ECONOMICS - BLOCK REVISION MOCK 3

QUESTIONS

NUMBER ONE
a) Discuss the different approaches used in the measurement of the National
Income of a country.

(6 marks)
b) The Economic Advisory Department of Examland has estimated that its
country‟s marginal propensity to consume equals 0.6, investment in millions of
shillings equals 2,000, Government spending 8,000, autonomous consumption
10,000 and net exports 1,000.

Required:
1. Calculate the level of equilibrium of National Income for this economy.
(5 marks)
2. If the currency of Examland depreciated, what would likely happen to the
National Income? Why?
(3 marks)
c) What are the main problems associated with National Income Accounting in
developing countries?
(6 marks)
(Total:
20 marks)

NUMBER TWO
(a) Explain what is meant by the terms own price, income and cross elasticities
of demand.
(9 marks)
(b) How and when is the concept of elasticity applied in economic policy
decisions. (11 marks)
(Total: 20 marks)

NUMBER THREE
(a) Define the term Monetary Policy.
(2 marks)
(b) Discuss any four instruments of this policy used to control and regulate
money supply by the Central Banking Authorities.
(12 marks)

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(c) What limits the successful application of these tools (in b above) in
developing countries?
(6 marks)
(Total: 20
marks)

NUMBER FOUR
(a) State the main sources of monopoly powers.
(5 marks)
(b) Explain why the marginal revenue curve lies below the average revenue
curve in a monopolistic firm
(3 marks)
(c) Illustrate diagrammatically the output levels for both profit-maximizing and
the loss making monopolist firm in the short-run. Give brief explanations.
(12 marks)

(Total: 20 marks)

NUMBER FIVE
Write brief notes on the following economic concepts:
(a) Choice , Scarcity and opportunity cost. (5
marks)
(b) Exchange rate. (5 marks)
(c ) Producer‟s surplus. (5
marks)
(d) Isoquants. (5
marks)
(Total: 20
marks)

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NUMBER SIX
(a) Make a distinction between fixed and variable costs of production. Give
examples of each. (5 marks)
(b) In a perfectly competitive market the average revenue and average cost
functions are:
AR = K1Q – K2 and AC = K1 - K2 respectively.
Q
K1, K2 are constants
Q is the output level

Based on the given functions, determine:

(i) Fixed and Variable cost functions
(6 marks)
(ii) The level of output at which the firm breakevens
(3 marks)
(c) Distinguish between implicit and explicit costs.
(6 marks)

(Total: 20 marks)

NUMBER SEVEN
Kenya is planning to be a newly industrialized country by the year 2020 A.D.
What obstacles are likely to impede the achievement of this objective and what
steps must be taken to overcome such obstacles?
(Total: 20 marks)

NUMBER EIGHT
(a) Assume there are 10,000 identical individuals (consumers) in the market for
commodity x each with a demand function given by Qdx = 12 – 2Px and
1,000 identical producers of commodity x, each with a supply function
which takes the form Qsx = 20 Px.
Required:
(i) Determine the market demand and market supply functions for
commodity x. (4 marks)
(ii) Compute the market equilibrium price (Px) and quantity (Qx)
(6 marks)

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(b) One of the determinants of demand for a commodity is advertising.
Required:
(i) Explain the extent to which advertising influences demand.
(5 marks)
(ii) State the factors that a business firm should consider while developing
an advertising policy.

(5 marks)

(Total: 20 marks)

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 ANSWERS
NUMBER ONE

(a) There are basically three methods of measuring National Income:

 Income approach
 Expenditure approach
 Output/Value Added approach
 The Income Approach:

Each time something is produced and sold someone obtains income from those
activities/transactions. More precisely, each unit of expenditure will find its
way partly into wages/salaries, profits, interest and rents. Income earned for
purposes other than rewards for producing goods and providing services are
ignored i.e. transfer payments such as unemployment benefits, pension and
grants to students, which if included would lead to double counting.

All factor incomes are summed up including the estimated value of earnings in
kind (such as the market value of rent-free housing) and subsistence income.
These incomes are in the form of employment income (including self
employment), profits of private companies and public enterprises, interest on
capital and rent on land and buildings.

The sum of these incomes give the Gross Domestic Income (which is an
equivalent of Gross Domestic Product). To Gross Domestic Income we add the
net property Income from abroad (the difference between what foreigners earn
at home and what nationals earn abroad). This gives Gross National Income
(GNI) from which capital consumption (depreciation) is deducted to arrive at
the Net National Income (NNI).

 The Expenditure Approach:

This method centers on the component of the final product demand which
generates production. It thus measures (GDP) as the sum total expenditure on
final goods and services produced/rendered in an economy, and is given by the
national expenditure equation:

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 Y ≡ E = C + I + G + (X – m) where

C: Private consumption expenditure

I: Expenditure by investors (Investment expenditure)
G: Government expenditure on goods and services (such as health, education,
general administration including Law and Order) provided by the
government to the public – usually referred to as the public consumption
expenditure. This component (G) excludes transfer payments such as
unemployment benefits. Instead, its taken as a measure of the value of the
services provided by the center (including Local Governments), and public
authorities.

(X – M): Expenditure on exports less expenditure on imports and its value is

often negative for most developing countries. Under this approach,
expenditure on financial assets such as bonds and shares an on second hand
goods should be excluded as they do not involve any new output.

 The output/Value Added Approach:

The most direct method of measurement where output from all sectors (private
and public) of an economy is summed up. To avoid double counting, it‟s the
value added at each stage of production that is taken into account (i.e. final
product). Such sectors include farming, milling, trading; final products include
subsistence output which is the output produced and consumed by producers
themselves, and export output.
The value added approach takes the form of an example of a farmer selling
maize to millers at Kshs. 900, millers to traders at Ksh. 1,400 and traders to
final consumers at Kshs 1,500, such that the value taken for accounting
purposes is given by (900 + 500 + 100) = 1,500 which is the same as the price
to final consumers.

(b) (i) C = 10,000 + 0.6Y

I0 = 2,000

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 G0 = 8,000

(X – m) = 1000
Y = C + I + G + (X – m)
Y = 10,000 + 0.6Y + I0 + G0 + (X – m)
Y = 10,000 + 0.6Y + 2000 + 8000 + 1000
Y – 0.6Y = 21,000
0.4Y = 21,000
Y = (21,000) = 52,500
0.4
therefore Y = Sh. 52,500 million.

ii Depreciation of the currency of Exam land would increase the nominal

value (monetary value) of National Income; since depreciation constitutes a
reduction in the relative value of the domestic currency of Exam land, the
tendency is for prices to increase, thereby increasing the nominal value of
National Income. Nominal value, in this case, refers to the value of NI at
current prices (which have not been adjusted for inflation). This is where
the GNP deflator (the ratio of nominal GNP to real GNP) is required to
remove the impact of inflation to give real values.

(c) Main problems of National Income Accounting:

 Incomplete/inadequate information
 Danger of double counting
 Changes in prices (price instability)
 Problem of inclusion, in terms of:
a) Subsistence output/income
b) Intermediate goods
c) Housing i.e. rent on owner-occupiers
d) Public services provided by the government
e) Foreign payments i.e. net income from abroad
f) Illegal activities eg. smuggled output
g) Revaluation of assets

NUMBER TWO
a) Elasticity is the responsiveness/sensitivity of one dependent variable to changes
in another independent variable.

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Elasticity of demand measures the responsiveness of demand for a commodity
to changes in any of the factors affecting it, mainly own price, consumer‟s
income and prices of related products (substitutes or complements); Thus,
price, income and cross elasticities of demand respectively.

(Own) price elasticity of demand: defined as a measure of the degree of the

responsiveness of quantity demanded of a commodity to changes in own price;
its given by the ratio of the percentage or proportionate change in quantity
demanded to the percentage or proportionate change in own price of the
commodity i.e.

% change in quantity demanded or ∆Q • P

% change in own price ∆P Q

Its usually negative for normal goods (positive for inferior goods) and can
either be elastic, inelastic, perfectly elastic perfectly inelastic or unitary. Its
elastic where a small change in price causes a more than proportionate
change in quantity demanded; inelastic where change in price causes a less
than proportionate change in quantity demanded; unitary where change in
price results into a proportionate change in quantity demanded – in which
case, the price elasticity absolute values are greater than one, less than one
and equal to one respectively.

Diagrammatic illustrations may be drawn/shown

Own price elasticity of demand is determined by factors such as the nature

of the commodity, availability of substitutes, durability, number of uses,
possibility for postponed use, proportion of income spent.

Income elasticity of demand is a measure of the degree of responsiveness of

demand to changes in consumers‟ income; expressed as the ratio of the
percentage/proportionate change in quantity demanded to the
percentage/proportionate change in consumers‟ income i.e.

% change in quantity demanded or ∆Q • Y

% change in consumer‟s income ∆Y Q

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where Y represents income. This ratio is positive for normal goods and
negative for inferior goods. Income elasticity of demand is determined by
the stage of economic development and the nature of the commodity.

Cross elasticity of demand is a measure of the degree of the responsiveness

of the quantity demanded of one commodity to changes in the price of
another related commodity, either a close substitute or complement. Its
expressed as the ratio of the percentage/proportionate change in the quantity
demanded of one commodity to the percentage/proportionate change in price
of another related commodity i.e.

% change in quantity demanded of commodity A or ∆QA • PB

% change in price of a related commodity B ∆PB QA

The above ratio is positive for substitutes and negative for complementary
goods as illustrated below:

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 Price of D PB D
Commodity B

D
D
0 Quantity demanded 0 QdA
of commodity A

Fig 2.1: substitutes Fig 2.2: Complementary goods

Cross elasticity of demand is largely influenced by the degree of substitutability

or complementarity of commodities.

b) The concept of elasticity can be applied in economic policy decisions in the

light of the following situations:
 Business pricing decisions: revenue can be increased by increasing prices
where demand is inelastic; where demand is elastic, revenue could be
increased by lowering prices. At the same time, its important to a firm when
seeking to estimate the effect of price changes of competing firms on its own
– where demand is elastic, a rational firm will decide to keep its prices
stable; This concept is also important when estimating or deciding on the
nature and scope of promotional activities such as advertising; persuasive
kind of advertising tends to make the demand for commodities relatively
more price inelastic.
 Consumer spending programmes: since resources are scarce, consumers
will more often seek to allocate their income in such a way that the most
pressing wants are satisfied first (scale of preference); preference in this case
is given to necessities whose demand is necessarily inelastic.
 Production decisions: To producers/suppliers, elasticity of demand is
relevant when deciding on what price and amount of inputs to purchase.
Such decisions will depend on the elasticity of demand of the final
product(s) for which the inputs help produce. If, for instance, demand for

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 the final product is inelastic, a firm may find it still
viable/rational/reasonable to purchase such inputs at relatively higher prices
since the additional cost could be covered by way of increasing the final
product prices. In situations of elastic demand for the final product(s), firms
should be more careful in making input purchases at least ensuring that the
input prices are comparatively low because any attempt to recover such costs
by increasing prices tends to reduce sales and thereby necessitating a price
reduction in order to survive the competitive market – the decision becomes
self-defeating.
 Government policy orientation from the stand point of:
 Tax policy: knowledge of elasticity assists the government when estimating
its revenue from indirect taxes. Those commodities which are highly price
inelastic in demand should be taxed more (eg. alcohol, cigarettes). The
government should however take into account the need not to tax (or tax
less) necessities such as food products/services whose demand is equally
inelastic – tax on such basic and most essential goods/services tends to have
negative welfare implications.
 Discouraging consumption: the government as a matter of policy can impose
higher taxes on those commodities whose demand is price elastic such as the
self actualization car models and pornographic materials (any exceptions
held constant). Tax, in this case, has an effect of increasing prices and thus a
downward pressure on demand. Tax may also be used as a means of
effecting environmental protection programmes eg. against pollution.

 Protectionism: Its in the interest of most governments to protect their

domestic industries against unfavourable external competition (largely
because of the state of unequal footing between domestic and foreign
industries producing virtually the same or close substitute products) by
imposing tariffs on imports. This policy can only be effective where the
domestic demand for both local and foreign substitutes is highly price
elastic; this way, an increase in import prices by the amount of tariff should
be sufficient to deter or discourage domestic demand for them, at least in
favour of domestic substitutes (assuming that the quality and other buyer
benefits or factors are held constant).
 Price controls/minimum wage guidelines: Depending on the nature of an
economy, minimum wage legislations can be effective only where the
demand for labour (in the labour market) is highly inelastic; If elastic, any
attempt to set a minimum wage will be met by a drastic fall in demand for

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 labour hence unemployment, a situation which makes job seekers much
more willing to accept lower wages, rendering the legislation ineffective.
 Regulation of farmers‟ income especially during bumper harvest – demand
should be inelastic otherwise the government will be forced to buy and store
or even dispose of the surplus to external markets (dumping). This depends
on the nature of the commodity (perishable or durable) and the ability of the
government to pay farmers promptly (eg 1994/1995 maize bumper harvest
in Kenya)
 Devaluation policy: reducing the relative value of a domestic currency i.e.
making it cheaper in terms of another (foreign) currency. This has an effect
of making exports cheaper and imports relatively expensive, the aim being
to encourage (increase) exports and discourage (reduce) imports so as to
improve the country‟s balance of payments (BOP) position. This policy is
effective only when demand for both imports and exports is highly price
elastic.

Knowledge of elasticity is also relevant in the event of:

 Price discrimination: market segmentation where more is supplied/sold

in the price elastic than inelastic markets and charging lower and higher
prices respectively.
 Shifting the tax burden: It is possible to shift the indirect tax burden to
the consumer where demand is price inelastic.
 Production of commodities whose income elasticity of demand is
positive and high eg. TV‟s, cars etc.

NUMBER THREE
a) Monetary policy refers to the manipulation of money supply, liquidity
and interest rates in the economy in order to achieve increased
employment, economic growth, reduced inflation and improved balance
of payments.
b) Monetary policy works through the intermediary of monetary policy
instruments such as the bank rate, open market operations (OMO),
variable reserve requirement (cash and liquidity ratios), funding,
marginal requirement, selective credit control and moral suasion .
This policy relates mostly to credit control which is the control of the
lending capacity of commercial banks and other financial institutions.

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 Monetarists largely content that inflation is caused by a prior increase in
money stock, and therefore to control inflation, the growth of money
supply must first be controlled.

Instrument of Monetary policy:

- The Bank rate:- During inflation, for instance, money supply should be
reduced. This could be achieved by way of increasing the bank rate ( the
rate at which commercial banks borrow from the Central Bank) to
discourage borrowing by Commercial banks from the Central Bank and
by the public from commercial banks (since an increase in the bank rate
translates into higher commercial banks lending rates to individuals or
corporates). The Central Bank could increase money supply by reducing
the bank rate and thereby reducing the interest rates charged by
commercial banks to the public.

- Open Market Operations (OMO):- During inflation, the government sells its
securities (such as treasury bills and bonds) in the stock exchange market
(money market) which has an effect of reducing the amount of money in
circulation (held by the public and commercial banks). If however, the
government wishes to stimulate the aggregate demand (by increasing money
supply) the decision should be to buy back the securities from the
public/commercial banks; this increases the lending capacity of commercial
banks and the purchasing power of the public.

- Variable Reserve Requirement (VRR):- This instrument involves the cash

and liquidity ratios, taken as a proportion of total deposits in cash and liquid
forms, respectively. Money supply can be increased (decreased) by
reducing (increasing) these ratios, depending on the economic objectives of
the Monetary Authorities.

- Funding:- This is the conversion of short-term debt agreement into long-

term. The government could be having budget deficits which it wants to
control at manageable levels, and feels that it cannot afford to honour its
short-term repayment obligations as they fall due. Moreover, this decision
also has an effect of reducing the present money supply level although its

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 going to be expensive servicing such long-term debts in future, in terms of
high interest rates.

c) In developing countries like Kenya, the open market operations (OMO) are
not quite virtually effective in controlling money supply. The main reason
for this is the less developed money and capital markets, and the limited
quantity and range of financial assets (securities, etc) held in the country
which the Monetary Authority can buy or sell in order to increase or
decrease cash holdings with the public. Sometimes, commercial banks are
less sensitive to changes in their cash base. Partly, this is because they have,
since the development of independent monetary system, found themselves
with excess liquidity, especially due to the scarcity of good/viable projects
and credit – worthy borrowers to whom they could lend. The other reason
could be that such commercial banks are branches of foreign banks to which
they can turn for more funds whenever their lending capacity is considerably
reduced by the monetary authorities. This reduces the ability of the
monetary authorities to control inflation by reducing money supply.
The bank rate is less effective in most developing countries for a variety of
reasons such as the limited range of liquid financial assets. Even if interest
rates are successfully raised (or lowered), the effect on investment may be
limited. Public sector investment is not likely to be very sensitive to
changes in interest rates. For local private entrepreneurs who find it difficult
to get access to capital, availability of credit may be more important than its
cost/price. The greater emphasis on development is likely to reduce the role
played by the rate of interest, which has been kept low and stable by most
developing countries in order to encourage capital formation. Moreover,
development objectives have generally involved making credit available on
concessionary terms to sectors like manufacturing and agricultural small-
holders, further reducing the scope of the impact of the interest rate policy.
In the case of variable reserve requirement, increased liquidity may still be
offset in part if commercial banks have access to external lines of credit
from partners or their parent companies. Its also possible that a variable
reserve asset ratio is likely to be much more useful in restricting the
expansion of credit and of the money supply than in expanding it; if there is
a chronic shortage of credit-worthy borrowers and desirable (viable )
investment projects, reducing the required liquidity ratio of the banks may
simply leave them with surplus liquidity and not cause them to expand
credit. Similarly, if banks have substantial cash balances (reserves) the
change in the statutory cash ratio required may have to be very large.

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 Funding may be effective in controlling liquidity. However, its expensive
since the rate of interest on long-term debt is usually much higher than on
short-term loans. Considerable funding of debts might therefore have
undesirable effect of increasing long-term interest rates and inflationary
tendencies. Governments should therefore try as much as possible to
maintain strict budget discipline to avoid frequent debt conversions whose
long-term financing militates against efficient and effective discharge of
government functions.

NUMBER FOUR
(a) Sources of Monopoly power:

 Exclusive ownership and control of resources (factors of production)

 Patent rights eg. beer brands like Tusker, soft drinks like Coca Cola etc.
 Natural monopoly which results from economies of scale i.e
minimization of average total cost of production. The firm could produce
at the least cost possible and supply the market.
 Market Franchise i.e. the exclusive right by law to supply the product or
commodity; most firms that fall in this category arise from government
policy eg. Kenya Railways.
 High (prohibitive) initial size and cost of capital – the initial cost of
setting up a firm may be high and most potential firms find it hard to
venture.
 Collusion/mergers/cartels/contrived monopolies: purposely to control or
dominate the market i.e. large firms may come together in agreement on
the quantity of supply or prices to charge thus driving away other
potential firms out of business eg. the oil producing and exporting
countries (OPEC).

Price Output/quantity TR MR AR

(Kshs) (Kgs) (Kshs.) (Kshs.) (Kshs.)

10 1 10 10

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9 2 18 8 9

8 3 24 6 8

7 4 28 4 7

6 5 30 2 6

5 6 30 0 5

4 7 28 (2) 4

3 8 24 (4) 3

2 9 18 (6) 2

1 10 10 (8) 1

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 Revenue

TR

●MR = 0; TR is maximum & εd =

1
TR since MR<0
(i..e negative)
& εd <1
AR = D

0 6 Output
MR

The total loss resulting from a decrease in price (while the monopolist seeks to
increase sales) is deducted from the selling price of the last unit in order to
compute the net increase in total revenue/receipts resulting from the one-unit
increase in sales. Therefore, MR is less than the price at each level of sales (since
a firm can only increase sales by reducing price).
Suppose that the firms initial price was Ksh. 10 and current level of sales is 3 units
of X; price per unit is Ksh. 8 and total revenue is Ksh. 24. If the firm desires to
increase sales per unit of time to 4 units of X it must reduce the price per unit to
Ksh. 7. The fourth unit brings in Ksh. 7.
However, the firm takes a Ksh. 1 loss per unit on its previous sales volume of 3
units. The total loss of Kshs. 3 must then be deducted from the selling price of the
4th unit in order to compute the net increase in total revenue resulting from the one-
unit increase in sales. The MR at a sales volume of 4 units is Kshs. (7 – 3) = 4
(also the difference between Kshs. 28 and 24)
Therefore MR< AR at all levels of output.

Revenue and Cost

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 SMC

SAC
P ●A

C ●B
AR = D
●e

MR
0 X
Output (Q)

Fig 4.2: Short-run profit maximization in monopoly

Diagrammatic representation of short-run profit maximization by a monopolist in

terms of per unit costs and revenue is presented in Figure 4.2. Profits are
maximum at output X, at which SMC = MR. The price per unit that the
monopolist can get for that output is P. Average cost is C and profits are equal to
(CP x X). At smaller outputs, MR>SMC; thus larger output (i.e. beyond x),
MR<SMC; hence increases beyond x add more to TC than to TR and cause profits
to shrink.

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 Revenue & Cost
SMC
SAC

AVC
C ●B

P ●A

●e
AR = D

MR

0 X Output (Q)

Fig 4.3: Short-run loss minimization in monopoly

There is a common misconception that a monopolist always makes profits.

Whether or not this is so always depends on the relationship between the market
demand curve faced by the monopolist and the cost conditions. The monopolist
may incur losses in the short-run and like the purely competitive firm, continue to
produce if the price more than covers average variable costs. In figure 4.3, the
monopolist‟s costs are so high and the market so small that at no output will the
price cover average costs. Losses are minimum provided the price is greater than
the average variable costs, at output X, at which SMC = MR. Losses are equal to
(PC x X).

Another common misconception is that the demand curves, with the exception of
those faced by firms under conditions of pure competition, range from highly
elastic toward their upper ends to highly inelastic toward their lower ends and
cannot be said to be either elastic or inelastic. They are usually both, depending on
the sector of the demand curve under consideration. The output that maximizes a

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monopolists profits will always be within the elastic sector of the demand curve if
there are any costs of production. Marginal Cost is always positive; therefore, at
the output at which MC = MR, MR must also be positive. If it is positive, then the
elasticity of demand must be greater than one.

NB: A monopolist continues production at a loss in the short-run as long as its

covering its average
variable cost (AVC), that is, so long as AR>AVC: shown in the diagram.

NUMBER FIVE
(a) Choice, scarcity and opportunity cost:

 Scarcity being the central economic problem is defined as the

inadequacy/insufficiency/inability of (economic) resources or goods and
services available to satisfy them. Scarcity is therefore not the same as
„few‟ resources. Since resources are scarce (limited in supply) it implies
that such resources have alternative uses and command a non-zero price;
thus, scarce resources are known as economic resources and goods and
services made available (produced) by utilizing such resources are
referred to as economic goods and services. A resource be it land,
capital, labour or entrepreneurial ability, can be put to alternative uses
(used to satisfy a variety of human wants)

eg. in terms of land, a plot can be used for various purposes with a view
to satisfying wants on it, one can construct residential houses,
commercial buildings, an educational center or farming.
 Choice is (may be) defined as the power of discretion that is the ability
and freedom to select from alternatives; choice arises due to scarcity of
resources with such resources having alternative uses and therefore
cannot satisfy all human wants pertaining to them at the same time.
Choice is made between alternatives depending on scale of preference
which differ between an individual consumer, producer (firm/investor) or
government determined by the view to maximize satisfaction, return and
equity on provision (especially) of public and merit goods respectively.
A rational consumer chooses those goods (and services) from which
maximum satisfaction is derived; for an investor, choice is made of those
ventures which yield the highest possible return at least costs; a
government that embraces the dictates of good governance would seek to

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 ensure equity in distribution of resources by prioritizing between
alternatives, for instance choosing to spend more on public and merit
goods (such as defence/law and order and education and health
respectively).
 Opportunity cost of an action is the value of the benefit expected from
the next best foregone alternative. It‟s a derivative concept which arises
due to the scarcity of resources (for production) or goods and services
(for consumption) which necessitates the making of choice between
competing alternative uses where more of a commodity is produced or
consumed by reducing the production or consumption of another. From
the standpoint of an entrepreneurial ability, the opportunity cost of
deciding to organize land, labour and capital in the manufacture of
fertilizer in a factory is the value of organizing the same resources in
establishing and running a (private) school; the opportunity cost of
choosing to be a doctor is the value of the benefit forgone by not being a
lawyer.

A CPA course student could have Ksh. 200 and requires both economics
and FA1 text books, each costing Kshs. 200. This amount (Kshs. 200) is
certainly not enough (such that the two items are mutually exclusive) and
therefore calls for the student to choose between the two alternatives, that
is, to either buy the economics textbook and forgo the FA text book or
vice versa. Assuming that the student opts to buy the economics text
book, the opportunity (economic) cost is the value of the benefit forgone
by not buying the FA textbook. Accounting profits net of opportunity
cost gives economic profit, opportunity cost being an implicit cost.

Opportunity cost can be illustrated by way of a diagram using a

production possibility curve/frontier which is concave to the origin
denoting increasing opportunity cost as shown below:

Agricultural Product (A)

A1

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 A2

0 M1 M2 P
Manufactured product (M)

- To increase production of M from M1 to M2 the producer has to reduce

production of A from A1 to A2 ; thus, the opportunity cost of production of (M1
M2 ) units of M is the value of (A1 A2 ) units of A forgone.

b) Exchange rate: refers to the rate at which one currency exchanges for another
that is the amount of one currency that is exchanged for a unit of another
currency in a given exchange rate regime.
In a fixed exchange rate regime, the exchange rate is determined by the
government; in a floating exchange rate regime, it‟s the market forces of
demand and supply that determine exchange rates.
When the government increases the exchange rate and thus reducing the relative
value of its currency, the process is known as devaluation. Similarly, where the
exchange rate increases as determined by the free interaction of the market
forces such that the relative value of the currency falls, the process is referred to
as depreciation.

D S

Kshs/$

78 ●E
Exchange rate

D
60
S
54

($)

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 0 Quantity of dollars
traded on the
foreign exchange
market

Where: DD: Demand for US dollars.

SS: Supply of US dollars

Fig: 5.1: Determination of exchange rates

Market forces determine the exchange rate at Ksh. 78/dollar, given by the
intersection of the supply (SS) and demand (DD) curves at E.
The government on its part (in a fixed exchange rate regime) has the prerogative to
fix the exchange rate at, for instance, Ksh. 54 or 60 per dollar.

(c) Producer‟s Surplus:- is the difference between the total amount producers
receive for any given quantity of a product and the minimum amount they
would have been willing to accept for that quantity.
It can also be defined as the gain to producers arising from the difference
between the price they actually receive (market price) and the price they were
willing to accept instead of going without selling any of the products (expected
price)
It‟s measured diagrammatically by the area above the supply (marginal cost)
curve but below the price at which that quantity is sold.

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 Price
SS(MC)

PX ●c

0 X1 Quantity

Fig: 5.2: Producer‟s Surplus

(d) Isoquants: An Isoquant is a locus of technically efficient combinations of two
factors of production their utilization from which the same level of output is
produced; its slope measures the marginal rate of technical substitution (MRTS)
of one factor (eg labour) for another factor (eg. capital), that is MRTSLK or
capital for labour i.e. MRTSKL
Isoquants have the following properties:

(i) Negatively sloped – denoting marginal rate of technical substitution

(ii) Do not intersect – if they do, it would mean that an Isoquant represents
two levels of output, which is inconsistent with the definition of
Isoquants.
(iii) Convex to the origin – since the two factors of production are not perfect
substitutes and therefore subject to diminishing marginal rate of technical
substitution of one factor for another.
(iv) Isoquants higher above and further away from the origin of an Isoquant
map represent higher levels of output.
These properties are represented by way of diagrams as shown below:

Capital (k)

k1
MRTSLk

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 k2
QX

0 L1 L2 Labour (L)

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 Capital (k)
A●B●
(ii)

●C

QX2
QX1

0 Labour (L)

Capital (k)

(iii)
k1

Diminishing MRTSLk

k2

k3

k4

QX

0 L1 L2 L3 L4 Labour (L)

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(iv) Capital (k)

QX4

QX3
QX2
QX1

0
Labour (L)

NUMBER SIX

(a) Fixed Cost (FC): - Do not vary with the level of output i.e. remain constant
(same) at all
levels of possible output depending on the size of the plant eg.
Administrative costs (in terms of salaries of top management etc),
depreciation, rent & rates, interest on loans. Such costs are associated with
the fixed inputs in the short-run. Fixed costs come about because in the
short-run the firm cannot vary all its inputs. Fixed inputs are fixed by
definition and those costs associated with fixed inputs constitute the firm‟s
total fixed cost.

Cost (C)

(25) = C0 TFC

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 0 X1 X2 X3 Output (Q)
(6) (7) (8)

At all levels of output X1 , X2 , X3 etc fixed cost (TFC) remains constant at CO = 25.
Fixed Costs are also known as “overhead costs” or “unavoidable costs”.

Variable cost (VC): - Vary directly with the possible levels of output both in short-
run and long-run eg. raw material cost, cost of direct labour, running expenses of
fixed capital such as fuel, ordinary repairs, routine maintenance, electricity etc.
Such costs are associated with variable inputs in the short-run and long-run.
Variable cost function takes the form TVC = f(Q). For a firm to increase its output
level, it will require more variable inputs hence higher variable costs. Variable
costs are often referred to as “direct costs” or “avoidable costs”. They can be
avoided by not hiring the variable factor.

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 Cost (C)

TVC

(73) = C2

(53) = C1

(25) = C0

0
X1 X2 X3 Output (Q)
(6) (7) (8)

(Total) variable cost vary with change in the level of output such that its for
instance CO (25) at X1 (6), C1 (53) at X2 (7), C2 (73) at output level X3 (8)
etc.

Cost (c)

TC
TVC

98

73

25 TFC

0 8 Output

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NB: Average Fixed Cost & Average Variable Cost may also be included as part of
the

answer to this question.

(b) AR = K1 Q – K2
AC = K1 – K2
Q
(i) AC = K1 – K2 = TC/Q
Q
TC = (K1 – K2 )Q
Q
K1 Q - K2Q
Q
TC = K1 - K2Q -------- (Total Cost Function)
TFC = K1 ------------- ( Fixed Cost Function)
TVC = - K2Q ---------(Variable Cost Function)

When Q = 0, TVC = 0
When Q = 0, TC = 0 + TFC
TC = TFC
TFC = TC = K1 - K2Q but Q = 0
So TFC = TC = K1
TFC = K1

AFC = TFC/Q = K1 ; AFC = K1

Q Q

TC = TFC+ TVC
TC = K1 – K2 Q
TFC = K1
at all levels of output TFC = K1, thus at any level of output,

TVC = TC – TFC
TVC = K1 - K2 Q - K1
TVC = - K2 Q

AVC = TVC/Q
AVC = - K2 Q/Q
AVC = - K2

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(ii) At breakdown, TR = TC
AR = K1 Q – K2 = TR
Q
TR = (K1 Q – K2 )Q
TR = K1 Q2 - K2 Q ---------------- (Total Revenue Function)
TC = K1 - K2 Q ---------------- (Total Cost Function )

TR = TC
2
∴ K1 Q - K2 Q = K1 - K2 Q
K1 Q2 = K1
Q2 = K1
K1
2
Q =1
Q = 1= 1
Q = 1 unit

NB: The breakeven point is where total revenue (TR) is equal to total cost (TC) so
that the
firm neither makes a profit nor a loss.

When total revenue (TR)> Total Cost (TC), the firm makes a profit; where
profit (II) =
TR – TC

When total revenue (TR) < Total Cost (TC), the firm makes a loss since it
spends more
than it gains.
(c) Implicit and explicit costs:

(i) Implicit Costs:

These are costs of self-owned, self employed resources used by a firm in the
process of production (abstract costs) eg. opportunity cost, individual
managerial skills etc. Such costs are not fixed and it‟s the owner who
evaluates them.

These costs are not expressly incurred but are implied. An example would be:
a firm that operates its business from a building situated on a piece of land

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 owned by the owners of the firm. Practically, if the land was rented out to
another person (3rd party) this 3rd party would pay rent on it. Likewise,
theoretically, the business having its premises on this land should charge itself
the rent it would be paying if it was not owning (holding) the land.

Otherwise, the stay on the land would not be economical since the opportunity
cost of it would be too high. This is because if this cost is not charged a large
amount is forgone in terms of rent „receivable‟.

(ii) Explicit Costs:

These are costs of resources hired or purchased by a firm for use in the
production process eg. wages, transport cost etc. profits calculated by only
taking into account explicit costs are known as financial profits.
Since such costs arise from acquisition of inputs (resources), the amount is
determined by price.

NB: Profits calculated on the basis of both implicit and explicit costs are
called economic
profits.

NUMBER SEVEN
Industrialization being a process, requires a multi-faceted effort; it requires a
strong government with a comprehensive representative focus, people having
institutionalized sense of nationalistic ideals and an international community that
truly values mutuality in international development partnership.
The government should have clear policies and incentive guidelines to attract
investors. This should go along with aggressive marketing of the business
opportunities both locally and abroad.
The country‟s infrastructure needs to be restored and maintained so as to reduce
incidental costs of transportation eg along the Mombasa - Nairobi highway.
Institutions like the Kenya Roads Board should be strengthened (in terms of
resources, expertise and independence) to make it possible the prioritization of
issues particularly relating to the physical aspect of infrastructure. Other aspects of
infrastructure to be looked into include the railway network (to avoid constant
derailings), airports‟ navigation equipment.
Training needs should be addressed with specific reference to the technical aspects
of industrialization. No country would industrialize without a corresponding
technically trained and skilled labour force.

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Technical Training Institutions should therefore be streamlined and strengthened in
order to meet the challenges of the industrialization status Kenya plans to achieve.
Special consideration should also be given to Information Technology (IT) on
which almost every aspect of business (commerce) and industry relies.
Corruption should be rooted out at all costs to avoid instances like tax evasion
(which denies the government its rightful revenue and thereby causing frequent
costly budget deficit financing), dumping of substandard goods, smuggling and
awarding of contracts devoid of merit (on individual whims of power brokers).
There should be no conflict of interest when dealing with national issues,
and the rule of law must be upheld so that offenders are firmly dealt with. It also
involves giving the Kenya Anti- Corruption Authority (KACA) the full backing of
the law to allow it to operate independently in carrying out its mandate of
investigating and prosecuting economic crimes. This should be enhanced by
widening the scope of commercial courts (eg appointing more judges to handle
cases) and ensuring that there are no undue injunctions that interfere with the
necessary justice of timely conclusion of cases. Moreover, there is a strong need
for the adoption of the civil service code of ethics to make civil servants more
transparent and accountable, and thereby minimizing chance of misuse of office
(misuse of public funds etc).
The agricultural sector also needs serious attention in terms of encouraging the
setting up of agro-based industries which add value to export products (such as tea,
coffee, pyrethrum and cashew nuts). This can be done by availing soft loans to
farmers (especially small scale farmers), subsidizing the cost of input (as the West
continues to do) and improving the quality of agro-products )to meet ISO
standards) and their prices. The government (Ministry of Agriculture and Rural
Development) has prepared a new National Agricultural and Livestock Extension
Programme (NALEP) as part of the Kenya Rural Development Strategy (KRDS)
and the poverty Reduction strategy paper (PRSP) initiative aimed at assisting
farmers to enhance food production, guarantee food security, increase incomes and
improve standards of living.

This programme (NALEP) prescribes alternative extension approaches and cost

effective methods of disseminating appropriate technologies to the farming
community with a view to producing beyond subsistence and becoming supportive
of the agro-based industries (by increasing the scope of supply of raw materials).
This the way forward, and this programme should be implemented as good as it is
on paper.

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Local industries should be protected from cheap imports. This can be done by
introducing primitive taxes (tariffs) on foreign goods and strengthening the
commitment to economic integration initiatives particularly relating to the rules of
origin. Currently, Kenya is witnessing its domestic market flooded with cheap
imports or even used imports otherwise known as „Mitumba”; motor vehicle
assembling industries are witnessing a considerable decline in volume of activity,
textile and shoe industries the same (eg RIVATEX, Bata Shoe Company etc).
Kenya cannot under any circumstance, industrialize if such industries are left to
continue with this trend; if there is no market, existing industries close down (and
possibly shift to alternative countries), unemployment increases, purchasing power
(effective demand) falls and the general level of poverty increases. These facets
are certainly not good for a country that struggles to industrialize. No rational
investor would want to establish a new industry when similar ones are closing
down. Micro and small scale enterprises at the grass root or even estate level
should be encouraged a great deal, extension of credit facilities for such ventures at
relatively low interest rates must be put in place so as to encourage upcoming
entrepreneurs. To this end, a number of NGO‟s are currently in the field as well
as banks but their interest rates are still relatively very high; may be the Central
Bank of Kenya (Amendment) Act 2000 “The Donde Bill” (approved by parliament
on the 27th of July 2001 which seeks to impose a cap on lending rates by banks of
4% above the prevailing 91 day Treasury Bill rate, restricts the total amount of
interest levied to not more than the original capital lent, imposes restrictions on the
lending fees that are normally charged to borrowing customers, and prescribes the
deposit rate payable on interest earning accounts at 70% of the prevailing Treasury
Bill rate) is going to help. The government together with state corporations such as
the Kenya Industrial Estate (KIE) and the Industrial Development Bank (IDB)
should play a leading role towards this endeavor.

Though a lot of emphasis has been on the informed sector lie the Jua Kali, the
quality of products unless internationally competitive in terms of the ISO standards
will not take Kenya any much further in the industrialization process.

Power is another item which needs urgent attention as a factor in industrial

undertakings. The charges levied in this country are some of the highest in the
world. In the current situation, all manufacturers want to make the best out of the
least, unfortunately, the power sector has not been rationalized, even with the
separation of the generation (now under Ken Gen) and the distribution (by Kenya
Power & Lighting Company Ltd) functions. Compared to the neighboring
countries, the charges remain unreasonably high. This is attributable to past poor

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sectoral planning strategies which are now translating into power crisis occasioned
by eventualities such as drought (1999/2000). The Sondu Miriu Power project in
Nyanza province now being constructed (2001) with the assistance from the
Japanese government is as a realization of the lack of foresight in the establishment
of the seven Forks dam (Tana river) in eastern province in the drastic fall in the
water levels in these dams forced the Ministry of Energy to institute the necessary
yet very painful power rationing programme (1999/2000) which seriously
impacted (negatively) on the entire spectrum of the Kenyan economy (eg
increasing production costs etc) especially the manufacturing sector.

Kenya should also make a strong effort to reduce the cost of fuel of which the
industrial growth is largely a function. Fuel products‟ (such as petrol & diesel)
prices have a direct relationship with the costs of production which eventually
determine final product prices. Bringing down fuel prices means reducing
production costs to the industrial sector, which then translates into relatively lower
final product prices and increased effective demand necessary to spur industrial
growth. Kenya has recently (2001) made an effort in this direction by negotiating
with Sudan the possibilities of oil exploration (and investment) and importation.
Though this has generated much international and domestic criticisms from the
human rights organizations (claiming the possibility of an increased revenue base
for the SPLA forces in southern Sudan), it serves the purpose for Kenya to go
ahead (of course not unconditionally – Kenya being a member of the UN peace
keeping Missions) and import oil (crude or final) in order to reduce the cost of fuel
in this country.

Insecurity has also been another major problem in Kenya – car jackings, bank (and
other) robberies and a lot of illegal fire arms in the hands of the wrong people.
Since investment is a function of security, insecurity scares away existing and
potential investors. No investor would want to risk (life and capital) by venturing
in an insecure country.

Without a proper security machinery, Kenya will not go far in the industrialization
process initiatives like the setting up of the Export Processing Zones (EPZs). Of
course we cannot deny the government has made an effort in this direction by
increasing the budgetary allocations (eg. in the financial year 2001/2002) aimed at
improving the security status; the recent closure of the Somalia-Kenya boarder on
a presidential directive is one effort aimed at reducing the smuggling of five arms
into the country (of course such boarder closures never stay indefinitely but it only
act as a temporary measure while awaiting reorientation and harmonization of the
security machinery).

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Even tourists don‟t visit countries where they feel insecure, and remember tourists
are not just people who come to see animals and other attractive resorts; some of
them visit to discover or find out about the existing unique investment ventures
such as those available in the EPZs. They therefore constitute part of the potential
investors which the Kenya government should make them feel secure while it tries
to promote industrialization. These are the same people who (even if they do not
directly invest in the country) constitute the global market for Kenya‟s industrial
products (in their home countries).

Kenya should also carry out the implementation of (selective) reform programmes
in order to restore the donor confidence. Privatization should however be given a
Kenyan face (ownership by Kenyans or at most in partnership with foreigners,
otherwise known as strategic partners). This will then reduce the governments‟
burden of subsidizing loss-making public enterprises/entities, reducing at the same
time the budget deficits and eventually causing a downward adjustment in interest
rates (cost of capital) which is necessary to spur industrial growth.

The economic reforms specified by the donor institutions like the World bank and
the International Monetary Fund (IMF) are sometimes very punitive for the
developing countries like Kenya (eg down sizing of the Civil service –
retrenchment etc) but the only acceptable reason is the need to restore confidence
with the international development partners other than the Bretton Woods
Institutions eg. The Paris Club group of lenders whose lending decisions are a
derivative of the decisions of the World Bank and the IMF on the credit rating
status of a particular country. For most governments, it is only a public relations
exercise.

NUMBER EIGHT
a) i) Individual demand function: Qdx = 12 – 2Px
Market demand function: Qdx = 10,000 (12 - 2Px) = 120,000 – 20,000Px

Individual supply function: Qsx = 20 Px

Market supply function: Qsx = 1,000 (20Px) = 20,000Px

ii) At equilibrium, the quantity of a commodity supplied equals the quantity

demanded such that the price at this point is the equilibrium price and the
quantity, the equilibrium quantity.
Thus at market equilibrium, Qsx = Qdx

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 20,000Px = 120,000 - 20,000Px
40,000Px = 120,000
Px = (120,000/40,000) = 3 Px = 3 units of a currency

To obtain the market equilibrium quantity (Qx) we use either the market supply
function or the market demand function by substituting the value of Px for Px, in
which case, the value of Qx obtained should be the same:

Qdx = 120,000 – 20,000 Px but Px = 3

Qdx = 120,000 – 20,000 (3) = (120,000 – 60,000) = 60,000 units of x.
Qsx = 20,000 Px but again Px = 3
Qsx = 20,000 (3) = 60,000 units of x
Thus at Px = 3, Qdx = Qsx = 60,000 units.

b)

i) Advertising refers to the whole process or set of informative, educative and

persuasive promotion activities aimed at influencing the perception of the
consumer and therefore the effective demand for a product or service.
On information, advertising is a medium through which the existing or

potential consumers are made aware about (of) the existence (of say a new

product or service), price(s) charged per unit, content and even the

comparative quality. The educative aspect of advertising is largely to do

with usage, that is, advertising spells out the procedure/way(s) of using a

particular product e.g. the Kobil Mpishi (gas cooker) etc.

In terms of persuasion, advertising creates a positive perception of a

product/service and therefore an urge of taste among consumers who may
start buying so that, with time, they develop brand loyalties. Over and
above, advertising should also be entertaining as a means of capturing a

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 wider scope of target audience and prolonged attention. Any form of
advertising that virtually has all these components is widely expected to be
successful in terms of creating, maintaining or even increasing the demand
for an existing or new product/service just introduced into the market. One
such powerful and effective advertising is that of Omo Pick-a-Box show
running every Sunday on KBC TV, which has kept Omo well ahead of other
similar detergents in the market – people have kind of developed some brand
loyalty to Omo with Power foam – with the slogan “The Strongest Washing
Powder for the Cleanest Wash”.

i) A business firm should consider the following factors while developing an

advertising policy:

a) Advertising elasticity of demand

b) Cost of advertising
c) Target group e.g. the youth, business community, professionals, etc.
d) The appropriate time to advertise
e) Means of advertising e.g. electronic or print media, billboards, field
demonstrations and geographical spread
f) Cultural background including religion – which tend to have certain norms
and conventions
g) Language – for effective communication – easily understood to avoid
communication breakdown.

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