Schedule
Total Market
Price ($) Firm A Firm B Firm C
Supply
1 10 15 0 25
2 20 25 30 75
3 30 40 50 120
4 40 60 90 190
5 50 80 130 260
Movement along the supply curve and a shift in the supply curve
A movement along the supply curve occurs when quantity supplied changes because of a change in the price
of the commodity alone, while other factors affecting supply remain constant. In fact, when a supply curve
is drawn, only the price of the product is allowed to vary, while the conditions of supply do not change. The
movement along the supply curve is shown as follows:

Changes in price of the product itself

Price
B
P1
P
A
P2 C
Q1 Q Q2
Quantity Supplied
A shift in the supply curve or a change in supply occurs when quantity supplied changes only because there
are changes in conditions of supply such as weather conditions, prices of factor inputs, etc., while the price
of the commodity remains constant. The supply curve can shift either to the right or to the left, depending
upon the changes in the conditions of demand. The shift in the supply curve is shown as follows:

Shift in the Supply Curve

Price
S2 S S1
Decrease Increase
Q2 Q Q1
Quantity Supplied
The Determinants of supply factors affecting supply

1. The price of the good itself:
Changes in the price of the commodity will lead to changes in quantity supplied of that commodity. For
instance, a rise in the price of good X will lead to a rise in quantity supplied of good X. This is because
good X is now more profitable and producers supply more of it. Changes in own price of a commodity
cause a movement along the supply curve that is expansion and contraction in supply when price increase
and decrease respectively.
Non-Price determinants of supply

Non-price determinants of supply are the factors other than price that can influence supply. Changes in the
determinants of supply cause shifts in the supply curve. A rightward shift means that for a given price, supply
increases and more is supplied; a leftward shift means that for a given price, supply decreases and less is
supplied. The following are the non-price determinants of supply.
2. Prices of Inputs - These are the prices firms pay to obtain factors of production or inputs. Firms pay
wages and salaries for hiring labour, rent for the use of land and interest for borrowing capital. Increase
in input prices in turn increases cost of production thereby causing supply to decrease. A decline in input
prices lowers costs of production and increases supply.
3. Technology - The kind of technology a firm uses to produce its products determines the type and quantity
of inputs necessary to produce to produce a given quantity of a product. When a firm uses the best
technology available, it can produce a unit of a good at the lowest possible cost (economic efficiency).
An advancement or improvement in technology is the development of new means of producing a good
using a smaller quantity of inputs than was previously possible (technical efficiency). Technological
innovation also results in the development of new products that are less costly to produce than the

products they replace. Thus, technological change lowers production costs, which in turn leads to
increase in profits and, therefore, increases supply.
4. Weather / climatic conditions - The supply of agricultural products is affected by changes in weather
conditions. A favourable climatic condition may bring bumper (abundant) harvest so that producers
supply more of the agricultural products. On the other hand, an unfavourable season which results in a
poor harvest may cause quantity supplied to fall.
5. Prices of other products/outputs
i. Competitive supply products: Firms are not permanently committed to the production of particular
products. Because firms have the objective of maximising profits, rising prices for other products
could cause firms to switch to the production of these products. For example, if the price of soft
drinks were to rise sharply, breweries might switch form beer production to soft drink bottling. Such
products are said to be in competitive supply. The same resources may be used to produce them.
ii. Joint-supply products: These are products that are always produced together. One is seen as the
by-products of the other. Examples are beef and hide. An increase in the price of say beef, which
increase the quantity of beef supplied to the market, will automatically increase the supply of hides,
from which leather products are made.
6. Taxes (indirect taxes or taxes on profits) - Firms treat taxes as if they were costs of production.
Therefore, the imposition of a new tax or the increase of an existing tax represents an increase in
production costs, so supply will fall and the supply curve shifts to the left. The elimination of a tax or a
decrease in an existing tax represents a fall in production costs; supply increases and the supply curve
shifts to the right
7. Subsidies - A subsidy is a payment made to the firm by the government, and so has the opposite effect
of a tax. (Subsidies may be given in order to increase the incomes of producers or to encourage an
increase in the production of the good produced.) The introduction of a subsidy or an increase in an
existing subsidy is equivalent to a fall in production costs, and gives rise to a rightward shift in the supply
curve, while the elimination of a subsidy or a decrease in a subsidy leads to a leftward shift in the supply
curve.
8. The number of firms - An increase in the number of firms producing the good increases supply and
gives rise to a rightward shift in the supply curve; a decrease in the number of firms decreases supply
and produces a leftward shift. This follows from the fact that market supply is the sum of all individual
supplies.
9. “Shocks”, or sudden unpredictable events - Sudden, unpredictable events, called ‗shocks‘, can affect
supply, such as weather conditions in the case of agricultural products, war, or natural/man-made
catastrophes.
Types of Supply
 Joint Supply- Products have joint supply when the supply of one product is in association of the
supply of other products. The other goods are seen as by-products of the main product supplied.
Examples are beef and hide (leather), oil and petrol, gas and coke.
 Competitive Supply- This entails the supply of goods/services which can most easily be produced
with the resources at the firm`s disposal.

Price and output determination in competitive markets
The Market Equilibrium
Equilibrium is defined as a state of balance between different forces, such that there is no tendency to change.
This is an important concept in economics that we will encounter repeatedly. When quantity demanded is
equal to quantity supplied, there is market equilibrium; the forces of supply and demand are in balance, and
there is no tendency for the price to change.
For each economic good there is a supply schedule and a demand schedule. If the two are brought together,
we find that quantity demanded and quantity supplied will be equal at one and only one market price. This
is called equilibrium price or the market price. The equilibrium price may be determined from the demand
and the supply schedules or as is more usually the case form the point at which the demand curve and supply
curve intersect as shown below.
Quantity of Chocolate Bars Quantity of Chocolate Bars

Price of Chocolate Bars ($)
Demanded (Per Week) Supplied (Per Week)
5 4,000 12,000
4 6,000 10,000
3 8,000 8,000
2 10,000 6,000
1 12,000 4,000
The market equilibrium is $3 where demand is equal to supply at quantity of 8000 units. The equilibrium
price and quantity can be presented on the graph as follows.

Market Equilibrium
D S
Surplus
Price of chocolate bars $5
$3
$1
Shortage
4 8 12
Quantity of Chocolate Bars
If quantity demanded of a good is smaller than quantity supplied, the difference between the two is called a
surplus, where there is excess supply; if quantity demanded of a good is larger than quantity supplied, the
difference is called a shortage, where there is excess demand. The existence of a surplus or a shortage in a
free market will cause the price to change so that the quantity demanded will be made equal to quantity
supplied. In the event of a shortage, price will rise and in the event of a surplus, price will fall.
Changes in Market Equilibrium
Once a price reaches its equilibrium level, consumers and firms are satisfied and will not engage in any
action to make it change. However, if there is a change in any of the non-price determinants of demand or
supply, a shift in the curves results, and the market will adjust to a new equilibrium. Market prices are
determined by the interaction of demand and supply and in competitive market changes in market prices
must be due to changes in demand and supply or both.
Effects of changes in demand

The effects of changes in demand may be stated in terms of economic laws:
1. Other things being equal, an increase in demand will raise the price and increase the quantity supplied.
2. Other things being equal, a decrease in demand will lower the price and reduce the quantity supplied.

Effects of changes in Demand on Equilibrium
Increase in Demand Decrease in Demand
Initial Final Final Initial

Price Equilibrium Equilibrium S Price Equilibrium Equilibrium S
P2 C P1 C
B
A B A
P1 P3
D2 D1
D1 D3
Q1 Q2 Q3 Q1
Quantity Quantity
In the diagram above, D1 intersects S at point a, resulting in equilibrium price and quantity P1 and Q1.
Consider a change in a determinant of demand that causes the demand curve to shift to the right from D1 to
D2 (for example, an increase in consumer income in the case of a normal good). Given D2, at the initial
price, P1, there is a movement to point b, which results in excess demand equal to the horizontal distance
between points a and b. Point b represents a disequilibrium, where quantity demanded is larger than quantity
supplied, thus exerting an upward pressure on price. The price therefore begins to increase, causing a
movement up D2 to point c, where excess demand is eliminated and a new equilibrium is reached. At c, there
is a higher equilibrium price, P2, and greater equilibrium quantity, Q2, given by the intersection of D2 with
S.
A decrease in demand, shown in diagram (b), leads to a leftward shift in the demand curve from D1 to D3
(for example, due to a decrease in the number of consumers). Given D3, at price P1, there is a move from
the initial equilibrium (point a) to point b, where quantity demanded is less than quantity supplied, and
therefore a disequilibrium where there is excess supply equal to the horizontal difference between a and b.
This exerts a downward pressure on price, which falls, causing a movement down D3 to point c, where
excess supply is eliminated, and a new equilibrium is reached. At c, there is a lower equilibrium price, P3,
and a lower equilibrium quantity, Q3, given by the intersection of D3 with S.
Effects of a shift in Supply

The effects of changes in supply may also be summarized in the form of 2 economic laws:-
1. Other things being equal, an increase in supply will lower the price and increase the quantity
demanded.
2. Other things being equal, a decrease in supply will raise the price and reduce the quantity demanded.

Effects of changes in Supply on Equilibrium
Increase in Supply Decrease in Supply
Initial Final Final Initial

Price Equilibrium Equilibrium Price Equilibrium Equilibrium
S S1 S3 S1
P1 A P3 C
B
P2 C P1 A
B
D D
Q1 Q2 Quantity Q3 Q1 Quantity
In diagram (a), the initial equilibrium is at point a where D intersects S1, and where equilibrium price and
quantity are P1 and Q1. An increase in supply (say, due to an improvement in technology) shifts the supply
curve to S2. With S2 and initial price P1, there is a move from point a to b, where there is disequilibrium
due to excess supply (by the amount equal to the horizontal distance between a and b). Therefore, price
begins to fall, and there results a movement down S2 to point c where a new equilibrium is reached. At c,
excess supply has been eliminated, and there is a lower equilibrium price, P2, but a higher equilibrium
quantity, Q2.
A decrease in supply is shown in diagram (b) (say, due to a fall in the number of firms). With the new supply
curve S3, at the initial price P1, there has been a move from initial equilibrium a to disequilibrium point b,
where there is excess demand (equal to the distance between a and b). This causes an upward pressure on
price, which begins to increase, causing a move up S3 until a final equilibrium is reached at point c, where
the excess demand has been eliminated, and there is a higher equilibrium price P3 and lower quantity Q3.
Functions of prices in a market economy
In a free market economy, price is determined by the interactions of demand and supply. In such an economic
system, price performs three functions. It acts as an Allocative mechanism, rationing device and signalling
device.
Changes in prices produce incentives for producers to reallocate available resources towards profitable
markets. For instance, suppose price of good X increases due to an increase in demand of good X. This rise
in price will act as an incentive for higher production because it reflects higher profits. Hence, producers will

divert resources from the production of other goods, which are unprofitable, to the production of good X.
This is illustrated as follows:
Prices in a Market Economy

Price of
D2
Good X S
S1
D1
Long Run
P1 C1
C B
P
Q Q1 Quantity of
Good X
Other
Goods
C1
G
C2
G1
E E1 Quantity of
Good X
Allocative Function - At the initial market price of good X, 0P, and quantity, 0Q, producers are allocating
0E amount of resources in the production of good X and 0G in the production of other goods, that is, at
combination C along the production possibility curve, AB. When demand for good X rises to D1D1, the
price also rises to 0P1. This rise in price acts as an incentive for producers to reallocate more resources in
the production of good X which is now more profitable. As a result, producers devote 0E1 amount of
resources in X and 0G1 in the production of other goods. Hence, the rise in price shows how resources are

allocated in the production of X rather than other goods, that is, a movement from C to C1. However, in the
long run supply rises to S1S1.
Rationing Function - Besides, price acts as a rationing device. In other words, price serves to ration the
scarce goods among the people who are demanding them. Where the supply of a good or service is
insufficient to meet the demands of prospective buyers at the existing price, the market price will rise and
continue to rise until the quantity demanded is just equal to the existing supply. Those unable to pay a higher
price will be eliminated from the market. Price rations scarce goods to those who can afford to pay the price.
Hence, for price to act as a rationing mechanism, the effect of a rising price must be to reduce the quantity
demanded by some individuals.
Signaling Function - the market price of a good provides the necessary signal to both buyers and sellers
about the relative scarcity of the good, which in turn would get manifested in their consumption and
production plans. A change in price would indicate a change in consumer behaviour, for example, an increase
in price may come about as a result of an increase in demand due to a change in taste. On the other hand,
prices also indicate changes in the conditions of supply.
Consumer Surplus and Producer Surplus
Consumer Surplus - is defined as the difference between the price a customer willing to pay for a product
and the price that he actually ends up paying. When a consumer gets to purchase a good at a lower price than
the price he is willing to pay, he gets more benefits creating a consumer surplus. As an example, for a
necessity like food consumer would be willing to pay a higher price as it is a necessity. But at normal market
conditions consumer can obtain food at a relatively lower price than what he is willing to pay and it creates
a consumer surplus. When the utility (satisfaction) of a good falls the consumer surplus reduces as the
consumer will not be willing to pay higher price. The consumer surplus can be visually represented as
follows:

Consumer Surplus
Price
P1 A
C B
P
Demand
Q
Output
The consumer is willing to buy the good for P1 but he finally pays P0. The area of the consumer surplus is
the area under the demand curve and above the price line. It is shown by the shaded area (ABC) on the
diagram above.
Important!
Imagine rummaging through a rack of clothes at Edgars. You come across a shirt, and
immediately a price pops into your head. You think to yourself, I would be willing to pay
$25 for this shirt. That means $25 is your marginal benefit (or demand – the willingness
to pay). Then you look at the price and see a tag of $16. You are happy!!! You have a
consumer surplus of $9.
Change in Consumer Surplus

Consumer surplus may change due to changes in demand and supply conditions. For instance, an increase in
supply causes price to fall. As a result, consumer surplus rises. This can be illustrated as follows:

Changes in Consumer Surplus
Price
S S1
A
P
C
P1 B
Q Q1 Quantity
At the initial equilibrium price is 0P, consumer surplus is represented by the area PKA. A rise in supply to
S1S1 causes equilibrium price to fall to 0P1 and quantity to rise to 0Q1, thereby, causing a rise in consumer
surplus to KP1B. In fact, consumer surplus increases by PABP1. It increases because of the fall in price. On
the other hand, a fall in supply causes equilibrium price to rise, and hence, a fall in consumer surplus.
Similarly, a change in demand conditions may also change consumer surplus. But, the change depends upon
the price elasticity of supply. If demand increases and supply is elastic, consumer surplus may increase
because the price will not rise much when demand rises.

Changes in Consumer Surplus
Price
A1
S
E
P2
P1 C
D1 D2
Q1 Q2
Quantity
When demand rises to D1, consumer surplus changes from PAC to PA1E. Since the increase in price is less
than the increase in demand due to elastic supply, consumer surplus increases. On the other hand, when
supply is inelastic, consumer surplus may even fall because the price will rise significantly with a rise in
demand.
Besides, the change in consumer surplus depends upon the price elasticity of demand. Consider the following
diagrams when demand is inelastic.
Consumer Surplus and Inelastic Demand

D
Price Price
S
S
Consumer
Consumer
Surplus
Surplus
P
P
Q Quantity Q Quantity

When demand for a good is inelastic, consumer surplus is high. Thus, when demand is perfectly inelastic,
consumer surplus is at maximum. On the other hand, when demand for a good is elastic, consumer surplus
is low. Hence, when demand is perfectly elastic, there is no consumer surplus. This can be illustrated as
follows:
Consumer Surplus and Elastic Demand
Price Price
S
A S
Consumer
Surplus B
P
B
P D
Producer Surplus
Producer Surplus - occurs when the producer receives a price for a product he sells which is more than
what he was willing to sell the good for. The producer surplus is equal to the area above the supply curve
and below the price line.
Producer Surplus
Price
B C
P
Demand
A
Q
Output

The producer is willing to sell the good at price at A but he finally sells it at price level P1. The shaded area
ABC represent producer surplus.
Total Surplus –It is the sum of consumer and producer surplus. On the diagram it is the area between the
supply and demand curve up to the equilibrium quantity.
Total Surplus
Price
Supply
Producer
Surplus
Equilibrium B C
Price
Consumer
Surplus
Demand
A
Equilibrium
Quantity Quantity
NB-changes in the equilibrium price can cause consumer equilibrium and producer equilibrium to change.
An increase in the market price will result to fall in consumer surplus and an increase in producer surplus.
The opposite apply when the market price decrease.

Price Controls
Whenever the forces of demand and supply are allowed to fix market prices of commodities in a competitive
market, some of the prices may be unfairly high to buyers or unfairly low to sellers. In such instances, the
government may attempt to regulate or limit prices through legislation.. Price controls prevent markets from
moving to equilibrium. Price controls are in the form of either maximum price (price ceiling) or minimum
price (price floor)
Maximum Price Control (Price Ceiling)

An effective maximum price or price ceiling is a legal price set below the equilibrium market price above
which a seller cannot change for a product. It is set to safeguard consumers when the equilibrium market
price for a commodity is found to be unfairly high. Governments use legislation to enforce maximum prices
for:
 Staple foodstuff s, such as bread, rice and cooking oil

 Rents in certain types of housing
 Services provided by utilities, such as water and electricity
 Transport fares especially where a subsidy is being paid.
 Pharmaceutical drugs
When a maximum price is set for a good it increases the quantity demanded while the quantity supplied
decreases thereby resulting in persistent excess demand or shortage of the good.
Maximum Price
Price S
PE
Maximum
P
Price
Shortage
Q1 QE Q2 Quantity

The diagram above indicates that at the price ceiling of P1, production is not sufficient to satisfy everyone
who wishes to buy the product. Too few resources are being allocated. Consequently, as price cannot rise,
the available supply has to be allocated on some other basis.
Effects of maximum price

The persistent shortage created by price ceiling will in turn pose the following problems:
i. Negative welfare impacts
Maximum Price
Price
Welfare S = MC
Loss
B
PE
D
C
Maximum
P
Price
E
D = MC
Q1 QE Q2 Quantity
In the diagram above, with no price control, the market determines price PE and quantity QE at
equilibrium. Consumer surplus, or the area under the demand curve and above PE, is equal to areas
A + B. Producer surplus, the area under PE and above the supply curve, is equal to areas C + D +
E. Consumer plus producer surplus is maximum and is equal to A+B+C+D+E
Also MB = MC and there is Allocative Efficiency.

If a price ceiling, P, is imposed, only the quantity Q1 is produced and consumed. Consumer surplus
is now the area under the demand curve and above P, but only up to Q1, since that is all that is
consumed. Therefore, consumer surplus becomes A + C. Producer surplus is the area above the
supply curve and below P, also only up to Q1 since that is all that is produced.

Producer surplus therefore falls to area e. Total social surplus after the subsidy is A + C + E.
Comparing with total social surplus before the subsidy, we see that the shaded areas b and d have
been lost and represent welfare loss (deadweight loss), or lost social benefits due to the price ceiling.
Welfare loss represents benefits that are lost to society because of resource misallocation.
We can see there is Allocative inefficiency also because MB > MC at the point of production, Qs:
the benefit consumers receive from the last unit of the good they buy is greater than the marginal
cost of producing it. Therefore, society is not getting enough of the good, as there is an under
allocation of resources to its production.
ii. Consequences for various stakeholders

Question - Discus the consenquences of imposing a price ceiling in the stakeholders in a market
including consumers, producers and the government.
Consumers - Consumers partly gain and partly lose. They lose area b but gain area c from
producers on the diagram above. Those consumers who are able to buy the good at the lower
price are better off. However, some consumers remain unsatisfied as at the ceiling price there is
not enough of the good to satisfy all demanders.
Producers - Producers are worse off, because with the price ceiling they sell a smaller quantity
of the good at a lower price; therefore, their revenues drop from Pe × Qe to Pc × Qs. This is
clear also from their loss of some producer surplus, area c, (which is transferred to consumers),
as well as area d (welfare loss) in the diagram above.
Workers - The fall in output (from QE to Q1 on the diagram above) means that some workers
are likely to be fired, resulting in unemployment; clearly these workers will be worse off.
Government - There will be no gains or losses for the government budget, yet the government
may gain in political popularity among the consumers who are better off due to the price ceiling.
iii. Rationing - Government may have to apportion the quantity supplied of OQ1 among buyers who
want to consume a greater amount of OQ3. This may be done through the issue of coupons which
must be surrendered together with cash, to obtain the good.
iv. Queuing - Whenever the good is available people will form long queues for it. The queues may be
physical lines of people outside suppliers‘ shops typically in the case of essential commodities like
drugs, bread, milk, etc. or tall waiting lists in the case of consumer durables such as cars, television
sets, government flats/houses, etc.
v. Black market - Black or parallel markets in which the good will be illegally sold and bought will
spring up. In these illegal markets the price at which the good will be sold will even be higher than
the equilibrium price
vi. Selling at sellers preferences - Sellers may choose several ways to sell the good – first-come, first-
served, selling to relatives and friends first, etc.
vii. Random allocation - This is selling by luck or chance. This may defeat the aim of setting the
maximum price to ensure that the poor as well as the rich get the good. Selling may go to all rich, or
all poor.

viii. Under allocation of resources to the good and Allocative efficiency - Since a lower than
equilibrium price results in a smaller quantity supplied than the amount determined at the free market
equilibrium, there are too few resources allocated to the production of the good, resulting in
underproduction relative to the social optimum (or ‗best‘). Society is worse off due to under
allocation of resources and Allocative inefficiency.
Government may solve the various problems caused by maximum price control by accompanying it
with certain other policies such as:
i. The government coming out with policies to reduce consumption of the good. Policies that will
discourage consumption may include:
 Reducing income levels through increased direct taxes when good is a normal good.
 Finding cheaper substitutes for the good.
 Creating impression that the price of the good would be reduced further in future to enhance
consumer expectations of a further price cut so that they demand less now.
ii. Government may also adopt economic policies that would increase supply of the good. Such supply
management policies may include:
 Government subsidizing the cost of producing the good.
 Creating investment incentives to attract new firms to supply more of the good.
 Importing more of the good from cheaper sources to augment domestic supply.

Minimum Price Control (Price Floor)
An effective minimum price or price floor is a legal price set above the equilibrium market price. One can
buy at or above the minimum price but cannot buy at a price below it. It is set to protect incomes of producers
when the equilibrium market price for a product is found to be unfairly low. Governments use legislation to
enforce minimum prices for:
 Demerit goods such as tobacco products and alcohol

 Wages in certain occupations, usually low skilled, to avoid exploitation by employers
 Certain types of imported goods where domestically produced close substitutes are available.
 Agricultural products to protect the incomes of farmers and labour.
When a minimum price is set for a good it reduces quantity demanded while quantity supplied increase
thereby resulting in persistent excess supply or surplus of the good.
Minimum Price
Price
S
Excess
Supply
P
PE
Q1 QE Q2 Quantity
The diagram above indicates that at the minimum price, suppliers are willing to supply considerably more
products than are demanded by consumers. As price cannot fall, supply is restricted to Q1 – this is all
consumers can afford to buy. A lower quantity is traded than would have occurred at the equilibrium price.

The persistent surplus created by price floor will in turn pose the following problems to producers of the
good:
 It brings about a lot of frustrated sellers wishing to dispose off surplus supplies.
 The sellers out of frustration, undercuts the legal minimum price and sell below equilibrium market
price.
 The sellers will allocate quotas among themselves
 There will be buyers’ preferences as they choose whom to buy from.
 It brings about conditional sales. The good with surplus may be sold with others that are in shortage.
To make minimum price control policies achieve their aim certain policies should be adopted by the
government concurrently:
 Government may increase incomes of consumers so that they can buy more if the commodity is a
normal good, and/or increase consumption of the commodity through advertisements and other sales
promotions.
 The government enters the market after setting the price floor to buy the surpluses, store and sell
from its own stock piles during times of shortage.
 Financial institutions may make funds available for private individuals to buy and store the surpluses
and sell them during lean season.
 The surpluses could be exported to needy countries. The government could promote such exports by
creating incentives for exports.

Elasticity of Supply
Price elasticity of supply (PES) is the relationship between the proportionate change in quantity supplied due
to a proportionate change in price.
PES is the responsiveness of quantity supplied to a change in price.

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝑺𝒖𝒑𝒑𝒍𝒊𝒆𝒅
𝑷𝑬𝑺 =
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑷𝒓𝒊𝒄𝒆
PES is positive since the supply curve slopes upwards from left to right
Where PES is >1 → supply is elastic
Where PES is <1 →supply is inelastic
Where PES is = 1 → supply has unitary elasticity
Where PES is = 0 → supply is perfectly inelastic
Where PES is = ∞ → supply is perfectly elastic
Diagrammatically
Price Elasticity of Supply
Price S1
S2
S3
Quantity
S1 - Supply is inelastic
% Δ in quantity supplied < % ΔP. The supply curve is steep.
S2 - Elasticity of supply is unity
% Δ in Quantity supplied = % Δ P. The supply curve passes through the origin

S3 - Supply is elastic
% Δ Quantity supplied > %ΔP, the supply curve is gentle or almost flat.
A perfectly inelastic supply curve.
Perfectly Price Inelastic Supply
Price S
PES = 0
Quantity
PES = 0. A change in price has no effect on quantity supplied. The supply curve is vertical in shape.
A perfectly elastic supply curve.
Perfectly Elastic Supply Curve
Price
PES = ∞
Quantity

Producers will supply any amount at the ruling price. PES = ∞. The supply curve is horizontal
Numerical
Terminology Description
Values
Whatever the percentage change in price
0 Perfectly Inelastic Supply
no change in quantity supplied.
A given percentage change in price leads
0 < PES < 1 Relatively Inelastic Supply to a smaller percentage change in quantity
supplied.
1 Unit Elastic Supply to exactly the same percentage change in
quantity supplied.
1< PES < ∞ Relatively Elastic Supply to a larger percentage change in quantity
supplied.
An infinitely small percentage change in
∞ (Infinity) Perfectly Elastic Supply price leads to an infinitely large percentage
change in quantity supplied.
Time Period and Elasticity of Supply

PES increases with time as producers have a longer period to adjust to changes in demand. Alfred Marshal
maintained that there are 3 periods of supply.
1. The Momentary Period

This is a period of time during which supply is restricted to the quantities actually available to the market.
Supply is fixed (i.e. perfectly inelastic). Normally this period will be a very short one. In the case of
perishable goods e.g. fruits, vegetables, fish, supply for the day in local markets is limited to quantities
delivered in the morning. SUPPLY IS PERFECTLY INELASTIC IN THE MOMENTARY
PERIOD.
2. The Short Run Period

This is the interval which must elapse before more can be supplied with the existing capacity. The SR
period is the period of time which allows for changes to take place in the quantities of the variable factors
employed e.g. labour. Other factors of production are fixed. Changes in supply in this period are shown
as movements along the normal supply curve. SUPPLY IS INELASTIC IN THE SHORT RUN

Price Elasticity of Supply & the Long Run
Price S-Monetary
S - Short Run
S - Long Run
S - Very Long Run
Quantity
3. The Long Run Period
In the LR all factors of production are variable and firms may enter or leave the industry. This is a period
long enough for fundamental changes to take place in the scale of industry. SUPPLY IS ELASTIC IN
THE LONG RUN
Determinants of Price Elasticity of Supply

1) Time period– PES increases with time i.e. from momentary to short run and finally long run period of
time. Supply changes from being perfectly inelastic to inelastic, then elastic and finally perfectly elastic.
2) Factor immobility – i.e. the easiness with which factors of production can be moved from one use to
another will affect PES. The high factor mobility, the greater will be elasticity.
3) Natural constraints restrict supply e.g. droughts, earthquakes, floods, cyclones. Supply becomes inelastic.
4) Risk Taking – The more willing entrepreneurs are to take risks, the greater will be the PES (supply
becomes elastic)
5) Where an industry is operating below capacity and there are unemployed resources supply will be elastic.
6) Where suppliers are holding large stocks supply will be elastic. An increase in demand can bemet by
running down stocks.
7) In a situation of full employment the supply of most goods and services will be inelastic.
Application of Elasticity Concepts - Incidence of Indirect Taxes and Subsidies

The concept of elasticity is important in determining who pays (consumer and/or producer and what %) when
the government imposes an indirect tax on a good/service; and who benefits (consumer and/or producer and
what %) when a good/service is subsidized.
Imposition of an indirect tax or and subsidies affect three areas:

 Incidence of tax - who pays the indirect tax, the buyer or the seller or both.
 Revenue - how much tax revenue a government will raise or how much a subsidy will cost the
government.
 Resource allocation - to what extent the behaviour of buyers are affected by a tax or a subsidy.
Types of Taxes
 Direct tax is a tax upon income. Income includes wages, rent, interest and profits.
 Indirect tax is a tax on goods or services. It is taken indirectly from income when spending occurs.
Types of Indirect Taxes
 A specific or flat rate tax is when a specific amount is imposed upon a good/service e.g. $1 per litre
of whisky.
 A percentage or ad valorem tax (VAT) is when the tax is a percentage of the selling price e.g. a
sales tax of 10% of the selling price of the good/service.
Effect of imposing a flat rate tax

The tax is collected by the seller for the government. However, not all the amount of the tax will necessarily
be passed on to the consumer. The supply curve for the good or service will shift upwards by the amount of
the tax. However, because the demand curve is not vertical but sloping, then the price rises by less than by
the full amount of the tax as illustrated below:
Effects of Tax on Supply & Equilibrium
Price S1
Vertical Distance is
P2
the amount of tax
P1
Q2 Q1 Quantity
Effect on:

1. Incidence – payment of the tax is shared between buyers and sellers. The price rise is not the same as
the tax, which means the full amount of the tax is not paid by the consumer, therefore some must be paid
by the producer. The only situation where the consumer pays the full amount is when there is perfectly
inelastic demand.
2. Government revenue – the government will receive the full amount of the tax. The government‘s
revenue is equal to the amount of the tax multiplied by the quantity sold.
3. Resource allocation – there are fewer resources allocated to the production of this good. The quantity
demanded and the quantity supplied of the good will both have fallen (0Q1 to 0Q2). There may be a loss
of satisfaction to both consumers and producers. The government may wish to reduce the demand for
harmful goods (e.g. cigarettes) by imposing an indirect tax.
Taxation and Elasticity

The PED and PES are what determines the:
 The incidence of the tax.

 The revenue a government receives from a particular tax.
 The effect upon resource allocation.
Example 1: Perfectly Inelastic Demand
Perfectly Inelastic Demand
Price D S1
B
P2
P1 A
Q1 Quantity

Example 2: Perfectly Elastic Demand
Perfectly Elastic Demand
Price S1
B
P1 D
T A
Q1 Quantity
1. Incidence:
Diagram (1): 100% on consumer.
Diagram (2): 100% on producer.
2. Government Revenue:
Diagram (1): area P1abP2; there has been no fall in quantity bought.
Diagram (2) area tabP1, 2 is small; there has been large fall in quantity sold.
3. Resource Allocation:
Diagram (1): unaffected. Same quantity bought and produced.
Diagram (2): significantly affected. Major decline in production, from 0Q1 to 0Q2.

Example 3: Perfect Inelastic Supply
Perfectly Inelastic Supply
Price S
B
P1
T A
Q1 Quantity
Example 4: Perfectly Elastic Supply
Perfectly Elastic Supply
Price
A
P2 S2
P1 S1
B
Q2 Q1 Quantity

1. Incidence:
Diagram (a): 100% on producer.
Diagram (b): 100% on consumer.
2. Government Revenue:
Diagram (a): area tabp1 is relatively large; there is no fall in quantity.
Diagram (b) area p1abp2 is relatively small.
3. Resource Allocation:
Diagram (a): no change. Quantity sold remains the same.
Diagram (b): this is likely to change considerably.
Ad Valorem or Percentage Taxes

A percentage or Ad Valorem tax is when the tax is a percentage of the selling price e.g. a sales tax of 10%
of the selling price of the good/service. This is when a tax is applied as a percentage, the supply schedule
and curve will move up proportionately at each price. Means the amount of tax paid will be higher at higher
prices.
Effects of Tax on Supply & Equilibrium
S1
Price
P2
P1
Q2 Q1 Quantity
The supply curve will move away from the original supply curve as the quantity supplied increases.

Subsidies on Goods and Services

Subsidies are money paid to producers by the government. Whether producers share the subsidy with
consumers will depend on PED and PES Curves. Subsidies have the opposite effect to a tax.
A subsidy shifts the supply curve down by the amount of the subsidy.
Effects of Subsidy on Supply & Equilibrium
Price S1
S2
Vertical Distance is the

P1
amount of Subsidy
P2
Q1 Q2 Quantity
Effects of a Subsidy
1. Given the PED and PES Curves drawn above, the subsidy will be shared between the producer and the
consumer. The full amount of the subsidy is a vertical distance between the two supply curves. This is
more than the fall in price.
2. It costs the government the amount of the subsidy multiplied by the quantity produced.
3. Resource allocation has changed; an extra amount is consumed and produced (0Q1 to 0Q2).

Summary
Three issues emerge when an indirect tax is imposed:
1. Incidence of the tax – who pay the tax, producers or consumers.

2. Government expenditure – what is the total revenue to the government.
3. Resource allocation – how is consumption and production of the good/service affected.
Three issues emerge when a subsidy is given:
 Incidence of the subsidy – who benefits from the subsidy, producers or consumers.
 Government expenditure – what is the total cost to the government.
 Resource allocation – how is consumption and production of the good/service affected.

The Theory of
Consumer Behavior
 Introduction
 Cardinal Utility
 Diminishing Marginal Utility
 Ordinal Utility
 Indifference Curve Approach
 Budget Line
 Consumer Equilibrium
 Income & Substitution Effect

Introduction
Utility is the level of happiness or satisfaction that a person receives from consumption of a good or
service. Utility can be considered in terms of cardinal utility and ordinal utility.
Measurement of Utility -There are two approaches for measurement of utility.
Measurement of Utility
Cardinal Utility Ordinal Utility
Cardinal Utility
It is the concept of utility which is based on the idea of a consumer quantifying the utility he derives
from consuming a particular commodity. In the 19th Century, many economists among them Alfred
Marshal believed that it was possible for utility to be quantified/measured in cardinal numbers as
opposed to ordinal numbers – these economists are termed cardinalists. A cardinal measure of utility
implies that we can quantify how much more utility one unit of a good gives to a person than the next.
Assumptions of the cardinalists approach
1. Rationality - Consumers are assumed to be rational/sensible decision makers which mean they
weigh the costs and benefits of each decision they make. Rational decision involves the
consumer choosing those items that give him the best value for his money i.e. the greatest benefit
relative to cost or where they derive maximum utility.
2. Cardinal utility - Cardinal utility refers to the fact that the utility can be measured in monetary
units. The monetary unit is conceptualized in terms of the amount a consumer is prepared to pay
for another unit of the commodity.

3. Constant Marginal Utility of money - The measurement rod is a monetary unit and the
marginal utility of money must not change as income changes, otherwise the measurement will
be useless. This implies that for a rational consumer to purchase an extra unit of a commodity,
his expected satisfaction from the consumption of the extra unit must be greater than the utility
of money which he must spend in order to obtain it. The maximum sum of money that a consumer
is willing to spend in order to acquire an extra unit of a good can – serve as an indication of the
amount of utility that he expects to realize from the consumption of that unit. Therefore, whether
there is an increase or a decrease in the income of a consumer, the marginal utility of money
must remain the same.
4. Diminishing Marginal Utility - The marginal utility derived from a commodity diminishes as
its consumption increases. This means that the more a particular good is consumed, the less the
additional satisfaction derived.
5. Consumers possess perfect knowledge of the price in the market.
6. The choices of the goods are certain in the market.
7. The prices of various commodities are not influence by variations in their supply.
8. There are no substitutes and that the utilities are measurable in terms of money.
9. A consumer does not buy a commodity simply because its price is very low or very high.
10. The units of the commodity must be appropriate.
11. The tastes of consumer do not change.
12. Utility of different commodities are independent of each other.
Total utility is the overall satisfaction that an individual get from the consumption of all units of a good
or service over a given period of time.
Marginal utility is the additional satisfaction derived from the consumption of one more unit of a
particular good or service. Consumers are rational because they want to maximize satisfaction. Rational
consumers would not consume a product when the marginal utility falls to zero.
The law of diminishing marginal utility

The law states that “other things being equal, as more and more units of a commodity are consumed, the
additional satisfaction or utility derived from the consumption of each successive unit will fall or
decrease”, as illustrated in the table.

Quantity of product X
Total Utility (Utils Per Week) Marginal Utility (MU)
Consumed per Week
0 0
1 30 30
2 46 16
3 56 10
4 60 4
5 55 -5
6 45 -10
The marginal utility decline as each successive unit is consumed. If a consumer goes on consuming
more and more units, eventually total utility actually decreases so that marginal utility becomes negative.
Negative utility is referred to as disutility or dissatisfaction.
Logical consumers would not consume a product when marginal utility falls to zero, the marginal utility
curve in practice would be downward sloping from left to right like the one below. This curve may look
familiar. It is the basis of the demand curve. Indeed people‘s demand curve for a product is the same as
their marginal utility curve for that product measured in money terms. Whilst utility is a subjective
matter, and is so difficult to measure, it can be estimated. One way of doing this is to look at what a
person is prepared to sacrifice in order to obtain a commodity. Price measures the sacrifice in the sense
that it indicates what other things might have been obtained with the money. Since marginal utility
diminishes; consumers will be tempted to buy more of a good only if its price is lowered. By assuming
that the sacrifices a person is prepared to make in order to obtain something gives an indication of the
utility derived from that good, it is possible to obtain the demand curve. Different individuals will derive
different levels of satisfaction, and so will have different demand curves. Therefore the market demand
curve is the horizontal summation of the individual demand curves at different prices.

Total Utility and Marginal Utility
Total
Utility 60
Total Utility
40
Curve
20
1 2 3 4 5 6 Quantity of Good X
Consumed per week
Marginal
Utility
(Utils)
30 Marginal
Utility Curve
20
10
Quantity of Good X
1 2 3 4 5 6
Consumed per week
The figure illustrates total and marginal utility. As the consumption of product x rises, as seen in (a),
then the total satisfaction (utility) obtained by the individual rises up to a certain point. Marginal utility
(b) relates to the extra satisfaction obtained from consuming one extra unit of the product over a given
period of time. The figure illustrates diminishing marginal utility.

Factors affecting the Law of Diminishing Marginal Utility

 The time period over which decisions are made e.g. a person who has not had a meal/ food for several
hours will place a high value on food than a person who has just had a meal or is full (therefore he
will not place any value or will place very low value on food).
 Addiction e.g. smokers may find that the more they smoke the more they want to smoke – they will
always place very high value on cigarettes
 The level of consumer‘s income.
 The price level of goods or services.
 The type of good e.g. inferior goods versus normal goods.
 Trends in fashion i.e. if in fashion consumers derive more additional utility.
 Advertising i.e. informative, persuasive and generic
The whole satisfaction derived from a basket of goods is a function of how many goods there are in the
basket e.g. if there are unknown (n) goods in a basket i.e.𝑿𝟏 , 𝑿𝟐 , 𝑿𝟑 , 𝑿𝟒 , 𝑿𝟓 , . . . , 𝑿𝒏 , The total utility
derived would be:
𝑻𝑼 = 𝑭(𝑿𝟏 , 𝑿𝟐 , 𝑿𝟑 , 𝑿𝟒 , 𝑿𝟓 , . . . , 𝑿𝒏 )
With the above assumption, if a consumer consumes the above set of goods, then total utility/satisfaction
derived will be:
𝑻𝑼 = 𝑻𝑼𝟏(𝑿𝟏 ) + 𝑻𝑼𝟐(𝑿𝟐 ) + 𝑻𝑼𝟑(𝑿𝟑 ) + 𝑻𝑼𝟒(𝑿𝟒 ) + 𝑻𝑼𝟓(𝑿𝟓 ) + . . . + 𝑻𝑼𝒏(𝑿𝒏 )
Or
𝑼 = 𝑼𝟏(𝑿𝟏 ) + 𝑼𝟐(𝑿𝟐 ) + 𝑼𝟑(𝑿𝟑 ) + 𝑼𝟒(𝑿𝟒 ) + 𝑼𝟓(𝑿𝟓 ) + . . . + 𝑼𝒏(𝑿𝒏 )
Equilibrium of the consumer under the cardinalist approach/method

The “consumer equilibrium” is the consumption bundle where total utility is a maximum. In considering
the consumer equilibrium a number of assumptions are made, namely that the individual:
 Has a limited income;

 Acts in a rational manner; and
 Aims to maximize his or her total utility subject to the income constraint.
The individual consumer is said to be in equilibrium when it is not possible to switch a single dollar
worth of expenditure from product x to product y and obtain an increase in total utility, given the
individual‘s income level and the prices that he or she faces. This occurs when the ratio of marginal
utility to price is equal for all the products consumed.
In other words when:
𝑴𝑼𝒙 = 𝑷𝒙

If 𝑴𝑼𝒙 > 𝑷𝒙 the consumer should buy more of X to derive additional satisfaction. If 𝑴𝑼𝒙 < 𝑷𝒙
the consumer should reduce the consumption of X to increase satisfaction.
𝑴𝑼𝒙 = 𝑷𝒙 is the point of consumer equilibrium, though it is very difficult to attain but at this point the
consumer achieves maximum utility.
The above analysis is basically for only one commodity. When a consumer consumes more than one
good e.g good X, good Y and good N, the consumer will obtain his equilibrium when there is equality
between the ratios of the marginal utility of each good to its price.
𝑴𝑼𝑿 𝑴𝑼𝒀 𝑴𝑼𝒁
= =
𝑷𝑿 𝑷𝒀 𝑷𝒁
This is referred to as the Equi-marginal Principle.
A change in the price of any of the goods will cause a change in a person‘s spending patterns. From the
𝑴𝑼𝑿
above principle, the value of the expression will now fall as the price of x is increased so the 𝑴𝑼𝒙
𝑷𝑿
per dollar spent will now be less than any other good. The consumer will therefore increase TU by
spending less on good X and more on all other goods. In other words the consumer only maximizes TU
by buying less of good X. The conclusion is that the demand curve is downward sloping.
Example of how the equilibrium is established

Suppose there are two commodity X and Y. Price of Good X = $2 per unit and Price of Good Y = $3per
unit. Consumers money income = $24. Marginal utility of X and Y are given in the table below.
Units Marginal Utility of X Marginal Utility of X

1 20 24
2 18 21
3 16 18
4 14 15
5 12 12
6 10 9
In order to maximize his satisfaction the consumer will not equate marginal utility of “X” with the
marginal utility of y because prices of these two goods are different. He will equate (per $ MuX) with
(per $ MuY). So, reconstructing the above table by dividing marginal utilities (MuX) of X by $2 and
marginal utilities (MuY) of Y by $3, we get the table below. Table marginal utility of money
expenditure.

𝑴𝑼𝑿 𝑴𝑼𝒀
Units
𝑷𝑿 𝑷𝒀
1 10 8
2 9 7
3 8 6
4 7 5
5 6 4
6 5 3
In order to have maximum utility consumer will purchase 6 units of x any 4 units of y because it satisfies the
following two conditions required for consumers equilibrium.
𝑀𝑈𝑥 10
𝐴𝑡 6 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑋 = = =5
𝑃𝑥 2
𝑀𝑈𝑌 15
𝐴𝑡 4 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑌 = = =5
𝑃𝑌 3
𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑋 𝑎𝑛𝑑 𝑌 = 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 = (𝑄𝑋 × 𝑃𝑋 ) + (𝑄𝑌 × 𝑃𝑌 ) = (6 × 2) + (4 × 3) = $24
Therefore for the consumer to arrive at the equilibrium he should take 6 units of Good X and 4 units of Good
Y. At this level of consumption the consumer enjoys maximum level of satisfaction.
Criticisms of the Cardinalists Approach

Even though the multi-commodity version of marginal utility theory is useful in helping/demonstrating the
underlying logic of consumer choice, it still has major weaknesses:
1. Utility is Subjective:
Utility is a subjective concept. It relates to man's psychology. It is not possible to be objective about it.
But the analysis of consumer's demand is objective.
2. Marginal Utility cannot be estimated for all Commodities:

Utility analysis is based on the concept of marginal utility. Marginal utility of only those commodities
can be measured which are divisible But division of some commodities T.V set, refrigerator, etc.,is not
possible.
3. Marginal utility of money does not remain constant:

The other assumption of utility analysis is that marginal utility of money remains constant. This
assumption is also not realistic. As the quantity of money with a person increases, its marginal utility
diminishes and as his quantity of money decreases, its marginal utility increases.

4. Consumer is regarded as Computer:

It considers consumer as a computer. According to this analysis, while spending his money, a consumer
always compares the amount of gain he will have by way of utility of the commodity purchased with the
loss that he will have to suffer by way of sacrifice of the money spent. But in real life none of consumer
is so calculating.
5. Does not explain Giffen Paradox:

Cardinal utility analysis does not explain Giffen paradox. It has no answer to explain as to why the
demand curve of many inferior goods slopes upwards (positive slope) from left to right. In other words,
why does demand extend with rise in price and why does demand contract with fall in price.
6. Cardinal Measurement of Utility is not possible:

Utility cannot be measured in cardinal numbers like 1,2,3,4, etc. As such, utility derived from different
quantities of the goods can neither be added nor subtracted Marshall sought to measure marginal utility
indirectly in terms of money. But According to Pigou, it is not possible to measure marginal utility
indirectly in terms of money, because money can, at the best, measure the intensity of demand for a good.
It cannot measure the actual satisfaction.
7. Every Commodity is not an independent commodity:
The analysis is based on the assumption that every commodity is an independent commodity. In real life,
utility of a commodity is very much dependent upon the utility of other commodities. No commodity is
an independent commodity. Consumer's behaviour cannot therefore be precisely measured through
utility analysis.
8. Theories based on utility place a great emphasis upon rationality and search for utility maximization but
many decisions made by people lack rational behavior.
9. Those who work in advertising i.e. persuasive and informative advertising are well aware that it is often
the emotional content of a product that is more important that the rational.
Ordinal Utility
It is the concept of utility which is based on the idea of preference ordering and ranking rather than the
concept of measurable utility. It is assumed that a consumer is capable of comparing any 2 alternative bundles
of goods and deciding whether he prefers one bundle to the other or is indifferent between them. Several
assumptions are made about the nature of this preference ordering which lead to the conclusion that all
possible bundles of goods can be grouped into sets in such a way that the consumer is indifferent between
all bundles in one set and not indifferent between sets. These indifferent sets can be arranged in increasing
order of preference. It is often convenient though not necessary to assign numbers to these sets adopting the
convention that the higher a set is in order of preference the higher its number should be.

The indifference curves (ordinal) Approach

An indifference curve is a curve that describes a combination of two goods that yield the same level of
satisfaction or utility to the consumer. It shows the various sets of goods that make a consumer indifferent
to the satisfaction derived from consuming them. Based on the same utility derived from various baskets of
goods, it becomes uneasy for a consumer to choose a particular basket of goods because utilities derived
from a series of combinations to another are indifferent.
Assumptions of Indifference Curves

 Rationality – the consumer always aims to maximize satisfaction from goods consumed.
 Ordinal Utility (assumption of completeness) - It is axiomatically believed that the consumer can
rank his preferences in accordance with the utility derived from various baskets of goods, utility
measurements can only be handled using the ordinal method and not the cardinal method. The total
satisfaction derived by a consumer is a function of the total quantity of commodities consumed i.e.
𝑻𝑼 = 𝑭(𝑸𝟏 , 𝑸𝟐 , 𝑸𝟑 , 𝑸𝟒 , . . . 𝑸𝟏 )
 Non satiety - consumers always prefer more to less. They will never reach the point of satiety ie the
maximum level of satisfaction.
 Consistency and transitivity of choice - Since we assume that a consumer is rational, his choice of
goods has to be consistent. When he chooses a particular point in time, he is not expected to choose
B over A in another time A>B, then A must be preferred to B. Similarly if A>B>C – A>C. Meaning
that if a consumer preferred bundle A to bundle B and bundle B to C, then bundle A must be preferred
to bundle C.
 There must be two baskets of goods for the analysis to be complete. The indifference curve analysis
will not be complete if the bundles are used in isolation of the other basket.
Properties/Characteristics of Indifference Curves

1. Negative Slope - An indifference curve slopes down from left to right. This means that the consumption
of the 2 goods along the indifference curve is negatively related to each other i.e. if the quantity of one
commodity (Y) consumed decreases the quantity of the other (X) must increase in order to maintain the
same level of satisfaction.

Indifference Curve
Good
Y
IC
Good X
2. Non Intersection - Indifference curves must not intersect. If the 2 curves intersect, the point at which
the intersection occurs will represent 2 different levels of satisfaction, thereby violating the consistency
assumption.
Crossing Indifference Curves
Good
S
Y
B
F IC 1
IC 2
Good X

In the above diagram, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the consumer because both lie on
the same indifference curve IC2. Similarly the combinations shows by points B and E on indifference
curve IC1 give equal satisfaction top the consumer. If combination F is equal to combination B in terms
of satisfaction and combination E is equal to combination B in satisfaction. It follows that the
combination F will be equivalent to E in terms of satisfaction. This conclusion looks quite funny because
combination F on IC2 contains more of good Y (wheat) than combination which gives more satisfaction
to the consumer. We, therefore, conclude that indifference curves cannot cut each other.
3. Convexity - The indifference curve is convex to the origin. This means that the curve is inwardly curved
from left downwards to the right signifying diminishing marginal rate of substitution (DMRS).
Convexity of an Indifference Curve
Good
Y ∆Y
∆X B
P
∆Y
C
Q ∆X
∆Y
D
R ∆X
IC
Good X
In the above diagram, as the consumer moves from A to B to C to D, the willingness to substitute
good X for good Y diminishes. The slope of IC is negative. In the above diagram, diminishing
MRSxy is depicted as the consumer is giving AP>BQ>CR units of Y for PB=QC=RD units of X.
Thus indifference curve is steeper towards the Y axis and gradual towards the X axis. It is convex to
the origin. If the indifference curve is concave, MRSxy increases. It violets the fundamental feature
of consumer behaviour. If commodities are almost perfect substitutes then MRSxy remains constant.
In such cases the indifference curve is a straight line at an angle of45 degree with either axis. If two
commodities are perfect complements, the indifference curve will have a right angle. In reality,

commodities are not perfect substitutes or perfect complements to each other. Therefore MRSxy
usually diminishes.
4. Higher Indifference Curve Represents Higher Level of Satisfaction: Indifference curve that lies
above and to the right of another indifference curve represents a higher level of satisfaction. The
combination of goods which lies on a higher indifference curve will be preferred by a consumer to
the combination which lies on a lower indifference curve.
The Indifference Map is a conglomeration of indifference curves. A higher curve than another one
signifies a higher level of satisfaction. The indifference map shows various indifference curves that
stand for different levels of satisfaction. It should be noted that bundles or basket of goods found on
the same indifference curve produce the same level of satisfaction. An indifference map ranks the
preferences of the consumer. The higher the indifference curve or the farther away from the origin it
is, the more preferable it is to a rational consumer. On the other hand, the lower the indifference
curve, or the closer the curve is to the origin, the less preferable it is.
An Indifference Map
Good
Y
IC 3
IC 2
IC 1
Good X
From the diagram IC3 > IC2 and IC2 > IC1.Though the level of satisfaction might not be determined,
the utility associated with I1 is less than that attached to IC2 and satisfaction attached to I2 is less
than that of IC3. Given that consumers are rational most purchases of goods and services will like to
consume along the highest indifference curve i.e. IC3.

5. Diminishing Marginal Rate of Substitution (DMRS) - The technical term for the negative slope of
an indifference curve is marginal rate of substitution (MRS). The MRS is the amount of one good a
consumer is ready to sacrifice in order to obtain an additional unit of another good. The act of
increasing and decreasing the commodities eg good X and Y i.e. the willingness to give up one good
for the other along the indifference curve is called Diminishing Marginal Rate of Substitution. The
slope of the indifference curve = MRS = MUx/ MUy
The Budget Constraint / Budget Line
A budget line shows combinations of two products which can be purchased with a given level of income.
 The budget line slope shows the relative prices of the two goods i.e. Px/ Py
 A consumer‘s ability to purchase goods and services is limited by his level of income and the prices
of goods and services.
 A budget constraint/budget line or consumption possibilities curve measures the relative scarcity
between two goods.
 The line shows the combination of goods a consumer can purchase given his/her income at market
prices.
 It also classifies attainable and unattainable regions.
 The budget constraint in the case of two goods x and y is formulated as follows:
𝑰 = 𝑷𝑿 𝑸𝑿 + 𝑷𝒀 𝑸𝒀
Where: 𝑰 is the consumer‘s income
𝑷𝑿 is the price of the good x
𝑸𝑿 is the quantity of the good x
𝑷𝒀 is the price of the good y
𝑸𝒀 is the quantity of the good y
For Example - A budget of $100 and prices for y of $2 per unit and for x of $5 per unit.
Option Good Y ($2) Good X ($5)

1 50 0
2 0 20

Budget Line
Good
Y
50
C
U
20 Good X
The consumer can attain or consume any combination along the budget line e.g. C i.e. consumes all income.
Inside the budget line e.g. U i.e. consumer doesn‘t exhaust all the income – points along the budget line are
attainable and points outside the budget line e.g. W is not attainable i.e. they are beyond the consumer‘s
income. A budget line measures Marginal Rate of Transformation (MRT).
Shifts in the Budget Line

An increase or decrease in the level of the consumer’s income will result in an outward shift of the budget
line. Changes in prices affect the level of real income, if prices decreases real income increases and the
budget line shifts outwards. The reverse is true for increase in prices.eg if prices decrease by 50%, the effect
will be as follows.

Shifting of the Budget Line

Good
Y
100
50
20 40 Good X
Changes in prices of one good results in the slide of the budget line showing that any combination less or
more of a product will be purchased. For example if price of Good X decrease by 50% the effect will be as
follows:
Slide of the Budget Line
Good
Y
50
20 40 Good X

If the price of the good increases or decreases the budget line will not shift. It will pivot inwards or
outwards depending on the circumstances.
The Consumer Equilibrium under Indifference Curves Analysis

Given the consumer income and the prices of goods or supplies in the market, the consumer maximizes
satisfaction at the point of equilibrium. Graphically it is the point where the budget line is tangential to
the highest possible indifference curve.
Conditions of consumer’s equilibrium
The conditions of consumer equilibrium where he would maximize his satisfaction is as follows:
 At equilibrium point budget line or price line should be tangent to indifferent curve.
 At equilibrium point slope of the indifference curve must be equal to the slope of budget line.
 At equilibrium point = (𝑷𝑿 𝑸𝑿 ) + (𝑷𝒀 𝑸𝒀 ) = 𝑰𝒏𝒄𝒐𝒎𝒆
Consumer Equilibrium
Good
Y Consumer
Equilibrium
A
E
QY IC 3
IC 2
B
IC 1
QX Good X
Indifference Analysis and Consumers equilibrium

Point E is the equilibrium point. The equilibrium quantities are QX and QY. The slope of the budget
line = Px/ Py (marginal rate of transformation for good x and y (MRT)) and the slope of the indifference
curve = MUx/ MUY (marginal rate of substitution for good x and y (MRS xy)) are equal at their point
of tangency. At this point marginal rate of substitution is equal to marginal rate of transformation and
satisfaction will be equal to income. At point A MRS > MRT and at B MRS < MRT.

Applications of Indifference Curves Analysis/Changes in Consumer Equilibrium

1. Effects of Changes in Income
A rise in the level of the consumer‘s income shifts from C to C1 to C2 as more of both x and y are
consumed. The line C, C1, C2 is income consumption line/curve (ICC/ICL) or the Engel curve (EC).
Income Consumption Curve (ICC)
Good
Y
P3
P2
ICC
P1
Q3
Q2
Q1
IC 3
IC 2
IC 1
Good X
An income consumption curve is the line that traces the different equilibrium points of the consumer
arising from changes in his income. If the increase in income leads to an increase in the quantity
demanded of a good then this is a normal good.

Engel Curve (EC) – Normal Goods
EC
Income
M3 T
500
M2 S
400
M1 R
300
Q1 Q2 Q3 Good X
In the diagram above increases in the level of income positively affected the level of quantity
consumed as shown on the Engel curve (EC). If the increment in income results in a reduction in
quantity purchased, the good is inferior as shown on the diagram below:
Engel Curve (EC) – Inferior Goods
EC
Income
M3
500
M2
400
M1
300
Q3 Q2 Q1 Good X

2. Effects of changes in prices

Changes in price of Good X, while that of Good Y remains fixed. As the price of Good X falls, the
budget line pivots outwards and the consumer equilibrium shifts from A to B to C. TSR is the price
consumption curve/line (PPC).
Consumer Equilibrium – Changes in Price of Good X
Quantity
Consumed
Good Y
T
Y1
S
Y2 R
PCL
Y3
IC 3
IC 2
B1 IC 1 B2 B3
X1 X2 X3 Quantity
Consumeed
Good X
A price consumption curve (PPC) is a line that traces or joins the new equilibrium points as a result
of continuous falling or increasing of the price of a commodity.
3. Derivation of the demand curve using the indifference curves approach.

Indifference curves can be used to show how an individual demand curve is derived.

Derivation of the Demand Curve
Quantity
Consumed
Good Y
PCL
IC 3
IC 2
B1 IC 1 B2 B3
X1 X2 X3 Quantity
Consumed Good X
P1
P2
P3
Demand
X1 X2 X3 Quantity of Good X
Distinguishing between income and substitution effects

Total Effect - Total price effect measures the impact on quantity of good as a result of changes in the
price of that commodity. The effect can be divided into two different components of substitution and
income effects.
Income and substitution effect for a normal good

A normal good is a good such that when the constraints income increases people buy more of the good.
On the diagram below B2 is the original budget line with the consumer in equilibrium at point A with
indifference curve IC1. If the price of product x falls this will lead to a pivot in the budget line to B3,

allowing the consumer to reach a higher indifference curve (IC2) and a new equilibrium of point C. The
result of this is that the quantity of product x bought has risen from X1 to X3.
Substitution and Income Effect
Quantity
Consumed
Good Y
B1
A
C
B
IC 2
IC 1
B2 B3
X1 X2 X3 Quantity
Consumeed
Good X
Substitution Income
Effect Effect
Given a budget line of B2 and an indifference curve of IC1 a consumer is in equilibrium at point A. The
price of product X falls, hence the budget line pivots to B3. The substitution effect involves a move from
point A to B, where the relative prices of products x and y have changed but real income has remained
constant. The income effect involves a move from B to C, where real income increases while relative
prices remain unchanged.
Income and substitution effect for an inferior good

When people‘s incomes increase, they will buy less of inferior goods e.g. public transport, second hand
clothing, poor foodstuffs etc. since they will now be able to afford better quality goods (and vice versa).
On the diagram below, if the price of product x falls it leads to a substitution effect towards the product,
i.e. a movement from A to B, with more being consumed (X1 to X2). However, the income effect is
negative, unlike that for a normal good, and this means a movement from B to C with less being
consumed, X2 to X3.

Although the income effect is negative, in this case it is not sufficient to outweigh the substitution effect,
which means that overall there is still more of the product demanded as the consumer has moved from
X1 to X3. In other words, the demand curve for product x is still downward sloping. It is possible,
however, for the negative income effect to be sufficiently large to outweigh the substitution effect.
Substitution and Income Effect
Quantity
Consumed
Good Y
C
B1 IC 2
A
B
IC 1
B3
B2
X1 X2 X3
Quantity
Consumeed
Good X
Substitution Income
Effect Effect
The figure relates to an inferior good with the income effect (represented by a move from B to C)
working in the opposite direction to the substitution effect (represented by a move from A to B)
following a fall in the price of product X. The substitution effect is greater than the income effect and
so the demand curve for the product is still downward sloping.
Critique of the Indifference Curves Approach

 In practice, it is virtually impossible to derive indifference curves since it would involve the
consumer having to imagine a whole series of different combinations of goods and deciding in each
case whether a given combination gave more, equal or less satisfaction than other combinations.
 Consumers may not behave ―rationally‖ and hence may not give careful consideration to the
satisfaction they believe they will gain from consuming goods. They may behave impetuously
(i.erashing or acting without considering) e.g impulsive buying.
 Consumers are not perfectly knowledgeable. Therefore the ―optimum consumption‖ point may not
in practice give consumers maximum satisfaction for their money.
 The belief that consumers are rational may be influenced by advertising.

 Indifference curves are based on the assumption that marginal increases in one good can be traded
off against marginal decreases in another. This will not be the case with consumer durables e.g. cars,
TVs, sofas. Houses etc. since they are purchased only now and again and then only one at a time.
Usefulness of Indifference Curves
 To demonstrate the logic of rational consumer choice.

 Derivation of individual‘s demand curve
 Income and substitution effects of a price change.
 Price consumption curve (PCC) and income consumption curve (ICC).

Theory of the Firm
 Introduction.
 Law of Diminishing Returns
 Economies of Scale
 Costs of Production
 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly

Introduction
A plant/establishment is a unit of production in an industry. It can be a factory, a shop, a farm, a hotel

or any economic unit that carries its own business at one geographical location. A firm is a unit of
ownership and control. A firm may consist of just one pant in which case it is referred to as single plant.
However many large firms are likely to comprise a number of plants – they are multiplant.
An industry is all firms concerned with a particular line of production or all firms producing similar
products e.g. automobile industry, tourist industry, mining industry and agricultural industry etc. Going
beyond the supply curve, we need to find how the rational producer (or firm) will behave.
We will be looking at the benefits and costs to the firm of producing various quantities of goods or
services and using various alternative methods of production.
Questions to answer:
 How much will be produced?

 What combinations of inputs will be used?
 How much profit will be made?
The traditional theory of supply or theory of the firm assumes that firms aim to maximize profits.
Rational Producer behavior is when a firm weighs up the costs and the benefits of alternative courses of
action and then seeks to maximize its net benefit
The Short Run (SR) Period of Production

It is the period of production when at least one factor of production is variable e.g. labour and the rest
are fixed (i.e. land, capital and entrepreneurship).
The Law of Diminishing Returns
Sometimes called The Law of variable proportions/The Law of Diminishing Marginal Productivity. The
law states that ― as we add successive units of the variable factor of production to fixed amounts of
other factors of production, the increments to total output or total product (TP) or total physical product
(TPP) will first increase and then decline. E.g. assume some particular crop is to be grown on a fixed
price of land say 2 acres. We shall assume also that the amount of capital to be used is also fixed. Labour
will be the only variable factor of production.

Total Physical Average Physical Marginal Physical

Number of workers
Product (TPP) Product (APP) Product (MPP)
0 0 - -
1 3 3 3
2 10 5 7
3 24 8 14
4 36 9 12
5 40 8 4
6 42 7 2
7 42 6 0
8 40 5 -2
Assumptions
1. Labour is the only variable factor of production.
2. All units of the variable factor of production are equally efficient.
3. There are no changes in the techniques of production.
Total Product (TP) or Total Physical Product (TPP) - It is the total output of a product per period of
time that is obtained from a given amount of inputs.
Average Product (AP) / Average Physical Product (APP) - It is output per worker. AP is also called
efficiency / productivity.
Marginal Product (MP) / Marginal Physical Product (MPP) - It describes changes in total output
brought about by varying employment by one person. MP = TP of n workers – TP of (n-1) workers.
Returns to the variable factor

Since labour is the only variable factor of production, changes in output are related directly to changes
in employment – we speak of changes in the productivity of labour i.e. returns to the variable factor of
production which is labour. Diagrammatically:

Returns to Variable Factor
40 TPP
30
TPP
20
10
1 2 3 4 5 6 7 8
14
12
APP 10
& 8
MPP 6
APP
4
2
1 2 3 4 5 6 7 8
-2
MPP
Increasing Returns (0 to 3 units of labor) - TP is increasing at an increasing rate. MP is increasing

Constant returns (not illustrated) - TP is increasing at a constant rate. MP is constant.
Diminishing Returns / Decreasing Returns (3 to 7 units of labour) - TP is increasing at a decreasing

rate. MP is falling.
Zero Returns (7 units) - Total product is constant. MP is zero.
Negative Returns (7 to 8 units of labor) - Total product is falling. MP is negative.

Diminishing returns set in because too many cooks spoil the meal. The law of diminishing returns deals
essentially with Short-run Period situations. It is assumed that some of the resources (factors of
production) used in the production process are fixed in supply.
Long-Run Production Period
Returns to Scale
The law of diminishing returns deals with essentially SR situations. It is assumed that some of the
resources used in production process are fixed in supply. In the LR period it is possible for a firm to
vary all factors of production employed. In the LR period it is possible for a firm to change the scale of
its activities.
Units of Land Total Output Increase in size

Units of Labour Increase in TPP
(Acres) (Tones) of Firm
4 20 100 100% 150%
8 40 250 50% 68%
12 60 420 33% 33%
16 80 560 25% 20%
20 100 672 22% 16%
24 120 780
It is a feature of production that when the scale of production is changed, output changes are usually
proportionate. When a firm doubles its size, output will change by more than 100% or less than 100%.
The relationship changes of production and changes in output are described as returns to scale.
Increasing Returns to Scale - Output increase more than proportionality e.g. as the firm increases its
size from 4 people / workers and 20 acres to 12 workers and 60 acres of land.
Constant Returns to Scale - Size of firm and output changes by the same % e.g. a change of scale from
12 people / workers and 60 acres to 16 workers and 80 acres.
Decreasing Returns to scale - Output increases less than proportionality e.g. a change of scale from 20
workers and 100 acres to 24 workers and 120 acres.
Those features of increasing size which account for increasing returns to scale are generally described
as economies of scale. The causes of falling efficiency as the size of the firm increase are described s
diseconomies of scale. In the LR period it is possible for a firm to change the scale of its activities. When
an increase in the scale of production results in a more than a proportionate increase in output, the firm
is said to be experiencing economies of scale (Increasing Returns to Scale). Economies of Scale are
the benefits which accrue to a firm as it grows in size or they are the advantages of expansion. They are

seen as the LRAC decrease or fall. Diseconomies of scale are the disadvantages of expansion
(Decreasing Returns to Scale). They are seen as the LRAC start to increase. Minimum Efficient Scale
(Constant Returns to Scale) is seen by the constant part of the LRAC.MES exist if the proportionate
change in scale of production is the same as the change in output. This can be illustrated by an envelope
curve.
Long-run Returns to Scale
SRAC1
AC LRAC
SRAC2
SRAC3 SRAC5
SRAC4
ECONOMIES DISECONOMIES
OF SCALE OF SCALE
Q1 Q2 Q3
The diagram illustrates the long run production of a firm. Firms always operate at the least part of the
average cost curve. This firm was currently operating at Q1 at the least point of SRAC2.Assuming that
demand of the firm‘s products increases and output Q2 is now demanded. If this firm decides to continue
operating in the short run (SRAC2) its costs increases. To avoid this increase in cost this firm should
alter all its factors of production and starts operating on SRAC3, producing the same output of Q2.This
firm can increase output until it reaches Q3.
Economies of Scale
Economies of Scale can be classified into 2 groups: Internal Economies of Scale or External
Economies of Scale.

Internal Economies of Scale

These are the benefits which accrue to a firm independent of what is happening to other firms / the
industry. They arise simply from the increase in the scale of production in the firm itself.
External Economies of Scale - These are the advantages in the form of lower C which a firm gains
from the growth of the industry. These economies are available to all firms in the industry independent
of changes in the scales of their individual outputs.
Internal Economies of Scale can be divided into plant economies and firm Economies of Scale.
Plant Economies of scale include:
 Increased specialization – concentration of firms in producing a good or service.

 Indivisibility – full utilization of massive machinery or highly qualified personnel.
 Increase in output doubling or trebling employment.
 Increased dimensions of factors of production – output increases
 Principle of multiples – full use of multiple machinery unlike for small firms where some
machinery lie idle.
 By product economies – waste products being recycled e.g. fabric cuttings to make rags or
manure from chicken
 Stock economies – e.g. joint supply, banc assurance, banking services and estate agent
Firm Economies of Scale include:
 Technical Economies:
o Marketing Economies –bulk buying and huge discounts.
o Employment of specialist buyers.
o Lower packaging costs.
o Massive advertising.
 Financial economies – creditworthy borrower
o Special interest rates huge.
o Collateral or security of finance.
o Access to more sources of finance.
 Risk bearing – diversification eggs not put into one basket
 Research and development economies
 Managerial economies – specialist mergers
 Staff facilities economies – staff canteens
o Sports grounds.
o Medical care.
 Plant specialization economies – a firm may be large enough for individual plants to specialize
– advantage of specialization.

Internal Diseconomies of Scale

These are the disadvantages experienced by a firm due to expansion. They are normally seen as the AC
of production begins to rise. The main problems which rise when a firm grows too large are thought to
be mainly attributable to management difficulties.
1. Management Problems
o As the size of the firm increases management becomes more complex. It becomes
increasingly difficult to carry out the management functions of
o Coordination – coordinating various debts becomes more and more difficult.
o Control – taking decisions and seeing to it that these decisions are carried out becomes
difficult workers don‘t do what they are supposed to be doing.
o Communication – keeping everyone informed through vertical and lateral combination
becomes more difficult.
o Morale / industrial relations – latitude of workers to management is of critical importance
to the efficient operation of the organization. Workers end up not cooperating.
2. Increases in prices of inputs e.g. raw materials, rentals, labour, energy, transport etc
External Economies of Scale

External economies of scale are the advantages which accrue to a firm from the growth in the size of the
industry. These advantages are gained by firms of any size. External economies of scale are especially
significant when industries are heavily localized / concentrated in industries clusters.
In this particular case they are referred to as economies of concentration e.g.
 Labour
 Ancillary Services Disintegration
 Cooperation
 Commercial Services
 Specialized Markets
External Diseconomies of Scale

A firm may also experience disadvantages as a result of the industry to which it belongs becomes too
large. These are referred to as external diseconomies of scale. This can be due to the following reasons:
 Shortage of Labour
 Increasing demand for raw materials may also bid up prices and cause costs to rise
 If the industry is heavily localized land for expansion will become scarce and hence more
expensive to purchase or rent.

Costs of Production
Opportunity Cost
Opportunity cost is the next best alternative forgone when one makes economic choice. Opportunity
cost is what we have to ―sacrifice or give up‖ in order to gain something we value / something of
economic value. We are forced to make a choice since economic goods are not free i.e. they are limited
in supply
Sunk Costs
Sunk costs are costs which cannot be recouped or recovered once a firm leaves an industry (e.g. by
transforming assets to other businesses, marketing costs like advertising). Sunk costs act as barriers to
exit for incumbents given the large capital outlays involved. They also represent barriers to entry for
now firms, which may be reluctant to enter an industry if faced with the prospect of substantial sunk
costs should they not be successful.
User Costs
The economies term for the reduction in the value of a machine or capital asset from its use. User cost
is not incurred if the item is idle or cannot be used.
Shadow cost or Implicit Cost

Sometimes called imputed price or shadow price which is a price which is imputed. As the true marginal
value of a good or opportunity cost of a resource and which may differ from the market price. External
costs and benefits (negative and positive externalities) are not easy to measure since by definition they
do not have a price attached to them. E.g. the possible external costs arising from an overhead railway
may include visual pollution, congestion near the stations and some noise pollution.
The external benefits are likely to be greater and may include less air pollution, less overall road
congestion, fewer road accidents (thereby reducing the burden on the police, health services etc), and
savings in travel time. Shadow costs / imputed prices are used to estimate these. Shadow prices / costs
are imputed prices based on opportunity cost.
Private Costs
Private costs are also called internal costs. They are costs incurred by those who buy products and by
those who produce products e.g. if a person buys a bottle of whisky, the cost (in the form of price
charged) may be $15, and if a firm produces a car the cost (in terms of wages, parts, overheads etc) may
be $4 000.

Costs in the Short-run period
Fixed Costs
These are costs of production which do not vary with the level of output. Production or no production
they have to be borne e.g. rent, interest payments on loans, and depreciation. Fixed costs are also called
overhead costs or indirect costs. FC are only found in the SR period of production and not in the LR.
Fixed Costs Curve
Cost
FC
Quantity Produced
Variable Costs (VC)

These are costs directly related to the level of output e.g. wages / salaries, costs of raw materials, fuel,
power, water bills etc. Variable costs are also called direct costs or prime costs.
Variable Costs Curve
VC
Cost
Quantity Produced

Total Costs in the Short-run

Total costs in the Short-run combines the short-run fixed costs and the variable costs as shown in the
diagram below.
Total Costs Curve
TC
Cost
VC
FC
Quantity Produced
Average Costs of Production

Average Costs (AC) are costs per unit of production. As production or output of the firm increases
average costs first decrease and there will come a point when they will start to increase – the AC curve
is U-shaped.
Marginal Cost (MC)

Marginal cost tells us what happens to total costs when we vary / change output by some small amount.
When production commences TC will begin to rise as VC increases. MC is the extent to which TC
changes when output is changed by one unit. MC = TC of n units – TC of (n -1) units.
The MC curve is also U – shaped because of diminishing returns experienced as output rises. As output
increases both MC and AC and AVC begin to fall, reach minimum and then begin to rise. When plotted
graphically AC = MC when AC is at its minimum value AVC = MC when AVC is at its minimum value.
Average Total Cost

The ATC curve is elongated U-shape. This is always so in the SR period. ATC always start at infinity
and then fall rapidly as FC are spread over more and more units. It continues to fall until the point of

optimum efficiency or optimum capacity is reached. AC then begins to rise as diminishing returns set
in and the increase in AVC outweighs the fall in AFC.
Shut down conditions during the Short-run period

The firm will / should continue to produce in the short-run as long as price of the product is above the
AVC because the Average Fixed Costs of production are being covered by the price. As long as price is
less than average variable costs (AVC), the firm should shut or stop production.
Average Costs in the LR Period

Every plant size or level of fixed input is represented by a SRAC curve, each SRAC curve is tangent to
the LRAC curve. The LRAC curve is always referred to as the envelope curve of all SRAC curves. It
shows the minimum attainable unit cost for each and every level of output. The LRAC curve therefore
consists of a series of points of different SRAC curves. These points represent the lowest costs attainable for
the production of any given output. If it is assumed that there are many such SRAC curves, the LRAC curve
will be an ―envelope curve‖.It is U-shaped because of economies of scale and diseconomies of scale.
Note: In practice, evidence suggest that in these industries investigated economies of scale exist but
diseconomies of scale either do not or are outweighed by economies of scale. In other words the LRAC curve
is more “L-shaped” than “U-shaped”.
Total Revenue
Total revenue is the amount of money which a firm gets from selling its units of output.
TR = Price × Quantity
Average Revenue
Average Revenue is the other name for price if the good. AR is the amount a firm gets from each unit sold.
AR = P (Price) (NB: only exception is when a firm sells its output at different price) – AR will be the
weighted average price.
Marginal Revenue
Marginal Revenue is the extra / additional revenue obtained when sales are increased by one unit.
MR of the nth unit = TR of n units = TR from sale of (n-1) units • MR

Market Structures
Market structures are the various market conditions under which firms operate in order to determine prices
and output to be produced. We are going to look at four types of market structures which are:
1. Perfect competition
2. Monopoly/monopolist
3. Monopolistic competition
4. Oligopoly
Perfect Competition
Perfect competition is a market structure where there are many sellers and buyers selling homogeneous
or identical products.
Assumptions / Features
 All units of the commodity are identical / homogeneous (i.e. one unit is exactly like the other)
 There are many sellers and many buyers and their behavior has no influence on the price.
 Buyers and sellers have perfect knowledge of the market conditions and market activities.
 There are no barriers to movement of buyers form one seller to another.
 There are no restrictions on entry or exit of firms from the market.
 There will be one and only one market price and this price is beyond the influence of any one
buyer / seller.
 There is no advertising.
 There is perfect mobility of resources that firms wishing to expand their output can attract
resources.
 Firms can‘t change different prices because they are selling identical / homogeneous products.
 Each of them is responsible for a tiny part of the total supply and the buyers are fully aware of
what is happening in the market.
The Individual Firm under Perfect Competition

The individual firm under perfect competition is powerless to exert any influence on price. It sees the
price as ―given‖ i.e. established by market forces of demand and supply beyond its control. E.g. in most
countries the individual farmer has no influence on the price he sells his wheat, beef, milk or vegetables.
Any changes in the amounts of the products which he brings to the market will have negligible effects
on price. The firm under perfect competition is a “price taker”.
The demand curve for the product of the single firm must be a horizontal line at the ruling price, in other
words a perfectly elastic demand curve. No matter how many units the firm sells, it can‘t change the

price. It can sell its entire output at the ruling price. If it tries to sell at a higher price, its demand will
drop to zero and obviously there will be no incentive to sell at lower prices.
Perfect Competition
The Industry The Firm
D S
Price Price
D = AR = MR
P P
Q Quantity Quantity
The diagrams above show the determination of the market price P* by market forces of demand and
supply. D is the demand curve facing the industry and supply S is the total market supply provided by
all firms in that industry – equilibrium market price is P and quantity Q.
The market price P is externally determined and the firm sees the demand curve for its product as being
perfectly elastic. The firm can now supply any quantity it wishes at the ruling price P. If it rises to reduce
or increase price, demand for its product falls to zero.
Average Revenue and Marginal Revenue

The firm under perfect competition will determine output by looking at the shape of its MR and AR
curves as well as cost curves. A firm will continue to expand its output as long as the revenue it receives
form additional output exceeds the cost of producing that additional output.
 Total Revenue (TR) is the total amount of money a firm receives from output sold. TR = P x Q
 Average revenue (AR) is revenue per unit sold. AR is another name for price. AR = P
 Marginal Revenue (MR) is the additional revenue obtained when sales are increased by one unit or
more precisely it is the change in TR when quantity sold is varied by one unit.
The output of the firm under perfect competition in the Short-run period
It is assumed that firms producing under conditions of perfect competition any business are profit
maximizers. As long as the price (AR) it receives for each unit exceeds the AC of production, a firm
will be making abnormal profits / supernormal profits or economic rent. The diagram below shows that

when price is P, the firm will be making supernormal -s in the range of output Q to Q3 because at all the
outputs in this range AR is greater than AC of production.
Short-run industry equilibrium & firm under Perfect Competition
Price
MC AC
S
P AR D = AR = MR
AC
Q Quantity
Quantity
(a) The Industry (b) The Firm
From the diagram, at price P the firm will be making loss in the range of output Q because at all outputs
AR > AC. We have to determine which output level yields maximum total profits. Output level Q will
yield the maximum profit per unit but firms seek to maximum total profits not profit per unit.
In the case of a perfectly competitive firm, TTs are maximized at the point where MC=MR=AR=P=D
demand only during the SR period of production.
Normal profit
If firms in the short run are making profits, there are incentives for new firms to enter the market. This
will increase market supply, causing market price to drop and the profit of incumbent firms to be eroded.
This can occur because there are no barriers to entry. The price will drop to the point where productive
efficiency is achieved.

Long-run equilibrium under Perfect Competition
Price
Price
& MC AC
S Cost
S1
P AR AR
P1 AR1
Quantity
Quantity
(a) The Industry (b) The Firm
The shutdown point

In the short run, a firm operating at a loss [R < TC (revenue less than total cost) or P < ATC (price less
than unit cost)] must decide whether to continue to operate or temporarily shut down. The shutdown
rule states "in the short run a firm should continue to operate if price exceeds average variable costs."
Restated, the rule is that for a firm to continue producing in the short run it must earn sufficient revenue
to cover its variable costs. The rationale for the rule is straightforward. By shutting down a firm avoids
all variable costs. However, the firm must still pay fixed costs. Because fixed cost must be paid
regardless of whether a firm operates they should not be considered in deciding whether to produce or
shutdown. Thus in determining whether to shut down a firm should compare total revenue to total
variable costs (VC) rather than total costs (FC + VC). If the revenue the firm is receiving is greater than
its total variable cost (R > VC) then the firm is covering all variable cost plus there is additional revenue
("contribution"), which can be applied to fixed costs. (The size of the fixed costs is irrelevant as it is a
sunk cost. The same consideration is used whether fixed costs are one dollar or one million dollars.) On
the other hand if VC > R then the firm is not even covering its production costs and it should immediately
shut down. The rule is conventionally stated in terms of price (average revenue) and average variable
costs. The rules are equivalent (If you divide both sides of inequality TR > TVC by Q gives P > AVC).
If the firm decides to operate, the firm will continue to produce where marginal revenue equals marginal
costs because these conditions insure not only profit maximization (loss minimization) but also
maximum contribution.
Another way to state the rule is that a firm should compare the profits from operating to those realized
if it shut down and select the option that produces the greater profit. A firm that is shutdown is generating

zero revenue and incurring no variable costs. However, the firm still has to pay fixed cost. So the firm's
profit equals fixed costs or −FC. An operating firm is generating revenue, incurring variable costs and
paying fixed costs. The operating firm's profit is R − VC − FC. The firm should continue to operate if
R − VC − FC ≥ −FC, which simplified is R ≥ VC. The difference between revenue, R, and variable
costs, VC, is the contribution to fixed costs and any contribution is better than none. Thus, if R ≥ VC
then firm should operate. If R < VC the firm should shut down.
A decision to shut down means that the firm is temporarily suspending production. It does not mean that
the firm is going out of business (exiting the industry).] If market conditions improve, and prices
increase, the firm can resume production. Shutting down is a short-run decision. A firm that has shut
down is not producing. The firm still retains its capital assets; however, the firm cannot leave the industry
or avoid its fixed costs in the short run. Exit is a long-term decision. A firm that has exited an industry
has avoided all commitments and freed all capital for use in more profitable enterprises.
However, a firm cannot continue to incur losses indefinitely. In the long run, the firm will have to earn
sufficient revenue to cover all its expenses and must decide whether to continue in business or to leave
the industry and pursue profits elsewhere. The long-run decision is based on the relationship of the price
and long-run average costs. If P ≥ AC then the firm will not exit the industry. If P < AC, then the firm
will exit the industry. These comparisons will be made after the firm has made the necessary and feasible
long-term adjustments. In the long run a firm operates where marginal revenue equals long-run marginal
costs. The shutdown position can be illustrated as follows:
Shut down point under Perfect Competition
Price
& MC AC
Cost
AR D= AR = MR
Quantity

Efficiency in perfect competition

Five reasons why Perfect Competition is efficient:
1. Allocative Efficient: This is because P = MC.

2. Productive Efficient: Firms produce where MC=ATC.
3. X Efficient: Competition between firms will act as a spur to increase efficiency.
4. Resources will not be wasted through advertising because products are homogenous.
5. Normal profit means consumers are getting the lowest price. This also leads to greater equality
in society.
Evaluation
The benefits of Perfect competition:
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and knowledge is shared evenly
between all participants.
2. There are no barriers to entry, so existing firms cannot derive any monopoly power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is perfect knowledge and firms can
sell all they can produce. In addition, selling unbranded goods makes it hard to construct an effective
advertising campaign.
5. There is maximum possible:
• Consumer surplus
• Economic welfare
6. There is maximum allocative and productive efficiency:
o Equilibrium will occur where P = MC, hence allocative efficiency.
o In the long run equilibrium will occur at output where MC = ATC, which is productive
efficiency.
7. There is also maximum choice for consumers
The disadvantage of perfect (or pure) competition

1. It produces what is demanded under the given distribution of income. We can imagine a scenario
with a very few rich people with pet dogs or cats which dine extremely well on chicken and the like,
while the masses starve.
2. Spillovers and externalities can exist. These are costs caused to others, e.g. the disposal of nuclear
waste or toxic chemicals by dumping them in streams.
3. No economies of scale possible - all the firms are too small.
4. Perfect competition is consistent with a limited choice of range of goods; monopolistic competition
may have a much wider range. An example is motorcars – there are an awful lot of different models

and competition is much less than perfect. Little or no research and development is possible because
there are no funds for it. Under perfect competition there are no surplus profits (in the long run they
are whittled away!) R&D is possible under monopoly because of the surplus profits available.
MONOPOLY
Definition: Technically it is a sole supplier that is there is one firm in the industry. It “is” the industry.
But there are degrees of monopoly - if one firm supplies, say, 80 per cent, it is close to a monopoly and
will usually act like one.
Types of Monopolies/Causes of Monopolies

 Economies of scale: One firm grows large, its cost curves are lower than the others, so it is able to
sell more; in the end it grows to become the sole firm. This is the so-called natural monopoly. An
example of a natural monopoly is the distribution of water. To provide water to residents of a town,
a firm must build a network of pipes throughout the town. If two or more firms were to compete in
the provision of this service, each firm would have to pay the fixed cost of building a network. Thus,
the average total cost of water is lowest if a single firm serves the entire market.
 The law. The government may restrict the industry to one nationalized firm to supply a certain
product or service.
 Regulations. A trade union may have a monopoly over the supply of one kind of labour
 Agreement between firms, so that they all act together and behave as one monopolist. This is often
illegal but it happen
 Exclusive ownership of a unique resource: if there is only one well in town and it is impossible to
get water from anywhere else, then the owner of the well has a monopoly on water. Not surprisingly,
the monopolist has much greater market power than any single firm in a competitive market. In the
case of a necessity like water, the monopolist could command quite a high price, even if the marginal
cost is low. Although exclusive ownership of a key resource is a potential cause of monopoly, in
practice monopolies rarely arise for this reason. Actual economies are large, and resources are owned
by many people. Indeed, because many goods are traded internationally, the natural scope of their
markets is often worldwide. There are, therefore, few examples of firms that own a resource for
which there are no close substitutes.
 Copyrights, patents and licences are particular forms of this exclusive ownership. The patent
and copyright laws are two important examples of how the government creates a monopoly to serve
the public interest. When a pharmaceutical company discovers a new drug, it can apply to the
government for a patent. If the government deems the drug to be truly original, it approves the patent,
which gives the company the exclusive right to manufacture and sell the drug for 20 years. Similarly,
when a novelist finishes a book, she can copyright it. The copyright is a government guarantee that
no one can print and sell the work without the author‘s permission. The copyright makes the novelist

a monopolist in the sale of her novel. The effects of patent and copyright laws are easy to see.
Because these laws give one producer a monopoly, they lead to higher prices than would occur under
competition. But by allowing these monopoly producers to charge higher prices and earn higher
profits, the laws also encourage some desirable behavior. Drug companies are allowed to be
monopolists in the drugs they discover in order to encourage pharmaceutical research. Authors are
allowed to be monopolists in the sale of their books to encourage them to write more and better
books. Thus, the laws governing patents and copyrights have benefits and costs. The benefits of the
patent and copyright laws are the increased incentive for creative activity.
Marginal Revenue and Monopoly

Marginal revenue is the addition to total revenue from the last unit sold. A perfectly competitive firm
can sell as much as it wants at an unchanged price. Its MR curve is equal to the price – every time it
sells one more item it receives, say, an additional 50 cents, which adds 50 cents to TR.
A monopolist is the industry, so it faces a normal downward sloping demand curve. So if wants to sell
more of the good or service it must lower the price. And of course it must sell all its products at that
lower price. This means it loses by selling the items it used to sell earlier at a higher price at the new
lower price. So the price of the marginal product is not the MR – the firm‘s total revenue increases by
less than this sale, because of the bit it lost on the price on all the other products.
As Quantity Increases Must Lower Price Total Revenue Alters Marginal Revenue
1 7 7 7
2 6 12 5
3 5 15 3
4 4 16 1
5 3 15 -1
6 2 12 -3
7 1 7 -5
Note: The Marginal Revenue is less than the price for all quantities after the first one.
Profit Maximization for a Monopoly

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal
cost (point A as shown below). It then uses the demand curve to find the price that will induce
consumers to buy that quantity.

Profit Maximization of a Monopoly

Revenue
&
Cost
MC AC
AR
AC
A
AR= D
MR
Q1 Q Q2 Quantity
Suppose, first, that the firm is producing at a low level of output, such as Q1. In this case, marginal cost
is less than marginal revenue. If the firm increased production by 1 unit, the additional revenue would
exceed the additional costs, and profit would rise. Thus, when marginal cost is less than marginal
revenue, the firm can increase profit by producing more units. A similar argument applies at high levels
of output, such as Q2. In this case, marginal cost is greater than marginal revenue. If the firm reduced
production by 1 unit, the costs saved would exceed the revenue lost. Thus, if marginal cost is greater
than marginal revenue, the firm can raise profit by reducing production. In the end, the firm adjusts its
level of production until the quantity reaches Q, at which marginal revenue equals marginal cost. Thus,
the monopolist’s profit maximizing quantity of output is determined by the intersection of the marginal
revenue curve and the marginal-cost curve.
A Monopoly’s Profit
How much profit does the monopoly make? To see the monopoly‘s profit, recall that profit equals total
revenue (TR) minus total costs (TC): Profit = TR - TC. We can rewrite this as:
𝑇𝑅 𝑇𝐶
𝑃𝑟𝑜𝑓𝑖𝑡 = ( − )×𝑄
𝑄 𝑄
TR/Q is average revenue, which equals the price P, and TC/Q is average total cost ATC. Therefore,
𝑃𝑟𝑜𝑓𝑖𝑡 = (𝑃 − 𝐴𝑇𝐶) × 𝑄

This equation for profit (which is the same as the profit equation for competitive firms) allows us to
measure the monopolist’s profit in our graph. Consider the shaded box in diagram below The height of
the box (the shaded segment) is price minus average total cost, P – ATC, which is the profit on the
typical unit sold. The length of the box is the quantity sold Q1. Therefore, the area of this box is the
monopoly firm‘s total profit.
Monopoly equilibrium
Equilibrium is where MC = MR, as usual. When you are drawing the diagram and answering questions
you should locate that point first and draw it in.
Problems with monopoly, “what is wrong with monopoly” or "the welfare effects
of monopoly"
 A monopoly limits output and keeps price high.
 A monopoly redistributes income from all the consumers to this one firm or person (an equity issue).
 Monopolists may develop political and social power over others, which reduces the efficiency of
democracy and is inequitable. There are political dangers of a few very rich and powerful people
(Marx called them ―monopoly capitalists‖ who misuse their position and exploit people).
 A monopoly may behave badly in an anti-social way. For instance it may force out a rival firm by
selling its product at give-away prices, well below cost and taking the short term loss. After it has
forced out the competitor, it will then put the price back up again. This behaviour may or may not
be legal. It depends on the country involved and its legislation but it is always reprehensible.
 The lack of competition tends to promote inefficiency, there is no need to try hard, and it lacks
dynamism. This is probably the main criticism.
 The result is lazy managers and owners. This means that technical progress is reduced, leading to
slow economic growth of the country and a lower standard of living than we could have.
 Resources are misallocated. Too many go to the monopolist and they are not fully used by him. This
is a waste for society and in addition, the price mechanism is prevented from working properly.
 A monopoly reduces consumer choice. There is no one else to buy from and no other producer‘s
product.
 A monopolist may ignore small market demands as he cannot be bothered to meet them.
 The long run effect from the existence of monopolies is slightly slower growth; a lower standard of
living; higher unemployment (because the monopolist restricts output and so requires fewer people);
higher prices (which monopolies charge); a slightly poorer balance of payments as a result of this; a
less equal income distribution; and poorer resource allocation.
Benefits of monopoly
 A monopolist can use monopoly profits for research and development, leading to product
improvement, faster growth, and lower costs, despite the argument above that they are inherently
lazy. Joseph Schumpeter argued that they are important for innovation; he felt that big firms are the
only ones that are able to afford the necessary laboratories, equipment and research staff. Against

this, research exists that shows many of the breakthroughs come from small firms, for example Apple
began making those computers in a garage.
 Monopolists may be able to reap economies of scale. Economies of scale mean lower costs. A state
monopoly may be safer than a private one. A private monopoly may be more tempted to cut corners
and reduces necessary maintenance to lower costs, and this could be particularly serious in some
areas like the railways or air traffic control.
 Monopolies creates employment.
Monopolistic Competition
The theory of monopolistic competition was developed by Edward Chamberlin (1899-1967), an

American economist. He was dissatisfied with the two extreme theorems that existed at the time, perfect
competition and monopoly, so wanted to devise something more realistic that would sit between the two
existing theories. In simple terms, a monopolistically competitive market is one with many competing
firms where each firm has a little bit of market power. This is why we have the term "monopolistic", as
firms have some ability to set their own prices.
The assumptions of monopolistic competition

The industry is made up of a fairly large number of firms.
The firms all produce slightly differentiated products. This means that it is possible for a consumer to
tell one firm's product from another.
The firms are small, relative to the size of the industry. This means that the actions of one firm are
unlikely to have a great effect on any of its competitors. The firms assume that they are able to act
independently of each other.
Firms are completely free to enter or leave the industry. That is, there are no barriers to entry or exit.
The only difference from perfect competition is that in monopolistic competition there is product
differentiation. Product differentiation exists when a good or service is perceived to be different from
other goods or services in some way. Products may be differentiated by brand name, colour, appearance,
packaging, design, and quality of service, skill levels, and many other methods. Examples of
monopolistically competitive industries are nail (manicure) salons, car mechanics, plumbers and
jewelers.
Although it may appear to be a small difference from the assumptions of perfect competition, this leads
to a markedly different market structure. As the products are differentiated there will be some extent of
brand loyalty. This means that some of the consumers will be loyal to the product and continue to buy
it if the price goes up a little. For example, it may be that the customers of a certain plumber will stay

with that plumber when she raises her prices above local rivals, because they believe that she is slightly
more skilled than her competitors.
This brand loyalty means that producers have some element of independence when they are deciding on
price. They are, to an extent, price-makers, and so they face a downward sloping demand curve.
However, demand will be relatively elastic since there are many, only slightly different, substitutes.
Profit Maximization of Monopolistic Competition
Revenue Revenue
& &
Cost Cost
MC AC LRMC
LRAC
AR AR
AC AC
AR=D
MR MR - LR AR - LR
(a) Short-run (b) Long-run
A monopolist firm is like a monopoly in the short-run enjoying abnormal profits from product
differentiation. However, in the long-run other firms will also differentiate in line with this firm or more
firms will enter the market hence wiping out the abnormal profits. The demand curve facing a
monopolistically competitive firm is shown in above both in the short-run and the long-run.
The firm faces a downward sloping demand curve with a marginal revenue curve that is below it and
produces so that it is maximizing profits where MC = MR. This means that the firm in will produce an
output of Q and sell that output at a price equal to the AR.
In this case, the firm is maximizing profits by producing at the level of output where MC = MR, and the
cost per unit (AC) of C is less than the selling price of P. There is an abnormal profi.t that is shown by
the shaded area.
The long-run equilibrium of the firm in monopolistic competition whether firms are making abnormal
profits or losses in the short run, because of the freedom of entry and exit in the industry there will be a
long-run equilibrium, where all of the firms in the industry are making normal profits.
If the firms are making short-run abnormal profits, then other firms will be attracted to the industry.
Since there are no barriers to entry it is possible for these other firms to join the industry. As they enter,

they will take business away from the existing firms, whose demand curves will start to shift to the left.
If firms are making short-run losses, then some of the firms in the industry will start to leave. The firms
that remain will find that their demand curves start to shift to the right as they pick up trade from the
leaving firms. This analysis explains why it is not uncommon to see similar shops or services spring up
in an area. Imagine that a new sushi restaurant opens up in a district. Soon it is so popular that there is a
line outside the door every evening. Other catering entrepreneurs will be attracted to the possibility of
doing so well, and so it is likely that another sushi restaurant will open up in the area. It may not happen
immediately, but eventually this is likely to result in a fall in demand for the original sushi restaurant as
some of its customers will switch.
If demand continues to be strong, then even more restaurants will open. Each restaurant will try to
distinguish itself from the others perhaps by staying open longer, offering a "Happy Hour", special theme
nights, or free children's meals to name just a few possibilities.
This product differentiation is also known as non-price competition. Whatever the short-run situation,
in the long run the firms will end up in the position shown making normal profits.
Perfect Competition, Monopoly, Monopolistic Competition and Oligopoly:

Graphing Tips
 For all firms, the MC curve must intersect the ATC at the minimum of the ATC curve.
 When a firm is making positive profits, the ATC curve must lie at least partially below the demand
curve.
 When a firm is making negative profits (losses), the ATC curve must lie entirely above the demand
curve.
 When a firm is making zero profits (breaking even), the ATC curve must be tangent to the demand
curve.
 For perfect competition, the firm‘s demand curve must be horizontal and the same as the MR curve.
 For monopolistic and monopolistically competitive firms, the firm‘s demand curve slopes down to
the right. Theoretically, the monopolistic firm has a steeper demand curve than the monopolistically
competitive firm. For both the monopolistic and monopolistically competitive firms, the MR curve
is twice as steep as the demand curve (if the demand curve is a straight line).
 When a perfectly competitive firm is making zero profits, the ATC curve is tangent to the demand
curve at the minimum of the ATC curve. When the monopolistic or monopolistically competitive
firm is making zero profits, the ATC curve is tangent to the demand curve at an output level that is
lower than the output at the minimum of the ATC curve. The tangency must be directly above the
intersection of the MR and MC curves.
 When the oligopolist (in the kinked demand curve model) is making zero profits, the ATC curve is
tangent to the demand curve at the kink in the demand curve. This occurs at an output level that is
lower than the output at the minimum of the ATC curve. The tangency must be directly above the
intersection of the MR and MC curves.

 For the oligopolist (in the kinked demand curve model), the MC cost curve intersects the MR curve
in the vertical segment of the MR curve. Each of the downward-sloping segments of the MR curve
is twice as steep as the corresponding section of the demand curve (if the demand curve segments
are straight lines).
Market failure
Market failure is a concept within economic theory describing when the allocation of goods and
services by free market is not efficient, that is there exist another conceivable outcome where a market
participant may be made better off without making someone worse off. Market failures can be viewed
as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient. The
existence of market failure is often used as a justification for government intervention in a particular
market.
What does market failure mean? It means that we do not have full efficiency; we could produce more
with the resources we have; and we could satisfy consumer demands better with the resources we have.
There is waste in the system.
Types of efficiency in economics:
1. Allocative efficiency. This means good resource allocation, when we cannot make any consumer
better off without making some other consumer worse off. This approach looks at the given resources
and tries to get the most output from them and it also means that firms sell at a fair price to consumers
that reflects the real resource use. (P = MC)
Allocative efficiency occurs when the value the consumer puts on a good or services is the same as
the cost of the resources used in producing it. This occurs when price= marginal cost. In this position,
total economic welfare is maximized. In the perfect competition diagram below, where MC = MR
for the firm, we have allocative efficiency because the firm‘s price is the marginal revenue (it can
sell any amount at the unchanged price - each extra unit sold at that price provides the marginal
revenue), so MC = P. In fact, at that point we have more equalities MC = P= MR = AR. “AR” is
merely another word for price – it is ―average revenue‖ which we get by dividing total revenue by
quantity. We know that quantity multiplied by price gives us total revenue, so it follows that price
actually is average revenue.

Allocative Efficiency
Price
& MC AC
Cost
Output
2. Productive efficiency. This means that production is done at the lowest possible cost. We are at the
bottom of the average cost curve (which is always U-shaped). In that position we have what is called
“X-efficiency”. And this means we are also on the production frontier, not somewhere inside it. This
exists when we are actually on the production frontier. That means we are using the least resources
we can. In turn, it says that we are at minimum average costs = the bottom of the AC curve. Perfect
competition is like this – so economists prefer this position and you will recall that it is known as
“X-efficiency”– it is where we are totally efficient.
Where market equilibrium is totally efficient, we cannot make someone better off without making
someone else worse off (this is sometimes called ―the Pareto optimum position‖).
The production possibility curve: When we are below the production possibility curve (e.g., at ―X‖
in the diagram below), we can move north-east and get onto the curve, thus making everyone better
off; only when we are on it do we have proper productive efficiency. And only when we are on it
does the concept of opportunity cost arise. If we are below it, we do not have to give anything up to
get more of the other thing; we can have more of both simply by moving out to the curve.

PPC & Productive Efficiency
Apples Apples
PPC
PPC
Banana Banana
Note: we can have allocative efficiency and productive efficiency but still have inequity in the country,
which can also stop us reaching “perfection”.
Example 1. If you personally have all the income in your suburb, the other residents will be poor and
might even starve, which does not sound at all like perfect! The market system is amoral i.e., it is not
concerned with good or bad. Economics is not about ethics.
Example 2. Drug dealers could wait at the gates of primary and secondary schools, give away drugs for
free to six year old children and in this way build up a market as they become addicted. This would
create a demand, which the drug dealers could then supply later at a price. Most people would regard
this situation as totally wrong, exploitative, and immoral – but the market would be working - and
possibly very “efficiently” too.
Social efficiency matter not just private

We might produce too much or too little as a society, for our own good, even if have perfect competition
and an acceptable distribution of income and nothing illegal or immoral is occurring. This can happen
because of externalities. We move on to consider these next.
Sources of market failures

 Monopoly elements or market dominance.
 Externalities.
 Public goods.
 Merit goods.
 De-merit goods.
 Information failures.

 Factor immobility.
 Undesirable income and wealth distribution
Externalities
Externalities, social cost and private costs

Externalities are said to exist when the actions of producers or consumers affect themselves as well as
third parties who are offered no compensation to the loss generated. Externalities can be known as
external diseconomies and economies as well as third party spillover effects. They exist because the
market cannot deal properly with the side effects of many economic activities. Externalities involve an
interdependence on utility and production functions. An external benefit or a positive externality refers
to the benefit from production or consumption experienced by people other than the producers or
consumers. This occurs when an externality-generating activity raises the production or the utility of the
externality-affected party. Hence, the economic activity provides incidental benefits to others for whom
they are not specifically intended.
A negative externality or external cost refers to the cost of production or consumption borne by people
other than the consumers or producers. The undesirable effects on the allocation of resources by an
externality can be explained by the Marginal Social Cost (MSC). The Marginal Social Cost is a sum of
the Marginal Private Cost (MPC) and the Marginal External Cost (MEC). MPC is a share of marginal
cost caused by an activity that is paid by the people who carry out the activity and MEC is the share
borne by others. When the firm‘s activities generate negative externalities, its MSC will be greater than
MPC. Since, in equilibrium, the market will yield an output at which consumers marginal benefit is
equal to a firm‘s MPC. Thus, as shown in Figure 1, MPB is less than MPC, hence the costs that is
incurred to society outweighs the benefit derived from the good. Consider the soap industry which, in a
free market would discharge waste products into the air and into rivers. The owners of soap factories
being profit maximizers will only consider their private costs and ignore the wider social costs of their
activities. Thus, MSC is more than MPC.
An example of an activity which generates an external benefit in consumption is vaccination. If an

individual makes a decision to be inoculated against a particular disease, then he will receive the private
benefit of not being infected by that particular disease. However, there are also other possible benefits
to all others with whom he comes into contact as they will not contract the disease from him. The
vaccination protects not only the person who is vaccinated but also the entire community that person
lives in, by preventing the spread of contagious diseases. Thus, MSB is greater than MPB. The
individuals consider only private benefits and costs in their consumption decisions. Hence, they will
consume OQ1 units where MPB=MPC. However, the socially efficient output occurs at OQ2, where
MSB=MSC. There is thus an under consumption of Q1Q2 of the good which results in a deadweight
loss equalto the area of E2BE1. Insufficient scarce resources are being devoted to the production of this
product. The market has failed to allocate resources efficiently.

Private costs are the costs incurred when producing something. Social costs are greater than private
costs. Social costs include things like pollution and congestion that are suffered by society in general,
not by any one producer.
These problems are called ―externalities‖ i.e., they are external to the firm producing them. They can
be negative externalities (which harm society) or positive externalities (which help).
Social cost = private cost + externality (if any). Cost-benefit analysis tries to measure all the costs to
society of a project.
Negative Externalities – Social Costs

Social Social
Costs Costs
&
Costs
Private
Costs
P2
P1
D = Social Marginal
Benefit
Q2 Q1 Quantity
Equilibrium will be where private costs cut the demand curve at Q1, as firms try to maximize profits
and charge price P1. But because of negative externalities (pollution maybe), the socially optimum
position should be where social costs cut the demand curve. These would mean producing at Q1, reading
from the social costs curve, and selling at the higher price P2 to cover these costs.
Negative Externalities
 Common types of negative externalities by producers:
o Air pollution, e.g., smoky factory chimneys.
o Soil pollution, especially by farm chemicals (closely related to the next type).
o Water pollution, e.g., rainwater run-off containing farming pesticides and fertilisers.
o Noise pollution. Do you live near an airport or by a building site?
 Some types of negative externalities by consumers:
• Pollution of air and water.

• Soil pollution, e.g., lead pollution in soils from motorcar exhaust emissions.
• Litter on streets; decomposing rubbish in land-fill sites.
• Noise pollution, e.g., motorcycle noise in urban areas, especially when the baffles have been
deliberately removed from the silencer.
• Vandalism; graffiti on walls.
• Smoking and alcohol abuse, causing NHS expenditures to rise.
• We are unsure why the urban sparrow population has plummeted in recent decades but it would
seem to be the result of some externality.
Positive Externalities
When these exist, society would gain more than the producer – who therefore is producing less than the
optimal social amount.
Examples include:
 Labour training in firms; one firm may do little, as it knows that when a trained worker leaves,
someone else benefits - but the first firm paid for all the training!
 Education generally.
 Health generally, especially in poor Third World countries.
 The provision of playing fields at or near schools so that the health and sporting skills of the children
improves.
 Free museums and art galleries that can encourage the poor and uneducated to widen their horizons,
educate themselves, and generally improve.
To draw the diagram for positive externalities: just reverse the labeling of the curves of social cost and
private costs above. This is done in the diagram below where you can see that we produce too little for
society if firms profit maximize for them (as they do). They choose to produce at Q1 and sell for a price
of P1, but for the greatest good of society they should be at Q2 and selling at the lower price of P2.

Positive Externalities - Social Benefits

Social Private
Costs Costs
&
Costs
Social
Costs
P1
P2
D = Social Marginal
Benefit
Q1 Q2 Quantity
Government intervention may be necessary to correct or offset market failure caused by negative
externalities – usually the government chooses to tax those producing too much, or they may use the
law to prosecute for water pollution or whatever externality the government is tackling.
There are probably fewer cases of external benefits, but if we find any (such as private firms training
labour well) we can encourage this by tax breaks or subsidies.
Government action with external diseconomies
Government might try (and does):
 Taxation.
 Regulation.
 Perhaps extending property rights.
Let‘s think about polluters – what can the government do using the three points above?
1. Taxing polluters
The need is to try to stop the problem being “external” and try to “internalize” it, i.e., to make the
polluter pay for it via a tax. As economists, what we are really doing is trying to get the firm to stop
looking only at the private costs and benefits. In the diagram below, we do this by putting a tax on,
which shifts the supply curve up from “S Private costs” to “Private costs + tax”. If we get it right,
this moves the equilibrium quantity produced from Q1 to the smaller output Q2.

Tax & Negative Externalities

Social Social
Costs Costs S + Tax
&
Costs
S
P2
P1
D = Social Marginal
Benefit
Q2 Q1 Quantity
But there are problems with taxing polluters:
 When it works, output is reduced and prices are higher – but this can reduce the consumer
surplus, which some feel is not a good thing (Unit 4 looks at this concept).
 It is often hard to identify the particular firms that are causing the pollution, and then
determine how much each is responsible for the total pollution.
 Poor legislation can hurt the innocent, e.g. households who wish to get rid of large items of
waste may not be allowed to take them to the dump.
 It is not easy to put a monetary figure on the damage pollution is causing.
 Producers can pass on much of the tax to consumers if demand is inelastic and not pay it
themselves.
 Taxes on demerit goods (to limit their consumption) can be regressive, i.e., hit poor
households the hardest. The tax on cigarettes does this because the poor are statistically more
likely to smoke than the wealthier.
2. Regulating polluters approach (a second way that can be used in addition to tax).
 Banning cigarette advertising at sporting events, or in places like cinemas.
 Making workplaces no-smoking areas.
 Increasing the penalties for firms that break the regulations.
3. Extending property rights (a third way that can be used)

 If a lorry crashes into your garden and destroys the wall and all your trees you can get
compensation – but if a polluting factory puts out acid smoke and destroys the same trees you
cannot.
 If we extend property rights so you could sue for compensation, it would make the polluter think
again and perhaps install anti-smoke devices on factory chimneys!
Benefits - The property owner knows the value of the property better than the government does,
so the figures will probably be more accurate (but owners can, and perhaps would, lie!). The
polluter is forced to pay those suffering from his or her activities.
Disadvantages - The damage may occur abroad. Global interests and national interests may
conflict. The Zimbabwe cannot make Zambia extend property rights over Zambians trees which
are being killed off at a rapid rate.
Trading permits to pollute

Many believe that it is so difficult and expensive to stop companies polluting (identifying who did it can
be impossible e.g., with one stream and dozens of factories discharging into it) that instead we should
auction off the right to pollute. Only those firms that pay a high price for the limited number of licences
would be allowed to pollute. The government could then use the large sum of money raised to tackle the
pollution itself. The end result could be much better than we currently have.
If we allow a firm to sell its right to pollute (it may have used only 80 per cent of what it is permitted,
for example) then those with the greatest demand for their product, and hence the most profitable, can
buy the remaining 20 per cent. It means the things we most desire still get produced but the government
has the resources to tackle the resulting pollution.
Coase’s Theorem
Ronald Coase established that there is no need to tax or regulate polluters at all! He saw that if polluters
compensated those suffering, the market would solve it properly, with just enough ―acceptable‖
pollution occurring and still no one suffers without being compensated.
Public goods
Economic goods can further be subdivided into public and private goods. A public good is one that has
two characteristics that private goods do not. Firstly, public goods are non-exclusive. This means that a
producer or seller cannot separate non payers from benefitting from the good. As a result, the payer too,
eventually does not want to pay. As a consequence, the market will not produce a public good. This is
market failure.
Using the concept of externality for public goods, there are no private benefits or revenue for the
producer at all but more benefit for the society. Examples of public goods are street lighting, defence
and radio broadcasts. The second characteristic is that public goods are non-exhaustible. This means
that the use by one person does not reduce the amount available to another. As a result, there is no rivalry

in consumption. As a result, there is no additional opportunity cost for the second and third person to
use.
Public goods are collectively consumed and the market may simply not supply them; e.g., defence of
the country (a police force and army), a fire brigade, street lighting, or lighthouses. The market system
does not work well in this area.
Some goods are “semi-public goods”, “quasi -public goods” or “collective consumption goods”, for
instance roads. These are often supplied by the state, but in principle they can be privately supplied, and
sometimes are.
Public goods require:
 The lack of ability to exclude (if I am defended, so are you, even if you do not pay).
 The consumption by one does not reduce the consumption available to the others (if you walk down
the street after dark you do not use up any of the street lighting.).
These two requirements may be called the “non-rivalry” and “non-excludability” features.
One of the jobs of government, both central and local, is to supply public goods or services that are
needed but otherwise would not be made available by the market.
Merit Goods
These are goods with extensive external benefits. These are provided by the market - but in smaller
amounts than are needed for the good of the state. Health and education are the most obvious ones –
there will be some privately-supplied health and education but the state as a whole benefits if everyone
has access to them, not just a few. For instance, in the health area, the National Health Service tends to
reduce mass epidemics; the health service also means that fewer people will be off work sick. In the
case of education, society would not function as well if half the population could not read the instructions
on the label.
Private consumers individually value merit goods less than the state does. The market system fails to
provide enough merit goods which is why the state steps in to make them more widely available. It does
this by subsidizing the production of some merit goods or services.
Merit goods may be targeted at certain groups and rationed; for instance, we might limit access to higher
education to those passing A-levels well. It is assumed that such people are the most intelligent in
society.

Subsidy on Merit Goods
Price S1
S2

P1
amount of Subsidy
P2
Q1 Q2 Quantity
In the diagram, a subsidy equal to the vertical height is applied by the government – this shifts the supply
curve downward and to the right. The equilibrium position then moves from P1Q1 to P2Q2. The result
is that more is then consumed at the lower price i.e., the demand for merit goods has extended.
Demerit Goods
Demerit goods are exactly the opposite of merit goods in that they are over-consumed by individual
people and this causes problems for the nation as a whole.
Cigarettes are a clear example: they cause unpleasant smoke which is dangerous to people in the area
who are forced to become passive smokers. They also cause cancer and a whole range of nasty diseases,
including emphysema. They inflate the national health bill because both the smokers and the passive
smokers get sick and visit the doctor. But smokers will not stop, perhaps are unable to stop, because
they are addicted.
Too many demerit goods are demanded, so the government steps in and taxes cigarettes highly in order
to reduce consumption and to raise revenue which is needed anyway to spend on treating smokers. The
government also advertises heavily to try to persuade people to stop smoking and the young not to start
and is seriously considering banning smoking in all public work places, as Ireland did in 2004. Some
individual doctors are also refusing to treat smokers for smoke-related diseases unless they stop smoking
which adds to the pressure.

The effect of the government taxation is in the diagram below. The indirect tax EB is added vertically
to the supply curve, which shifts upward and to the left from S1 to S2.
Subsidy on Merit Goods
Price S2
S1
P2
P1 amount of Tax
Q2 Q1 Quantity
This reduces the consumption from OQ1 down to OQ2, (a move from the equilibrium point A to B) as
price rises from P1 to P2 and consumers contract up the unchanged demand curve.
Rather than simply relying on tax to decrease the supply curve and force up the price, the government
may also try to tackle the demand side. It can do this in the ways mentioned above and the diagram is
reproduced below. You will observe that, if successful, the quantity smoked falls.

Reduction in Demand of Demerit Goods
Price
S1
P1
D1
P2
D2
Q2 Q1 Quantity
The government uses both methods, reducing demand and taxing heavily, to deal with smoking as a
demerit activity.
Information Failures
Consumers lack information on things like:
 What goods are available and what new goods have recently come onto the market.
 What the quality of the different models or makes available is like.
 How long an item will last before breaking down?
Information lack is particularly common in both the health service and in education where consumers
do not know much - although we now know more than a few years ago. This lack of perfect knowledge
means that we may choose badly through ignorance. The demand curves would be different, and better,
if we did know everything. This means of course that the existing demand curves do not give us a perfect
market solution.
Producers lack information on:
 What new demands are arising and how old ones are starting to change, so the producers may
produce more (or less) than they should.
 What their existing rivals, and any new ones about to emerge, are doing or might do.
Which means that the producers may produce the wrong type of goods or the wrong quantity of goods?

We know that in the world in which we live, new firms start up and many die away within the first two
years – they usually got it wrong on the demand for their service or goods in that particular place,
although sometimes they simply were not good enough at the job. In the process of being born and
dying, the firms used up resources (including the labour of the would-be entrepreneur) in a less than
fruitful way.
Workers lack information on:
 All the jobs available now. Many of these will be local but more particularly they are usually ignorant
of opportunities elsewhere in the country or in the EU for that matter. So the workers may not move
to where they are needed though simple lack of knowledge.
 Which industries will grow and which will wither away in the future. This means that workers may
join a firm that will disappear in a few years’ time, throwing them out of work but not for any fault
of their own. Technical change can render whole jobs out of date.
 A real problem is that those leaving school or college may join an industry and train in skills that
will shortly be no longer needed.
So here again the market does not reach the “correct” or “optimal solution”. The response to information
failures:
Private firms gather information and try to sell it. For instance:
 Private Job centers may open up to try to find a job for people. These are mostly in large cities and
for service workers, rather than for manufacturing. Such firms are trying to improve the flow of
information for profit. • Magazines like ―Which?‖ exist. They test and investigate the quality of
goods and services and publish the results.
 Specialist magazines are produced for things like hi-fi, TV, motorcars, or computers – such
magazines also test and report the results.
 In order to help producers, various trade associations and chambers of commerce gather information
and inform their members about what is happening. They also organise conferences and set up fact-
finding trips abroad and the like.
The state tries to provide information by:
 Establishing job centres.

 Providing advice to careers advisers in schools.
 Issuing pamphlets and working papers to try to improve peoples’ knowledge. The newspapers pick
up this information and may publicize it.
Overall, as information improves, consumers adjust their demand patterns to favour what fits their needs
best. Producers chose the most suitable and cheapest sources for their inputs. This of course means the
market mechanism then works better to supply what people want and are willing to pay for.

Factor immobility
The factors of production that we have are land, labour and capital plus a remainder term (L, N, K, + R)
– most economists and textbooks focus on labour immobility, but this is not guaranteed for the exam
We can also have land immobility:
 Some land is good for growing one or two particular crops and not very good at some other crops.
It is not easy to change rice (which needs wet soils) to wheat (which needs drier conditions).
 It is not possible to move land from where it is to somewhere else.
 Climate change may be occurring and farmers are often traditional, growing what they or their family
have done for years or even generations. They may be unaware of, or refuse to try growing, a now
more suitable crop.
 Economic Union subsidies keep many farmers’ attention on producing the crops that are highly
subsidised (as it gains them a higher income) rather than what might be more suitable for their land
or sell better. Quite often the EU gets it wrong, so we ending up with a lot of produce that is hard to
sell. Dumping it on international markets annoys other countries that produce such goods efficiently
as it reduces their market. Dumping it into the sea causes criticisms of waste in a world of poverty.
And capital immobility
 Some capital is specific e.g., it makes light bulbs, and it cannot be transferred to another use, like
producing ball point pens.
 Some capital is very big and heavy, e.g., a steel mill, and it is difficult or impossible to move it to
another geographic areas.
 Some old decaying industries may be subsidised by government and continue to exist for years, well
beyond their shelf life. This keeps the capital (and the associated land and labour) where it is so that
it is not released for use where it is more wanted by society. That is to say, government subsidises
prevent factors of production moving to turn out what people now demand. The fact that the industry
is decaying shows that demand has changed and people no longer want that good or service as much
as they once did.
 Some (usually small) firms stay in business despite making poor profits because the owner does not
want to move or to cease production; or perhaps the owner is too old to bother to make any major
change. Labour immobility (the really interesting one – we ourselves are people)
Geographic immobility of labour
 People are usually happy where they are: they have got relatives and friends, they know the town
and area, and they are members of various clubs and other social groupings. They do not wish to
move.
 They may not know about the money they could get if they were to move (―information failure‖).
Information failure actually costs money to overcome: people must pay to use the Internet, or have
to buy newspapers and magazines.

 Moving house costs money: there are estate agents‘ fees, lawyers‘ fees, a government stamp duty
and the cost of transporting furniture and all the other household effects.
 Inertia: people often do not like a big move as they have a sort of fear about it, so they just stay
where they are.
Institutional immobility of labour
 Trade unions and government pass rules or laws that prevent people from entering a new job easily.
 Pension schemes may tie people into a particular company – if a worker moves, he or she will
probably lose the amount paid in by the employer on their behalf (this can amount to several
thousand dollars).
 Council houses (state subsidised housing) are let below market rents and can prevent people moving;
if they move it means they must give up their cheap house unless they are able to arrange for a house
exchange with another council tenant.
 Foreign-trained doctors may not be allowed to work in the Zimbabwe unless they spend several
years retraining - and not always even then.
Sociological and economic differences causing immobility of labour
 Minority groups often get paid less. For instance, it may be harder for migrants who do not naturally
speak English to find work and to receive the same pay. If they are not selected for a vacancy, it
renders them less mobile. Even women, hardly a minority, find it hard to get the same pay as men,
despite the existence of long-standing legislation.
 We can think of this as a lower demand curve for them, because employers do not like hiring them
as much.
 Married or very close couples: one may not be able to take a better paid job offered elsewhere
because it would render the other partner unemployed, so total family income would fall if they
moved.
 The skills a person has may not fit the new demand for workers, so he or she would find it hard to
get another job. As demands in society change (taste + higher incomes + new goods + new
technology + fashion and trends…) it means new skills are needed and old ones become redundant.
How many chariot wheel makers do we now need?
 Age: once past fifty years, or even forty years of age, it is difficult to get a new job.
Employers often prefer younger people. If an applicant is old, the employer fears that they will not learn
new skills quickly; and if the applicant is older than the employer, he or she may feel uncomfortable
giving them orders and so simply refuse to hire them in the first place; and old workers who join the
firm will only pay into pension scheme for, say, ten years until they retire, but will take out for perhaps
another thirty years until they die. An ageing population makes this scenario more common.
Such factors mean that wage differences (and unemployment) can permanently exist between industries
and between regions. The market does not work well enough to equalise wages and long term wage
differences persist. Diagram: the wage of labourers in London and Cornwall: London has a greater

supply but a much greater demand so the curves are further to the right. And of course in London, the
level of wages and the quantity of workers are higher.
Wages of Laborers in London & Cornwall
Wages
S - Lab Wages
S - Lab
W1
W1
D - Lab D - Lab
Q Q
Quantity of Labor Quantity of Labor

London Cornwall
What can be done? Government intervention may help produce a better market solution. Government
training and retraining for the new skills that society needs. The government may improve or alter the
educational system and encourage academic courses to be more geared to the needs of a modern
economy (although some intellectuals disagree and think education should not do this).
We can retrain workers at government expense. The state can pay for retraining courses and give
generous tax breaks to those choosing to receive new skills. The government may tackle the geographic
problem. It may pay workers to move; or pay the costs of buying or selling the house; or end (or reduce)
the stamp duty for such people; or pay the unemployed to travel to look at job opportunities in a new
area.
It may subsidise firms to move to old decaying areas. This approach is generally inefficient, as it means
costs will be higher than they need be, as it is probably not a good location for the firm (which we can
assume or the firm would be there already or willing to go without a subsidy). This would make the
Zimbabwe less competitive with other countries.
The government may allow pension mobility, i.e. when a person leaves a firm he or she can take their
pension rights with them – the new stakeholder pensions do this. The push for people to take out their
own private pensions means that workers are more mobile than they once were. There is a slight problem

in that the rich who are usually already mobile are taking out stakeholder pensions, but the poor, less
mobile, are tending to avoid them.
The government could change the laws as needed
 Example 1. The government could make all company pension schemes pay out the employer‘s
contribution when worker leaves.
 Example 2. The government could make the Zimbabwe Medical Association (ZMA) allow
foreign doctors in to work more easily. The ZMA is rather restrictive and keeps some well-
trained foreign doctors from working in the Zimbabwe unless they requalify or take special tests.
This reduction in supply means there is a permanent shortage of doctors which helps the ZMA
to pressure the government for pay increases, better conditions, or whatever it wants.
 Example 3. The government could pass ―non ageist‖ legislation to try to stop older but good
being refused jobs or even fired (government is planning to do this - eventually).
Other areas of law no doubt could be similarly changed – watch the newspapers for articles and examples
that you could quote in the exam room.
Cost Benefit Analysis (CBA)
Cost-budget analysis (CBA) is a framework for evaluating the social costs and benefits of an investment
project. This involves identifying, measuring and comparing the private costs and negative externalities
of a scheme with its private benefits and positive externalities, using money as a measure of value.
 Step 1: identify all costs and benefits using the principle of opportunity cost
 Step 2: measure the benefits and costs using money as a unit of account
 Step 3: consider the likelihood of the cost or benefit occurring (i.e. sensitivity analysis)
 Step 4: take account of the timing of the cost and benefit (i.e. discounting). A £1,000 benefit now
is worth more than £1,000 benefit in 10 years’ time
Identify All Costs and Benefits
A firm deciding on an investment project will only take account of its own private costs and benefits
e.g. total cost and total revenue. Firms ignore externalities. CBA will take account of both private and
external costs and benefits.
Consider a project to build a bridge over a river:
 Private Costs e.g. construction costs, operating costs and maintenance costs
 External Costs i.e. costs incurred by non-owners (a) monetary e.g. loss of profits to competitors e.g.
to ferry owner and (b) non-monetary e.g. noise, loss of countryside, inconvenience
 Private benefits direct the amount consumers are prepared to pay e.g. the tolls paid
 External benefits i.e. benefits to non-owners e.g. consumer surplus of users; time savings for
travelers and fewer accidents.

Measure the Benefits and Costs

Benefits and costs can be valued using money. Private costs and benefits are relatively easy to measure
in monetary terms.
Total costs and total revenue. - Private costs build the bridge: £5,000, 000 to operate it £200,000 a year,
to repair and maintain £ 50,000. Private benefits 1,000,000 users each paying £1 each = £1,000,000 a
year Externalities are more difficult to measure:
 Noise or loss of countryside. What value do people place on these? By how much do those who
suffer need to be compensated Ask them using a questionnaire! If 50,000 affected people value the
annual loss of countryside at £5 then cost = £250,000
 Time savings. What value do we place on work time saved or leisure time saved? Is the time saved
worth the same to everyone? If 100,000 hours re saved and valued at £4 per hour, benefit = £400,000
 Fewer accidents. Economists value human life using money. One life = £750,000. If the bridge saves
on life a year, annual benefit is £750,000
Likelihood of the cost or benefit.

If there is a 50% chance that a life will be saved then the benefit is
£750,000 x 0.5 = £375,000
The timing of the cost and benefit.

The major cost of the project occurs straight away. The benefits occur over the life of the project. The
bridge may cost £5m to build but consumers benefit by £1m a year. If the expected life of the bridge is
25 years then economists use discounting to value now the £1m of benefit in 25 years’ time. Commonly
the rate of interest or inflation is used to discount the future earnings as the £1m in 25 years’ time will
be worth substantially less today.
Is a project worth undertaking?

Yes if discounted benefits outweigh discounted costs. If the government has to choose between
competing projects then the ones with the highest positive net present.
General points regarding CBA

Here are some common examples that can be applied to many CBAs they will hopefully assist you in
answering any question.
The most common external costs arising from production are:
 Noise.
 Pollution of atmosphere, rivers etc.
 Danger to workers and public.
 Congestion.

The most common external costs arising from consumption are:
 Pollution from motor vehicles.

 Litter.
 Noise pollution.
 Externalities from smoking and drinking alcohol.
External benefits from production and consumption are often grouped together, the following are the
most commonly used examples:
 Industrial training by firms.

 Education which leads to an increase in human capital.
 Healthcare.
 Knowledge.
 Employment created.
 Arts and sports.
 Neighborhood watch schemes.
A range of different projects often attract cost-benefit analysis, e.g., The building of a new road.
 The building of new airport/runway.

 The expansion of a factory.
 The building of a supermarket.
 The provision of a public or merit good.
There are a number of problems with cost-benefit analysis:
 If the project leads to a time saving, it can often be difficult to place a value on the time saved.
 Lives may be saved, again what value do we place on a life?
 How do we place a monetary value on an eyesore, pollution or illness? These require a level of
judgment that may vary from person to person.
 Over time the value of the benefits will fall as inflation erodes the value of the pound. Any future
benefits would have to be discounted.
It is accepted that cost-benefit analysis can be an imprecise; however it is deemed to be better than
making no attempt to recognise the externalities at all. Due to the amount of judgment involved when
coming to the figures and discount rate the results should be viewed with caution. All of the assumptions
made in the cost-benefit analysis should be explicitly stated.
It is important to note who is carrying out the cost-benefit analysis and do they have a particular agenda,
i.e., do they want the project in question to be approved/turned down. Depending upon their stance will
affect what data they choose to include and their methods of interpreting it

Macroeconomics

Distinction between micro economics and macroeconomic
Microeconomics is concerned with a section, or part, of the economy e.g. the study of a particular
market structures, the behaviour of households or of businesses.
Macroeconomics means the whole economy is studied e.g. the output of all industries, the total
unemployment in the country, the economic growth and development of the nation, price stability, and
external equilibrium.
Five (5) Major macroeconomics policy objectives

1. Economic growth is an increase in Real GDP per capita.
2. Economic development includes economic growth plus an improvement in the standard of
living.
3. Full employment exists when the labour market clears allowing for structural, seasonal and
frictional unemployment. These three types of Equilibrium Unemployment are also known
as the natural rate of unemployment.
4. Price stability is a situation in which the average level of prices is moving within an
acceptable band, known as creeping inflation, usually defined as between 2% to 3% p.a.
5. External equilibrium is concerned with the Balance of Payments (BOP) on Current Account
of a country. That is, whether it is in balance, surplus or deficit. It is a reflection of the
external health of an economy. All of the above are closely inter-related. This is the key.
Students should understand how a change in one policy objective would affect all other
macroeconomic objectives. This will be covered throughout the following sections.

National Income
 Introduction
 Circular Flow of Income
 Nominal & Real National Income
 National Income Determination
 Aggregate Demand & Aggregate Supply
 Macroeconomic Equilibrium

National Income
National Income (N.I.) is the sum total of all final goods and services of a country produced in a year
and measured in money terms.
Note the word “final” in the above definition. This means that intermediate goods and services are
excluded. For example, there are thousands of components in a car: these are not measured twice, only
once at the final stage of the completed car. Also note the words “money terms” in the above definition.
This means that the figure is a Nominal figure. The figure had not been discounted by the inflation rate
to arrive at a Real figure.
The circular flow of income
A “flow” is a measure over a period of time e.g. over a year. National Income is a “flow”. A “stock”
is a measure at a point in time e.g. the number of students in the class at this moment.
Wealth is a stock concept, it is the sum total of all things of an economic value at a point in time. The
wealth of a family might consist of a house, a car etc. The money value of these added together is family
wealth at a particular time e.g. 30th June 2005. The family income is derived from adding together the
flow of income from wages, rent, interest and profit over a period of time e.g. one year.
There is a connection between the two – people with high incomes often use their incomes to gather
wealth. People can hold their wealth in forms that give income e.g. shares that give dividends, property
for rent income. A family is a microeconomic unit; these concepts also apply for a macroeconomic unit,
like a country. A country that creates high national income can invest part of it in wealth creation, like
factories, roads etc. This wealth can then help create higher future incomes.
National Income – can be shown in a ―circular flow of income diagram‖. It is a model of the macro
economy. To begin with, we take a simple model, and assume that there is only two sectors only –
households and firms. Households own and provide the factors of production. Firms provide the goods
and services.

Two sector flow of income
Two Sector Economy
Households
Factors of
Production: Goods
Land and
Labour Services
Capital
Enterprice
Firms
Households provide the factors of production. Firms produce the goods and services. Each of the
above resources has a flow and counter-flow.
Two Sector Economy – Circular Flow of Income
Households
Factor
Payments: Goods Consumer
Rent Factors of and Expenditure
Wages Production Services $
Interest
Profit
Firms

The above diagram shows the payments for goods and services running from households as Consumer
Expenditure. It also shows payments to the factors of production as wages, rent, interest and profit
running from firms to households.
Injections and Leakages

Some income earned is not used to buy goods and service from domestic firms; it is saved, taken as tax
by the government, or to buy overseas goods and services known as imports.
Circular Flow of Income – Leakages & Injections
Leakages = Savings (S)

Households Taxes (T)
Imports (M)
Consumption
Income Expenditure
Firms Injections = Investments (I)

Government
Expenditure (G)
Exports (X)
While households receive Income (Y) from firms, they do not spend it all on domestically produced
goods and services. There are leakages in the form of Savings (S), Taxes (T) and Imports (M). Firms
receive part of Consumption Expenditure (C) of households. They also receive other spending flows.
These spending flows are known as injections and include Investment (I), Government Spending (G)
and Exports (X).
Major concepts in National Income Accounting
Governments use three ways to measure the money value of all final goods and services produced in a
nation in one year.
These three measures are:
 National Output is the money value of all final goods and services produced in a nation in one year.
It is final goods and services, so it does not include intermediate goods (e.g. steel used in a car).
 National Expenditure is the spending on national output.

 National Income is all factor payments (wages, rent, interest, profit) earned from the factors of
production used in producing National Output. Therefore,:
𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆 = 𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑶𝒖𝒕𝒑𝒖𝒕 = 𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆

These three must be equal by economic definition. There are adjustments to make sure they are equal.
National Income also has a generic meaning: it is an overall term for the three measures.
Some Distinctions in National Income Accounting

 Gross Domestic product (GDP) is the sum of the value of all economic activity within a country. It
includes output and incomes generated by foreigners operating in a country.
 Gross National product (GNP) is the sum of all the value of all economic activity within a country
less output and incomes generated by foreign firms operating in the country plus Income earned
overseas. (i.e. “net property income to abroad”).
 Net National Income is the value of all output less depreciation. Depreciation is the wearing out of
capital goods (e.g. machines, buildings)
National Income at Factor Cost and National Income at Market Prices

National Income (NI) at market value is the value of final goods and services (National Output)
expressed in money terms. National Income at factor cost is equal to National Output, minus indirect
taxes plus subsidies.
“Market prices” and “factor cost”

All these measures of national income can be expressed either at “market prices” or at “factor cost”.
 Market prices- Here the value placed on any output uses the prices observed in the marketplace
(where these are available). Such prices may, however, be distorted by taxes and subsidies. For
example, the market prices of some products may be higher than they otherwise would be due to the
taxes levied on them. Alternatively, the market prices may be lower than they otherwise would be
due to subsidies received on them. “Market prices” is a valuation approach which includes these
impacts on price of both taxes and subsidies.
 Factor cost- Here the value placed on any output seeks to exclude the “distorting” impacts on the
prices of products of any taxes or subsidies.
a) Taxes are subtracted from the valuation at market prices.
b) Subsidies are added to the valuation at market prices.
Nominal & Real National Income
Nominal National Income is national income at current prices. Real National Income is N.I. for the
current year adjusted to take account of inflation. Also called N.I. at “constant prices”. This enables us

to measure the value of output compared to previous year. To see whether the increase is due to increases
in prices or increases in production. The latter-an increase in production- is the important measure.
Calculating Real GDP from Nominal GDP

The nominal GDP is reduced by the amount of the price increase-that is, inflation. The nominal figure
has to be deflated by the price increase; the price increase over “X” years is known as a deflator.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 100
× = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
1 100 + % 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒
Calculation of National Income

As stated earlier, there are three basis measures. These are:
1. Gross Domestic Product (GDP) by the Expenditure Method

GDP at market prices = C + I + G + X–M, where…
 Consumption Expenditure (C) is spending by individuals and households on durable goods

(those that last more than one year), non-durable goods (e.g. food) and services.
 Government Expenditure (G) is spending by all levels of government.
 Investments Expenditure (I) includes spending by firms on capital goods plus changes in
stock (inventories) and work in progress (uncompleted goods).
 Exports minus Imports (X-M) include the exports of a country minus its imports.
The formula GDP = C + I + G + X–M can also be expressed as…
AD = C + I + G + X–M, where AD = Aggregate Demand.
Aggregate Demand is the relationship between the aggregate quantities of goods and services
demanded-or Real GDP- and the price level– the GDP Deflator-holding everything else constant.
AD = C + I + G + X-M.
2. GDP by the Income Method

When calculating national product as a flow of incomes it is important to ensure that only the rewards
for factor services which have contributed to output in that year are included. In other words, only
those incomes paid in return for some productive activity during that year and for which there is a
corresponding output are included. Of course, it is the gross value of these factor rewards which
must be aggregated, since this represents the value of the output produced. Levying taxes on factor
incomes reduces the amount the factors actually received, but it does not reduce the value of the
output they produced. Rewards of factors of productions are shown below:

Factor of Production Income

Labor Wages
Land Rent
Capital Interest
Entrepreneurship Profit
 Transfer payments- These are simply transfers of income within the community, and they are
not made in respect of any productive activity. Indeed, the bulk of all transfer payments in
Zimbabwe are made by the government for social reasons. Examples include social security
payments, pensions, and child allowances and so on. Since no output is produced in respect of
these payments they must be excluded from the aggregate of factor incomes.
 Undistributed surpluses- Another problem in aggregating factor incomes arises because not all
factor incomes are distributed to the factors of production. For example, firms might retain part
or all of their profits to finance future investment. Similarly, the profits of public bodies may
accrue to the government rather than to private individuals. Care must be taken to include these
undistributed surpluses as factor incomes.
 Stock appreciation- Care must be taken to exclude changes in the money value of inventory or
stock caused by inflation. These are windfall gains and do not represent a real increase in the
value of output during the year.
 Net property income from abroad- When moving from GDP to either GNP or NNP we have seen
that it is necessary to add net property income from abroad to the aggregate of domestic incomes.
3. GDP by the Output Method

The value of output from each industry is added. Final output only, not intermediate goods and
services, to avoid double counting. A country‘s national income can be calculated from the output
figures of all firms in the economy. However, this does not mean that we simply add together the
value of each firm‘s output. To do so would give us an aggregate many times greater than the national
income because of double counting.
Avoiding double counting - The outputs of some firms are the inputs of other firms. For example,
the output of the agriculture industry is used in part as an input for the milling industry and so on.
To avoid including the total value of the wheat used in bread production twice (double counting) we
adopt one of two possible approaches. Either sum only the value added at each stage of production
or alternatively we sum only the value of final output produced for the various goods and services.
This can be illustrated as follows:

Intermediate
Activity Value Added Gross Price Sector
Cost
Farmer --- $2 $2 Primary
Miller $2 $1.60 $3.60 Secondary
Baker $3.60 $1.00 $4.60 Secondary
Retailer $4.60 $1.00 $5.60 Tertiary
Total $10.20 $5.60 $15.80
Basing on the hypothetical data above, if a country fail to consider double counting $15.80 will be
recorded as national income. This value over states the value of national income. To avoid overstating
national income, a country should only record the value of output added at each stage of production
and the value of national income will be $5.60.
All the other transactions involve the sale or purchase of intermediate goods or services.
 Inventories- We must also ensure that any additions to “stock and work in progress”
(inventories) are included in the output figures for each industry since any build-up in stock
during a year must represent extra output produced during that year.
 Public goods and merit goods - The government provides many goods and services through
the non-market sector, such as education, healthcare, defence, police and so on. Such goods
and services are clearly part of the nation‘s output, but since many of these are not sold through
the market sector, strictly they do not have a market price. In such cases, the value of the
output is measured at resource cost or factor cost. In other words, the value of the service is
assumed to be equivalent to the cost of the resources used to provide it.
 Self-provided commodities- A similar problem arises in the case of self-provided
commodities, such as vegetables grown in the domestic garden, car repairs and home
improvements of a do-it-yourself type. Again, these represent output produced, but there is no
market value of such output. The vast majority of self-provided commodities are omitted from
the national income statistics because it is impractical to monitor their production.
 Exports and imports- Not all of the nation‘s output is consumed domestically. Part is sold
abroad as exports. Nevertheless, GDP is the value of domestically produced output and so the
value of exports must be included in this figure. On the other hand, a great deal of domestically
produced output incorporates imported raw materials and components. Hence the value of the
import content of the final output must be deducted from the output figures if GDP is to be
accurately measured.
 Net property income from abroad -This source of income to domestic residents will not be
included in the output figures from firms. We have already noted that the net inflow (+) or
outflow (−) of funds must be added to GDP when calculating the value of domestically owned
output, i.e. GNP.

Calculating Real GDP from Nominal GDP

The nominal GDP is reduced by the amount of the price increase-that is, inflation. The nominal figure
has to be deflated by the price increase; the price increase over “X” years is known as a deflator.
Consideration of Uses and Limitations of National Income Accounts: Uses of

National Income Accounts
1. Forecasting changes in the economy. The forecasts are often used in planning.
2. Comparison of economic performance over time and between countries.
3. To make judgements about economic welfare within a country.
4. Comparing standards of living between countries.
5. Measuring economic trends.
6. Assist in the formulation of economic policies and allocation of resources.
7. Required by international bodies and institutions e.g. IMF, World Bank etc.
8. Measuring the rate of economic growth.
9. Assessing employment levels.
Do national income statistics give a good indication of a country‘s standard of

living?
If we take into account both inflation and the size of the population, and use figures for real per-capita,
will this give us a good indication of a country‘s standard of living?
The figures do give quite a good indication of the level of production of goods and the incomes generated
from it, provided we are clear about the distinctions between the different measures. But when we come
to ask the more general question of whether the figures give a good indication of the welfare or happiness
of the country‘s citizens, then there are serious problems in relying exclusively on GDP statistics.
Problems with national income statistics as an indicator of country‘s standard

of living
 Distribution of income is not reflected in the GDP per head. It is an average figure and there may
be a very unequal distribution of income in a country. For example, the USA has the highest per
capita income in the world but in some groups there is a great deal of relative poverty.
 GDP figures do not take into account productive activity that is not paid for (marketed) e.g.
persons doing house duties. Nor does it count the “underground economy” or black market
economy.
 The composition of output is not revealed. A country may produce a lot of military goods as part
of its GDP and few consumer goods. As well, there may be very few capital goods; this would
mean there would be less production in the future.
 The quality of goods is not measured. Improvements in goods produced have been significant.
 Production does not equal consumption. Production is desirable only to the extent that it enables
us to consume more. If GDP rises as a result of a rise in investment, this will not lead to an
increase in current living standards. It will, of course, help to raise future consumption. The same

applies if GDP rises as a result of an increase in exports. Unless there is a resulting increase in
imports, it will be consumers abroad that benefit, not domestic consumers.
 The human costs of production. If production increases this may be due to technological advance.
If, however, it increases as a result of people having to work harder or longer hours, its net benefit
will be less. Leisure is a desirable good, and so too are pleasant working conditions, but these
items are not included in the GDP figures.
 GDP ignores externalities. The rapid growth in industrial society is recorded in GDP statistics.
What the statistics do not record are the environmental side-effects: the polluted air and rivers,
the ozone depletion, the problem of global warming. If these external costs were taken into
account, the net benefits of industrial production might be much less.
 The production of certain “bads” leads to an increase in GDP. Some of the undesirable effects
of growth may actually increase GDP. Take the examples of crime, stress-related illness and
environmental damage. Faster growth may lead to more of all three. But increased crime leads
to more expenditure on security; increased stress leads to more expenditure on health care; and
increased environmental damage leads to more expenditure on environmental clean-up. These
expenditures add to GDP. Thus, rather than reducing GDP, crime, stress and environmental
damage actually increase it.
In spite of the weaknesses mentioned above, Real GDP per capita is still the best single indicator of
Standard of Living (SOL).
Comparing living standards of different nations

Taking account of exchange rates: the use of Purchasing Power Parity measures. There is a big problem
with comparing GDP figures of different countries. They are measured in the local currency and thus
have to be converted into a common currency (e.g. dollars) at the current exchange rate. But the
exchange rate may be a poor indicator of the purchasing power of the currency at home. For example,
Z$1 may Exchange for, say, 200 Rands. But will Z$1 in the Zimbabwe buy the same amount of goods
as 200 Rands in South Africa? The answer is almost certainly no. To compensate for this, GDP can be
converted into a common currency at a purchasing-power parity rate. This is a rate of exchange that
would allow a given amount of money in one country to buy the same amount of goods in another
country after exchanging it into the currency of the other country.
National income statistics are used to compare the living standards of different countries. Apart from
the problem of exchange rate fluctuations over time between the countries being compared, there are a
number of other difficulties when making international comparisons.
There may be differences not only in the way national income is calculated but also in the reliability of
the collected data.
 The two countries in question may have different climates. So, for example, when comparing
Sweden and Zimbabwe, Sweden may need to spend a higher proportion of its national income
on heating and clothing in order to achieve the same “quality of life” as Zimbabwe. Countries

will, therefore, have different needs and tastes which cannot be readily taken into account when
making international comparisons.
 The two countries may provide other differences in quality of life which are even more difficult
to reflect in terms of a monetary value, e.g. feelings of safety from attack, freedom to express
one‘s viewpoint without fear of retribution, access to the countryside.
 Other factors that make international comparisons difficult might include variations between
countries in any or all of the following:
o The level of unrecorded activity, such as activity in the informal (“black”) economy.
o ● Numbers of hours that people work.
o The level of public provision of goods and services.
o The distribution of national income (i.e. levels of inequality).
o The levels of negative externalities such as road congestion/pollution.
Difficulties which are involved in the measurement of national income

The measurement of national income is a complicated problem and is beset with the following
difficulties.
 Non-availability of statistical material: Some persons like electricians, plumbers, etc., do some
job in their spare time and receive income. The state finds it very difficult to know the exact amount
received from such services. This income which, should have been added to: the national income is
not recorded due to lack of full information of statistics material.
 The danger of double counting: While computing the national income, there is always the danger
of double or multiple counting. If care is not taken in estimating the income, the cost of the
commodity is likely to be counted twice or thrice and national income will be overestimated.
 Non-marketed services: In estimating the national income, only those services are included for
which the payment is made. The unpaid services, or non-marketed services are excluded from the
national income.
 Difficulty in assessing the depreciation allowance: The deduction of depreciation allowances,
accidental damages, repair, and replacement charges from the national income is not an easy task. It
requires high degree of judgment to assess the depreciation allowance and other charges.
 Housing: A person lives in a rented house. He pays $500 .per month to the landlord. The income of
the landlord is recorded in the national income. Let us suppose that the tenant- purchases the same
house from the landlord. Now the income of the owner occupant has increased by $ 500. Is it not
justifiable to include this income in the national income? Should or should not this income be
recorded in the national income is still a controversial question.
 Transfer earnings: While measuring the national income, it should be seen that transfer payments
should not become a part of national income. The payments made as relief allowance, pensions, etc.
do not contribute towards current production. So they should be excluded from national income.
 Self-consumed production: In developing countries, a significant part of the output is not
exchanged for money in the market. It is either consumed directly by producers or bartered for other
goods. This unorganized and non-monetized sector makes calculation of national income difficult.

 Price level changes: National income is measured in money terms. The measuring rod of money
itself does not remain stable. This means that national income can change without any change in
output.
 Self-consumed-bartered consumption: Some of the transactions of agricultural goods in the
villages are done without the use of money. The statisticians, therefore, cannot measure the exact
amount of the transactions for inclusion in the national income.
 No systematic accounts maintained: Most of the producers do not keep any record of the sale of
the products in the market. This makes the task of national income still more complicated.
 No occupational classification: There is no occupational specialization in the under-developed
countries. People receive Income by working in various capacities. One person sometimes works as
carpenter and at another time as mason. The statisticians cannot accurately measure the income of
such persons.
 Unreliable data: The statisticians themselves do not feel the importance of figures which they
collect. They also do not take much pains for getting the reliable data. The figures of national Income
are, therefore, not up-to-date in the under-developed countries. Again the public is also not ready to
provide the correct figures about the income due to the fear of income tax. Lastly, some people do
not keep any proper account about their business income, so their income is not included in the
national income.
 Shortage of trained staff: There is a shortage of trained staff which may collect the statistics about
the national product.
National Income Determination
Macroeconomic Models
A model is a simplification of reality. In Economics, models are used to help in the understanding of
complex economic issues. In this section we study the Aggregate Demand/Aggregate Supply Model
(AD/AS model). Aggregate Demand (AD) is the sum total of all final goods and services purchased in
the economy.
The formula for AD is: AD = C + I + G + X-M
Aggregate Demand is related to the price level. A rise in the price level usually results in a fall in AD.
A fall in the price level usually results in an increase in AD. It is shown on an AD curve that slopes
down from left to right. The price level is an average of all prices, measured by an index of prices.
Derivation of the AD Curve

Aggregate Demand is the total planned spending by all sectors for all final goods and services in the
market. This figure is known as National Income. It can be measured in 3 separate ways: National
Income (NI), National Output (NO) and National Expenditure (NE). For the model, we use NE. We
measure the sum of planned expenditure of all sectors in the economy; that is Aggregate Demand (AD).

The formula is: AD = C + I + G + X-M, where:

AD = Aggregate Demand
C = Consumption Expenditure
I = Investment Expenditure
G = Government Expenditure
X = Exports.
M = Imports.
As we are relating the Total Output of goods and services to changes in the price level we must use the
Real National Income or the Real GDP figure. That is, nominal GNI/GDP has been deflated by the
inflation rate. The AD Curve slopes downwards to the right.
Aggregate Demand Curve
Price
Level
AD
Real GDP
Determinants of Aggregate Demand

There are six main factors that cause a shift in the AD Curve. These are:
1. Fiscal policy
2. Monetary Policy
3. Foreign Incomes
4. Currency Exchange Rates
5. Expectations
6. External Shocks
A shift in the AD Curve is shown in the diagram below

Shifts in the AD Curve
Price
Level
AD1
AD
AD2
Real GDP
A shift in the AD Curve to the right, from AD to AD1, shows an increase in Real GDP. A shift in the
AD Curve to the left, from AD to AD2, shows a decrease in Real GDP. The below are determinants of
aggregate demand.
1. Fiscal Policy (FP)

Fiscal Policy refers to the government‘s policy on taxation (T) (direct and indirect), government
expenditure (G) and transfer payments (G) and their effect on aggregate demand and aggregate
supply. Fiscal Policy involves the government budget. All governments prepare and publish an
annual budget. This lists major items of revenue and expenditure and sets out government policy in
each of these key areas.
Government policy can be used to change AD through changing items in its Budget like tax (T),
government spending (G) and transfer payments (G).
Changes in Fiscal Policy can increase AD and/or decrease AD.
Examples of an increase in AD, where
YD = disposable income
→ = leads to/results in
↑ = increases
↓ = decreases
If the government reduced income tax → personal income tax↓→Yd↑→C↑→AD↑

If the government increased transfer payments→ G→Yd↑→C↑→AD↑

If the government reduced company tax → company profits↑→ I↑→ AD↑
If the government spends more money on infrastructure like roads or hospitals or on wages for public
servants→ G↑→AD↑
Note: Government fiscal policy can also be used to reduce AD.
2. Monetary Policy (MP)

Monetary Policy (MP) involves changes in the rate of interest rates (i/r) and money supply (MS).
MP in most countries is determined by the Central Bank. It is, therefore, independent of Fiscal
Policy.
However, in some countries- such as China, North Korea, MP is controlled by the Government. This
means that the government controls both MP and FP. This can cause economic problems. For
example if i/r ↓→ the cost of borrowing is cheaper for both households and firms→ C↑ & I↑→AD↑
Or if MS↑→C↑→AD↑ or
→i/r↓→C↑ & I↑→AD↑
3. Foreign Income Changes

If incomes in other countries, (particularly the country‘s major trading partners)↑→X↑→AD↑. If
domestic incomes↑→M↑→AD↓

Exchange rate is the price of a currency expressed against another, or group of currencies, on the
foreign exchange market. Depreciation of currency is the reduction in the value of a domestic
currency against foreign currencies under a regime of floating exchange rates. Appreciation of
currency is an increase in the value of a domestic currency in terms of other currencies. Occurs as a
result of market forces.
If the value of the currency ↓→ the price of exports↓→X↑→AD↑ and → the price of
imports↑→M↓→AD↑
If the value of the currency↑ → the price of exports↑→X↓→AD↓ and → the price of
imports↓→M↑→AD↓
5. Expectations
If consumers expect prices to rise, an increase in inflation, they may buy now. Therefore, →
C↑→AD↑ or if firms are optimistic about future sales it is likely that they will buy more capital
goods →I↑→AD↑. If consumers expect their incomes to rise → C↑→AD↑
6. External Shocks

If AD increases suddenly, and then falls back again to its original level, is known as external shock
or demand-side shock. Example: the Earthquake/Tsunami in December 2004.
Derivation of the Aggregate Supply Curve

Aggregate Supply is the total value of all the goods and services that firms plan to produce. Short Run
is the period when prices of goods and services rise but factor prices do not change. Factor prices include
the prices of labour (wages) and capital (interest).
Long Run is the period when factor prices rise to adjust to price changes in goods and services. AD and
AS are equal in all markets in the L.R., including labour demand and supply. There is Full Employment
(FE) in the L.R. in the labour market when there is L.R. equilibrium. It is not zero percentage
Unemployment (U.E.) The U.E. that still exists is „the natural rate of unemployment‟.
Short-Run Aggregate Supply (SRAS)

SRAS is the relationship between Aggregate Supply (AS) of final goods and services and the price level,
holding all else constant. In this Model, the important assumption is that factor prices remain constant.
Short-run Aggregate Supply Curve
Price
Level SRAS
Depression Intermediate Physical

Range Range Limit
Real GDP
Depression Range: The firm will be willing to produce increasing amounts at the same price. Why?
Because factor prices do not increase. For example, there is unemployment and workers will not demand
higher wages, so the firm‘s costs will not increase in this range.
Intermediate Range: It is the normal range in which the economy would operate. Firms can charge
higher prices for their goods and services, without an increase in factor prices. Their profits would
increase, so they produce more goods and services.

Physical limit: there are no more resources available so firms are unable to produce beyond this amount
no matter how much the price level increases. All the resources are employed. The SRAS Curve is
perfectly inelastic.
The SRAS Curve in the intermediate range
SRAS – Intermediate Range
Price
Level SRAS
Real GDP
Two reasons why SRAS Curve is upward sloping:
 The law of diminishing returns.

 The existence of resource, or supply side, bottlenecks. That is, as the economy moves closer to
full employment some of the factors of production are in short supply – e.g. certain skilled labour.
Long Run Aggregate Supply (LRAS)

Long Run Aggregate Supply (LRAS) is the relationship between real output and the price level at full
employment. Full Employment (FE) includes “the natural rate of unemployment”. The diagram below
shows the levels of production where firms would normally operate, which is the intersection of the
SRAS and the LRAS Curves.

Long-run Aggregate Supply Curve
LRAS
Price
Full Unemployment / Natural
Level Rate of Unemployment
SRAS
Unemployment Full Unemployment

Range Range
Real GDP
 LRAS Curve is vertical, at the full employment level of production. Because factor prices rise for
the reasons outlined above, there is no incentive to produce more because profits will be consumed
by the higher costs. In the Short Run factor costs did not rise so profits generated by price rises were
not used up by rising costs.
 If output increased above the full employment level, decreasing ‗the natural rate of unemployment‘,
the shortage of labour forces wages up so that they rise faster than price rises, profits will fall, firms
will cut production and their number of workers and so unemployment will fall back to the natural
rate.
Determinants of Aggregate Supply

Factors that cause a shift in SRAS\LRAS Curve include:
1. A change in the quantity and quality of capital investment.

2. A change in the quantity and quality of labour.
3. Supply side polices of government.
4. Government legislation.
5. Weather.
7. Supply-side shocks

Shifts in the LRAS Curve
LRAS1 LRAS2
Price
Level
Q1 Q2 Real GDP
1. Quantity and Quality of Capital Investment

An increase in the amount of capital investment (e.g. more computers or machinery) will increase
the productivity of workers and consequently lead to an increase in production. Known as Capital
Widening. Productivity is the output per unit of input. An improvement in the quality of capital
(improved technology) also leads to increased supply. Known as Capital Deepening.
2. Quantity and Quality of Labour

Human Capital is the investment that takes place in the factor of production-labour aimed to increase
productivity, well-being and job satisfaction. Occurs through the investment in education and
training of people.
A larger number of workers (labour force) will lead to increased output. For example, an increase in
the labour force will occur if there is increased migration or increased participation of women in the
workforce. Better training and education will result in a better quality workforce. This, in turn, will
lead to increased productivity and production. The development of Human Capital is one of the most
important factors for a country to increase is Aggregate Supply.
3. Supply-Side Policies
Supply-side policies and deliberate government action to increase AS. Government action to
increase the quantity and quality of the labour force e.g. more Government spending on education
and training.
4. Changes in Legislation

Changes in laws can affect AS: e.g., changes in the school leaving age can affect the size of the
labour force.
5. Changes in Weather
Production and output of some sectors of the economy are weather-dependent. As a result, SRAS
will be affected. For example, weather can affect the level of agricultural production. A drought or
a flood can reduce the amount produced in a particular year. However, these are only temporary
changes and shift only SRAS.
Note: Current theory argues that the LRAS curve remains unaffected. Economic reality suggests
otherwise; that is, the LRAS curve shifts.

AS will be affected by changes in the exchange rates.
 If the value of the currency ↓→ the price of exports↓→X↑→AS↑ and → the price of
imports↑→M↓→AS↑
 If the value of the currency↑ → the price of exports↑→X↓→AS↓ and → the price of
imports↓→M↑→AS↓
7. Supply-Side Shocks
These can be the same as demand-side external shocks, except they affect AS. For example,
international political, social or natural events can affect the output of firms and governments thus
affecting AS. Examples include, a tsunami, war and an earthquake. All can cause major disruptions
to AS.

Macroeconomic Equilibrium
Short-run Equilibrium
Price
Level
SRAS
P1 Macroeconomic
Equilibrium
AD
Q1 Real GDP
Now we bring SRAS and AD together. Macroeconomic equilibrium occurs where SRAS = AD.
Macroeconomic equilibrium is where SRAS = AD. The price level is P1, and Real GDP is 0Q1.
Macroeconomic Equilibrium and Full Employment

The economy is at full employment when it on the LRAS Curve. Note: The definition of full
employment includes “the natural rate of unemployment”. Macroeconomic equilibrium where AD
= SRAS may be equal to, less than, or greater than, full employment (on the LRAS Curve) Real GDP.
In the “perfect/ideal world”, governments and economists strive to achieve a macroeconomic situation
where SRAS =AD =LRAS.
Three Types of Macroeconomic Equilibrium

i. Full Employment Equilibrium:

Full Employment Equilibrium
LRAS
Price
Full Unemployment / Natural
Level Rate of Unemployment
SRAS
Macroeconomic
PE
Equilibrium
AD

Range Range
QE Real GDP
Where SRAS = AD = LRAS. Real GDP = 0QE, Price level = P1. The economy is operating at
full capacity, full employment exists, and Real GDP is maximized.
ii. Unemployment Equilibrium:

The economies of the majority of countries are operating in this range. Where macroeconomic
equilibrium (SRAS = AD) is less than full employment equilibrium (on LRAS Curve).
Recessionary Gap
LRAS Full Unemployment / Natural

Price
Rate of Unemployment
Level
Macroeconomic SRAS
Equilibrium
Recessionary Gap
P1
AD

Range Range
Q1 QE Real GDP

Actual Real GDP =0Q1 and Potential Real GDP = 0QE. In this situation, the actual level of Real
GDP, 0Q1, is less than the level of potential Real GDP, 0QE, at price level P1. Thus, the economy
is operating in the unemployment zone. Less than full employment is achieved. A recessionary gap
exists. As a result, we can see that the following macroeconomic objectives are not being achieved:
o Economic Growth.
o Economic Development.
o Full employment.
Without additional information it is difficult to comment on whether the other two macroeconomic
objectives-price stability and external equilibrium-are being achieved. With regard to external
equilibrium, we can say that the Balance of Payments on Current Account could be improved
because the economy is operating below its potential. That is because actual Real GDP is less than
potential Real GDP. This is less than an ideal/satisfactory situation and of concern to economists,
and the government and Central Bank.
iii. Above Full Employment Equilibrium
Inflationary Gap
LRAS Full Unemployment / Natural

Price
Rate of Unemployment
Level
SRAS
Inflationary
Gap Macroeconomic
P1
Equilibrium
AD
Unemployment Above Full

Range Unemployment Range
QE Q3 Real GDP
In this situation, the actual level of Real GDP, Q3, is greater than the level of potential Real GDP,
QE, at price level P1. Thus, the economy is operating in the above full employment zone. An
inflationary gap exists. This cannot exist in the long run. As a result, we can see that the following
macroeconomic objectives are being achieved:
o Economic Growth.

o Economic Development. This depends on whether resources from (a) are directed in this
area.
o Full employment.
Because an inflationary gap exists, we can say that the macroeconomic objective of price stability is
not being achieved. Without additional information it is difficult to comment on whether the other
macroeconomic objective of external equilibrium is being achieved.
With regard to external equilibrium, we can say that the Balance of Payments on Current Account
is likely to worsen due to domestic inflationary pressures. Domestic goods and services will now be
less competitively internationally. As a result, X‘s are likely to decline and M‘s (which will become
relatively cheaper) are likely to increase. This is less than an ideal/satisfactory situation and of
concern to economists, and the government and Central Bank.

International Trade
 Introduction.
 Absolute & Comparative Advantages
 Trade Protectionism
 Economic Integration
 Balance of Payments
 Exchange Rate System

Introduction
International trade refers to a situation when two or more countries exchange goods and services. There
two forms of trade that is bilateral trade and multilateral trade. Bilateral trade is trade between only two
countries and multilateral trade is trade between more than two countries.
Reasons for international trade

Countries trade with each other for the following reasons:
 To gain access to those products which are not found naturally within their geographical boundaries
e.g. Zimbabwe need to import fuel from countries that are richly endowed in petroleum deposits.
 To share cultural heritage and historical experiences e.g. tourists will love to visit the Great
Zimbabwe ruins in Masvingo for them to appreciate the life of the great Rozvi Empire.
 To foster political relations, that is, countries trading with each other consider themselves to be
partners and hence will be less likely to engage each other in a war situation. This explains why upon
signing political agreements countries proceed to sign trade agreements.
 To introduce new technology and ideas, for example, developing countries have to import modern
technology from the developed countries.
 Trade stimulates competition that may lead to reduction in prices and improvement in the quality of
goods produced.
 The volume of goods consumed in a country will increase hence the standard of living of the people
will improve.
Determinants of Trade Flows between Countries

There are a number of factors that explain trade flows between countries.
Gains from trade theories

International trade makes the problem of scarcity less acute or less severe. The following theories
illustrate how countries may gain from specialisation and international trade. They are also used to
illustrate situations when countries should trade with each other. In other words, countries should trade
with each other if there is an absolute advantage or a comparative advantage.
Simplifying assumptions: For the purpose of our discussion, we assume that:
 There are only two countries in the world, Country A and Country B.
 Each of these two countries produces two goods, Good X and Good Y.
 In each of the two countries, there are only two factors of production available, Labour and
Capital.
 There are no barriers to trade and no transport cost that is goods are free to move from one
country into another country without for example being charged customs duty or transport cost.
 Factors of production within each country are perfectly occupationally mobile but cannot move
from one country to another.

Basing upon these simplifying assumptions we can illustrate absolute and comparative advantages
models.
The absolute advantage theory
An absolute advantage exists when a country is more efficient than the other in the production of one of
the commodities. For example, if with two units of resources , country A produces 20 units of good X
and 100 units of good Y, while country B produces 10 units of good X and 150 units of good Y as
summarised by the following production possibilities table and frontier. Table below shows Production
possibilities before specialization with Output per unit resources.
Country Units of Good X Units of Good Y

A 20 100
B 10 150
Total World Output 30 250
Production possibility curves before specialization
PPC before Specialization
Good Y
150
Country B
100
Country A
10 20 Good X
The diagram shows that with one unit of resources, country A is more efficient in the production of good
X, while with the same quantity of resources, country B is more efficient in the production of good Y.
Thus country A has an absolute advantage in good X production while country B has absolute advantage

in good Y production. Country A must specialise in good X production while country B specialises in
good Y production. Each country will move its two units into the production of the good it has absolute
advantage in producing. The changes in total world production would be represented by the following
production possibilities table.
The production possibilities table after specialization with Output per unit resources

A 40 0
B 0 300
Total World Output 40 300
Net Gain +10 +50
By allowing for specialisation the world total output of both goods has increased. The two countries can
trade with each other with each county exporting its surplus in exchange for that commodity it does not
produce. For example country a will export surplus units of good X in exchange for units of good Y
from country B.
The comparative advantage theory

Comparative advantage analysis arises from a situation when one country has absolute advantage in the
production of both commodities. A comparative advantage exists when a country can produce a certain
good at a lower opportunity cost than the other country. For example if with its units of resources country
A produces 10 units of good X and 8 units of good Y while with the same amount of resources country
B produces 2 units of good X and 4 units of good Y as represented by the following production
possibilities table and frontier.

A 10 8
B 2 4

PPC before Specialization
Good Y
Country B
Country A
2 10 Good X
The diagram shows that country A has an absolute advantage in the production of both goods. To
determine the basis for trade we look at the opportunity cost of one good in terms of units of the other
in each country. The opportunity cost of one unit of good X in terms of good Y and that of one unit of
good Y in terms of good X, in each country is as follows:
Opportunity Cost Table

In Country A: 1X = 0.8Y and 1Y = 1.3X
In Country B: 1X = 2.0Y and 1Y = 0.5X
Country A has a comparative advantage in the production of good X while country B has comparative
advantage in the production of good Y. Therefore country A specialises in good X and country B in
good Y production.
Causes of cost differences

There are mainly two reasons why the cost of producing one commodity differs from one country to
another.
 Some countries are endowed in certain natural resources or climate conducive to the production of
certain commodities than the others. For example Zimbabwean climate is favourable to the
production of tobacco than Botswana’s climate.
 Some people have innate qualities of manual dexterity, scientific ability, and enterprise and which
give them advantages over other countries e.g. the Japanese.

Limitations of the gains from trade theories

 The theories are simplistic. They assume the existence of two countries producing two goods using
two factors of productions. In practice there are more than two goods, two factors and trade is
multilateral rather than bilateral.
 Goods are assumed to be of the same quality, that is, they are homogenous. This is unrealistic
because the quality of goods differs from one country to another.
 The theories assume that there are no transport costs and there is free trade. In reality, the advantages
of specialisation can be cancelled by trade restrictions and transport costs.
 Opportunity Cost is not constant in the real world.
 The Production Possibility Frontier is not a straight line, but a curve convex\concave to the origin.
 Immobility of the factors of production.
 Dangers of being over-specialized.
 The models does not allow for uncertainty and risk. Concentration on a few primary commodities
subjects developing countries to considerable risk. Why? Because: - synthetic substitutes replace
primary goods and developed countries protect their primary industries against cheap imports.
 In the comparative advantage model prices reflect opportunity cost. However, it is only under
conditions of Perfect Competition that relative prices reflect opportunity costs. Governments distort
prices; for example through subsidies and taxes.
 The models does not take into consideration who gains from trade. As the majority of world trade is
by developed countries, and MNCs, it is them who gain the most from trade, not the developing
countries.
 The model assumes full employment (and, therefore, countries are producing on their PPF). Not
true. Developing countries experience high levels of unemployment and under-employment.
 The model does not allow for economies of scale. Developing countries may enjoy lower
opportunity costs in the future through economies of scale.
Other Determinants of Trade Flows

Greater Economies of Scale
The theory of long run costs shows that firms frequently gain economies of scale as they grow and
the average cost of production falls as production increases. Trade allows business to sell in much
larger markets than just selling in the domestic market. With lower average costs of production,
firms are better able to compete in world markets. Exports increase, improving the BOP on current
account.
Increased International Competition

International trade may well increase efficiency in industries which would otherwise enjoy a
domestic monopoly and/or reduced competition, leading to a very competitive market with lower
prices and higher output. For example, domestic monopolies or oligopolies will face increased
international competition in their domestic market. To now compete, these firms will have to

improve their operational efficiencies, lower prices, improve quality and so on. Domestic consumers
will benefit through increased competition and lower prices.
The Spread of Modern Technology

Best practice in production techniques spreads rapidly with international trade. China is a very good
example. Since opening its doors to major trade in the 1980s, many MNCs have established
manufacturing operations in China. These companies have brought, and introduced into China, new
modern technology and manufacturing best practices.
Lower Domestic Prices/Importing Deflation

Generally with expanding world trade comes lower domestic prices because of increased
competition. This is a major benefit to consumers. It is also a benefit to domestic producers that use
imports as major inputs in their production. From a macroeconomic view, cheaper imports can result
in countries “importing deflation” with resultant flow-on benefits to the whole economy. Lower
inflation leads to cheaper goods/services, higher consumption, increased investment, increased
exports, and increased AD and SRAS.
Technology Deflation
Technology deflation is a sustained decrease in the price of goods and services that result from
improvements and application of technology. Examples include digital cameras and DVDs.
Expanding world trade has resulted in technology deflation in many countries. Other reasons for
trade include: political, military, cultural and social gains; greater variety and choice of goods and
services.
Terms of Trade (TOT)
Terms of trade refers to the quantity of exports that must be exchanged for a unit of imports. It is the
rate at which a country exchanges its exports for imports and it can be expressed as an index as follows:
𝑰𝒏𝒅𝒆𝒙 𝒐𝒇 𝑬𝒙𝒑𝒐𝒓𝒕 𝑷𝒓𝒊𝒄𝒆𝒔
𝑻𝒆𝒓𝒎𝒔 𝒐𝒇 𝑻𝒓𝒂𝒅𝒆 = × 𝟏𝟎𝟎
𝑰𝒏𝒅𝒆𝒙 𝒐𝒇 𝑰𝒎𝒑𝒐𝒓𝒕 𝑷𝒓𝒊𝒄𝒆𝒔
If the index is less than 100 it is unfavorable terms of trade while if the index is greater than 100 it is
favourable terms of trade. Terms of trade reflect the opportunity cost of one good measured in terms of
the other. From the previous opportunity cost table, good X and Y can be exchanged for.
Causes of Changes in the Terms of Trade

1. Short Run: day-by-day changes in a floating exchange rate will affect both X and M prices. Capital
movements dominate this change.
2. Long Run: the movement in domestic prices determines the trend of exchange rates. The domestic
inflation rate and productivity determine domestic prices. The relative inflation rates of trading
countries are important.

Volatility of the Terms of Trade for developing countries

Most developing countries are heavily dependent on a few primary products for exports. Major factors
that determine developing countries Terms of Trade include:
1. Their Primary products tend to be PED inelastic.

2. Their Primary products tend to be PES inelastic.
3. Their Primary products tend to be YED inelastic.
4. Their imports tend to be PED elastic.
5. They are subjected to major supply-side external shocks.
6. Most developing countries are heavily reliant on oil imports. Oil prices always fluctuate.
Trade protectionism
Trade protectionism is where a country erect trade barriers with the purpose of hampering the free
movement of goods into an economy from the rest of the world. These barriers interfere with the gains
from free trade. In other words the gains from trade theories illustrated how countries stand to benefit if
they allow for specialisation and trade. In practice, these benefits are eroded by the various tariffs,
embargos, etc that are imposed on goods from other countries.
Methods of trade protectionism

The methods that could be used reduce or prevent entry of goods from other countries into a country
include:
1. Tariffs
A tariff is a tax or customs duties levied on imported or exported goods. The tariff can either be
expressed as percentage of value (ad valorem) or per unit of the imported or exported commodity
(specific). The effect of a tariff is that it increases the final price of the imported or exported
commodity. For example a vehicle imported for US$5 000 may end up costing US$10 000 to a local
importer if an 80% customs duty and 20% surtax is added to the import price. Thus tariffs make
imports more expensive.
The Effects of a Tariff

Partial Equilibrium of a Tariff
A tariff reduces the quantity of imports and moves a market closer to the equilibrium that would
exist without trade. Total surplus falls by an amount equal to area D + F. These two triangles
represent the deadweight loss from the tariff.

Partial Equilibrium of a Tariff
Price of
steel
Domestic
Supply
Equilibrium
Without Trade
B
Price with
Tariff Tariff
C D E F
Price without
World Price
Tariff G Import with
Tariff Domestic
Demand
Q1 Q2 Q3 Q4 Quantity of
Steel
Imports without
Tariff
The diagram above shows the market for steel. Under free trade, the domestic price equals the world
price. A tariff raises the price of imported steel above the world price by the amount of the tariff.
Domestic suppliers of steel, who compete with suppliers of imported steel, can now sell their steel
for the world price plus the amount of the tariff. Thus, the price of steel both imported and domestic
rises by the amount of the tariff and is, therefore, closer to the price that would prevail without trade.
The change in price affects the behaviour of domestic buyers and sellers. Because the tariff raises
the price of steel, it reduces the domestic quantity demanded from Q1 to Q2 and raises the domestic
quantity supplied from Q1 to Q2. Thus, the tariff reduces the quantity of imports and moves the
domestic market closer to its equilibrium without trade. Now consider the gains and losses from the
tariff. Because the tariff raises the domestic price, domestic sellers are better off, and domestic
buyers are worse off.
In addition, the government raises revenue. To measure these gains and losses, we look at the
changes in consumer surplus, producer surplus, and government revenue.

Before Tariff After Tariff Change

Consumer Surplus A+B+C+D+E+F A+B -(C+D+E+F)
Producer Surplus G C+G +C
Government Revenue None E +E
Total Surplus A+B+C+D+E+F+G A+B+C+E+G -(D+F)
Before the tariff, the domestic price equals the world price. Consumer surplus, the area between the
demand curve and the world price, is area A+ B + C + D +E +F. Producer surplus, the area between
the supply curve and the world price, is area G. Government revenue equals zero. Total surplus, the
sum of consumer surplus, producer surplus, and government revenue, is area A + B +C + D +E+ F
+ G. Once the government imposes a tariff, the domestic price exceeds the world price by the amount
of the tariff. Consumer surplus is now area A + B. Producer surplus is area C + G. Government
revenue, which is the quantity of after-tariff imports times the size of the tariff, is the area E. Thus,
total surplus with the tariff is area A+ B +C + E + G.
To determine the total welfare effects of the tariff, we add the change in consumer surplus (which is
negative), the change in producer surplus (positive), and the change in government revenue
(positive). We find that total surplus in the market decreases by the area D + F. This fall in total
surplus is called the deadweight loss of the tariff.
2. Quota
A quota is a quantitative restriction on imports or exports. Once the quota is satisfied or met no additional
quantity will be imported or exported. The situation is the same for domestic producers as with the tariff,
but importers now receive the revenue the govt. used to receive.

Partial Equilibrium of a Quota
Price of
steel
S1
D1
S2
P2 New Equilibrium
S2 = With
P3 Free Trade
Q1 Import Q2 Q3
Quantity of
Steel
Domestic Production Domestic Production
Before Quota Post-Quota
Total Domestic Supply
Supply Curve: at Q2, increases from S2 to S3

Price: this is increased from P2 to P3
Domestic Supply: 0Q1 plus Q2-Q3
Imports: Q1 to Q2
Winners: domestic producers because price is higher at P3
Losers: domestic consumers because the cheaper quantity of imports is less and they have to pay
the higher domestic price Results in reduced the consumption of the good or service compared
to Free Trade.
3. Embargo - An embargo is a complete ban prohibition on trade for example trade in hard drugs such
as cocaine.
4. Import controls
Import controls refer to a situation where the government puts in place legislation or measures that
regulates the importation of certain products. For example agricultural products such as maize and
live animals can only be imported upon receiving the authority in the form of import licenses from
the Ministry of Agriculture and Ministry of Health and the Department of Veterinary Services.

5. Exchange controls - Exchange controls refer to when the availability of foreign currency is
restricted in order to control the volume of imports. If people do not have the foreign currency they
cannot import.
6. Subsidies
A subsidy is the opposite of a tax. A subsidy refers to a situation where the government pays a part
of the production costs for a domestic commodity. If domestic goods are subsidized, they become
cheaper as compared to imports. If placed upon exports. This lowers their price below their true
production cost. Make them cheaper compared with their overseas competitors.
Major Effects:
1. Distorts the market.

2. Results in artificial pricing mechanism.
3. Allocation of resources is non-optimal.
4. Protects inefficient domestic producers.
5. Disadvantages efficient foreign producers.
6. Distorts BOP on Current Account, Balance of Trade, and Terms of Trade.
7. Voluntary Export Restrictions (VER)
Voluntary export restrictions are imposed by a foreign government on its own exports and is a way
of getting around the WTO rules which forbid tariffs and quotas. A VER is where an exporting
country agrees to a voluntary quota of exports into a second country.
8. Administrative Obstacles
Administrative barriers can be set up which make it expensive for importers to compete. Often
―hidden‖ costs. For example establishing stringent (tough) safety, health and/or legal requirements
for goods/services to be imported.
Example: Zimbabwe (in the cases of farm produce) has often been accused of this. Why? To protect
local Zimbabwean farmers.
Effects: domestic consumers often pay higher prices. Exporters may be prevented from supplying
goods as importers find it difficult to compete.
9. Health and Safety Standards -Health and safety standards may be imposed which make it
expensive for an importer to compete by requiring certain safety or health standards for products.
10. Environmental Standards - Environmental issues are of great concern to many countries.
Governments are worried about the economic, social, health and political effects of pollution and

environmental degradation. These concerns may lead to the imposition of environmental standards
on imports of certain items. Again, if this happens it is a form of protectionism.
11. Import Licensing - This is a form of rationing. A license, or permission to import, has to be obtained
from the Government. The Government limits the number of licenses available to importers.
12. Import substitution - Occurs when the government find a substitute for the imported goods so as
to shift demand from imports to locally produced goods e.g. the Jatropha project in Zimbabwe.
Reasons for Trade Protectionism

Various arguments have been forwarded in favour of the imposition of barriers to trade. Among them
are:
 Infant industry argument -The argument is that infant industries need to be protected from foreign
competition until growth is attained. An infant industry is a new or emerging industry that usually
face high average costs of production because it will not be enjoying economies of scale. Because
of its high average costs, the firm will be charging high and uncompetitive prices and cannot compete
with long established international firms that will be enjoying economies of scale. Infant firms need
to be protected from such foreign competition until they are able to compete. However the argument
against such protection is that from experience, firms that enjoy such protection prefer to remain
small and continue to enjoy the protection than to grow and face the competition.
 Strategic industry argument - Industries which are vital or strategic for the integrity of the country
such as the Zimbabwe Defence Industries or the agricultural industry requires protection from
foreign competition. The idea is to reduce dependence on foreign supplies which tends to
compromise a country’s sovereignty.
 Revenue argument - Most governments in developing countries raise revenue needed to finance
their expenditure from tariffs such as customs duty. In addition these tariffs earn the government
foreign currency.
 Anti-dumping argument - Dumping refers to the sale of goods in a foreign country at prices lower
than that in the home country. Rich countries may dump goods which may be harmful such
genetically modified food or untested medical drugs. By imposing trade barriers such goods may
not find their way into the country.
Key effects of dumping in the country in which they occur are:
o Loss of sales and profits for domestic firms. Some may go out of business.
o Increased domestic unemployment.
o Reduced AD.
o Worsening BOP on current account.
o Less taxation revenues for government.
o Less government revenues to fund economic development programmes.
 Balance of payment argument -A country faced with a BOP deficit can either correct the situation
by reducing the volume of imports through the imposition of tariffs or increase the volume of exports

through export promotions. Thus trade protectionism may be a way to discourage expenditure on
imports and thus correcting a BOP deficit.
 Employment argument -Trade barriers may seek to switch expenditure from imports to domestically
produced goods. This will increase demand for domestic goods and domestic production will
increase. Thus the level of employment in the country will increase.
Arguments against Protectionism

 Inefficiency of resource allocation - Protectionism can lead to monopoly power in the market.
Firms earn supernormal profits. As P>MC, economic efficiency is not achieved. There is non-
optimal allocation of scarce resources. Consumers/society are worse off.
 Costs of long run reliance on protectionist methods - As long as there is a schedule to remove
tariffs, infant industries will learn to grow up and compete internationally. If we continue protection
for infant industries, the difference between their costs and the costs of international competitors
will become capitalized into the cost structure of the companies. That is, instead of being cost
minimizers, infant industries will simply allow costs to rise to the import prices plus the tariff. They
will never become economically efficient.
Reliance on protectionism in the long run can also result in the following costs
being incurred:
 The costs of imports are more expensive. Domestic industries that import goods either in finished
form or as inputs in their manufacturing process-pass these costs on to other manufacturers and to
consumers. Given the above, the cost of higher domestic goods/services will be passed on to
consumers.
 Increased prices of goods and services to consumers -Trade can never be mutually beneficial, one
partner always reaps the gain at the other's expense. The principle of comparative advantage shows:
it is possible for both to gain, but it is the terms of trade which determine the distribution of these
gains. Imposing tariffs will raise the price of imports for consumers.
 The cost effect of protected imports on export competitiveness – Don’t buy foreign goods, keep the
money at home to provide jobs.‖ Foreign countries can only buy exports from your country if your
currency can be purchased internationally to buy your exports. That money can only get there if you
have imported goods and services from other countries. It is only because the domestic currency can
be used to purchase domestic goods that foreign countries want it. If we continue to protect our
import competing industries, we will never develop the competitive cost structures needed to sell
exports. We need foreign competition to make us more competitive.
 Often lower quality of goods/services produced in the domestic market are consumed.
 Lower standard of living as a result of limited choice of goods/services.

Economic integration
Economic integration refers to a situation when different countries in different parts of the world are
organising themselves into economic and political blocs. It can be described as encompassing measures
which are designed to abolish discrimination between economic units belonging to different national
states. Economic integration aims at liberalising trade between countries either generally or with specific
countries.
Criteria for successful integration
A number of common factors stand out as necessary for successful economic integration. Among them
is that:
 Member countries should be at roughly similar levels of economic development.

 Each member country must be satisfied that it is benefiting from the arrangements.
 Governments must be prepared to cede some sovereignty to a supranational institution.
 Political conflict between members must be containable.
Trading Blocs
There are a number of smaller trading blocs including:
 ASEAN: the association of South East Asian Nations, currently the group is considering a free
trade area with China, South Korea and Taiwan.
 LAFTA: the Latin American free trade area
 CARICOM: the Caribbean community
 Mercosur: involving Argentina, Brazil, Bolivia, Chile, Paraguay and Uruguay.
Free Trade Areas

Trade restrictions between member states are removed but each state retains the right to use trade policy
against non-member states. Each country maintain its own external tariff\external barrier to non-member
states. A free trade agreement requires a value added agreement, otherwise a member of the group could
lower external tariffs and ship goods through without tariffs from a country which would normally face
high tariffs in the importing country.
Customs Union
A customs union is a group of countries who agree to free trade amongst themselves and a common set
of barriers against imports from the rest of the world i.e. non-member states.
Common Markets
A common market includes free trade amongst member states and a common tariff for non-member
imports. There is also complete mobility of factors of production (labour and capital) amongst member
states. Customs unions that may operate with the following additional elements:

 Common system of taxation.

 Common employment legislation and workers’ rights.
 Common agricultural policy.
 Common competition policy.
 The absence of special treatment by member governments of their own domestic industries.
Economic union
An economic union includes a common market plus the eventual harmonization of monetary and fiscal
policies union with fixed exchange rates or single currencies, plus common macroeconomic policies.
The best example is the European Union (EU) which recently signed an agreement with European Free
Trade Association (EFTA) making the combined group the largest free market in the world.
Obstacles to Achieving Integration
 There is often reluctance to surrender political sovereignty in the various trading agreements.
 There is also reluctance to surrender economic sovereignty:
 The least constricting is the FTA where each state has the power to use trade policy against non-
members.
 The most constricting is the economic union which moves the nations towards almost complete
economic integration. For the EU nations, they have given up sovereignty over trade, monetary and
most of fiscal policy.
Advantages of economic integration

 Increased specialisation.
 Promotes peace, security and political stability.
 Expanded markets both to sellers and buyers.
 Improved welfare to the members of the region.
 Ensures uplifting of tariffs between member countries, thus enhancing trade links.
 A stronger bargaining position with the rest of the world.
 Accelerated rates of investments in the region.
Disadvantages of economic integration

 There will be increased competition that may injure domestic industries.
 Loss of state revenue if tariffs are uplifted.
 Countries that are better than others may dump goods in poor member countries.
 Economic domination by those countries which are better than the others e.g. South Africa in
the SADC region.
 Member countries may follow economic policies that can threat cooperation e.g. the land
redistribution in Zimbabwe in the SADC region.
Trade Creation and Trade Diversion

Important to make distinction between:

 Trade creation - Trade creation causes total economic welfare to increase as a result of the new trade
grouping.
Example: prior to joining new trade grouping if a country was protecting an inefficient industry, then
consumers would have been paying more for goods/services. After joining, consumers have lower
costs of good/services that leads to lower prices and increase in quantity consumed.
 Trade Diversion - This occurs when a country was already benefiting from low cost goods/services
on the world market before entering the trade grouping. Trade diversion occurs when a country
divert from low cost to high cost producers as a result of joining a trading bloc.
Balance of Payments (BOP) Accounts
BOP is an account showing a country’s financial transactions with the outside world over a given period
of time, usually a year. The BOP accounts are made up of three separate accounts namely, current
account, capital account and official reserves and liabilities account.
Current account
The current account records a country’s commercial transactions, that is, the import and export of goods
and services. It is subdivided into two sections:
 Trading account- which record transactions in merchandised goods that is export and import of
goods which are tangible or visible. The balance on the trading account is called the Balance of
Trade (BOT). It is obtained by exports less imports of goods. BOT is favourable if it is positive and
unfavourable if imports exceed exports.
 Services account- which record trade in services which are invisible or intangible. The balance on
the services account is called the Invisible Balance.
NB* the sum of the BOT and the Invisible Balance is the Balance on Current Account
 Investment Income Flows: e.g. profits, interest, dividends etc. Both coming in and going out.
 Government Grants: Both outflow and inflow. e.g. foreign aid.
 Private Transfers: e.g. wages and pensions sent home or received from abroad.
Capital account
The capital account records the movement of money for non-trade reasons. That is the inflow and
outflow of money for non-commercial transactions. The bulk of these flows are for investment purposes.
The capital account is subdivided into: -
 Short-term capital flow- which measures capital flows arising from investments in assets with
contractual maturity of less than one year. These funds are held in bank accounts or treasury bills

and move around the world in search of relatively high rates of interest and are referred to as hot
money.
 Long-term capital flow- that record capital movements that arise from investments in assets whose
contracts are for more than one year e.g. bonds and the establishment of industries or construction
of factories in foreign countries (foreign direct investment).
Official reserves and liabilities account

The official reserves and liabilities account serves two purposes in the BOP accounts:
 It records a country’s holding of foreign reserves and gold.

 It serves as the means of correcting imbalances between inflows and outflows of foreign currency,
that is, it is a balancing item. For example, if there were no capital flows and a country incurs a BOP
deficit in one year, the difference will be made up by a decline in the official reserves. This section
provides a link between the current and capital accounts and hence can be viewed as a balancing
item.
Factors influencing the balance of payments include:

 Income: as national income rises the demand for imports rise shifting the current account toward
a deficit.
 Changes in relative prices: as domestic prices rise relative to foreign prices, imports appear
cheaper and exports more expensive and the current account will move toward a deficit.
 Changes in relative investment prospects: as return on investment rises, foreign capital will be
attracted into the country and the capital account will move toward a surplus.
 Changes in relative interest rates: as domestic interest rates rise, short term capital is attracted
moving the capital account toward a surplus.
The importance of BOP accounts

A country’s BOP accounts are very important because,
 They show how a country is performing externally.

 They reveal the trend of trade and the major trading partners of a country.
 BOP accounts are a barometer of economic performance e.g. persistent BOP deficits implies that
the economy is not performing well.
 Government can see where to intervene with trade regulations.
Correcting a balance of payments deficit

If a country is said to have a deficit on its balance of payments this means that there is a net outflow on
the current and capital accounts. If there is a deficit in a particular year this means that there has been a
net outflow of funds from the country. Clearly, this outflow cannot continue as a country cannot keep

spend more than it earns in foreign currency – eventually it will run out of reserves and other countries
will cease to be willing to loan it money.
Government can seek to reduce a balance of payments deficit in a number of ways.
 Contraction of the Domestic Economy -By reducing overall demand in the domestic economy a
government will be able to reduce demand for imports. Reducing demand in the home economy
should also reduce inflationary pressures, reducing export prices and making them more competitive.
Conversely, suppressing demand in the home economy could lead to an increase in unemployment.
 Import Controls -Government could seek to restrict imports. This could be achieved by direct
imposition of tariffs or quotas or through exchange controls limiting the supply of sterling available
to buy overseas currencies to pay for imports. The imposition of trade barriers is highly controversial,
however, and is likely to breach WTO regulations.
 Boost Exports -The Zimbabwean government could seek to boost exports in a number of ways:
o Provide subsidies to Zimbabwean exporters to allow them to reduce export prices.
o Devalue Zimbabwean dollar to increase the cost of exports.
o Extend export credit guarantees to more countries, reducing the risk for Zimbabwean
companies of non-payment for exports.
 Interest rates-Increasing interest rates would make Zimbabwe a more attractive location for
investment, increasing inward investment flows and generating a surplus on the financial account to
off-set the deficit on the capital and current accounts. Hot money, as this type of financial flow is
known, is very volatile and highly mobile and is unlikely to provide long term stability for balance
of payments.
Increasing interest rates can also have a number of damaging effects elsewhere in the economy:
o It discourages investment in the home economy as the cost of borrowing increases

o It can cause a country‗s currency to strengthen (appreciate) due to demand for Zim dollars
from overseas investors. This can actually worsen the deficit on the current account as it
increases the price of Zimbabwe exports, whilst making imports cheaper.
 Expenditure reducing and expenditure switching methods of correcting BOP deficit.
Expenditure switching policy instruments: these policy instruments seek to improve the balance of
payments by raising the relative attractiveness of domestic products as compared to foreign products
so that domestic consumers switch from the now relatively more expensive foreign imports to
domestically produced goods and overseas consumers switch away from their home produced
products to the now relatively less expensive exports from the domestic country. Changes in the
exchange rate have this effect. For example, a fall in the exchange rate makes imported foreign
products more expensive in the domestic market and domestic products cheaper in foreign markets,
encouraging just such a “switching” of expenditures.
Expenditure switching methods includes:
o Devaluation

o Protectionism methods e.g. tariffs

o Import substitution
Expenditure reducing policy instruments: these policy instruments seek to dampen domestic
aggregate expenditure, especially consumption expenditure (C) and government expenditure (G)
within aggregate expenditure (E = C + I + G + X). Expenditure reducing methods includes;
 Contractionary monetary policy

Tight monetary policy involves increasing interest rates and reducing money supply. Higher interest
rates will increase the cost of debt and mortgage repayments and leave people with less money to
spend. Therefore, this will reduce their consumption of imports, improving the current account. Also,
higher interest rates will cause a fall in AD and therefore reduce economic growth. This will reduce
inflation and help to make Zimbabwean exports more competitive. Deflationary policies will also
put pressure on manufacturers to reduce costs and this will lead to more competitive exports and so
exports may increase in the long run because of this effect.
Evaluation of monetary policy for reducing current account
The main issue with using monetary policy to reduce a current account deficit, is that an increase in
interest rates will tend to cause hot money flows and therefore an appreciation in the exchange rate.
This appreciation makes exports less competitive, and imports more attractive. Assuming demand
is relatively elastic, this appreciation will worsen the current account.
Therefore, monetary policy has two conflicting effects.
1. Higher interest rates reduce spending on imports – improving current account

2. But, higher interest rates cause an appreciation in the exchange rate – worsening the current
account.
The overall effect is uncertain – it depends which effect is bigger. It maybe that since Zimbabwe has
a high marginal propensity to import higher interest rates will cause a reduction in AD improves the
current account significantly. It depends on many other factors, for example, if the economy is
growing strongly, a rise in interest rates may not actually reduce consumer spending – because
income growth is high and confidence high.
 Tight\deflationary fiscal policy

An alternative to using monetary policy is to use fiscal policy. For example, the government could
increase income tax or reduce its expenditure. This would reduce consumer discretionary income
and reduce spending on imports. The advantage of fiscal policy is that it would not have an adverse
effect on the exchange rate. Higher income tax would also improve government finances.
However this policy will conflict with other macroeconomic objectives – with lower aggregate
demand (AD), growth is likely to fall causing higher unemployment. A government is unlikely to
want to risk higher unemployment just to reduce a current account deficit.

Sometimes correcting the balance of payments may need a combination of both expenditure
switching and expenditure reducing policy instruments. For example, if the economy is at or near
“fall capacity” output, there may need to be a reduction in aggregate expenditure in the domestic
economy. This will help to create the “spare capacity” needed if domestic industry is to produce
more substitute products to replace imports and to shift output from the (easier) domestic market to
overseas markets to raise exports.
Problems and solutions of BOP disequilibrium

Cause of Problem Suggested Remedies
Deficit Problems
Problem 1:
a. Inflationary pressures, exports low because a. Increase Productivity to lower prices and
prices too high, e.g. UK 1989. increase exports.
b. Interest rates low and therefor “hot” money b. Tight fiscal policy and dear money policy to
flows out to earn high interest elsewhere. deflate economy; also high interest rates to
attract “hot money”.
Problem 2:
a. Currency overvalued, therefore exports low a. Depreciate or devaluate the currency if
despite unemployment in the domestic import/export elasticities are favourable.
economy e.g. UK 1981 & 1992.
b. Capital outflow because of investment b. Stop or remove drain, e.g. by exchange
overseas or too much government control regulations on investment.
expenditure overseas.
Surplus Problems
Problem 4:
a. Spare capacity in the economy, prices a. Easy fiscal and cheap money policies, with
relatively low, exports high e.g. West low taxes and higher government
Germany 1982. expenditure, boost internal economy while
b. Interest rates high, “hot money” flows in to lower interest rates reduce inflow of “hot
earn high interest. money”.
Problem 4: a. Appreciate or revalue currency: this will
a. Currency overvalued, embarrassment to reduce exports and increase imports if
trading partners, exports artificially cheap Marshall-Lemer conditions fulfilled.
while imports dear, domestic living b. Increase capital expenditure overseas of
standards restricted, e.g. Japan 1983. increase foreign aid.
Adopted from Beardshow

Exchange rates systems
An exchange rate indicates the value of one currency relative to some other currency. It is the amount
of Zimbabwean dollars that will be required to buy a unit of foreign currency. It is the price at which
purchases and sales of foreign currency or claims of it take place and thus exchange rates act as signal
and rationing devices. There are three traditional exchange rate regimes namely flexible, fixed and
managed float exchange rate systems
Flexible exchange rates

This is a system in which the market forces of demand and supply determine the rates without any
government intervention. No reserves are theoretically required as there is self-adjustment of relative
prices of exports and imports through the free fluctuating rates.
Demand for foreign currency arises out of a desire to buy imports or to invest abroad or to repay our
foreign debt. On the other hand the supply for foreign currency arises from earnings from exports or
inflow of capital from foreign investors. The market exchange rate will be established at the point where
the demand for currency equals the supply of currency as illustrated on the following diagram.
Market Exchange Rate

Price of
Currency S
P1
Q1 Quantity of
Currency

Demand for a currency

Demand for dollars comes from a number of sources:
 It is required to pay for Zimbabwean exports

 Overseas investors making investments in Zimbabwe will need Zimbabwean dollars e.g. an
American property company buying a factory building in Zimbabwe will have to pay in dollars.
 Speculators may buy dollars if they feel it is about to increase (appreciate) relative to other
currencies.
 The government may wish to buy dollars to manipulate the exchange rate.
The demand curve for a currency will be downward sloping i.e. as the price (exchange rate) of the
currency falls, exports from the Zimbabwe will become cheaper increasing demand for dollars to pay
for them.
Supply of a currency
Supply of a dollar is derived from a number of sources:
 Zimbabwe residents wishing to buy imports will need to sell Zimbabwean dollars e.g. and buy
foreign currency.
 Zimbabwe residents making overseas investments will need to sell Zimbabwean dollars and buy
foreign currency.
 Speculators may sell Zimbabwean dollars if they feel its value is about to decrease (depreciate)
relative to other currencies).
 The Zimbabwean government may sell currency on the international markets to weaken the
currency to improve export performance.
Factors affecting demand for and supply of foreign currency

 Seasonal fluctuations e.g. in Zimbabwe, the supply of foreign currency increases during the
tobacco selling season.
 Changes in consumer preferences e.g. if Zimbabweans start to prefer American goods demand
for the US$ will increase.
 Differentials in interest rates that is if Zimbabwe start to offer high real rates of interest on short
term investment foreigners may increase their deposits of foreign currency in the country to
benefit from the high real returns (‗hot money‗). iv. Relative price changes (inflation).
 Granting of foreign loans and developmental aid which directly contribute to foreign currency
supply.
 Changes in capital flows (foreign direct investment) - where an increase in foreign direct
investment results in an increased flow of foreign currency into the country.
Shifts in Demand and Supply Curves

Increase in Demand for Currency

Prior to the increase in demand, market equilibrium is where demand and supply curves intersect. Price
= P1. Quantity = QE. The market clears. The diagram below shows what happens when the demand for
a currency increases.
Increase in Demand of a Currency

Price of
Currency S
P2
P1
D1
Q1 Q2 Quantity of
Currency
The increase in demand results in a shift in the demand curve to the right, from D to D1. The quantity
of the currency increases from Q1 to Q2. The price of the currency increases from P1 to P2 i.e.
appreciation. The market clears at the new price, P2.
Decrease in Demand for Currency

= P1. Quantity = 0QE. The market clears. With reference to the diagram above, a decrease in demand
will result in the demand curve shifting from D1 to D.
The decrease in demand results in a shift in the demand curve to the left from D1 to D. The quantity of
the currency decreases from Q2 to Q1. The price of the currency decreases from P2 to P1. The market
clears at the new price, P1.
Increase in Supply of a Currency

= P1. Quantity = 0QE. The market clears. The diagram below shows what happens when the supply of
a currency increases.

Increase / Decrease in Supply of a Currency

Price of
Currency S
S1
P1
P2
Q1 Q2 Quantity of
Currency
The increase in supply results in a shift in the supply curve to the right, from S1 to S2. The quantity of
the currency increases from Q1 to Q2. The price of the currency decreases from P1 to P2 i.e.
depreciation. The market clears at the new price, P2.
Decrease in Supply of a Currency

Prior to the decrease in supply, market equilibrium is where demand and supply curves intersect. Price
= P1. Quantity = 0QE. The market clears. With reference to the above diagram, a decrease in supply
shifts the supply curve to the left and upwards from S1 to S.
The decrease in supply results in a shift in the supply curve to the left, from S1 to S. The quantity of the
currency decreases from Q2 to Q1. The price of the currency increases from P2 to P1. The market clears
at the new price, P1.
Note: Market forces are affecting both the demand and supply at the same time. Consequently, both
curves will shift.
The Advantages & Disadvantages Of Floating Exchange Rates

Arguments in Favour of a Floating Exchange Rate
 Automatic balance of payments adjustment - Any balance of payments disequilibrium will
tend to be rectified by a change in the exchange rate. For example, if a country has a balance of
payments deficit then the currency should depreciate. This is because imports will be greater
than exports meaning the supply of Zimbabwean dollars on the foreign exchanges will be

increasing as importers sell Zimbabwean dollars to pay for the imports. This will drive the value
of the Zimbabwean dollars down. The effect of the depreciation should be to make your exports
cheaper and imports more expensive, thus increasing demand for your goods abroad and
reducing demand for foreign goods in your own country, therefore dealing with the balance of
payments problem. Conversely, a balance of payments surplus should be eliminated by an
appreciation of the currency.
 Freeing internal policy - With a floating exchange rate, balance of payments disequilibrium
should be rectified by a change in the external price of the currency. However, with a fixed rate,
curing a deficit could involve a general deflationary policy resulting in unpleasant consequences
for the whole economy such as unemployment. The floating rate allows governments freedom
to pursue their own internal policy objectives such as growth and full employment without
external constraints.
 Absence of crises - Fixed rates are often characterised by crises as pressure mounts on a currency
to devalue or revalue. The fact that, with a floating rate, such changes are automatic should
remove the element of crisis from international relations.
 Flexibility - Post-1973 there were great changes in the pattern of world trade as well as a major
change in world economics as a result of the OPEC oil shock. A fixed exchange rate would have
caused major problems at this time as some countries would be uncompetitive given their
inflation rate. The floating rate allows a country to re-adjust more flexibly to external shocks.
 Lower foreign exchange reserves - A country with a fixed rate usually has to hold large
amounts of foreign currency in order to prepare for a time when they have to defend that fixed
rate. These reserves have an opportunity cost.
Disadvantages of the Floating Rate

 Uncertainty - The fact that a currency changes in value from day to day introduces instability
or uncertainty into trade. Sellers may be unsure of how much money they will receive when they
sell abroad or what their price actually is abroad. Of course the rate changing will affect price
and thus sales. In a similar way importers never know how much it is going to cost them to
import a given amount of foreign goods. This uncertainty can be reduced by hedging the foreign
exchange risk on the forward market.
 Lack of investment - The uncertainty can lead to a lack of investment internally as well as from
abroad.
 Speculation - Speculation will tend to be an inherent part of a floating system and it can be
damaging and destabilising for the economy, as the speculative flows may often differ from the
underlying pattern of trade flows.
 Lack of discipline in economic management - As inflation is not punished there is a danger
that governments will follow inflationary economic policies that then lead to a level of inflation
that can cause problems for the economy. The presence of an inflation target should help
overcome this.
 Does a floating rate automatically remedy a deficit? - Zimbabwe experience indicates that a
floating exchange rate probably does not automatically cure a balance of payments deficit. Much

depends on the price elasticity of demand for imports and exports. The Marshall-Lerner
condition says that a depreciation in the exchange rate will help improve the balance of payments
if the sum of the price elasticity for imports and exports is greater than one.
 Inflation - The floating exchange rate can be inflationary. Apart from not punishing inflationary
economies, which, in itself, encourages inflation, the float can cause inflation by allowing import
prices to rise as the exchange rate falls. This is, undoubtedly, the case for countries such as
Zimbabwe where we are dependent on imports of food and raw materials.
Effects of change in Value of Currency on Balance of Payments

Any change in the value of the currency will impact on the Balance of Payments (BOP). Remember that
the BOP figure is expressed in a monetary unit. This is arrived at by Quantity (Q) x Price (P). Price is
influenced by the exchange rate. Any change in the exchange rate will affect the value shown in the
BOP figure.
Depreciation of Currency
Depreciation in the value of the currency will lower the price of exports of the country. Exports will
become more competitive internationally and should increase. Depreciation in the value of the currency
will raise the price of imports of the country. Imports will become dearer and should decrease. The
combined effect is an improvement in the Merchandise Trade Account, Balance of Trade and in the
BOP on Current Account.
Appreciation of Currency
Appreciation in the value of the currency will raise the price of exports of the country. Exports will
become less competitive internationally and should decrease. Appreciation in the value of the currency
will lower the price of imports of the country. Imports will become cheaper and should increase. The
combined effect is deterioration in the Merchandise Trade Account, Balance of Trade and in the BOP
on Current Account.
Fixed exchange rates

Fixed exchange rate refers to a situation where the exchange rates are fixed at preannounced par values
that are only changed when they can no longer be defended. The exchange rate is therefore determined
by the authorities and not by market forces. An essential precondition of fixed exchange rates is that the
Reserve Bank must be able to buy and sell any quantities of foreign currency necessary to eliminate
excess supply and demand of foreign currency at the controlled rate. Thus the Reserve Bank should set
up a reserve fund of convertible currencies in order to carry out this intervention policy.
Advantages of fixed exchange rates
 Increased Certainty: businesses do not like uncertainty because it makes it difficult to plan and
budget. Exchange rates are beyond their control.

 Possible Increased Trade: there is no evidence that this happens. Not a strong argument.
 Eliminates Currency Speculation: very important. Therefore, no destabilization of currency.
 Promotes Government Discipline: by definition the Government cannot influence the exchange
rate to influence macroeconomic policy. Therefore, the
 Government needs disciplined economic policies.
 Eliminates influence on Domestic Inflation: eliminates the effect of an appreciation of currency
that leads to an increase in M prices that leads to increased inflation.
Disadvantages of Fixed Exchange Rates:
 Central Bank must keep large stocks of Gold & Foreign Reserves to intervene in the FOREX
and support the currency.
 Domestic policy is dictated by the world economy: domestic inflation is dictated by world
inflation rates that cannot be neutralized by domestic monetary policy. Major macroeconomic
disadvantage.
 No automatic adjustment: means that there is a real danger of large changes in exchange rate
Managed float
In this scenario the exchange rate is still fundamentally set by the interaction between supply and
demand. However, the government may set upper and lower exchange rate limits and will intervene in
the market to keep the currency within these bands. Imagine that the government has set lower and upper
limits for Zim dollar against the Rand of 1.45 R and 1.55R. Zim dollar is in danger of falling below
1.45R, what can the Bank RBZ do?
 It could put up interest rates to make Zimbabwean dollar more attractive to boost demand for the
currency.
 It could try to restrict the supply of Zimbabwean dollar by buying up large quantities of
Zimbabwean dollars on the international market.
 If when it buys Zimbabwean dollars it sells Rands it will also increase the supply of Rands,
weakening the Rand on the international market.
 It could impose exchange controls, which directly limit the amount of Zim dollars that can be
traded – this would be hugely controversial, and the RBZ would only use this policy as a last
resort.
Dirty Float
A Dirty Float is where there is interference to ―smooth‖ out changes in the floating exchange rate. It is
part of a managed float of the exchange rate. A Dirty Float affects an orderly adjustment, by the Central
Bank buying/selling currency using foreign exchange reserves.

Long Term Methods of Adjusting the Exchange Rate under a Managed System
1. Expenditure Switching is persuading people to switch expenditure between foreign and domestic
goods and services by changing their relative prices.
This can be achieved by:
1. Encouraging expenditure switching by using one or more forms of protection. Imposing

tariffs or subsidizing exports is a way of improving the Current Account result and
manipulating the value of the currency.
2. Encouraging expenditure switching via changing the exchange rate. A currency can be
depreciated to help improve the Current Account deficit. A depreciation of the exchange rate
make exports cheaper/imports dearer, which leads to an increase in volume of
exports/decrease in the volume of imports which leads to a reduction in the Current Account
deficit.
2. Expenditure Changing is changing the total amount spent on imports by altering income.
The government can do this through deflationary/contractionary policies. These policies aim to
reduce National Income/AD. In turn, this will lead to a reduction of imports, less supply of the
currency to the FOREX markets, and the value of the currency will rise.
These policies will affect the internal economy; unemployment will rise/fall and inflation will
fall/rise. How? Examples follow. An increase in the price of the currency will lead to an increase in
exports prices, a reduction in exports volume. Domestic production will decrease leading to an
increase in unemployment.
On the imports side, an increase in the price of the currency will lead to a decrease in imports prices.
This will follow through to lower domestic inflation. This will make domestic production cheaper
which will lead to an increase in Exports/reduction in imports. Unemployment will fall. Current
Account deficit will improve.
Deflation is likely to affect interest rates and thus the Capital Account. For example, if restrictive
monetary policies reduce income and imports, the corresponding rise in interest rates will attract
inflows on the Capital Account.
Purchasing Power Parity-Theory of Exchange Rates

Purchasing Power Parity (PPP) exists when a given amount of currency will buy exactly the same bundle
of goods, in each of two countries, at the current exchange rate.
The PPP theory holds that movements in exchange rates will offset movements in relative inflation rates.
It argues that the exchange rates will rise/fall in line with inflation. Why? The difference in inflation
rates will affect the balance of trade that will, in turn, result in a change in the demand for or supply of
a currency that will lead to an appreciation or depreciation of the currency.
Examples:

 An increase in inflation leads to an increase in the cost of local goods/services that will lead to
an increase in imports and thus an increase in supply of money. This will lead to a fall in the
price of the currency. Depreciation.
 A decrease in inflation leads to a decrease in the price of local goods/services that will lead to an
increase in exports and thus an increase in the demand for money. This will lead to an increase
in the price of the currency. Appreciation.
Single Currency/Monetary Integration
The Euro is the most widely used single currency resulting from monetary integration within the EU.
Most members of the EU use the Euro as their currency. There are exceptions, the major one being the
U.K. that still uses its own currency, the Pound Sterling.
Major advantages include:
 Lower transaction costs for businesses, consumers and governments.

 Benefits of economies of scale in terms of printing and stamping costs of the currency.
 The argument that a single currency eliminates exchange rate uncertainty is often advanced.
Major disadvantages include:
 No control over the exchange rate as a macroeconomic policy instrument. For example, the
European Central Bank (ECB) controls the Euro exchange rate.
 Because of the above limitation, the government cannot use the exchange rate to influence
External Equilibrium (BOP).
 As a result, adjustments to External Equilibrium (BOP) cannot be made to influence a country‘s
Internal Equilibrium (Budget).
 There are major structural differences between Members; each country is at a different stage in
their economic growth and development, and in their business cycle. A single currency does not
take this into major consideration.
Marshall-Lerner Condition
X – exports M - imports
Marshall-Lerner condition states that if the PEDx + PEDm > 1, then a depreciation of the exchange rate
will improve the balance of payments. If the PEDx + PEDm = 1, then the BOP will remain unchanged.
If the PEDx + PEDm < 1, then a depreciation will worsen the BOP.
PED for Exports: Depreciation of Exchange Rate
PED X‘s price elastic = depreciation will lead to improvement in BOP.
PED X‘s unitary = no change in BOP.
PED X‘s price inelastic = depreciation will lead to deterioration in BOP.
PED for Imports: Depreciation of Exchange Rate

PED M‘s price elastic = depreciation will lead to improvement in BOP.

PED M‘s unitary = no change in BOP.
PED M‘s price inelastic = depreciation will lead to deterioration in BOP.
A change in exchange rates affects both X’s and M’s at same time. It is possible to calculate the
combined effects of a depreciation on X‘s and M‘s jointly.
PEDx + PEDm > 1 BOP will improve.
PEDx + PEDm = 1 BOP will not change.
PEDx + PEDm < 1 BOP will deteriorate.
Above is known as the Marshall-Lerner condition.
For a country with BOP Deficit: depreciation of currency will be more effective the higher the combined
elasticity‘s of X‘s and M‘s. For countries with PEDx + PEDm < 1 BOP will deteriorate. Therefore,
depreciation will not work. Appreciation is better solution.
The J-Curve Effect

J-Curve effect refers to the way and the time frame in which the trade balance may initially worsen
before it improves, after a devaluation/depreciation of the exchange rate.
J-Curve Effect
Balance of
Payments
+ve
Time
-ve

When a devaluation/depreciation of a currency occurs the BOP is likely to worsen before it improves.
This is the J-Curve Effect.
Reason: it takes time before the adjustments take effect. Why? Time is an important determinant of
elasticity. In the short term, % change in imports < % change in exports because:
 It takes time for domestic producers/consumers to switch to local products. That is, away from
dearer M‘s to cheaper domestic goods/services.
 It takes time for overseas producers/consumers to switch away from dearer domestic
goods/services to cheaper M‘s (X‘s of country which has devalued).
In the short term, the J-Curve Effect over-rides the Marshall-Lerner Condition.
Changes in the External Balance, Aggregate Demand and the Domestic Macro-
economy
There is a strong relationship between External Balance (X-M) and Internal Balance (Budget surplus or
deficit). That is, between the BOP and AD = (C + I + G + X – M). A change in the external balance (X
– M) will affect the domestic economy. It acts through the multiplier (+ or -) to raise or lower National
Income.
This is summarised as follows:
If X↑ → AD↑
If X↓ → AD↓
If M↑→ AD↓
If M↓ →AD↑
If (X – M)↑ then AD (National Income) will increase and consequently may reduce unemployment or
add to inflation (if the economy is near to full employment levels of production). If (X-M)↓→ then AD
(National Income) will fall and this may lead to an increase in unemployment or a fall in inflation.
Effect on Five Macroeconomic Objectives

A change in the External balance will have an impact on all other macroeconomic objectives.
Deterioration in BOP Current Account
As discussed above, a deterioration in BOP Current Account will reduce AD. As a result:
 Economic Growth will decline.

 Economic Development will be less because the necessary funds from economic growth are not
available.
 Because Real GDP has declined, the Full Employment objective cannot be achieved.
 Inflationary pressures will abate, thus the objective of price stability is more likely.
 The objective of External Equilibrium is less likely.

Improvement in BOP Current Account

As discussed above, an improvement in BOP Current Account will increase AD. As a result:
 Economic Growth occurs.

 Economic Development will be more likely because the necessary funds from economic growth
are available.
 Because Real GDP has increased, the Full Employment objective is more likely to be achieved.
 Inflationary pressures will increase, thus the objective of price stability is less likely.
 The objective of External Equilibrium is more likely.

Money & Interest Rate
 Introduction
 Characteristics & Functions of Money
 Liquidity Preference Theory
 Supply of Money
 Determination of Interest Rate
 Interest Rate & The Economy
 The Quantity Theory of Money

Introduction
Money, as defined in economics, is anything that is readily and widely accepted as a medium for the
exchange for goods and services or in settlement of debts. Money plays a crucial role in the economic
system of any country. It is a means for promoting specialization and exchange on which modern
economic activity is based. Before the invention of modern money in the forms of currency notes and
coins as we know today, trade had been conducted by barter, through the use of commodity monies such
as gold, cow, iron bars, etc. The barter system refers to a situation where goods are directly exchanged
for goods. The problems associated with the system are:
1. Double coincidence of wants: It entails finding a person who has what you want and requires
what you have. For example, a person who has a cow and needs maize must search for another
person who has maize and needs a cow. This process is cumbersome and leads to a waste of
time.
2. No common unit of measure: It is difficult to arrive at a uniform or an easily acceptable
exchange rate between different commodities
3. The absence of a means of storing wealth or value: Under the barter system. It is difficult to store
wealth because most articles of trade, especially agricultural products are easily perishable.
4. Difficult in making deferred payment: As a result of exchange rate problem, it is difficult to
store wealth because most articles of trade, especially agricultural products are easily perishable.
5. Problem of bulkiness and indivisibility of most goods: The goods are often too bulky to be
carried from one place to the other, and are not capable of being into divided similar units to
facilitate transaction. The introduction of money has enabled man to overcome the problem
associated with the barter system.
The Characteristics of Money

For money to perform the functions effectively, it must possess the following attributes or qualities.
 General acceptability: It must be acceptable by all economic agents in the country in which it
is used in payment for goods and services, and in settling debts and obligations.
 Divisibility: It should be available in units of a standard size sufficiently divisible to facilitate
the purchase and sale of goods and services over a wide range of prices.
 Durability: It should be able to last for a long time without losing its value. This is the reason
why high quality papers are used to print paper currency and precious metals are used in minting
coins.
 Portability: Money should be convenient to carry about for easy transfer to other people during
transactions.
 Homogeneity: One unit of money must be the same in all respects (i.e. identical) everywhere
throughout the country. This will promote general acceptability.

 Relative Scarcity: It must be unique, not something that can be found easily anywhere. And it
must not be supplied in excess so as not to lose its value whereby will not be able to serve
effectively as a store of value and a standard of deferred payment.
Functions of money
 Medium of exchange
Money as a medium of exchange allows consumers to exchange their preferences. That is people
exchange their goods and services for money rather than for other goods and services like what used
to happen in barter trade. Thus money is usable in buying goods and services. Measure of value
Money as a measure of value becomes a common denominator upon which relative exchange values
can be established. The value of one product can be expressed in monetary terms (price). For
example the value of a vehicle can be expressed as $200m and not 20 herds of cattle.
 Store of wealth
Money presents a convenient form in which to store wealth especially because of its liquidity, that
is, money can easily be used to pay for transactions. People can prefer to keep their wealth in the
form of money which is liquid rather than illiquid assets such as bonds.
One other reason for this preference is because money is not perishable as compared to some other
assets such as cattle.
 Standard of deferred payments

Deferred payments are future payments obligations. Money as a standard of deferred payments
allows credit transaction to be undertaken. For example people can buy on hire purchase and sign a
contract to repay in monthly instalments.
NB* Money should maintain a constant purchasing power over a long period if it were to perform
these functions properly. The purchasing power of money is what a given currency can buy in the
domestic economy. The purchasing power or value money is reduced by inflation. For example, if
our Z$ loses its purchasing power, people would quote their prices in other currencies such as the
US$ and they would prefer to accumulate assets that appreciate in value such as houses rather than
storing their wealth in the form of money.
Types of Money
The three main types of money are classified as:
1. Paper money and coins
2. Bank deposits: These are money deposited with financial institutions, especially commercial banks
which can be withdrawn or transferable without prior notice by writing a cheque. Such deposits are
held in current account of the customer, and a fee is charged for processing the cheque.
Types of Bank Deposits

i. Demand deposits: It is deposit of funds (usually paper money and coins) with a bank which
are withdrawable or transferable without prior notice by writing a cheque. Such deposits are
held in current account of the customer, and a fee is charged for processing the cheque.
ii. Saving deposit: It is a deposit of fund with a bank which can be withdrawn with or without
a notice of withdrawal. Savings deposits are held in savings account and they yield interest
for the depositor.
iii. Time Deposit: It is a deposit of fund that cannot legally be withdrawn from the bank without
at least 30 days’ notice of withdrawal. Time deposits are held in fixed deposit accounts
opened for depositors and they yield interests.
3. Quasi - money or near money: These are assets which adequately serve as a store of value but do
not fulfil the medium of exchange function. Examples include saving and time deposits, stock and
shares, postal and money orders, treasury bills etc. What constitute quasi money varies from one
country to another.
The Nature of Money

The nature of money is usually discussed under three headings:
1. Legal tender: Money which by nature must be accepted in payment for goods and in discharge of
debt obligations. Currency notes and coins are legal tender in all modern economies.
2. Fiat money: Money that is not a commodity and it is not redeemable in any commodity. What gives
such money value and acceptability is their being declared as legal tender by the government. Money
in the form of currency notes fit into this description.
3. Token money: This refers to money whose face value is greater than the actual value of the material
of which it is made. In most economies, coins are token money, whose value as metal is less than
their monetary value.
The Supply of Money

Money supply or money stock refers to the total amount of money in the economy for purposes of policy
various definitions or variants of money supply (e.g. M1, M2, etc) Generally, the narrow money or
narrow definitions refers mainly to the money used as medium of exchange while the broad money or
broad definitions include money being used as a store of value.
In every country, the Central Bank always state which definitions of money it is adopting at any
particular time and for which purpose. The quantity of money in an economy has direct effect on the
price level and therefore on the value of money. Hence, to promote price stability and economic growth,
the total money supply is subject to government control through the Central Bank in every modern
economy.
Money Demand and Interest rates

Demand for money otherwise referred to as liquidity preference means the desire of people to hold their
resources or wealth in the form of cash i.e. currency notes and coins, instead of interest – yielding assets.

The British economist John Maynard Keynes (1883 – 1946) identified three reasons for demand for cash
balances or why people hold money:
1. Transaction Motive
2. Precaution Motive
3. Speculative Motive
What is interest?
The rate of interest has two roles. To a borrower the rate of interest is the payment which has to be made
in order to obtain liquid assets, namely cash. To the lender it is the reward received for parting with
liquid assets. When the term “”the rate of interest” is used it appears to imply a single rate of interest.
There are, however, many rates of interest on such things as mortgages, bank loans and government
securities, with the rate depending on such factors as how credit-worthy the borrower is and the length
of time the loan is required for. The level of inflation present in the economy will also affect the rate of
interest.
If inflation is increasing then one would expect lenders to seek a higher rate of interest to compensate
for the expected future loss in the real value of their capital. It is important to distinguish between
nominal and real rates of interest. The nominal or money rate of interest is the annual amount paid on
funds which are borrowed, whereas the real rate of interest takes account of inflation, therefore:
Real rate of interest = Nominal rate of interest − Inflation rate
Theories of Money Demand and Interest Rate Determination
Liquidity Preference Theory
The cash money is called liquidity and the liking of the people for cash money is called liquidity
preference. According to Keynes people demand liquidity or prefer liquidity because they have three
different motives for holding cash rather than bonds etc.
1. Transaction Motive
Day –to-day transactions are done by individuals as well as firms. An individual person has to buy
so many things during a day. For this purpose people want to keep some cash money with them.
This type of demand for liquidity is for carrying day to day transactions is called demand for liquidity
for transaction motive. So we can say that money needed by consumers, businessmen and others in
order to complete economic transactions is known as the demand for money for transactions motive.
This demand depends upon the following:
 Size of the income -If size of the income is high more will be the transactions and vice versa.
 Time gap between the receipts of income -If a person gets his pay daily he will demand less cash
money. On the other hand if time gap is more a person will demand more money to carry on his
daily transactions.

 Spending habit -If a person is spendthrift he will do more transactions. Naturally he will demand
more money and vice versa.
The demand for money for this purpose is completely interest inelastic.\
Demand for Money - Transaction Motive

Interest
Rate
Demand
i*
QM Quantity
2. Precautionary Motive
Every man wants to save something or wants to keep some liquid money with him to meet some
unforeseen emergencies, contingencies and accidents. Similarly business firms also want to keep
some cash money with them to safeguard their future. This type of demand for liquidity is called
demand for precautionary motive. This demand depends upon many factors:
 Size of the income -If the size of the income of a person or a firm is large, he will demand
more money for safeguarding his future.
 Nature of the person-Some persons are optimistic while others are pessimistic .The former
think always about the bright side of future. So they anticipates less, if any risk and danger
in the future. Naturally such persons will demand less money for precautionary motive. On
the contrary, pessimistic persons or firms foresee many dangers, calamities and emergencies
in the future. In order to meet these, they want to have more cash with them.
 Farsightedness -A farsighted person can see better about the future. He will make a proper
guess of the future. Thus if he expects more emergencies, he will keep more money with him
in cash and vice versa.
The demand for money for precautionary motive is also completely interest inelastic.

Demand for Money - Precautionary Motive

Interest
Rate
Demand
i*
QM Quantity
3. Speculative Motive
People want to keep cash with them to take advantage of the changes in the prices of bonds and
securities. In advanced countries, people like to hold cash for the purchase of bonds and securities
when they think it profitable. If the prices of the bonds and securities are expected to rise speculators
will like to purchase them. In this situation they will not like to keep cash with them. On the other
hand if prices of the bonds and securities are expected to fall people will like to keep cash with them.
They will buy the bonds and securities with the cash only when their prices would fall .So liquidity
preference will be more at lower interest rates.

Demand for Money - Speculative Motive

Interest
Rate
Demand
i*
QM Quantity
The Liquidity Preference Curve

The transactions balances and precautionary balances are held with the intention of being used to make
purchases as and when required, they are sometimes jointly referred as demand for active balances. The
important point about the demand for active balances is that it is not responsive to changes in the rate of
interest i.e it is interest inelastic. The demand for speculative balances, on the other hand is sometimes
referred to as the demand for idle balances.
We can have the community‘s total demand for money or liquidity preference schedule by adding the
demand for active (La) and idle balances (Li ) together.

Liquidity Preference Theory
Interest Interest Interest

Rate Rate Rate
Li LP (La + Li)
La
i* i* i*
i i i
Quantity of Quantity of Quantity of

Money Money Money
Supply of Money
The supply of money is quite different from the demand for money. No private individual can change
it. Supply of money is controlled by the central bank or its government. Money supply depends upon
the currency issued by the government and the policies of the central bank regarding with credit creation.
In the short run at a particular period of time supply of money remains constant. That‘s why the supply
curve money is perfectly inelastic.
Supply of Money
Interest
Rate
Supply
i*
QM Quantity
What determines the interest rate? The interaction of demand and supply of money determines the
interest rate.

Determination of Interest Rate

Interest
Rate
MS
i
LP
QM Quantity
In the above diagram LP is the demand for money and the MS is the supply of money. This gives an
equilibrium rate of interest i. At any rate of interest above i, the supply of money exceeds demand and
this will pull down the rate of interest, while at any rate of interest below i the demand for money exceed
supply and this will bid up the rate of interest. Once the rate of interest is established at i, it will remain
at this level until there is a change in the demand for money and or the supply of money. This implies
that the authorities have two choices:
 They can fix the supply of money and allow interest rates to be determined by the demand for
money; or
 They can fix the rate of interest and adjust the supply of money to whatever level is appropriate
so as to maintain the rate of interest.

The liquidity trap
Liquidity Trap
Interest
Rate
MS MS1
LP
QM Quantity
It is the situation in which changes in money supply have no influence on the rate of interest, monetary
policy cannot be used to influence other variables such as consumption and investment when the rate of
interest is i.
Loanable Funds Theory
Describe the concept of the loanable funds approach to interest rate determination. In your answer,
identify and explain the elements that comprise the supply of, and the demand for, loanable funds.
 Loanable funds approach - the rate of interest is determined by the supply of, and the demand
for, loanable funds.
 Loanable funds are the flows of funds into the market for securities.
Demand for loanable funds

There are two principal components:
 Business demand for funds - to finance its liquidity and capital investment requirements. The
lower the rate of interest, all else being constant, and the greater would be the volume of funds
demanded. This is represented by the downward-sloping curve (labelled B). Any factors that
cause an increase (decrease) by business in its demand for funds would be represented by a shift
to the right (left) in the B curve. The curve shown represents the net business demand for funds.

 Government sector demand for funds - the total public sector borrowing requirement– (PSBR).
This includes the borrowing requirement of the government and its departments. It is normally
proposed that the PSBR is independent of the rate of interest, and this is represented by the
vertical curve labelled G. With a smaller (larger) borrowing requirement, the G curve would be
located further to the left (right) in the diagram. The two demand curves are combined to give
the total demand for loanable funds (labelled G + B).
Loanable Funds

Rate Rate Rate
i*
i* i*
G+B
i i
B
G
Quantity Quantity Quantity
Supply of loanable funds:

There are three principal sources:
 Savings of the household sector - the curve (S) is drawn with an upward slope on the basis of the
presumption that as interest rates increase, people will save a larger proportion of their incomes.
The curve is steep because empirical evidence suggests increases in interest rates because only
small increases in the quantity saved.
 Changes in the money supply (∆M) - Since the money supply is assumed to be independent of
the rate of interest, changes in the money supply are represented diagrammatically as a vertical
line. When ∆M is added to the savings curve it simply changes the location of the curve (S +
∆M). It does not change the slope of the curve.
 If, for example, the Reserve Bank increased the money supply, the S + ∆M curve would be to
the right of the S curve.
 Dishoarding (D) - as interest rates increase, there is an incentive to acquire more securities, in
order to obtain the increased yields that are available. In attempting to buy more securities,
money is given up (or dishoarded). Dishoarding is added to the S + ∆M curve to give the total
supply of loanable funds curve.

Supply of Loanable Funds

Rate Rate Rate S+∆M
S+∆M+D
S S+∆M
i*
Quantity Quantity Quantity
 the equilibrium interest rate will be at the intersect of the demand and supply curves
A problem with the loanable funds approach to explaining interest rates is that since the supply and
demand curves are not independent of each other, a unique equilibrium rate of interest cannot be
determined. Explain and illustrate this problem with reference to the effects of an increase in:
a. Inflationary expectations:
The traditional approach to the analysis of the effects of inflation on interest rates is shown below;
 The initial equilibrium interest rate is i0, at the intersection of the original demand and supply
curves.
 With an increase in inflationary expectations, the suppliers of funds will demand a higher rate of
interest, in order to maintain the same real rate of return on their funds. Diagrammatically, the
supply curve will move vertically, by the extent of the inflationary expectation (pe), from
supply0 to supply1.
 The demand for funds will also change in response to the increased inflationary expectation. The
demand curve increases, by the extent of the inflationary expectations, from demand0 to
demand1. The demand for funds increases because businesses, in anticipating higher inflation,
recognize that they will require a greater quantity of funds merely to maintain their pre-inflation
investment plans.
 The result of the increased inflationary expectations is that interest rates will rise to the full extent
of the anticipated inflation, and the quantity of loanable funds will remain unchanged at Q, this
is referred to as the Fisher effect a shown in the diagram below.

Fisher Effect
Interest
Rate S1
S
i*
Pe
i
D1
Q1 Quantity of
Money
 It may be argued that non-Fisher effects will be evident which will lower the equilibrium interest
point. for example, increased inflation may reduce government demand for funds, and the
demand curve will not move as far to the right
 Also the supply curve may in fact move to the right rather than the left as savings increase, as a
result of higher wages and increased superannuation contributions
b. The expectation of a decrease in the level of economic activity:

o An expectation of decreased economic activity may come from the business sector.
o This will result in a decrease in business demand for funds to finance investment projects,
due to an anticipated fall in demand.
o In a loanable funds demand and supply graph, the decrease in B would shift the demand
curve to the left, resulting in an decrease in the rate of interest.
o As businesses decrease their investment in inventories and in capital equipment, they will
reduce their need to borrow and sell financial instruments to obtain funds.
o As the supply of financial instruments on the market decreases, the prices of those
instruments will rise and their yields will decrease.
o The higher prices on the securities (lower yields) will cause some savers to reallocate their
portfolios and sell securities; that is, hoarding will take place.
o The forecast decrease in interest rates is only a temporary equilibrium.
o There will be feedback mechanisms to consider in forecasting interest rate changes further
into the future.

o For example, the hoarding that accompanied the initial decrease in interest rates will cease
after the desired portfolio re-allocations have been completed.
o With no further hoarding, interest rates may have to fall further in order to prompt even
more hoarding.
o The decrease in business investment adds to the expected decrease in economic activity; as
output levels fall, there will be an decrease in savings and this will relieve some of the
downward pressure on interest rates.
o In addition, the decrease in output will see a worsening in the government budget position,
with an associated reduction in the government's borrowing requirement.
o The depreciation of the currency that might be expected to accompany the decreased interest
rate is likely to result in increased demand for exports and an decrease in the demand for
imports. Businesses in the export-competing and import-competing sectors of the economy
will increase their investment, and thus increase their demand for funds. This will place
some upward pressure on interest rates.
Interest rates and the economy
Changing the interest rate affects the economy in a number of ways:
 Savings: Higher interest rates encourage saving, since the reward for saving and thereby
postponing current consumption has now increased. Lower interest rates discourage saving by
making spending for current consumption relatively more attractive.
 Borrowing: Higher interest rates discourage borrowing as it has now become more expensive,
whilst lower interest rates encourage borrowing as it has now become cheaper.
 Discretionary expenditure: Higher interest rates discourage such expenditure. For many people
their mortgage is the most important item of expenditure. To avoid losing their home, people
must keep up with the mortgage repayments. Most people are on variable rate mortgages, so that
if interest rates rise they must pay back more per month, leaving less income to spend on other
things. Similarly, if interest rates fall, there will be increased income left in the family budget to
spend on other things.
 Exchange rate: Higher interest rates in Zimbabwe tend to make holding deposits in Zimbabwe
more attractive and an increased demand for dollars is likely to raise the exchange rate for the
dollar. Raising the exchange rate will make exports more expensive abroad and imports cheaper
in Zimbabwe. Lowering interest rates will have the opposite effect, reducing the exchange rate
for sterling, thereby making exports cheaper abroad and imports dearer in Zimbabwe.
Credit creation by commercial banks

In their duty of lending commercial banks create bank deposits that are directly related to money supply.
To determine the extent to which commercial banks create credit, we use the credit multiplier.
Simplifying assumptions

i. Assume a multiple banking system that is, assume that there are numerous banks in the economy.
ii. Assume a 20% cash reserve ratio, that is, 20% of total deposits need not be advanced as loans
but set aside as cash reserve requirement. This amount is set aside for client withdrawal and will
not be advanced as an overdraft.
iii. Bank transactions are only loans and payments are made and paid by way of cheques.
iv. There are no cash leakages and banks keep no excess reserves.
Illustration of the credit creation process

Based upon the above assumptions, an initial $100m deposit into CBZ will increase CBZ s deposits by
$100m. CBZ will have $100m at its disposable and can give out an 80% overdraft of $80m to Ben by
writing a cheque in his favour. Ben will deposit the cheque into his FBC account where upon FBC s
deposits will increase by $80m. FBC will give an overdraft of $64m to Chen while reserving $16m for
client withdrawal. Chen will deposit the cheque into his Stanbic account. The process will continue until
further deposits approach zero. The total deposits or credit generated can be summarised by the
following table.
Stage Bank Deposit Cash Reserve Overdraft

1 CBZ 100 20 80
2 FBC 80 16 64
3 Stanbic 64 - -
- - - - -
Total 5000 1000 4000
NB* It should be understood that the money supply in this case is not only notes and coins alone but the
invisible money called credit. Banks cannot create notes and coins but they can as illustrated, create
credit by giving out loans or overdrafts. The amount of cash money in the system remains the same. The
system works because of a fundamental assumption that the depositor, who is the bank’s creditor, comes
back to withdraw only a little which is catered by 20% cash ratio, in this case. A bank could collapse if
all depositors claimed their money back all at one time because the bank would not have enough liquidity
to pay cash (bank run).
However this seldom happens.
Limitations to the credit creation process

There are four limitations to the ability of commercial banks to increase money through credit creation.
i. No increase in deposits.
ii. Lack of willingness to borrow on the part of the public.
iii. Lack of willingness to lend on the part of commercial banks.

iv. The cash ratio, the smaller the cash ratio the greater the amount of credit created and the larger
the cash ratio, the smaller the amount of credit created.
This can best be illustrated if you answer the following example.
Example: Given an initial deposit of $200b into the banking system, how much credit or bank deposits
will be created if the cash reserve ratio is 10% and 50%?
Monetary policy
Monetary policy refers to deliberate attempts to manipulate the rate of interest and money supply in
order to bring about desired changes in the economy.
Aims of the monetary policy

In general terms monetary policy is used to regulate credit conditions and the supply of money in order
to fulfil macroeconomic objectives. The overall objective is to improve the standards of living within
the economy. Alternative objectives can be listed as follows: -
 To maintain stable prices, that is, control inflation or deflation.

 To attain a rising level of employment.
 To achieve real economic growth which is prerequisite to improvement in the standards of living.
 To secure a healthy BOP position.
Targets of monetary policy

To achieve the above objectives of economic policy, the authorities through monetary policy will seek
to manipulate:
 Interest rates.
 Growth in money supply.
 Exchange rate and,
 Growth in the volume of credit.
Instruments of monetary policy

There are two main categories of monetary policy instruments. On the one hand there are those
instruments of policy that are designed to have a general effect on the financial sector and through that
sector, on the whole economy. On the other hand there are instruments of control that are specific in
their effects on particular financial organisations.
1. Instruments for general control

General control instruments affect certain key interest rates or the authorities may directly engage in
transactions in key financial markets in order to affect credit throughout the economy.

i. Open Market Operations

Open market operations refers to the buying or selling of government securities (bonds or
treasury bills) by the central bank to the public. The principle is to exchange paper assets for
cash. For example, if there is excess liquidity in the market the central bank will enter the market
selling government securities. People will exchange their cash for the securities and hence the
excess liquidity is mopped up. Conversely if there is a shortage, the central bank will enter the
market buying the securities from the public thereby injecting liquidity into the market.
ii. Discount policy or accommodation window
The discount policy refers to variations in the rates at which the central bank discounts first class
bills and other terms at which the central bank, as a lender of last resort, advances funds to certain
domestic parties in the money market, usually to enable those parties to make good a reserve
asset deficiency. Holders of first class bills such as treasury bills can apply to the central bank
for the maturity dates of their bills to be brought forward. This is granted on condition that the
holder will receive an amount less than what they were going to receive upon maturity of the
bill. Thus the central bank will discount the bill. For example if an investor holds a $100m bill
that will mature in the next three months, the investor can apply to liquidate the bill today but
instead of receiving $100m the central bank will pay an amount less than $100m e.g. $80m. The
bill would have been discounted by 20% which is the $20m. Discounting increases the liquidity
situation in the market. Thus if the central bank is pursuing a tight monetary policy it will
increase the rediscount rate or the central bank can close the accommodation window facility.
iii. Non-marketable government debt
The government can seek to borrow direct from the central bank for some general or specific
purpose. In such cases, the terms of the loan are negotiated beforehand and those negotiating on
behalf of government will be anxious to ensure that the agreed interest rate does not have an
adverse influence on the absolute level of interest rates, in nominal terms.
iv. Public debt management
The Reserve Bank operates a government account through which borrowing and interest
payments pass. Government borrowing or specifically the PSBR directly fuels credit creation by
commercial banks if the government borrows from the banking sector.
2. Instruments of specific control

Specific instruments of control have their impact on specific financial institutions and that impact is
in the short-term restricted to those specific institutions.
i. Moral suasion
Moral suasion or moral persuasion consists of central bank requests or admonitions to banking
institutions to act or not to act in certain ways and it may cover any of the bank‘s activities e.g.

lending policy. Moral suasion in not compulsory and hence banks may not agree to change.
However because of the nature of the relationship between the central bank and these banks
moral suasion has been successfully implemented in Zimbabwe.
ii. Calling for special deposits with the Reserve Bank
The central bank can wish to make credit tighter and call specifically for a special deposit from
commercial banks. This dampens optimism and so curtails business spending.
iii. Ceilings and directional controls
This refers to lending ceilings and selective credit controls. It involves the authorities imposing
formal or informal maximum or minimum levels of amounts banks can lend to certain specific
borrowers or categories of borrowers or for certain specific purposes.
iv. Variable reserve ratio
This refers to attempts to control credit creation by commercial banks by manipulating the cash
ratio. From the illustration on the credit creation process we concluded that the smaller the cash
ratio, the greater the banks ability to increase money supply and vice versa. For example the
central bank can increase the cash ratio if it wants to reduce the level of money supply growth
from the creation of credit.
v. Statutory Reserve Requirement
Banks are required to maintain reserve cash balances with the Reserve Bank for management
purposes. These reserves can be varied depending on the monetary policy. For example with a
tight monetary policy the reserves can be increased so as to reduce excess cash in the market.
vi. Directives
The central bank can issue directives such as demanding pension funds to hold a portion of their
earnings in prescribed government paper.
Limitations of monetary policy in Zimbabwe

The advantage of monetary policy is that it is flexible and can be applied fairly quickly unlike fiscal
policy that needs to have both cabinet and parliamentary approval before it can be applied. However the
effectiveness of monetary policy in
Zimbabwe is affected by:
a. Financial dualism that is the existence of a monetised and non-monetised sectors in the economy.
The monetised sector uses money for its transactions while the non-monetised sectors engage in
barter trade. There is a large non-monetized sector which is little affected by monetary policy.
b. There is a narrow size and inactive money and capital market.
c. There is a limited array of financial stocks and assets.

d. The notes constitute a major proportion of total money supply, which implies the relative
insignificance of bank money in the aggregate supply of money.
e. Foreign owned commercial banks in Zimbabwe can easily neutralise the restrictive effects of a
strict monetary policy as they can replenish their reserves by selling foreign assets and can draw
on the international market.
The Quantity Theory of Money
In the Quantity Theory of Money, Milton Friedman improved Irvin Fisher s equation of exchange to
illustrate the role of money in the economy.
The Classical Quantity Theory

Fisher thought that money was used only as a medium of exchange. Its sole function was to act as a
means of payment in transactions for goods and services. According to Fisher, if the number of
transactions is independent of the amount of money, then the total money value of transactions will be
given by:
P, the price level of goods and services bought and sold, multiplied by,
T, the number of transactions, to equal PT (P x T = PT)
The amount of money required to pay for these activities is given by:
M, the money supply, multiplied by
V, the velocity of circulation, to give MV (M x V = MV).
The velocity of circulation (V) measures the speed at which money changes hands in the economy. MV
must always equal PT because they are simply two different ways of measuring the same transactions.
MV looks at society as consumers while PT looks at society as producers.
The new quantity theory

Friedman improved the classical quantity theory of money to
MV = PQ where,
M = Money supply
V = Velocity of circulation
P = General level of prices
Q = National income or real output.
The velocity of circulation (V) is assumed to be fairly constant. The economy is assumed to be at or
near full employment such that it is not possible to increase output. Thus Q is constant. Given that V
and Q are constants, a change in M will directly affect P. for example, if M doubles, Q must also double

for the equation to remain holding. Thus an increase in money supply will directly result in an increase
in the level of prices (inflation).
Criticism of the Quantity Theory

 The assumption full employment of resources is unrealistic. It is true that at full employment any
increase in the money supply can only result in a higher price level since output cannot expand.
With unemployed resources available, a rise in the amount of money is likely to result in changes
in production as well as prices.
 Velocity of circulation is unlikely to remain constant. An increase in the money supply will
probably cause an increase in velocity when people expect a sharp rise in inflation. They will try
to spend before prices rise. In every depressed economy, an increase in the money supply may
cause a compensating fall in velocity as people cut back spending. This leaves the price level
and the number of transactions unaltered.

Inflation
 Introduction
 Consumer Price Index
 Demand Pull Inflation
 Cost-Push Inflation
 Control of Inflation

Introduction
Inflation is a sustained or continuous rise in the general or average price level as reflected in changes
in the consumer price index (CPI). A once only rise in prices is not regarded as inflation.
Price Stability is when the changes in the average price level are small and don‘t have adverse effects
on the economy. The acceptable level of inflation rate is referred to as creeping inflation.
Measuring Inflation
It is useful to have a general understanding of how inflation is measured.
The most common measure of inflation is the “inflation rate”.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 ′ 𝑠 𝑃𝑟𝑖𝑐𝑒𝑠 − 𝐿𝑎𝑠𝑡 𝑌𝑒𝑎𝑟 ′ 𝑠𝑃𝑟𝑖𝑐𝑒𝑠 100
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = ×
𝐿𝑎𝑠𝑡 𝑌𝑒𝑎𝑟 ′ 𝑠𝑃𝑟𝑖𝑐𝑒𝑠 1
Constructing Consumer Price Index (CPI)
CPI is a statistical device that indicates the price level at any given time as compared with the level of
prices at some standard time called the base. CPI looks at price changes in retail shops hence it is also
referred to as the Retail Price Index (RPI).
Key terms:
 Price index: is a measure of the average level of prices in one period as a percentage of their
level in an earlier period (e.g. the previous year).
 Price level: is the average level of prices as measured by a price index.
 Regimen/Basket of goods: a sample of goods or services used in calculation of the price
index.
 Base year: the year chosen as the first year of measurement. It is given the value 100.
 Weighting: a value given to a good/service to indicate its importance in a regimen as
indicated by expenditure on the item compared to other good/service.
Steps followed in constructing consumer price index
Step 1: A regimen is chosen/Basket of goods. This can be done by a survey of households. Prices
are gathered for all the items. In Zimbabwe the prices are obtained from a survey carried out.
Step 2: The price of items in the basket in the base year is noted. The base year is the year in
which it is assumed that there were no chronic economic problems, that is, there is no inflation
Step 3: The price of goods in the basket is recorded in the current year and compared with base
year prices as a percentage (index) using the equation:

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒
𝐼𝑛𝑑𝑒𝑥 = × 100
𝐵𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒
For each good and service an index is calculated as follows:
• 2004 price of rice is $10 per kg; in 2005 it is $11.
• 2004 price of beer is $20 per box of ten and in 2005 it is $24.
• 2004 is chosen as the base year so its price index = 100.
• For 2005 the price index is calculated as follows:
24 100
𝐵𝑒𝑒𝑟 𝐼𝑛𝑑𝑒𝑥 = × = 120
20 1
11 100
𝑅𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 = × = 110
10 1
Step 4: The index of each item is then multiplied by its weighting to get the weighted index
𝑊𝑒𝑖𝑔ℎ𝑡 𝐼𝑛𝑑𝑒𝑥 = 𝐼𝑛𝑑𝑒𝑥 × 𝑊𝑒𝑖𝑔ℎ𝑡
Product Index Weight Weighted Index

Beer 120 0.2 24
Rice 110 0.8 88
112
Rice is much more important to consumers than beer; this is shown by how much they spend on
it. If consumers spend 0.2 of their income on beer and 0.8 on rice this becomes their weighting.
Step 5: The new CPI is found using the equation:
𝑇𝑜𝑡𝑎𝑙 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐼𝑛𝑑𝑒𝑥
𝐶𝑃𝐼 =
𝑇𝑜𝑡𝑎𝑙 𝑊𝑒𝑖𝑔ℎ𝑡
112
𝐶𝑃𝐼 = = 112
1
Step 6: The value of the CPI in the base year is always 100. The rate of inflation is the percentage
change in the CPI and is calculated using the equation:
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐶𝑃𝐼 − 𝐵𝑎𝑠𝑒 𝐶𝑃𝐼
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 112 − 100 = 12%

The weighted price index shows an increase of 12%,
Problems of Measurement
 Arrival and disappearance of goods-As time passes the regimen/basket of goods may not
accurately represent the spending patterns it was supposed to represent (e.g. of households). For
example, in Zimbabwe the survey is done after a long period of time. In that time some goods
may become common items (e.g. mobile phones) and some may no longer be purchased (black
and white TVs).
 Quality of goods-To compare the price of a good in two time periods its quality would need to
be constant. The quality of goods in the regimen may change significantly over time or there
may be additions, e.g. air bags in cars. The price increase may reflect these changes rather than
just general increases in the price level.
 Choice of Weight-The expenditure pattern that determines the weights used in the price index is
an average for the economy as a whole. It may not represent the pattern of certain group‘s e.g.
old-age pensioners or teenagers and so may be of little use in determining price changes of goods
and services used by those groups. Expenditure patterns change over time, and so the weights
based upon them will not remain accurate.
 How to define a standard basket, that is, which items should be included in or excluded from the
basket of goods?
 Different families have different tastes hence different weightings. How is an average family
found?
Causes of inflation
Inflation is termed with reference to what has contributed to the rice of the price level.
Demand pull inflation
Demand pull inflation occurs when aggregate demand (AD =C+I+G+NX) and output is growing at an
unsustainable rate leading to increased pressure on scarce resources and a positive output gap. When
there is excess demand in the economy, producers are able to raise prices and achieve bigger profit
margins because they know that demand is running ahead of supply. Typically, demand-pull inflation
becomes a threat when an economy has experienced a strong boom with GDP rising faster than the long
run trend growth of potential GDP. The effect of raising demand is strong if the economy is close to full
employment or is at the full employment. Demand pull inflation can be shown in diagrams below

Keynesians view
Demand Pull Inflation – Keynesians View
Price
Level AS
P3
P2
P1
AD3
AD2
AD1
P1 P2 P3 Real National
Output
The diagram illustrates the effects of changes in AD when the economy is close to full employment.
Changes in AD from AD1 to AD2 result to a small increase in prices from P1 to P2 because the economy
is close to full employment or is in the intermediate range. At output Y2 an increase in AD from AD2
to AD3 caused the prices to increase by a greater margin. At output Y3, the economy is now at full
employment and any further increase in AD would only cause the prices to increase and not output.

Classical view (monetarist)
Demand Pull Inflation – Classical View
Price
LRAS
Level
P2
P1
AD2
AD1
Real National
Output
The diagram above illustrates the monetarist view to demand pull inflation. They assume the long run
aggregate supply to be perfectly inelastic i.e. the economy is at full employment at Y1. An increase in
AD from AD1 to AD2 will cause the prices to increase from P1 to P2
Causes of Demand-Pull Inflation

What causes the increase in AD?
 An increase in one or more of the components of AD e.g. C, I, G, X-M. AD can increase as a

result of the following
 A depreciation of the exchange rate which makes exports more competitive in overseas markets
leading to an injection of fresh demand into the circular flow and a rise in national and demand
for factor resources – there may also be a positive multiplier effect on the level of demand and
output arising from the initial boost to export sales.
 Higher demand from a government (fiscal) stimulus e.g. via a reduction in direct or indirect
taxation or higher government spending and borrowing. If direct taxes are reduced, consumers
will have more disposable income causing demand to rise. Higher government spending and
increased borrowing feeds through directly into extra demand in the circular flow.
 Faster economic growth in other countries – providing a boost to country‘s exports overseas.
 Improved business confidence which prompts firms to raise levels of investment
 An increase in the money supply. Economists who believe this are monetarists. (Note: not all
economists believe this theory).
 Monetary stimulus to the economy- A fall in interest rates may stimulate too much demand

Cost push inflation
Cost-push inflation is associated with continuing rises in costs and hence continuing leftward (upward)
shifts in the Aggregate Supply curve i.e. decrease in supply. Such shifts occur when costs of production
rise independently of aggregate demand. If firms face a rise in costs, they will respond partly by raising
prices and passing the costs on to the consumer, and partly by cutting back on production. This can be
illustrated as follows:
Cost-Push Inflation
Price AS2
Level
AS1
P2
P1
AD
Q1 Q1 Real GDP
The diagram above illustrates that cost-push inflation occurs when there is an increase in the cost of
production not associated with AD. If a firm‘s costs increase they will react by increasing their prices
and reducing production. This is represented by a shift to the left in the AS curve and results in an
increase in the price level, P1 to P2, and a reduction in the real national income from Y1 to Y2.
Causes of cost push inflation

Cost push inflations result from an increase in the costs incurred by the firms. There are many reasons
why costs might rise these includes:
 Component costs: e.g. an increase in the prices of raw materials and components. This might be
because of a rise in global commodity prices such as oil, gas copper and agricultural products
used in food processing – a good recent example is the surge in the world price of wheat.
 Rising labour costs (wage push inflation) - caused by wage increases that exceed improvements
in productivity. Wage and salary costs often rise when unemployment is low (creating labour
shortages) and when people expect inflation so they bid for higher pay in order to protect their

real incomes this result to firms charging higher prices. This increase in prices is likely to lead
to further wage claims and this could result in what is known as the wage-price spiral.
 Higher indirect taxes imposed by the government (tax push inflation) – for example a rise in the
duty on alcohol, cigarettes and petrol/diesel or a rise in the standard rate of Value Added Tax.
Depending on the price elasticity of demand and supply, suppliers may pass on the burden of the
tax onto consumers.
 A fall in the exchange rate – this can cause cost push inflation because it normally leads to an
increase in the prices of imported products.
 Profiteering-This is perhaps less important than an increase in wage costs. There could be a
situation where firms use their monopoly power to increase prices in order to increase profit
margins. In this situation the increase in the price of the product is not associated with an increase
in consumer demand.
 Increase in Import prices-A rise in import prices can be an important contributor to inflation.
Imports may become expensive if the domestic currency depreciate, this result to higher prices
being charged. This is called imported inflation.
Effects of inflation
The effects of a period of inflation depend on:
 The rate at which prices are rising

 Whether the rate is accelerating or not
 Whether the rate is that which was expected i.e. anticipated or unanticipated
 How the rate compares with other countries, in particular the main trading partners.
Anticipated Inflation
The seriousness of the costs of inflation depend mainly on whether it is anticipated (expected) or not. If
people anticipate the inflation, then the effects will be less as they will build these expectations into their
behaviour. The costs of anticipated inflation may include:
 Costs to firms - called menu costs as firms will need to keep changing their prices.
 Costs to individuals - shoe-leather costs – we will be less likely to hold as much cash, as it loses
its value quicker when there is inflation. This means we will have to go to the bank more often
to get cash out - hence the term shoe-leather costs. It would perhaps be truer these days to call
them car tyre costs , or perhaps even telephone costs given the arrival of internet banking, but
the expression shoe- leather costs has stuck in economic theory
 Distortions to the tax system - both direct and indirect taxes are affected by inflation. Many
indirect taxes are a fixed amount. This is often true of taxes on cigarettes, petrol and alcohol. If
the amount is fixed, then inflation will gradually erode the amount the government receives in
real terms. The price of the good will be going up, but the tax will not. Income tax is also affected,
and in this case it is us as individuals that suffer rather than the government. As incomes increase,
so people may pay more tax. If tax thresholds are not increased in line with inflation, then fiscal

drag arises. This is when people are dragged into higher tax bands, or dragged over the threshold
for starting to pay tax.
Unanticipated inflation
The costs are more serious if the inflation is unanticipated. The main costs of unanticipated inflation are:
 Uncertainty -inflation makes life very difficult for firms who want to plan ahead as much as
possible. This uncertainty may particularly affect their investment plans. Many investment
projects take a long time before they generate returns. If the level of inflation is unpredictable,
then firms will find it more difficult to work out if the investment will be profitable. In that case,
they may simply not bother to take the risk. So higher inflation may adversely affect investment,
and this will slow down economic growth in the long run.
 Wage distortions - some groups will have more power to increase their wages to reflect changing
inflation than others and unanticipated inflation is likely to lead to the less well-off in society
being hit harder than the better-off, not least because a wage increase of, say, 5% of $100 is a lot
less than 5% of $1000
 Resource costs - if you see that the price of something that you buy has gone up, then that causes
a dilemma. Is it just that thing that is more expensive? Or is it all the other brands as well? In
other words, has there been a relative price increase (one thing relative to others), or a general
price increase (everything increasing in price). If it is a general price increase then you would
probably just buy it anyway and then moan about inflation. However, if it is a relative price
increase you may want to switch brands. Inflation may therefore distort the price signals in the
economy. These price signals are fundamental to the efficient workings of markets and inflation
can adversely affect them. Unanticipated inflation can therefore cause allocative inefficiency.
 Redistribution - inflation creates an arbitrary redistribution of income, and is unfair.
 People who have borrowed money will be better off as they have less to pay back in real terms.
E.g. If a person borrows $1,000 at 5% interest p.a. and repays it 12 months later and inflation
has risen by 10%, he/she gains. Often interest rates are not set high enough to cover the real
income loss due to inflation.
 Savers, on the other hand, will be worse off as inflation is eroding the value of their savings.
 People on fixed incomes or with fixed savings like pensioners may be the worst off. It can be
really demoralising to have saved all your life for retirement, only to find that the money you
have saved is worth less and less every year because of inflation.
 Export prices will change relative to import prices. If domestic inflation rates rise more than
prices in competing producer countries, overseas buyers may buy from an alternative country.
Exports will decline. As well, domestic consumers may buy more from overseas. Imports will
increase.
 Balance of payments / competitiveness - markets are becoming increasingly globalized and firms
have to compete with other firms all over the world. If a country's inflation rate is faster than
other countries, then it makes it much more difficult to compete. This will tend to make exports
suffer, but at the same time imports become relatively cheaper. Overall, the balance of payments

is likely to worsen. The uncertainty that normally accompanies inflation may discourage capital
and financial investment from coming into the country as well.
Control of Inflation
How inflation is controlled in an economy depends on the causes and the type of inflation economy is
experiencing.
Use of Fiscal Policy

Fiscal policy is one of the two main macroeconomic policies used to control aggregate demand and
thereby achieve economic stability. Fiscal measures relate to taxation, government expenditure and
public debt management, which seek to influence the level of aggregate demand in an economy. There
are three main tools of fiscal policy viz. government spending (G), the income tax rate (t) and
government transfer payments (Tr). In times of demand pull inflation these tools are used to reduce
aggregate demand. All increase in tax rate, decrease in government expenditure and decline in
government transfer payment will reduce aggregate expenditure in the economy. That is, there is
contractionary or tight fiscal policy.
Use of Monetary Policy

Monetary policy is that part of macroeconomic policy which regulates the changes in money supply in
order to maintain price stability. Tools of monetary policy are changing discount rate (d); changing
required reserve ratio (rr) reduces the extent to which commercial banks create credit hence reduces
money supply. When the discount rate is increased short term interest rates increase and this discourages
borrowing to finance investment spending. This invariably reduces aggregate demand. Central bank
selling of its own government securities to the general public reduces money supply which reduces
aggregate demand. Generally, there will be contractionary monetary policy.
The following diagram illustrates how monetary and fiscal policies shift the aggregate demand curve.

Decrease in Aggregate Demand
Price Level
AS
P1
P2
AD1
AD2
Q1 Q2 Real GDP
In the mainstream macroeconomics, monetary policy shifts the aggregate demand curve of an economy.
In the diagram above, the equilibrium price level is P1. If the central bank increases the discount rate
(d) or engages in open market sales or increases the required reserve ratio the AD-curve shifts to the left
(aggregate demand falls) from AD1 to AD1 and the price level declines to P2. This is known as
restrictive monetary policy. The central bank in an attempt to fight inflation may embark on restrictive
monetary policy.
Contractionary fiscal policy via reduction in government expenditure (G), decrease in transfer payments
(Tr) and increase in the income tax rate (t), would also cause the AD0 to shift to AD1.
Income and Price Policy

Income Policy measures may take the form of wage freeze, linking wage increases to increase in
productivity. Price Policy may also be used. Maximum prices are used in this case. These prices are the
highest possible legal prices for scarce goods. However, these prices may lead to queues, rationing and
black marketing in scarce products.
Supply Side Policies

In addition to the demand management policies, supply side policies could also be used in controlling
inflation. This however is a long-term measure. The following may increase aggregate supply.
Increasing productivity in all sectors of the economy. Increases in productivity may increase output,
which will subsequently increase supply. This may be achieved by the retraining of labour, improving
technology, removing all structural rigidities e.g. land tenure system, poor road infrastructure etc.

Unemployment
 Introduction
 Equilibrium Unemployment
 Disequilibrium Unemployment
 Consequences of Unemployment
 Why measure Unemployment

Introduction
An unemployed person is someone who is actively searching for a job but unable to find one within a
specified time period. An “expanded” definition of unemployment includes people who have the desire
to work but have become too discouraged to actively search for a job. The rate of unemployment is
calculated as the number of unemployed job seekers divided by the total number of employed and
unemployed persons (labour force) multiplied by 100.
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝑃𝑒𝑟𝑠𝑜𝑛𝑠
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 = × 100
𝐿𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
Two Major Types of Unemployment
Equilibrium unemployment\Natural rate of unemployment

The Natural Rate of Unemployment is the rate of unemployment when the labour market is in
equilibrium. It is the difference between those who would like a job at the current wage rate and those
who are willing and able to take a job. The natural rate of unemployment is unemployment caused by
supply side factors rather than demand side factors and always exist in an economy. The natural rate of
unemployment includes three causes:
1. Frictional unemployment
2. Structural unemployment
3. Seasonal unemployment.
Natural rate of unemployment can be illustrated as follows:

Natural Rate of Unemployment
ASL
Average Real
Wage Rate Total Labor
Force
A
WE B
ADL
QE Q1
Number of Workers
The above figure shows the total demand and supply of labour, and equilibrium occurs where aggregate
supply of labour (ASL) is equal to aggregate demand for labour (ADL) at a real wage of We. The Total
Labour Force line represents the total labour force. This includes the three causes of Equilibrium
Unemployment: frictional, seasonal and structural, also known as the Natural Rate of Unemployment.
At equilibrium point A, there is, consequently, natural unemployment of AB.
What Determines the Natural Rate of Unemployment?

M. Freidman argued the Natural rate of unemployment would be determined by institutional factors
such as:
 Availability of job information. A factor in determining frictional unemployment

 Skills and Education. The quality of education and retraining schemes will influence the level of
occupational mobilities.
 Degree of labour mobility
 Flexibility of the labour market E.g. powerful trades unions may be able to restrict the supply of
labour to certain labour markets
 Hysteresis. A rise in unemployment caused by a recession may cause the natural rate of
unemployment to increase. This is because when workers are unemployed for a time period they
become deskilled and demotivated and are less able to get new jobs.

Frictional unemployment
This type of unemployment includes those individuals who are between jobs. Workers who leave one
job in order to look for another need time to search because of the lack of information on all the possible
jobs available. There are “search” costs involved, in terms of lost earnings and travel expenses for such
things as interviews, but they can be viewed as an investment.
Frictional unemployment is related to and compatible with the concept of full employment because both
suggest reasons why full employment is never reached. Frictional unemployment is always present in
an economy, so the level of involuntary unemployment is properly the unemployment rate minus the
rate of frictional unemployment, which means that increases or decreases in unemployment are normally
under-represented in the simple statistics. Frictional unemployment coincides with an equal number of
vacancies. Numerically, it is therefore maximal when the labor market is in equilibrium. When for
instance demand far exceeds supply, the frictionally unemployed will be few as they will get many job
offers.
One kind of frictional unemployment is called wait unemployment: it refers to the effects of the
existence of some sectors where employed workers are paid more than the market-clearing equilibrium
wage. Not only does this restrict the amount of employment in the high-wage sector, but it attracts
workers from other sectors who wait to try to get jobs there. The main problem with this theory is that
such workers will likely "wait" while having jobs, so that they are not counted as unemployed.
Policies to reduce frictional unemployment include:
 Lower real values of unemployment benefit-If the government reduced the real value of
unemployment benefits, or limited the duration of a claim, search times between jobs could be
reduced even further as workers would have to quickly take on new positions before their
financial situations deteriorated.
 Improve job information- Improving the flow of information with regards to the availability of
particular employment is one such measure. This can be done by establishing public and private
employment agencies who are responsible for linking potential employee to their potential
employers.
 Cuts in direct taxes -The government could reduce direct taxes for the low paid to increase the
post-tax wage and, therefore, encourage them to find work more quickly. Most analysts believe
that tax cuts on their own are insufficient to reduce frictional unemployment. Complementary
reforms to the benefits system to reduce the problem of the poverty trap may also be needed.
 Relocation of industries and services
 Advertising in public media e.g. national newspaper
Structural unemployment
Structural unemployment is a form of unemployment where, at a given wage, the quantity of labor
supplied exceeds the quantity of labor demanded, because there is a fundamental mismatch between the
number of people who want to work and the number of jobs that are available. The unemployed workers

may lack the skills needed for the jobs, or they may not live in the part of the country or world where
the jobs are available. Structural unemployment is one of the five major categories of unemployment
distinguished by economists. Structural unemployment is generally considered to be one of the
"permanent" types of unemployment, where improvement if possible, will only occur in the long run.
Zimbabwe is currently experiencing this form of unemployment.
The possible causes of frictional unemployment includes the following;
 Obsolescence of a single technology will make specific expertise useless. For instance, jobs for
manual typesetters disappeared with digitalization of printing plate production.
 Increase of the efficiency in an economic sector reduces the number of required workers. For
instance, fewer agricultural workers are needed when the work is mechanized. Closely related is
the increased demand for skill, training and formal education, as the new machinery often
requires fewer, but higher-skilled workers. Due to this, unskilled laborers are the first to go
unemployed, and the most likely to stay so.
 Political changes and globalization also cause structural unemployment. Termination of
government subsidies, for instance, can lead to termination of production and unemployment.
 Reduced relative competitiveness of an industry in a country can also lead to structural
unemployment.
 Market inefficiencies can also cause structural unemployment. In an efficient market the
jobseeker and an employer wishing to recruit can connect, whereas in an inefficient market this
is impeded, for instance due to discrimination.
 Structural unemployment is caused by a mismatch between jobs offered by employers and
potential workers. This may pertain to geographical location, skills, and many other factors.
 Automation in the work place (e.g. need for higher and higher computer skills), rigidities in the
labor market, such as high costs of training.
Measures to correct Structural Unemployment

There are a number of different approaches that can be adopted to help alleviate structural
unemployment. These are sometimes known as active labour market policies. The first involves direct
government action to match jobs to the unemployed.
 Regional policy incentives-Gives grants and subsidies to firms to locate in areas of high
unemployment. However, this does not solve the problem of occupational immobility. Often
regional policy requires extra retraining schemes to give workers the relevant skills to allow
them to take up new jobs.
 Investment in worker training-Spending on training schemes to re-skill the unemployed through
investment in vocational education or guaranteed work experience for unemployed "outsiders"
in the labour market.
 Improving geographical mobility of labour-The government could provide grants or low cost
housing to encourage workers to move to other regions where there are jobs. The problem with

this policy is that people are inherently immobile as they are often bound by family and social
ties.
 Change the education curriculum to meet the requirements of industry. One approach is to simply
leave the problem of structural unemployment to the market. Some economists argue that
intervention slows the natural reallocation of resources to high growth areas and only makes the
problem worse. In areas of above average unemployment it may make some sense to allow wage
levels to fall to attract new capital into an area.
Seasonal Unemployment
Seasonal unemployment arise from seasonal changes that affect demand for labour. Workers are highly
demanded during the season time and less demanded during the off season. This type of unemployment
is mainly experienced in the following industries;
 Agriculture
 Tourism
 Retailing and
 Construction
Seasonal Demand for Labor
Average Real
Wage Rate Supply
W2
W1
Season
Off Season
Q1 Q2 Number of Workers
The diagram above illustrate that more workers are demanded during the season (Q2). Off season time
will result to a decrease in demand of labour from Q2 to Q1 .This fall in demand for labour will result
to seasonal unemployment measured by distance Q2 to Q1.

Measure to correct seasonal unemployment

 Introduction of irrigation schemes.
 Training workers so that they will be flexible.
 Government financial assistance to encourage self-employment.
Disequilibrium Unemployment
Occurs when the labour market is not in equilibrium due to classical (or real wage) unemployment and
demand-deficient or cyclical unemployment.
Cyclical Unemployment
Cyclical or Keynesian unemployment, also known as deficient-demand unemployment, occurs when
there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.
Demand for most goods and services falls, less production is needed and consequently fewer workers
are needed, wages are sticky and do not fall to meet the equilibrium level, and mass unemployment
results. Demand Deficient Unemployment is associated with an economic recession or a sharp economic
slowdown. It occurs due to a fall in the level of national output in the economy causing firms to lay-off
workers to reduce costs and protect profits. Demand deficient unemployment can be outlined by
reference to the diagram below.
Demand Deficient Unemployment
Price AS
Level
P1 E1
P2 E2
AD2
AD1
Y2 Y1 Real National
Output
The assumption is made that the economy is initially at full employment when aggregate demand
consisting of consumer expenditure (C), investment (I), government expenditure (G) and exports minus
imports (NX) is AD1, aggregate supply is AS and equilibrium national income is Y1. Suppose there is

now a reduction in investment, perhaps because of a fall in business confidence so that aggregate demand
falls to AD2 resulting in a reduction in equilibrium national income to Y2. This being the case, the fall
in national income/output from Y1 to Y2 will result in an increase in the numbers unemployed, i.e.
demand deficient unemployment.
With cyclical unemployment, the number of unemployed workers exceeds the number of job vacancies,
so that even if full employment was attained and all open jobs were filled, some workers would still
remain unemployed. Some associate cyclical unemployment with frictional unemployment because the
factors that cause the friction are partially caused by cyclical variables. For example, a surprise decrease
in the money supply may shock rational economic factors and suddenly inhibit aggregate demand.
Measures to correct cyclical/ demand deficiency unemployment

Keynesian economists on the other hand see the lack of demand for jobs as potentially resolvable by
government intervention. Policies to reduce Keynesian demand-deficient unemployment need to raise
the level of aggregate demand for goods and services in the economy. A number of options are available.
 Increased Government Expenditure-The Government can raise the level of its own spending.
This "fiscal pump-priming" directly increases aggregate demand and can have a multiplier effect
on equilibrium national income. The government could raise current expenditure (for example
raising pay levels in education and the health service) or expand spending on capital projects
which add to the stock of capital (for example spending on new roads, new hospitals or other
major infrastructural projects). Sustained economic growth provides a platform for more jobs to
be created in the economy.
 Lower Taxation-A reduction in direct taxation increases consumers' disposable income and
should boost household spending. The effect may be greater if taxes are cut for people on lower
than average incomes. These tax-payers are likely to spend a greater percentage of their
disposable income.
 Lower interest rates-A relaxation of monetary policy through lower interest rates encourages the
demand for credit, reduces saving and increases consumers' real 'effective' disposable incomes;
all of which will boost consumption and demand. It may also encourage firms to invest, as the
marginal cost of investment will fall.
 Depreciation of the exchange rate-A lower value for the pound should lead to a rise in the orders
of exports from Zimbabwean firms and to a reduction of import penetration by making exports
cheaper and imports more expensive.
Government policies to stimulate increased aggregate demand for domestic output take time to have
their effect. There are variable time lags between the government reflating the economy using fiscal and
or monetary policy and the final effect on output and employment in specific industries.
Classical unemployment /real wage unemployment

Classical or real-wage unemployment occurs when real wages for a job are set above the market-clearing
level, causing the number of job-seekers to exceed the number of vacancies.

Real Wage Unemployment
ASL
Average Real
Wage Rate
Above
Equilibrium
Wage Rate
W1
Equilibrium
WE
Wage rate
ADL
Q1 QE Q1
Number of Workers
The above figure shows the total demand and supply of labour, and equilibrium occurs where ASL =
ADL at the Average Real Wage Rate, We, and Number of Workers, 0QE. Then, due to the action of the
Unions and/or government minimum wages legislation, an Above Equilibrium Wage Rate of W1 is
established. In the above figure, the Average Real Wage, W1, is above the equilibrium level. ADL falls
to OQ2. ASL increases to OQ1. Q2-Q1 is the level of real wage unemployment (Disequilibrium
Unemployment).
Many economists have argued that unemployment increases the more the government intervenes into
the economy to try to improve the conditions of those without jobs. For example, minimum wage laws
raise the cost of laborers with few skills to above the market equilibrium, resulting in people who wish
to work at the going rate but cannot as wage enforced is greater than their value as workers becoming
unemployed. Laws restricting layoffs made businesses less likely to hire in the first place, as hiring
becomes more risky, leaving many young people unemployed and unable to find work.
However, this argument is criticized for ignoring numerous external factors and overly simplifying the
relationship between wage rates and unemployment.
Measures to correct classical/real wage unemployment

Measures for reducing real wage unemployment normally focus around the strategy of making each
labour market more flexible so that pay conditions become more adaptable to changing demand and
supply conditions. Real wages should rise when demand, output and employment are rising, but they
may need to fall if an industry experiences recession which puts jobs at threat.
Another way is to claim down the powers trade unions so as to reduce the bargaining powers.

Consequences of Unemployment
Unemployment affects individuals, society, businesses and the government through the following ways.
 Loss of output -The opportunity cost of each unemployed person is his or her foregone output.
If labour is unemployed the economy is not producing as much output as it could. An economy
with high unemployment is producing within its production possibility frontier. The hours that
the unemployed do not work can never be recovered.
 Loss of human capital -The unemployed labour gradually loses its skills because skills can only
be maintained by working. Unemployment wastes some of the scarce resources used in training
workers. Furthermore, workers who are unemployed for long periods become de-skilled as their
skills become increasingly outdated in a rapidly changing job market. This reduces their chances
of gaining employment in the future, which in turn increases the economic burden on
government and society.
 Fiscal cost to the government - Lost tax revenue-Growing unemployment means less direct
and indirect tax revenue because unemployed people stop paying income tax and their spending
will full considerably. This rise in government spending along with the fall in tax revenues may
result in a higher government borrowing requirement (known as a public sector borrowing
requirement)
 Social Costs - Unemployment brings social problems of personal suffering and distress and
possibly also increases in crime such theft and prostitution.
 Areas of high unemployment will also see a decline in real income and spending together with a
rising scale of income inequality. As younger workers are more geographically mobile than older
employees, there is a risk that areas with above average unemployment will suffer from an ageing
potential workforce - making them less attractive as investment locations for new businesses.
 Increasing inequalities in the distribution of income
What Is Full-Employment?
There is no unique definition of full-employment. Most economists are in agreement that unemployment
cannot fall to zero since there will always be some frictional unemployment caused by people moving
into the labour market (searching for work) and others switching between jobs and experiencing short
periods of time out of work.
Full-employment might also be defined as a situation where the labour market has reached a state of
equilibrium - i.e. when those in the active labour force who are willing and able to work at going wage
rates are able to find work. At this point the remaining unemployment would essentially be frictional.
Several countries have made significant progress towards reaching full-employment in recent years.
Some demand theory economists see the inflation barrier as corresponding to the natural rate of
unemployment. The "natural" rate of unemployment is defined as the rate of unemployment that exists
when the labour market is in equilibrium and there is pressure for neither rising inflation rates nor falling
inflation rates. An alternative technical term for this rate is the NAIRU or Non-Accelerating Inflation

Rate of Unemployment. No matter what its name, demand theory holds that this means that if the
unemployment rate gets "too low," inflation will accelerate in the absence of wage and price controls
(incomes policies).
Why do we measure unemployment?

 Unemployment is seen as a social evil, that should be tackled – we need to know the level of
unemployment to see how well the economy is doing.
 The government needs to know so it can intervene if necessary. Government may decide to alter
the level of aggregate demand or institute special policies e.g., sponsored training schemes, or
expand jobs in the public sector.
 We need to know the level of unemployment for social welfare purposes. The government need
to budget and wants a forecast of future payment levels to the unemployed and other social
security benefits.
 International obligations – the United Nations makes us collect data on unemployment – all
members of the UN accept the rules as a condition of membership
Problems involved in measuring unemployment
It may be surprising to realize that it is actually quite difficult to measure the size of the labour force and
the number of people that are unemployed. Each country has its own national system for measuring the
number of people that are unemployed. The following are the problems encountered in measuring
unemployment
 Data inaccuracy - Information is gathered from national censuses and surveys of the population,
along with administrative records such as unemployment insurance records and social security
information. It is worth noting that there may be inaccuracies in such data and there may also be
inconsistency in the definitions across different countries. Only those people that are registered
(i.e. for social security payments) as unemployed are included. Often people who may not qualify
for benefits, including school-leavers and part-time workers, are excluded from the calculation.
 Hidden unemployment - One problem that exists in the calculation of unemployment is the
existence of hidden unemployment. Hidden unemployment consists of several different groups
of people.
 The first group includes those people who have been unemployed for a long period of time and
have given up the search for work. Since they are no longer looking for work, presumably having
loss hope, they are no longer considered to be unemployed.
 Another group of people who make up the hidden unemployed are people who have pan-time
work but would really like to be working full time. Since they are working part time they are
obviously not considered as unemployed. They might not be earning as much as they would like,
or need, and would like to find a full-time job, but have to stay in the part-time job as it provides
better income than having no job.
 Another group of people hidden from official unemployment figures are people who are working
in jobs for which they are greatly over-qualified. Again, such people would like to find work that

utilises their skills and pays higher income, but must stay in the lower-skilled job as it is better
than no job at all.
 Distribution of unemployment-Along with differences in methods of measurement, and the
existence of hidden unemployment, it is worth pointing out another limitation of the
unemployment rate. As with many other indicators, a national unemployment rate establishes an
average for a whole country, and this is very likely to mask inequalities among different groups
within an economy. One should be careful in using the national rate as a basis for making
conclusions about different groups of people. These are some of the typical disparities that exist
among different groups of people within a country:
 Geographical disparities- Unemployment is likely to vary quite markedly among regions in a
country, as most countries do have some regions that are more prosperous than others. Inner city
unemployment might be quite a bit higher than suburban or rural unemployment.
 Age disparities- Unemployment rates in the under-25 age group are higher than the national
averages in many countries.
 Ethnic differences-Ethnic minorities often suffer from higher unemployment rates than the
national average. This may be the result of differences in educational opportunities or possibly
due to attitudes and/or prejudices of employers.
 Gender disparities-Unemployment rates among women have tended to be much higher than rates
for men in many industrialized countries. There may be all kinds of reasons for this: differences
in education, discrimination by employers, or other social factors.
 Different measures are used in different countries.
 Unemployment is a “stock” concept- i.e. it is measured at a point in time.
Questions & Answers

Evaluate the view that the main objective of government policy should be to achieve full
employment.
Macroeconomic objectives of the government will include: low inflation, increasing the sustainable
growth rate, full employment and balance of payments equilibrium.
Full employment involves zero or very low unemployment. In practice there will always be some
frictional unemployment as people are looking for new jobs or leaving school. Economists suggest an
unemployment rate of 3% is close to full employment. However, it is difficult to determine precisely.
Full employment implies the macro economy is operating at its full capacity and there is no output gap
or demand deficient unemployment.
High unemployment has various social and economic costs. Firstly, the unemployed will have low
income enabling little consumption. Also, the unemployed will become de motivated and deskilled. This
makes it more difficult to find employment in the future, (this is the Hysteresis effect) the government
will have to spend more on unemployment benefits this will increase government borrowing. Finally,
unemployment may exacerbate social problems such as crime and vandalism, especially if
unemployment is concentrated amongst young people.

To achieve full employment Keynesians will argue that it is necessary to increase AD when the economy
is in a recession.
Price
Level AS
P2
P1
AD2
AD1
P1 P2 Real National
Output
This can be achieved by loose fiscal or monetary policy e.g. lower interest rates. It may cause inflation
to increase, but, if there is spare capacity there will only be a small increase. Keynesians argue the
economy can be below full capacity for a long time if consumer confidence is low, and a negative
multiplier effect reduces AD further. The Phillips curve suggests there is a tradeoff between inflation.

The Phillips Curve

Rate of
Inflaiton
10%
8%
6%
4%
2%
1% 2% 3% 4% 5% Rate of
Unemployment
Monetarists disagree with Keynesians. They argue that unemployment cannot be reduced below the
Natural rate without causing inflation. Also, any reduction will be just a temporary fall. This is because
the economy will return to the equilibrium level of output.
Therefore, Monetarists don‘t believe there is any point in reducing unemployment below the natural rate
because the only effect will be to increase inflation.
However, it is worth trying to reduce the natural rate of unemployment by using supply side polices. For
example, better education can improve workers skills and therefore reduce structural unemployment.
However, these will take time and it may not be possible for the government to reduce all unemployment.
Low unemployment can also be achieved through keeping inflation low and maintaining steady and
sustainable growth. E.g. in the 1990s, both unemployment and inflation fell due to supply side policies
and effective demand management by the MPC. Therefore, this suggests that a low inflation target is
effective in meeting other objectives as well. However, this may prove more difficult if there was an
adverse shock to the economy.
Overall low unemployment is a desirable objective, but the policies to achieve this need careful
examination. Increasing AD will only be effective if there is a recession. To reduce the natural rate,
supply side policies will be needed.
Discuss whether demand side policies will be successful in reducing unemployment.

Demand side policies include expansionary fiscal and monetary policies. For example the government
could increase Government spending and lower taxes. G is a component of AD therefore this will cause

AD to increase, there may also be a multiplier effect causing AD to increase even more than the initial
effect.
Lower tax rates will increase consumer‘s disposable income and therefore spending will increase. Also
the MPC could cut interest rates, this makes borrowing cheaper and encourages spending rather than
saving, this will also have the effect of increasing AD.
Price LRAS
Level
P2
P1
AD2
AD1
YF Real National
Output
The above diagram shows an increase in AD causing higher real GDP and a higher price level. Note
there will only be an increase in real GDP if there is spare capacity in the economy.
If real GDP increases then there will be higher demand for workers, as firms need to increase production
to meet demand. Therefore, unemployment will fall. The Phillips curve shows the trade-off between
unemployment and inflation, as demand is increased there is lower unemployment with a trade-off of
higher inflation.
However classical economists disagree with this Keynesian analysis they argue that the LRAS is
inelastic therefore an increase in AD will not cause a rise in Real GDP.

Price LRAS
Level
P2
P1
AD2
AD1
YF Real National
Output
This diagram shows that an increase in AD will cause an increase in Real GDP in the short run. However
as prices increase firms face an increase in their wage bill so the SRAS shifts to the left. This causes
Real GDP to return to its original level of output. Therefore any fall in unemployment will only be
temporary according to classical economists. Therefore they believe there is no trade off as the Phillips
Curve suggests. This Monetarist view gained credence in the 1970s when there appeared to be a
breakdown in the relationship between inflation and unemployment. It is also possible that demand side
policies fail to increase AD in the Great Depression (and in Japan in the 1990s) cuts in taxes did not
increase AD because consumer confidence was very low. Therefore fiscal policy failed to reduce
unemployment.
Cyclical unemployment is only one cause of unemployment. Other types of unemployment include Real
Wage or (classical unemployment) this occurs when trades unions force wages above the equilibrium
reducing demand for labour. The Natural rate of unemployment refers to the supply side factors such as
structural and frictional unemployment. This type of unemployment will occur even when the economy
is at full output. Therefore these types of unemployment will not be reduced by demand side factors.
Demand side policies can only reduce cyclical unemployment, which will occur during a recession.
Classical economists argue that this will only last a short time and the markets will clear of their own
accord. However, in practice this often doesn‘t occur. Government intervention can shorten a recession
and therefore reduce unemployment. Nevertheless it will also be important for the government to tackle
different types of unemployment with supply side policies.
Is inflation lesser evil than unemployment?

Central Banks and governments often face a choice between reducing inflation and reducing
unemployment. Which imposes the greatest cost on society - inflation or unemployment? Firstly, it

depends on the magnitude of inflation. If we are talking about hyperinflation (over 10,000% a year) then
inflation can definitely devastate an economy leading to a breakdown in normal economic transactions.
Inflation imposes several costs on Society
 Inflationary growth is unsustainable. High inflation is often a sign the economy is overheating
(demand growing faster than supply). This kind of boom is often followed by a bust (recession).
An inflationary boom can lead to a recession. Targeting a low rate of inflation helps to keep
economic growth sustainable. Therefore, low inflation can help avoid recession and prevent a
sudden rise in unemployment.
 Inflation discourages investment. High and volatile rates of inflation can discourage firms from
taking long-term investment decisions. This is because of the uncertainty and confusion around
future revenues and profits. Therefore, it is argued countries with higher inflation rates tend to
have lower growth rates over time.
 Decline in international competitiveness. High inflation is likely to make your goods and services
less competitive leading to a fall in exports and current account deficit. Often this high inflation
will be offset by a fall in the exchange rate to restore competitiveness.
 Inflation can reduce real incomes. If inflation is above income growth, we can experience a fall
in real incomes
 Inflation can erode savings. If inflation is higher than interest rates, then inflation can wipe away
people's savings. Inflation reduces the value of money, so people who rely on income from
savings see a reduction in their living standards. This is often a problem for pensioners who rely
on savings. Therefore inflation can cause a redistribution of income in society from old to young
and from savers to borrowers.
 Legacy of Inflation. If people suffer from inflation, (e.g. lose savings, become worse off) then it
will impact their future decisions. For example, people may be reluctant to buy government
bonds because they fear the government will effectively default through inflation. People will be
more reluctant to save, leaving less room for investment.
Economic Costs of Unemployment

Inflation definitely has economic costs, however arguably the costs of unemployment are far greater.
Some of the costs of unemployment:
 Much lower income. The unemployed have to rely on unemployment benefits and they will see
a drastic fall in income. Unemployment is one of the biggest causes of home repossessions (when
you fail to keep up with mortgage payments) Losing your home is one of most traumatic events.
 Psychological costs. Unemployment is one of the biggest causes of stress. Without work, people
feel a lack of purpose and low self-esteem. This can precipitate health and psychological
problems.
 Social Problems. Unemployment can create a feeling of alienation from society. When you have
a high unemployment rate amongst a particular group (region, ethnicity, age). Feelings of social
exclusion can be exacerbated.

 Higher Government Borrowing. A rise in unemployment leads to lower tax revenue (less income
tax) and higher government spending on benefits. This may require lower spending elsewhere in
economy.
 Negative Spiral. Higher unemployment will lead to lower spending in the economy leading to
lower growth. The threat and fear of unemployment may be sufficient to reduce spending.

Economic Growth
 Introduction
 Determinants of Economic Growth
 Increase in Aggregate Demand
 Increase in Aggregate Supply
 Government Policy & Economic Growth
 Fundamentals of Public Finance

Introduction
Economic growth is a long-term expansion of the productive potential of the economy. Growth can also
be defined as an increase in what an economy can produce if it is using all its scarce resources. An
increase in an economy‘s productive potential can be shown by an outward shift in the economy‘s
production possibility frontier (PPF). Also a movement from a point inside the PPF represent economic
growth. Generally economic growth is measured in terms of increase in GDP per capita.
Trend growth refers to the smooth path of long run national output. Measuring the trend rate of growth
requires a long-run series of data perhaps of 20-30 years or more in order to calculate average growth
rates from peak to peak across different economic cycles
There are two main forms or types of economic growth that is potential growth and actual growth.
Actual Growth
Actual growth is measured as increases in real GDP. Actual output means the real output which the
country produces with the current employment of factors of production. It is experienced when the
economy shift the resources from the non-productive sectors of the economy to the productive sectors
of the economy and when the economy fully utilises the resources lying idle. This will result to a
movement from the point inside the PPC (Point Z) to the point on the PPC as illustrated below:
Actual Economic Growth
Capital
Goods
Consumer
Goods
Statistics of GDP growth rates refer to actual growth when they are published.

Causes of fluctuations in actual growth

Actual growth will tend to rise and fall. A vast rise in aggregate demand will create shortages, this will
have a tendency to encourage firms to increase output consequently reducing slack in the economy.
Also, a reduction in aggregate demand will leave firms with increased stocks of unsold goods. This
therefore makes them inclined to reduce output in some years there can be a high rate of growth; this is
when the country will experience what is known as a “boom”. A boom is affiliated with a rapid rise in
aggregate demand; the faster the rise in aggregate demand, the higher the short run rate of actual growth.
In other years quite simply growth is low or negative; this is when the country is in recession a period
of “slump” or “depression”. A recession is associated with a decline in aggregate demand. This series
of booms and recessions is commonly known as the business cycle. There are four “phases” of the
business cycle as shown in the diagram below:
Business Cycle
GDP
Boom
Recovery
Recession
Slump
Time
Potential growth
Potential growth is an increase in the capacity in the economy. And we have to note here that not all the
available resources are employed at any given time. However, potential output means what the economy
could produce if all the resources are fully employed. Therefore, if there is an increase in resources, or
if there is increase in productive capacity of the economy, then we say that the there is potential
economic growth. The simplest way to show potential economic growth is to bundle all goods into two

basic categories, consumer and capital goods. An outward shift of a PPF means that an economy has
increased its capacity to produce.
Economic Growth
Consumer
Goods
C1
C2
C3
K1 K2 K3 Capital Goods
Major factors that can contribute to potential economic growth include:
 An increase in resources – natural, labour or capital.

 Increase in the potential with which these resources can be used, through advances in technology,
enhanced labour skills or bettered organisation.
Potential growth can also be illustrated by an outward shift of the long run aggregate supply which is
perfectly inelastic. This can be illustrated as follows;

Economic Growth
Price LRAS LRAS 1

Level
P2
P1
AD
Y1 Y2 Real National
Output
The diagram above illustrate economic growth represented by an increase in real national output from
Y1 to Y2 as a result of the out ward shift of the long run aggregate supply from LRAS1 to LRAS2.
Asymmetric growth
An economy can grow because of an increase in productivity in one sector of the economy - this is called
asymmetric growth.

Asymmetric Economic Growth
Consumer
Goods
B
C2
C1
A
K1 Capital Goods
An improvement in technology applied to industry Y, such as motor vehicles, but not to X, such as food
production, would be illustrated by a shift of the PPF from the Y-axis only as illustrated above.
It is also important to compare the actual and potential growth, which is also known as the output gap.
The output gap signifies the economy is operating with spare capacity, which also means unemployment.
Therefore, if the output gap is too big, the unemployment will be a concern for the economy. However,
if the aggregate demand exceeds aggregate supply, which also means the economy is trying to operate
at overcapacity, there will be the problem of inflation.
Determinants of economic growth
Economic growth can result from an increase in aggregate demand if the economy is operating below
full employment this form of growth is known as short term growth. Economic growth also result from
an increase in aggregate supply, this growth is called long term growth.

Some Key Drivers of Economic Growth
Expanding the
Capital Stock
Increasing Active
Labor Supply
Extracting & Selling ECONOMIC

Natural Resources GROWTH
Improving Factor
Productivity
Driving Innovation
& Enterprise
Increase in aggregate demand
Growth can be achieved by increases in the components of aggregate demand, for example an increase
in consumer spending. The size of this increase depends on the size of the multiplier, and therefore any
changes in injections and leakages will have an impact on the degree of change in growth.
The following diagram shows increase in aggregate demand which results in increased output.
As we can see that the outward shift of AD increased real GDP. A positive change to any component of
aggregate demand (C+I+G+X-M) will increase aggregate demand and can result in economic growth in
the short run. However, price also could increase as we can see from the diagram. The more inelastic
the AS curve is, the higher the increase in price will be due to any increase in aggregate demand. That
means if there is spare capacity in the economy then an increase in AD will cause a higher level of real
GDP.

Increase in Aggregate Demand
Price
Level AS
P2
P1
AD2
AD1
P1 P2 Real National
Output
Aggregate demand can increase for the following reasons:
 Lower interest rates – Lower interest rates reduce the cost of borrowing and so encourages
spending and investment.
 Increased wages. Higher real wages increase disposable income and encourages consumer
spending.
 Increased government spending (G). E.g. if the government provide subsidies
 Fall in value of the country’s currency-which makes exports cheaper and increases quantity of
exports(X).
 Increased consumer confidence, which encourages spending (C).
 Lower income tax which increases disposable income of consumers and increases consumer
spending (C).
Increase in Aggregate Supply

Economic growth can also be achieved by an increases or improvements in any of the factors of
production, e.g. productivity growth or immigration. The effect is to shift the aggregate supply curve to
the right as illustrated below.

Increase in Aggregate Supply
Price AS1
Level
AS2
P1
P2
AD
Q1 Q2 Real GDP
Economic growth (long term growth) can also be shown by a long run rightward shift of the AD and AS
Curves shown in the diagram below.
Economic Growth
Price LRAS LRAS 1

Level
P*
AD
Y1 Y2 Real National
Output

LRAS or potential growth can increase for the following reasons:
 Increased capital. E.g. investment in new factories or investment in infrastructure, such as roads
and telephones. Growth in physical capital stock will result to a rise in capital per employee
(capital deepening)
 Increase in working population (active labour force), e.g. through immigration, higher birth rate.
A rise in the supply of labour can increase economic growth. Increases in the population can
increase the amount of young people entering the labour force. Increases in the population can
also lead to a boost in market demand thus increasing production. However, if the population
grows at a quicker rate than the level of GDP, the GDP per capita will drop.
 Increase in Labour productivity, through better education and training or improved technology.
 Discovering new raw materials e.g. discovery of diamonds in Chiyadzwa in Zimbabwe.
 Technological improvements to improve the productivity of capital and labour- Investment in
new technology increases potential output for all goods and services because new technology is
inevitably more efficient than old technology. E.g. Microcomputers and the internet have both
contributed to increased economic China's rapid growth rate owes much to the application of
new technology to the manufacturing process.
 Division of labour and specialization- A division of labour refers to how production can be
broken down into separate tasks, enabling machines to be developed to help production, and
allowing labour to specialise on a small range of activities. A division of labour, and
specialisation, can considerably improve productive capacity, and shift the PPF outwards.
 Employment of new production methods-New methods of production can increase potential
output. For example, the introduction of team working to the production of motor vehicles in the
1980s reduced wastage and led to considerable efficiency improvements. The widespread use of
computer controlled production methods, such as robotics, has dramatically improved the
productive potential of many manufacturing firms.
Similarly, if there is any opposite change to the above causes, it will turn out to be a constraint on
economic growth i.e. it result to economic decline illustrated by an inward shift of the PPC.
Threats / Challenges to Economic Growth

The following are the reasons why countries fail to attain higher levels of economic growth;
 Changes in the real exchange rate affecting competitiveness of domestic products.

 Cyclical fluctuations in national output and external trade e.g. high demand of imports negatively
affect domestic production.
 Financial instability e.g. unsustainable credit boom and fall in savings resulting to a fall in
investment.
 Volatility in world prices for essential imports and key exports.
 Political instability / military conflicts.
 Natural disasters and other external supply shocks.
 Unexpected decay in the state of technology.

 Depletion of natural resources.

 Unsupportive business environment.
 Poor governance e.g. high levels of corruption in developing countries.
 High levels of illiteracy.
 Poor infrastructure.
 Unfavorable investment policies.
Advantages of economic growth (positive effects of economic growth)

 Employment creation-Real economic growth stimulates higher employment since labour is a
derived demand. An increase in real GDP should cause an outward shift in the aggregate demand
for labour. Not all industries will share in the growth of an economy.
 The accelerator effect of growth on capital investment-Rising demand and output encourages
investment in capital, this helps to sustain GDP growth by increasing LRAS. This therefore
encourages a virtuous cycle of economic growth.
 Higher revenue for the government-Growth has a positive effect on Government finances. It
boost tax revenues and helping to reduce the budget deficit. More people at work, rising spending
and higher company profits all contribute to an increased flow of revenue to the Treasury.
 Greater business confidence-Growth has a positive impact on profits & business confidence.
 Improvements in living standards-Growth is an important avenue through which per capita
incomes can rise and absolute poverty can be reduced in developing nations. Higher average
incomes enables consumers to enjoy more goods and services and enjoy better standards of
living.
 Lower government borrowing-Economic growth creates higher tax revenues and there is less
need to spend money on benefits such as unemployment benefit. Therefore economic growth
helps to reduce government borrowing and also plays a role in reducing debt to GDP ratios.
 Improved public services-With increased tax revenues the government can spend more on public
services, such as the National Health Services and education etc.
 Money can be spent on protecting the environment-With higher real GDP a society can devote
more resources to promoting recycling and the use of renewable resources
Disadvantages of economic growth (negative effects of economic growth)

 Inflation risk-If the economy grows too quickly there is the danger of inflation as demand races
ahead of the ability of the economy to supply goods and services. Producer then take advantage
of this by raising prices for consumers.
 Externalities-Fast growth can create negative externalities (increased pollution and congestion)
which damages overall social welfare
 Environmental costs-Economic growth means greater use of raw materials and can speed up
depletion of non-renewable resources. It can also cause the destruction of the natural beauty of
the environment for example the destruction of vegetation as a result of mining activities

 Inequality-Not all of the benefits of economic growth are evenly distributed. We can see a rise
in national output but also growing income and wealth inequality in society. For example, those
with assets and wealth will see a proportionally bigger rise in the market value of rents and their
wealth. Those unskilled without wealth may benefit much less from growth.
There will also be regional differences in the distribution of rising income and spending.
However it depends upon things such as tax rates and the nature of economic growth. Economic
growth can also be a force for reducing absolute and relative poverty.
 Boom and bust economic cycles-If economic growth is unsustainable then high inflationary
growth may be followed by a recession. For example if there is an economic boom with growth
of over 5% a year causing inflation to rise to over 10%. To reduce inflation the government could
increase interest rates, this can cause the economy to slow down and then enter into a recession.
 Current account deficit-Increased economic growth tends to cause an increase in spending on
imports therefore causing a deficit on the current account.
Evaluation
The effects of growth depends on the nature of economic growth. If growth is balanced and sustainable
then it can occur without inflation. Also the environmental costs of economic growth can be minimized
through better use of technology.
Government policy and economic growth

Five (5)policy
Government Major macroeconomics
can help policy
the economy grow, two policies objectives
are the fiscal policy and
monetary policy these can influence the level of demand. If the government find that the
economy is growing too slowly then it can try to boost demand; to do this spending needs
to be encouraged and so either taxes or interest rates need to be cut. These policies are
all called reflationary policies. However, the Government would have to be careful. They
would have to watch mostly the level of inflation, because if demand rises too much, as a
result of extra spending firms may not be able to increase production quickly enough and
prices may rise instead of output. If this happens, the government may need to use the
opposite deflationary policies. This would result in taxes and interest rates getting
increasing. Open markets - internal and external competition in markets for goods and
services Promotion of free-thinking capital market providing a flow of liquidity to finance
investment Protection of private property rights Increase scale of government spending,
however may cause crowding out of the private sector if government spending is too much.
Efficiency of the tax and benefit system, however may create disincentives which
constrains the active labour supply Macro-economic stability and credibility of macro-
economic policy.

Fundamentals of Public Finance
Public finance is concerned with the revenue – raising and spending activities of the government and,
especially how such activities affect the economic life of people.
Government Revenue
Government exists in every society to perform a number of functions which are critical to the general
well-being of the people. Such functions include:
 Provision of legal framework and a social environment conducive to the effective operation of
the price system.
 Creation and maintenance of social and economic infrastructure e.g. roads, bridges, electricity,
pipe-borne water, sanitation, etc. They are called public goods or social overheads.
 Redistribution of income e.g through direct transter payments or welfare programmes for the
vulnerable members of the society.
 Re-allocation of resources, and
 Promotion of macroeconomic objectives.
To be able to perform these and other related functions, however, government requires some funds.
Government revenue is the income which accrues to the government to enable it to perform its traditional
functions. Sources of government revenue are conventionally classified into two:- tax revenue and non-
tax revenue.
Tax Revenue
A tax is a compulsory contribution imposed by the government on individual, business or institutions
without any service rendered to the tax payer in return. The composition of the various taxes in total tax
revenue i.e. the tax structure varies from one country to the other.
With the exception of major oil exporting countries like Nigeria and other members of Organisation of
Petroleum Exporting Countries (OPEC), tax revenue constitutes the major part of government revenue
in most countries.
Non – Tax Revenue

Sources of non-Tax revenue include
i. Fees, Fine, and Specific charges: These include fees received from services rendered by
government e.g. court fees, school fees, stamp duties, fines imposed for violating government
rules, charges like water rates, vehicles licences, toll fees, contrators‘ registration fees.
ii. Rents, Royalties, and Profits: These are income derived from the use of government property,
profits from government business enterprises and income from mining rights.

iii. Grants: These are income received in the form of aid from other countries or from international
organization, in most cases, to finance specific developmental programmes. But all grants are
voluntary gifts and are thus very uncertain source of government revenue.
iv. Loans: These are incomes generated by borrowing from private individuals or business within
the country (domestic public debt) or from foreign countries or international financial institutions
(external public debt).
Government Expenditure
This refers to government spending in the performance of its functions as identified above. They are
usually classified into two: recurrent expenditure and capital expenditure.
 Recurrent Expenditure: These are expenditures on running costs of government – that is,
expenses incurred in the maintenance of government‘s administrative machinery. Such
expenditures include salaries and wages of public servants and members of armed forces, interest
on public debts, travel and transport expenses, charges for utility services enjoyed e.g. electricity
bill, etc.
 Capital Expenditure: This refers to government spending on projects which are not recurrent
in nature, especially developmental projects that enhance the productive capacity of the economy
as well as improve the general standard of living of the people. Expenses on the construction and
maintenance of roads, bridges, dams, schools, and hospitals readily fall within this category.
Functional Classification of Government Expenditure

In a typical developing economy, each of recurrent and capital expenditures is usually grouped into the
following headings:
 General Administration: These are expenditures on defence, police and the cost of running the
entire civil service.
 Social and community services: These are expenditures on health care, education, public housing
and other items which promote social and community development.
 Economic Services: These are payments that take the form of a gift i.e., they are not for good
exchanged or service rendered and they need not be repaid e.g. pension payments,
unemployment allowance, payments to victims of national disasters like flood, fire, bird flew
and motor accidents as well as bilateral grants.
Direct Money Transfers are usually a very important instrument of government to share money
among the tiers of governments, as well as make payments to service debts
Growth of Public Expenditure

In Zimbabwe government expenditure has been growing over time. The reasons for this cannot be far-
fetched.

 Increasing population: As the population increases, there are many more people requiring
schools, hospitals, and other government-supplied amenities.
 Inflation: Government expenditure usually exhibits a rising trend because of rising price level
over time. For example, items of government expenditure become more expensive and contracts
and salaries are periodically adjusted upward in line with inflation rate.
 Growth in national income: The growth of public expenditure is functionally and positively
related to national income. As the level of national income rises, so also is the level government
expenditure.
 Development projects: After independence, the government embarked on development
projects, especially in the areas of dam construction, electricity, water supply, schools, hospitals,
etc. The implementation of such projects has partly explained the growth in government
expenditure.
 Public debt servicing: The servicing of both domestic and external public debts requires large
payments of interest and principal as they fall due. This has also contributed significantly to the
growth of government expenditure.
 Increased urbanization: Increasing rate of rural urban migration of people also translates into
increasing demand for social amenities such as road, water supply, electricity, sanitation
services, and consequently an increase in government expenditure.
 Promotion of technological progress: To accelerate economic growth and development some
developing countries established research institutes of various kinds. The need for adequate and
regular funding of such agencies has also led to the growth of government expenditure.
Taxation
A tax is a compulsory levy payable by individuals and business organizations to the government without
receiving any definite corresponding service or good directly from the government i.e. without quid pro
quo.
Elements in A TAX
There are three elements in a tax, the base, the rate, and the yield.
a. Tax Base: This is the object being taxed. For example, in personal income tax, the tax base is the
taxpayer’s income (salary), while in value added tax (VAT), taxpayers expenditure is the tax
base.
b. Tax rate: This refers to the proportion of the tax base which is paid in tax. It is usually expressed
as a flat rate (lump sum) or as a percentage.
c. Tax Yield: It is the amount of revenue received by the government from tax.
Principles of Taxation
A good tax system should have certain attributes. These are:

 Equity: Every taxpayer should pay tax in proportion to his income i.e. taxpayers should make
equal sacrifice by pay the same percent of their incomes in tax. This is also known as ability to
pay principle.
 Convenience: Taxes due should be paid at times most convenient to the taxpayer.
 Certainty: The taxpayer should know in advance the exact amount to pay and when to make the
payment.
 Economy: The cost of assessing and raising taxes should be kept to a minimum.
 Flexibility: It should be possible at any time to revise the tax structure to meet the revenue
requirements of government without delay and at no significant extra costs.
 Productivity: A tax should bring large revenue which should be adequate for the government.
 Simplicity: A tax should not be difficult to administer and understand so as not to breed
problems of differences in interpretation. Its calculations must be simple.
The first four principles were first mentioned by the acknowledged founder of modern economics, Adam
Smith (1723 – 1790), in his famous book – The Wealth of Nations (1776). He referred to these principles
as cannons of taxation.
Direct Versus Indirect Taxes

Taxes are classified as direct or indirect based on the method of payment or in terms of their incidence
i.e. how their burden is shared.
Direct Taxes
These are taxes levied directly on the incomes of individuals and business enterprises. The burden of
direct taxes falls directly on the taxpayers, but they are usually progressive.
Examples of direct taxes include personal income tax, company tax, capital gain tax, capital transfer tax,
petroleum profit tax.
 Personal Income Tax: It is levied as a graduated tax on the income of individuals after reliefs
and allowances in respect of personal needs, wife, children, dependent relatives, pension fund,
life insurance, research effort, etc. have been deducted. The pay-as-you-earn (PAYE) scheme is
applied to people in employment.
 Company Tax: This is levied on the net profits of companies. That is, it is applied to the whole
of a company‘s profit after deducting depreciation and other allowances.
 Capital Gain Tax: This is a tax on the appreciated value of an asset on disposal. This is usually
caused by inflation.
 Capital Transfer Tax: This tax applies to both life – time and after death transfer of wealth.
Advantages and disadvantages of direct taxes
Indirect Taxes
These are taxes levied on goods and services. The burden of such taxes first fall on the manufacturers,
wholesalers and importers who then pass it on to the consumers through upward review of prices.

Examples of indirect taxes are import duties, export duties, excise duties, value-added tax (VAT), and
sales tax.
 Import Duties: These are taxes levied on goods which are imposed from other countries. Apart
from being a source of government revenue, import duties are also used to protect import
substitution industries (ISIs) and to correct adverse balance of payments.
 Export Duties: These are taxes which are levied on goods that are exported to other countries.
 Excise Duties: These are taxes levied on goods which are manufactured within the country.
 Sales Tax: This is levied on goods as they are purchased by the consumer from the seller. The
producer or seller adds the tax to the cost of the product especially for a commodity whose
demand is price inelastic.
 Value – Added – Tax (VAT): It is a consumption tax levied on business at every stage of
production and distribution on the value they add to the raw materials and other inputs. The tax
is borne by the final consumer of goods and services because it is included in the price paid. It
has wide coverage as it applies to most goods and services.
Progressive, Regressive, and Proportional Taxes

An alternative classification of taxes is according to the proportion of a person‘s income (or the tax base)
which is paid in tax.
1. Progressive Tax: A tax is progressive if the proportion of income paid in tax varies directly with the
level of income. That is, the higher the income, the higher the proportion of that income which is
paid in tax. Personal income tax is a good example of a progressive tax.
Advantages and disadvantages of progressive taxation

Arguments in favor of progressive direct taxes
 They are levied according to the ability of individuals to pay. Individuals with a higher income
are more able to afford to give up more of their income in tax than low income earners, who need
a greater proportion of their earnings for the basic necessities of life. If taxes are to be raised
according to the ability of people to pay (which is one of the features of a good tax suggested by
Adam Smith) then there must be some progressiveness in them.
 Progressive taxes enable a government to redistribute wealth from the rich to the poor in society.
Such a redistribution of wealth will alter the consumption patterns in society since the poorer
members of society will spend their earnings and social security benefits on different types of
goods than if the income had remained in the hands of the richer people. Poorer people are also
likely to have a higher marginal propensity to consume than richer people, so leaving more
income in the hands of the poorer people is likely to increase aggregate demand in the economy
as a whole.
 Indirect taxes tend to be regressive and progressive taxes are needed as a counter-balance to
make the tax system as a whole more fair.
Arguments against progressive taxes

 In an affluent society, there is less need for progressive taxes than in a poorer society. Fewer
people will live in poverty in such a society if taxes are not progressive than in a poorer society.
 Higher taxes on extra corporate profits might deter entrepreneurs from developing new
companies because the potential increase in after-tax profits would not be worth the risks
involved in undertaking new investments.
 Individuals and firms that suffer from high taxes might try to avoid or evade paying tax by
transferring their wealth to other countries, or by setting up companies in tax havens where
corporate tax rates are low. However, tax avoidance and evasion are practised whether tax rates
are high or low. High taxes will simply raise the relative gains which can be made from
avoidance or evasion.
 When progressive taxes are harsh, and either tax high income earners at very high marginal rates
or tax the wealthy at high rates on their wealth, they could act as a deterrent to initiative. Skilled
workers might leave the country and look for employment in countries where they can earn more
money.
2. Regressive Tax: A tax that takes lower percentage of income as income rises. The most regressive
tax of all is the poll tax under which every person pays the same amount in tax, irrespective of each
person‘s income.
3. Proportional Tax: A tax is said to be proportional if taxpayers pay the same percentage of their
incomes in taxes, at any level of income. An example of proportional tax is the company tax.
Taxes
Progressive
Tax rate
5%
Proportional
Regressive
Income
Uses of Taxation
The various ways by which taxation can be used to further the growth and development processes,
especially in a developing economy are outlined below:

i. To finance government expenditure: The primary purpose of imposing taxes is to generate

revenue for the financing of government activities including maintenance of administrative
machinery of government and financing socio-economic infrastructures.
ii. To manage the economy: Government can grant tax concessions to local industries to stimulate
production activities in the domestic economy during economic depression or raise personal
income tax to lower aggregate demand during the period of inflation.
iii. To redistribute income and wealth: Under a progressive tax system more money is taken from
the rich than from the poor. Such money used to provide public goods that are equally beneficial
to both the rich and the poor.
iv. To protect infant industries: Import duties on imported goods that have local substitutes are
raised to protect import substituting industries.
v. To correct balance of payments deficit: A tax on imports especially on non-essential items will
also serve to reduce import volume and consequently reduce the deficits in the current account
component of the country‘s overall balance of payments account.
vi. To discourage the consumption of certain goods: High import duties on harmful goods will raise
the price at which they are available and serve to discourage their consumption.
Government Budget
A national budget is a document containing estimates of expected government revenue and intended
expenditure for the coming year. It usually consist of the review of the performance of the immediate
preceding budget, objectives of the present budget, revenue projection, estimates of current and capital
expenditures as well as policy measures to promote the achievement of the stated objectives.
Types of Budget
There are basically three types of budget.
1. Surplus budget: A surplus budget occurs when the government revenue is planned to exceed the
proposed government expenditure. It can be achieved by reducing government expenditure or
increasing taxation or both. A surplus budget is usually adopted to reduce inflationary pressures
because it reduces aggregate effective demand in the economy.
2. Deficit Budget: A deficit budget occurs when the government revenue estimate is less than the
proposed government expenditure. The fiscal deficit can be financed by raising loans from both
internal and external sources. A deficit budget may be used to stimulate domestic production during
economic recession or depression.
3. Balanced Budget: A government budget is balanced when its revenue estimate is equal to the
proposed expenditure. It is also called neutral budget because it is usually adopted to keep the level
of economic activities relatively stable as in the preceding year.
Sources of Finance for a Deficit Budget

The main sources of finance for government fiscal deficit are:

i. Internal borrowing: This involves raising loans from the bank and non-bank public within the
country. This could be through the sale of government securities.
ii. External borrowing from Bilateral Creditors: A bilateral credit is provided by one government
to another. Such credits are intended for development projects in the recipient country.
iii. External borrowing form Multilateral Creditors: This involves raising of loans from international
institutions funded by member nations. They include the World Bank, International Monetary
Fund (IMF), African Development Bank (ADB), etc.
iv. Drawing down on external reserves: An external reserve is like saving of a country. The
government may decide to draw from the external reserves to meet the discrepancy between
revenue and expenditure.
v. Printing of currency: Instead of borrowing, a country may decide to print more money currency
to finance fiscal deficit. But most countries rarely adopt this option because of its inflationary
consequences.
Public Debt
Public debt refers to the total outstanding debt obligations or accumulated borrowing of the government.
Public debt is usually divided into two: domestic public debt that which is owed by the government to
its citizens, and external public debt the total money owed by the government to overseas government
and residents. A government will resort to borrowing to finance its fiscal deficits.
Sources of Public Debt

Public debt may be contracted through the following sources:
 Internal sources: Public debt can be procured within the country through the purchase of
government securities by commercial and merchant banks, central bank, and non-bank private
individuals and financial institutions who subscribe to instruments such as treasury securities
bonds and development stocks.
 External sources: Most countries have contracted external public debt through the following
sources;
o Multilateral creditors: These are international institutions funded by member nations.
They include the World Bank Group, International Monetary Fund (IMF), African
development Bank (ADB) Group, International Fund for Agricultural Development
(IFAD), etc. These institutions provided credit for development purposes, balance of
payments support and private ventures.
o Bilateral Creditors: A bilateral credit is provided by a government to another government.
Bilateral credits are usually meant for developmental projects in the recipient country.
Economic Bases for Public Debt

Government borrowing may be justified on the following grounds.

i. Capital formation: Debts can be translated into real capital stock which in turn enhance the
growth of the economy.
ii. Investment opportunities: The availability of public debt gives private investors, public
corporation, state, and local government an opportunity to buy government securities which are
virtually risk free (gilt-edge).
iii. Stabilisation of the economy: A large public debt can serve as an automatic fiscal stabilizer. A
good proportion of the public debt is by the banking system to control the supply of money.
iv. Provision of development finance: Most development projects that are critical to the
development of low income countries like those in sub Saharan Africa e.g dams, water supply
etc. are financed by external loans.
Argument against Public Debt

Public debt has several disadvantages such as:
i. Problem of debt financing: If public debt is financed by selling bond to the public, it tends to
crowd out private investment. This may lead to loss of employment opportunities and income.
ii. Problem of debt servicing: Government may result to increasing taxation to be able to pay
interest on the loan and the principal to the creditors. This may reduce work and investment
incentives
iii. Inflationary potential: The expectation that loan facilities are readily available may tempt the
government into undertakings that are inflationary and economically unviable.
iv. Distortion of income distribution: Debt services and positive rate of interest would enhance the
economic status of bondholder. During the period of unanticipated inflation, government (as the
debtor) tends to gain at the expense of the public holders of government securities.
Fiscal Policy
Fiscal policy is the use of taxation and government expenditure to regulate economic activity, Fiscal
policy can be employed to achieve macroeconomic objectives of full employment, economic growth,
external balance, price stability, and equitable distribution of income and wealth. For example, a period
of economic recession or depression characterized by sluggish economic growth with rising
unemployment would call for an increase in the level of government expenditure (especially to raise
aggregate demand), as well as tax reliefs and concessions to local industries to stimulate domestic
production. These measures are collectively referred to as expansionary fiscal policy.
On the other hand, to control inflation pressure would require contractionary fiscal measures such as
curtailing the growth of government spending, and raising taxes to reduce disposable income and
aggregate demand.

Problems of discretionary fiscal policy

Compared to monetary policy, fiscal policy is less flexible and requires the approval of parliament before
it becomes effective. In addition the effectiveness of fiscal policy in addressing macroeconomic
problems is affected by the following problems.
 Timing - Fiscal policy can only become operational when approved by the parliament. As a result it
is not flexible and is affected by time lags. There can be considerable time delays between the
beginning of an economic disturbance and the impact of the change in fiscal policy. Economists
distinguish between several kinds of delays.
o Recognition lags occur when there are delays between changes in economic disturbances and
the actual recognition of these changes, especially due to delays in reporting procedures.
o Administration lags refer to the time delay that can occur between an economic problem
being recognized and administrative actions taken to correct the problem. Correcting the
problem is usually through the national budget that is an annual event.
o Implementation lags refer to the delay between action taken to correct some economic
disturbance (e.g. an economic downturn) and the impact of the action on the economy.
 Business uncertainty - Sudden and unexpected changes of fiscal policy either on expenditure or
revenue side may create uncertainty among businesspersons causing them to revise their plans.
 Expenditure inflexibility - Government expenditure is sticky downwards. That is government
expenditure can easily be increased but can be reduced with great difficulty.

Introduction to
Advanced
Level
Economics
Contact: Author
Brian Ropi
[email protected] | +263 772 230 130
Designed & Edited By: David Nyahodza

+263 775 573519 | +263 719 573519 | [email protected]

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Introduction to

1 “Think like an Economist” - By Brian Ropi

What is this chapter about?

 Important elements in the definition.

 Economics is a social science.

 The scientific method.

 Positive and Normative statements.

 Microeconomics and Macroeconomics.

 Pitfalls to sound economic reasoning.

2 “Think like an Economist” - By Brian Ropi

Important elements in the definition

Economics is a social science

The scientific method

3 “Think like an Economist” - By Brian Ropi

Two assumptions in economic model-building

Positive and Normative statements

4 “Think like an Economist” - By Brian Ropi

Microeconomics and Macroeconomics

Pitfalls to sound economic reasoning

5 “Think like an Economist” - By Brian Ropi

6 “Think like an Economist” - By Brian Ropi

7 “Think like an Economist” - By Brian Ropi

What is this chapter about?

 Four factors of production

 Renewable & Non-Renewable Resources

 The basic Economic Problem

 Production Possibility Curves

 Shifts in the Production Possibility Curves

8 “Think like an Economist” - By Brian Ropi

The four factors of production

Economists group factors of production under four broad categories:

Renewable and Non-Renewable resources

9 “Think like an Economist” - By Brian Ropi

Differences between renewable and non-renewable:

The basic economic problem

10 “Think like an Economist” - By Brian Ropi

11 “Think like an Economist” - By Brian Ropi

Three Basic Economic Questions

3. For whom to produce?

12 “Think like an Economist” - By Brian Ropi

Production Possibility Curve (PPC)

• Full employment-The economy is employing all its available resources.

Characteristics of the PPC

Production Possibility Curve

13 “Think like an Economist” - By Brian Ropi

Production Possibility Curve

Output A, B & C – Are efficient

The PPC, Scarcity, Choice and Opportunity cost

PPC – Scarcity, Choice & Opportunity Cost

14 “Think like an Economist” - By Brian Ropi

Production Possibility Curve and Economic Efficiency

15 “Think like an Economist” - By Brian Ropi

Production Possibility Curve

16 “Think like an Economist” - By Brian Ropi

Shape of Production Possibility Curve

Shape of the PPC - Concave

17 “Think like an Economist” - By Brian Ropi

Shape of the PPC - Convex

Shape of the PPC - Linear