1.

1 Introduction to Economics

Economics essentially studies the way in which mankind provides for

the material well being.

It’s thus concerned with the way people apply their knowledge, skills
and effort to the gift of nature in order to satisfy human their material
wants. Economics is a social science which studies the allocation of
scarce resources which have alternative uses among competing and
usually limitless wants of the consumers in the society.

It is therefore a social science which studies the relationship between

scarce resources and the various uses or needs which compete for the
resources.

Basic Economic Concepts

i) Human wants This refers to people desires for goods and services and
circumstances that enhance their material well being.

ii) Economic Resources These are ingredients that are available for
providing goods and services in order to certify the human wants. A
resource must be scarce and have money value. Resources can be
categorized as natural, or manmade.

iii) Natural Resources refer to anything given by God or nature such as

fertile soil, rivers, lakes, mountains etc.

iv) Man Made Resources refers to anything created by man to assist in

further production such as tools, equipments, roads and buildings etc.
N/B Economics resources also refer to as factors of production which
includes land, labour, capital and entrepreneurship.

v) Scarce and Choice if the resources available are not enough to produce
goods and services to satisfy all the wants then they are said to be scarce.
As a result, individuals and society cannot have all the things that they
want. Since resources are limited, choices have to be made. The choice to
satisfy one want implies

iv) Opportunity cost Refers to the alternative for gone or massed for
sacrificed to use the resources to satisfy one of the alternatives.

Scope of Economics

The main branches of economics are:

Microeconomics which is the study of the smallest economic decisions

making units of the society. Microeconomics theory is a branch of
economics that studies the behavior of individual decision making units
such as consumers, resource owners and business firm as well as
individual markets in a free market economy. The aim of
microeconomics is to explain the determination of prices and quantities
of individual goods and services. Microeconomics also considers the
impact of government regulation and taxation of individual markets. For
example, microeconomics analyses the forces that determine the prices
and quantities of television sets sold. Microeconomics can be considered
as the ultimate cellular structure of economics.

i) It is the study of individuals, households and firms. The major areas

are
- Demand and supply analysis

- Market equilibrium

- Consumer theory

- Theory of the firm

- Market structure

- Distribution theory

Macroeconomics is the study of bigger and complex systems.

Macroeconomic theory is the study of the behaviour of the economy as a
whole whereby the relationship is considered between broad economic
aggregates such as national income, employment and prices. The
economy is disaggregated into broadly homogenous categories and
determinants of the behavior of these aggregates are integrated to
provide a model to the entire economy.

ii) Macroeconomics focuses on the economic stabilization whereby

government policy is used to moderate business cycles and encourages
real economic growth. Macroeconomics became a separate topic of
discussion in the aftermath of John Maynard Keynes and the great
depression. The line between microeconomics and macroeconomics is,
however, blurred and there are many areas of overlap between the two.
Key areas of macroeconomics are:

- National income

- Economic growth and development

- Money and banking

- Public finance

- Unemployment

- Inflation

- International trade

Importance of Study Economics

It is useful to study economics for the following reasons

i) Economics provides the underlying principles of optimal resource

allocation and thus enables individuals and firms to make economically
rational decisions. Thus for example the preparation of budgets involves
knowledge of demand and elasticity analysis. The making of price policy
decisions draws heavily on the concept of elasticity in economics.
Additionally, the theory of production in economics is concerned with
the principles that facilitate the optical combination factors of
production.

ii) A study of economics enables individuals and organizations to

appreciate the constraints imposed by the economic environment within
which any entity operates. Thus an individual or firm is more fully
enabled to appreciate the implications of the annual budget considering
how for example the increased liberation of the economy will affect a
particular business entity and the economy in general. Additionally, the
student of economics is able to appreciate the effects of such economic
variables as inflation, exchange rates, interest rates money supply and
so on.
iii) The area of development economics is fundamentally concerned with
the reasons why societies develop and means of accelerating
development. It is vital for individuals as citizens to appreciate the
parameters that determine the development process so that they
contribute more fully to facilitate and contribute to solving the economic
problems that characterize their society.

iv) Economics is an analytical subject and its study can help develop
logical reasoning which is never superfluous.

Basic Economic Concepts

i) Human wants This refers to people desires for goods and services and
circumstances that enhance their material well being.

ii) Economic Resources These are ingredients that are available for
providing goods and services in order to certify the human wants. A
resource must be scarce and have money value. Resources can be
categorized as natural, or manmade

iii) Natural Resources refer to anything given by God or nature such as

fertile soil, rivers, lakes, mountains etc.

iv) Man Made Resources refers to anything created by man to assist in

further production such as tools, equipments, roads and buildings etc.

N/B Economics resources also refer to as factors of production which

includes land, labour, capital and entrepreneurship.
v) Scarce and Choice if the resources available are not enough to produce
goods and services to satisfy all the wants then they are said to be scarce.
As a result, individuals and society cannot have all the things that they
want. Since resources are limited, choices have to be made. The choice to
satisfy one want implies

Fiscal policy refers to the policies which the government uses to stabilize
the economy through government revenue and expenditure.

Monetary policy refers to the policies implemented by the central bank

to stabilize the economy by use of money supply and interest rates. Both
policies make up the budgetary policy of the government. others are
forgone. Individuals have to make choices e.g. consumers with their
limited income and unlimited wants have to choose how they spent their
income.

vi) Opportunity Cost refers to the value of benefit expected from the best
second alternative forgone. It is based on the fact that resources being
scarce have competing alternative uses.The choice to satisfy one
alternative means that another is forgone. The value of the second best
forgone alternative is the opportunity cost.

Economic Systems

These refer to the way in which different societies solve the three
different basic economic problems which are:

a Which goods should be produced and in what quantities?

b. How should various goods and services be produced?

c. How should various goods and services be distributed? These in turn
determine various political and economic structures in the society.

The economic systems are as follows:

(a) Free market economy Also referred to as capital system or laiser faire
economy. It refers to a system where decisions about allocation of
resources are made by individuals on the basis of prices generated by
forces of market prices of demand and supply. A free market economy
has the following features

- Private property individuals have the right to own or dispose off their
property as they may consider it fit.

- Freedom of choice and enterprise Individuals have the right to buy or

hire economic resources, organize them for production purpose and sell
them in the market of their choice. Such persons are referred to as
entrepreneurs.

- Self interest the pursuant of personal goals. The individuals are free to
do as they wish and have the motive of economic activity in self interest.

- Competition There is a large number of buyers and sellers such that

each buyer and seller accounts for but is insignificant to influence the
supply and demand and hence prices.

- Reliance on price mechanism This is an elaborate system of commerce

in which numerous choices of consumers and producers are aggregated
and balanced against each other. The interaction of demand and supply
determine prices.
- No government intervention Hence no price controls, taxes and
subsidies.

- There are property rights provided and enhanced by the government

through copy rights patents, trademarks etc.

Advantages of free market economy

- There is the matching of demand and supply. Production takes place in

response to demand hence a balance between what is produced and
consumed. No wastage.

- There is flexibility of the market in responding to changes in demand

and supply conditions.

- There are no resources wasted in planning as no planning is required

- Consumer sovereignty and competition gives rise to a wide variety of

goods and services giving consumers a wide range to choice from.

- Higher rates of economic growth due to the incentive available for hard
work which is motivated by profits.

- No wastage of resources on unrealistic projects because investment

decision are based on profits.

Disadvantages
- Income inequality the ability of some people and firms to acquire
excessive market power leads to greater inequality in income and
wealth.

- Monopoly power refers to the ability of a firm to control its prices

- Externalities spill over refers to social costs and benefits not taken into
consideration when determining price levels.

- Public goods. The price mechanism on its own cannot allocate

resources to the production of public goods such as roads, schools,
security etc., which have no rivals and no excludability.

- Instability and unemployment due to the trade cycles of recession,

depression, recovery and boom.

- The inability to deal with structural changes caused by wars, natural

calamities among others.

- Inadequate provision of merit goods. Merit goods are goods of

importance to the community such as health, education, security among
others

(b) Planned economy Also referred to as command economy or

government controlled economy, socialism or communism. It refers to
an economic system where the crucial decisions are determined a body
appointed by the state. The body takes up the role of mechanism which
prevails in a free market economy
Features of a command economy

- Leadership and control of economies. All important means of production

(resources) are publicly owned such as land, power generation, housing
among others.

- Rationing of certain commodities if supply of such fall bellow demand.

- Existence of production targets for different sectors of the economy.

The government determines how resources are allocated through
planning.

- Fixing of prices and wages

- Occasional existence of restricted labour market in which workers take

up jobs assigned to them.

- Government decides what is to be produced

Advantage of planned economy

- Avoids economic instability

- Minimize negative externalities

- Makes adequate provision of public and merit goods

- Facilitate the shift of resources in pursuant of grand schemes such

rapid industrialization
- Puts checks on monopoly power which are controlled by state
monopolies (Parastatals).

Disadvantages of Planned economy

- There is wastage of resources in production because consumers

demand is judged in advance without the use of price mechanism.

- The cost of gathering information for planning is expensive to the state.

- In absence of profit motive in production there is no incentives for hard

work and innovation.

- The power of consumer sovereignty is curtailed

(c) Mixed economy refers to an economic system where resource

allocation is determined by the state and price mechanism. This form of
economic system can exist in two ways:

- Where the means of production are privately owned but the

government through fiscal and monetary policies regulate the working
of price mechanism towards desired levels.

- The government does not only regulate the working of the price
mechanism but also strategic resource thus taking part in production.

Why government Intervene in the Economy

- To create a framework of regulations and rules to ensure fair
competition thus promote competition between firms both small and
big.

- Redistribute income through a system of taxation

- Prevent market failure of price mechanism

- Stabilize the economy

- Maintain competition by controlling monopoly

-Control of harmful goods.

Specialization

This refers to the process where people concentrate on those activities

where they are best at. It takes a form of division of labour which is
dividing up of economic tasks of production into tasks which people
specialize into. Division of labour therefore leads to specialization which
leads to increase in output.

Advantages of specialization

- It help individual development by exploring their talent

- It is possible to use machines to do specific/ particular task

- Increase in skills result in increased expertise and performance

- Time saving as a worker will accomplish more by doing a particular
task.

Disadvantages

- Leads to loss of craftsmanship. Extensive specialization leads to

increased use of machines which are more automated leading to loss of
basic skills

- Production of standardized goods limiting the range of goods

consumers can choice from. It does not cater for different tastes and
preferences.

- Monotony and boredom due to repetitions of the same work. This leads
increased accidents, absenteeism which is associated with lack of
motivation.

- Increased inter-dependence as a specialized system of production

increases the extent to which different sectors of the economy rely on
each other. If mistakes are made in one production unit it may cause the
fall of all or other organization which depend on items from that
production unit.

- Increase in risk of unemployment if ones skills are no longer required

in the market they may get an alternative employment.
CHAPTER ONE DEMAND AND SUPPLY

DEMAND ANALYSIS

Definition of Demand

Demand refers to the quantity of a commodity that consumers are

willing and able to purchase at any given price over a given period of
time. It is important to realize that demand is not the same thing as
want, need or desire. Only when want is supported by the ability and
willingness to pay the price does it become an effective demand and
have an influence on the market price. Hence demand in economics
means effective demand. It is different from desire in that it has to be
supported by the ability to purchase the product/service.

The price of a commodity is most important factor/determinant of

demand. All factors affecting demand other than the price are referred
to as conditions for demand. While analyzing the relationship between
price and quantity of demand economists assume that all factors
affecting demand remain constant. An individual demand for a given
good can be presented in a form of a demand schedule. A demand
schedule is a table showing quantity of a commodity that could be
purchased at various prices. The Table 2.1 shows an individual’s
demand for commodity X.
Price per unit in Consumers‟ weekly
Kshs demand

6 65

5 70

4 80

3 90

2 100

1 115
Table 2.1 Demand schedule for an individual commodity From the table,
65 units of commodity X will be demanded per week if the price is Kshs 6
per unit.

A demand schedule can be represented in the form of a graph known as

a demand curve.

Figure 2.1 shows the demand curve for commodity X. The curve shows
graphically the relationship between quantity demanded and the price
of the commodity. A demand curve has a negative slope. It slopes
downwards from left to right showing that as the price of a commodity
falls demand increases. The inverse relationship between the price of a
commodity and the quantity demanded is what is referred as the law of
demand.
This law states that, “ceteris paribus (other things remaining constant),
the lower the price of a commodity the greater the quantity demanded by
the individual and vice versa”.

Exceptions to the Law of Demand

There are some demand curves that slopes upwards from left to right
showing that as the prices of a product rise more is demanded and vice
versa. This type of demand curve is known as regressive, exceptional or
abnormal demand curve and occurs in the following situations:

i. When there is fear of a more drastic price changes in the future. This
will causes consumers to increase there quantity demanded to avoid
paying a higher price in the future. This situation is often found in the
stock exchange where there is often an increase in the demand of shares
of a company if its shares are expected to increase.
ii. In the case of giffen goods. This refers to basic foodstuffs that
constitute a high proportion of the budget of low income families. When
the price of a giffen good rises, the proportion of the total income of
individuals who consumes these giffen goods rises and since such
consumers are worse off in real terms, they can no longer afford to
consume other more expensive commodities like meat and fruits. To
make up for the goods they can no longer afford to buy, they are more
likely to purchase more of basic foodstuffs; conversely when the price of
basic foodstuffs falls. They become better of in real terms and are likely
to buy more or relatively more expensive foodstuffs and less basic
foodstuffs.

(iv) Goods of ostentation (Veblen goods). These are commodities whose

prices falls in the upper price ranges and that have a snob appeal. The
wealthy are usually concerned about status. Believing that only goods at
high prices are worth buying and worth the effect of distinguishing them
from other consumers. In the case of such commodities, a firm
increasing its prices may find that the sales of its product increase and at
lower prices less of the commodity may be bought as the commodity is
rejected as being substandard. Consumers often in making comparisons
between similar products with different prices opt for relatively more
expensive product believing it to be better. As prices increase demand
increases this is referred to as sonob effect. Examples of goods of
ostentation are expensive perfume, jewellery, cars clothes, etc.

The demand curve will be positively slopping as indicated in Figure 2.2.

The Determinants of Demand
1. The price of the product. When deciding whether or not to buy a
particular product, an individual will compare the price of the product
and the amount of utility or satisfaction expected to be received from the
product. If the price is considered worth the anticipated utility the
individual will buy the product and if not will not buy. A decrease in the
price of a product will probably increase individuals demand for it since
the amount of utility obtained is likely to be worth the lower price.
Conversely a rise in the price of a product will probably result in a fall in
demand, as the amount of utility received is less likely to be worth the
higher price to be paid. An example of this phenomenon is the hotel
industry in Kenya. There is usually an increase in domestic tourism
during the low season when many Kenyans consider the lower hotel
prices to be worth the level of satisfaction they are receiving. During the
high season when the hotel prices are high, many do not consider the
satisfaction they are receiving to be worth. If the amount a consumer is
willing and able to purchase due to change in the price, a change in the
quantity demanded is said to take place. If on the other hand the amount
the consumer is willing and able to purchase changes because of a
change in the price of a given commodity leads to a change in the
quantity demanded will be undertaken later in utility analysis and
indifference curve analysis.

2. The prices of related goods. The demand for all goods is interrelated in
that they are competing for consumer’s limited income. Two peculiar
interrelationships can be; Substitutes goods such as tea and coffee butter
and margarine, beef and mutton, a bus ride and a matatu ride, a mango
and an orange, CDs and cassettes. Two goods, X and Y are said to be
substitutes if a rise in the price of one commodity, say Y, leads to a rise in
the demand of the other commodity X. If the price of tea increases
consumers will find coffee relatively cheaper to tea as a result demand
for coffee increases? Substitutes are commodities that can be used in
place of other goods.
This phenomenon is illustrated in Figure 2.3. The graph shows the
relationship between the prices of tea over the quantity for coffee.

If the price of tea increases from P1 to P2 the quantity of coffee

demanded increases from Q1 to Q2.

Figure 2.3 Demand curve for substitutes

Compliments goods such as shoe and polish, pen and ink cars and petrol,
computers and software, bread and margarine, hamburgers and chips,
tapes and tape recorders. Demand for some commodities can also be
affected by changes in the prices of the complementary if a rise in the
price of one of the goods, say A leads to the fall in the demand of another
food, say B. Complimentary goods are usually jointly demanded in the
sense that the use of one requires or is enhanced by the use of the other.
Figure 2.4 illustrates the relationship between complementary goods
graphically. For example if the price of cars is lowered demand for petrol
increases because more cars will be bought/demanded. The curve shows
the relationship between the price and of a car and quantity demanded
for petrol. If the price of cars falls from P2 to P1 the quantity demanded
for petrol increases from Q1 to Q2.

Figure 2.4 Demand curve for commentary goods

Quantity (petrol)
3. Changes in disposal real income. An individual’s level of income has an
important effect on the level of demand for most products. If income
increases demand for the better quality goods and services increases.
This relationship however, depends on the type of goods and level of
consumer’s income.

The three types of are goods;

Normal goods these are goods whose demand increases as income

increases. The demand for normal goods increases continuously with
increase in income. It tends to become gently as people reach the desired
level of satisfaction.

(b)Inferior goods refer to goods for consumers with low income levels
such that as income increases its demand falls. At low level of income,
these individuals will tend to consume large amount of these goods but
as income increases they buy other goods which they consider superior
thus demanding less of the inferior goods. At very low level of income an
inferior good behave like a normal good only to behave inferior as
income increases.

(c)Necessities these are goods which consumers cannot do without such

as salt, match boxes among others. Their income demand curve tends to
remain constant other than at the lowest levels of income as indicated in
Figure 2.5
Figure 2.5 Demand curve for a necessity

4 .Changes in consumer tastes, preferences and fashion; Personal tastes

play an important role in governing the consumers demand for certain
goods For example, preferring to consume imported commodities
despite them being extremely expensive. Prevailing fashions are an
important determinant of tastes. The demand for clothing for example,
particularly is susceptible to changes in fashion.

5. Level of advertising is also an important determinant of demand. In

highly competitive markets, a successful advertising campaign will
increase the demand of a particular product while at the same time
decreasing the demand for competing products. Increase in advertising
will increase demand in the following ways;

- it helps inform about the product of a firm

- Can introduce new products to the market.

- Induce individuals to frequently use the product/service

6. The availability of credit consumers. This factor especially affects the
demand for durable consumer goods which are often purchased on
credit. For example a decrease in availability of credit or the
introduction of more stringent credit terms is likely to lead to a
reduction in the demand of some durable consumer goods.

7. The government policy The government may influence the demand of a

given commodity through legislation For example making it mandatory
for everyone to wear seatbelts. The consumers inevitably get to
purchase more seatbelts as a result. Subsidies it’s the opposite of
taxation. When the government grants subsidies prices of goods falls
leading to increase in demand and vice versa.

8. Climate change demand of various goods varies depending on

weather. For instance there is high demand for woolen clothes during
rainy reasons.

Movement Along and Shift in Demand Curve

Demand is a multi- variant function in the sense that it is influenced by

so many factors such as the price of the commodity, the price of other
related commodities, consumer incomes etc. The price of the commodity
is the most important determinant of demand and its relationship with
the quantity demanded give rise to a demand curve.

Movement along demand curve is demonstrated by a change in the price

of a good as shown in Figure 2.7 by movement from one point to another
on the same demand curve.
A change in price of a good from P1 to P2 causes a movement from point
A to B along the demand curve. This movement along demand curve
shows a change in quantity demanded which is an increase or a fall in
the quantity demanded. A shift in the demand curve is caused as a result
of a change in any factor affecting demand other than price such as
changes in consumer income tastes and preferences. For this reason all
other factors affecting demand other than price of the product are also
referred to as shifting factors as illustrated in Figure 2.8 Any change in
the shifting factors will cause changes in demand (an increase or a fall in
demand). A shift to the right (dd to d1d1) shows an increase in demand
while a shift from (dd to d2d2) shows a decrease in demand.
Terms used in demand

(a) Joint demand it is the demand whereby two commodities are always
demanded together. One good cannot be demanded in the absence of the
other such as car and petrol.

(b) Competitive/rival goods it is the demand for goods which are

substitutes such tea and coffee.

(c) Derived demand where goods are demanded in order to provide

goods such as cotton is required to produce cotton wool

(d) Composite demand (several uses) where some goods are used for
different purposes such as steel for cars machine etc

Elasticity of Demand
It can be defined as the ratio of the relative change of a dependent
variable to changes in another independent variable. Elasticity can be
analyzed in terms of demand and supply. It can also be defined as a
measure of responsiveness of quantity demanded of a good in to changes
in income or prices of other related goods.

There are three types of elasticity; price elasticity of demand, cross

elasticity of demand and income elasticity of demand.

1. Price elasticity of demand it‟s the measure of responsiveness of the

quantity demanded of a commodity to changes in its own price. It is also
referred to as own price elasticity. It abbreviated as PED/ED.

It is calculated as follows
If changes in prices cause more than proportionate change in quantity
demanded it is said to be price elastic, in this case ED >1. If changes in
the price causes less than proportionate change in quantity demanded,
then demand is said to be price inelastic this is represented by ED < 1. If
changes in price causes proportionate change in quantity demanded
then, demand is said to be unit elastic or unitary elastic where ED= 1.

To illustrate price elasticity consider the Table 2.3 which shows demand
schedule of commodity X.

Price Quantity

10 100

5 150

Calculate the PED when the price changes from Kshs per unit 10 to Kshs
5 per unit.
Types of elasticity of demand

There are five types of elasticity of demand.

(i) Perfectly elastic demand. Demand is said to be perfectly elastic when

the consumers are willing to buy an amount of a commodity at a given
price, but non at a slightly higher price. In this case elasticity of demand
is equally to infinity. The will be a horizontal straight line as illustrated
in Figure 2.28. This is a case of a commodity in a perfectly competitive
market. Where an increase in price may lead to a loss of all customers.
(ii) Elastic demand. Demand is said to be price elastic when a charge in
price causes more than proportionate change in quantity demanded. In
this case the value of elasticity of demand is greater than 1 and the
demand curve will be gently sloped as indicated in Figure 2.29. This
implies that if prices increase from P1 to P2 the quantity demanded falls
in greater proportion from Q1 to Q2 and vice versa. This is a case of
luxury commodity which consumes can do without or a case of a
substitute.

(iii) Unity elastic demand. Demand is said to unit elastic if changes in

price cause proportionate change in quantity demanded. If price
increase quantity falls in the same proportion and vice versa. ED = 1 and
the demand curve will be rectangular hyperbola as illustrated in Figure
2.30. This is a case of a good that lies between a luxury and necessity
such as soap opera film or movie.
(iv) Inelastic demand. Demand is said to be price inelastic if changes in
price causes less than proportionate change in quantity demanded. If
prices increases the quantity falls in less proportion and if the prices
falls the quantity demanded increases in less proportion ED < 1 as
illustrated in Figure 2.31. This is a case of a good which is a necessity.
These are goods which consumers cannot do without but need not be
consumed in fixed amount like an absolute necessity such a staple food
like ugali and milk. It also applies in the case of habit forming goods like
beer and cigarettes.
(v) Perfectly inelastic demand. Demand is said to be perfectly price
inelastic if changes in price has no effect on the quantity demand (ED=
0). In this case the demand curve will be vertical straight as illustrated in
Figure 2.32. This is a case of a good which is an absolute necessity. A
good that consumes cannot do without and have to consume in fixed
amounts such as salt
Factors affecting price elasticity of demand

(i) Substitutability. If a substitute is available in the relevant price range,

quantity demanded will be elastic. The demand for a particular brand of
cigarettes maybe considered being elastic because if there is existence of
other brands that are close substitutes. However, the total demand for
cigarettes may be inelastic because there are no close substitutes for
cigarette. It can hence be said that the greater the number of substitutes
for a given commodity, the greater will be its price elasticity of demand.

(ii) The proportion of a consumer’s income spent on the commodity. If this

proportion is very small as in the case of match boxes , the quantity
demanded will tend to be inelastic. On the other hand if this proportion
is relatively large as for example in the case of meat, demand will tend to
be elastic. This implies that the greater the proportion of income which
the price of the product represents, the greater price elasticity of
demand will end to be.
(iii) The extent to which the product is habit forming. Habit forming
products like cigarettes or alcohol have a low price elasticity of demand.
In the case of in addiction to, say drugs, the price elasticity of demand is
likely to be even lower.

(iv) The number of uses of a commodity. The greater the number of uses
of the commodity, the eater the price of elasticity. The elasticity of
alluminium for example is likely to be much greater than of butter
because butter is mainly used as food while alluminium has hundreds of
uses such as electrical wiring and appliances.

(v) The length of adjustments. The longer the period allowed for
adjustment in the quantity demanded as a commodity the greater its
price elasticity is likely to be. This is because it usually takes some time
for new prices to be known and for consumers to make the actual switch.
Consumers adjust buying habits slowly.

(vi) The level of prices. If the ruling price is at the upper end of the
demand curve, quantity demanded is likely to be more elastic than if it
was towards the lower end. This is always true for a negatively sloped
straight line demand curve.

(vii) Necessities and luxuries Demand for luxury is likely to be price

elastic while the demand for necessities is generally price inelastic.
However, this depends with availability of close substitutes.

(viii) Width/size of the market the wide definition of the market of a

good, the lower is the price elasticity of demand. Thus for wide markets
demand will tend to be price inelastic while for a small market demand
will tend to be price elastic.
(ix) Time demand for most goods and services tend to be more elastic in
the long run as compared to the short run period. This is because
consumers will take some time to respond to price changes. For
instance, if the price of petrol falls relative to diesel, it will take long for
motorists to respond because they are locked in existing investment in
diesel engines.

(x) Durability of the commodity durable goods have low elasticity of

demand or they are price elastic while perishable goods are price
inelastic.

2. Income Elasticity of demand

It is the measure of responsiveness of demand due to change in income.

Where income elasticity is positive this is a normal good. Where income
elasticity is negative this is an inferior good. When the demand of a good
does not change with increase in income then income elasticity is zero.
In wealthy countries for instance basic clothes will tend to have low
income elasticity of demand while foreign will have high elasticity of
demand as income increases. In poor countries basic commodities will
have high income elasticity compared to manufactured expensive items.

Importance of Income Elasticity of Demand

(i) Business firms- if demand of a commodity is elastic to price, its

possible to revenue by reducing prices. Businesses use specific
information to know which price to increase to eliminate shortages or
which price to reduce to eliminate surpluses.

(ii) Government uses elasticity to determine the yield of indirect taxes.

Inelastic commodities are highly taxed. However, if demand of a
commodity is elastic an increase in tax will hinder production
(iii) Price elasticity is relevant for a country considering devaluation as a
means of rectifying balance of payment disequilibrium. Devaluation
decreases imports and increases exports. However, this will depend on
demand of import and export elasticities.

(iv) It helps to explain price instabilities in the agricultural sector

(v) Monopolists apply price discrimination by understanding the

demand elasticities. High price is charged to those markets with lower
price elasticity

Factors affecting Income elasticity of demand

(i) Nature of the need that the commodity covers. For certain goods and
services the percentage of income spent declines as income increases
such as food.

(ii) The initial level of income of a country (level of development) TV

sets, refrigerators, motors vehicles are considered as luxuries in
underdeveloped countries while they are considered as necessities in
countries with high per capita income.

(iii) Time period. The demand for most goods and services will tend to
be income elastic in the long run as compared to short run period. This is
because the consumption pattern adjusts with time and also with change
in income.

3. Cross elasticity of demand

It is the measure of responsiveness of quantity demanded of a good due
to changes in the price of another related good. It is abbreviated as EXY
where X and Y are to goods. It is calculated as follows:

The sign of cross elasticity of demand is positive if the good X and Y are
substitutes and negative if X and Y are complimentary. The higher the
absolute value of cross elasticity of demand the stronger the degree of
substutability or complimentaribility. The main determinant of cross
elasticity is the nature of the commodity relative to their uses. If two
goods can certify equally the same need the cross elasticity will be high
and vice versa.

Importance of cross elasticity of demand

(i) Protection of local industries. If the government imposes a tariff on a

good with the intention of protecting a local industry then the local
product and the imported product must be close substitutes for the
government to achieve it objectives

(ii) If a firm is in a competitive market, there a high positive elasticity of

demand between its products and those of competitors. For such a firm,
it will not be in it‟s interests to increase the price of its product as this
may result to more than proportionate reduction in its sales. However, it
might consider lowering the prices of its products in the hope of
attracting customers from other firms.
(iii) For product with high degree of complimentarity, a fall in price of
one of the goods due to increase in supply will benefit the producers of a
compliment product due to an increase in sales. E.g. if there is a fall in
prices of vehicles, due to an increase in supply the suppliers of fuel
experience an increase in sales because more cars will be bought.
SUPPLY ANALYSIS

Definition of Supply

Individual supply refers to the quantity of a given commodity that a

producer is willing and able to sell at a given price over a specific time
period.

Market supply refers to horizontal summation of individuals

producers/firms supply in the market.

The supply schedule and the supply curve demonstrate the relationship
between market prices and quantities that suppliers are willing to offer
for sale. Supply differs from “existing stock” or the amount available
because it is concerned with amounts actually brought to the market.
The basic law of supply states that, “a greater quantity will be supplied at
a higher price than at a lower price”.

An individual producer‟s supply schedule shows alternative quantities

of a given commodity that a producer is willing and able to sell various
alternative prices for that commodity ceteris paribus (other things
remaining constant).
Price per unit in Kshs Quantity supplied each
week in units

30 500

31 550

32 600

33 650

34 675

35 700

36 725
Table 2.2 Supply schedule for commodity Y

This can be represented by the use of a graph referred to as a supply

curve as shown in Figure 2.9

Quantity X

Figure 2.9 Supply curve

A supply curve show the relationship between the price of the

commodity and the quantity supplied. The relationship is a direct one as
the supply curve slopes upwards from left to right. The direct
relationship is a graphical representation of the law of supply which
states that other things remaining constant a greater quantity will be
supplied at higher prices and vice versa
Determinants of Supply

The supply of a good is influenced by the following factors

1.Price of the good as the price of a given commodity say X rises, with the
costs and the prices of all other goods remaining unchanged, the
production of commodity X becomes more profitable. The existing firms
are therefore likely to expand their profit and new firms are to be
attracted into the industry. It should be noted however, that not just the
current rise but also expectations concerning the future increases prices
may motivate producers. The total supply of goods is expected to
increase as the prices rise.

2. Prices of other related goods changes in the prices of other

commodities may affect the supply of a commodity whose price does not
change.

(a). Substitutes; two goods X and Y are said to be substitutes in

production if the supply of good X is inversely/negatively related to the
price of Y. For instance barley and wheat or tea and coffee. If a firm
producing both tea and coffee notices that the price of tea is rising may
decide to allocate more resources to tea at the expense of coffee. The
supply of coffee will therefore fall as the price of tea increases. However,
the movement of resource from one use to the other is dependent on the
mobility of factors of production.
(b)Complimentary goods; two goods X and Y are said to be compliments
if an increase in the price of X causes an increase in the supply of Y such
as a vehicle and petrol.

(a)Jointly supplied goods; two goods X and Y are said to be jointly

supplied if an increase in the price of X causes an increase in the price of
Y such as petrol and paraffin. If the demand for petrol increases the
supply of petrol will rise and at the same time the supply of paraffin will
increase.

N/B The extent to which firms can move from one industry to another in
search of higher profits depends on occupational and geographical
mobility of the factors of production.

3 .Prices of factors of production as the prices of factors of production

used intensively by producers of a certain commodity rise, so do the firm
costs. This will cause the supply to fall since some firms will eventually
leave the industry. Similarly, if the price of one factor of production, say
land, increases, some firms may move out of the production of land
intensive products into the production of goods that are intensive in
other factors of production which are relatively cheaper. Finally other
less efficient firms will make losses and eventually leave the market.

4. The state of technology is a society‟s pool of knowledge concerning

industrial activities and its improvements. Technological improvements
or progress such as improvements in machine performance,
management and organization or an improvement in quality of raw
materials leads to lower costs through increased productivity and
increases the profit margin in every unit sold. This leads to increase in
supply.
 5 .Future expectations of price change Supply of a good is not only
influenced by the current prices but future expected price as well. For
example, if the price of a good is expected to rise the firm may decide to
reduce the amount of supply in the current period. This is to enable
them pile stock which they can offer for sale when prices increase in the
future. This is known as hoarding.

6. Government policies through tax imposition on goods increases the

cost of production hence decline in production and supply Through
subsidies -a grant to citizens of a country which lowers the cost of
production hence encourages production and increases in supply.
Through price control can either by price minimization where prices are
fixed above equilibrium encouraging producers to produce more hence
increase in supply. It may be undertaken through price maximization
where prices are fixed below equilibrium discouraging production
hence decline in supply. Though quotas where the government puts
restriction or limit production of various goods which leads to decline in
supply.

7. Weather /climate the supply of agricultural products is considerably

affected by changes in weather conditions. Output in agriculture is
subject to variations in weather from year to the next. An excellent
growing season associated with favorable weather conditions will result
in a bumper harvest leading to an increase in supply. An unfavorable
season that results in a poor harvest may be viewed as an increase in the
average costs of production because a given expenditure on inputs
yields a lower input than it would in a good/ favorable season. A bad
harvest is represented by a leftward shift of the supply curve.
8. Objectives of the firm a business may pursue several objectives such as
sales maximization, market leadership, quality leadership, survival,
profit maximization, social responsibility. Firms with sales maximization
as an objective aim at supplying greater quantities of its product than a
firm aiming at profit maximization where the later supplies less
quantities but at a higher price in order to maximize the profit.

9. Incidence of strikes lead to a reduction in supply of a product. The

supply of manufactured goods is particularly likely to be affected by
industrial disputes because of generally stronger unions in the
industrial sector.

Movement Along and Shift in Supply Curve

The relationship between price of a commodity and quantity supplied

give rise to a supply curve. Any changes in the price of a good causes
change in the quantity supplied. This can be traced by the movement
along supply curve as shown in Figure 2.11 The movement from point A
to B is caused by changes in price from P1 to P2 which bring fourth the
movement along the supply curve.

Figure 2.11 Movement along supply curve

A shift of supply curve is caused by a change in any other factors
affecting supply other than the price of the goods. This shift indicates
changes in supply as a result of e.g. advances in technology which makes
it cheaper to produce goods and services and therefore their supply will
increase. Similarly incase of increase in cost of production will lead to a
fall in quantity supplies as shown in Figure 2.12. A shift to the right from
S1S1 to S3S3 shows a fall in supply.

Figure 2.12 Shift in supply curve

The Concept of Equilibrium in Economics

Equilibrium in economics refers to a situation in which the forces
determine the behavior of variables are in balance and therefore exert
no pressure on these variables to change. In equilibrium the actions of
all economic agents are mutually consistent. Market equilibrium occurs
when the quantity of a commodity demanded in the market per unit
equals the quantity of the commodity supplied to the market over the
same period of time. Geometrically, equilibrium occurs at the
intersection point of the commodities market demand and market
supply curve. The price and quantity at the equilibrium are known as the
equilibrium price and equilibrium quantity respectively. The price Pe is
also referred to as market clearing point. At this equilibrium point the
amount that producers are willing and able to supply in the market is
just equal to the amount that consumers are willing and able to demand.
Both consumers and producers are satisfied and there is no pressure on
prices to change and thus the market for goods is said to be at
equilibrium.

This is illustrated in Figure 2.13 Equilibrium point

Quantity X

Figure 2.13 Equilibrium point

Equilibrium can be defined as a state of rest or balance in which no
economic forces are being generated to change the situation. These
economic forces are excess demand and supply.

Types of Equilibrium

The are three types of equilibrium; stable, unstable and neutral.

(i) Stable equilibrium If there is a force that distracts market equilibrium

then there will adjustment that brings back the prices and quantity
demand to the initial equilibrium. This is well explained in the previous
section.

(ii) Unstable equilibrium equilibrium is said to be equilibrium if there is

divergence from the equilibrium set by forces which push the prices
further away from the equilibrium prices. For example, in case of a giffen
good which assumes a demand curve which is positive?

(iii) Neutral equilibrium occurs when initial equilibrium is disturbed and

forces of disturbances leads to a new equilibrium point. It may occur due
to a shift of either demand or supply or through the effect of taxes

Shift in supply
 Increase in supply Consider Figure 2.18 which illustrates the effect of an
increase of supply on the market equilibrium. An increase in supply is
represented by a shift of supply curve to the right from S1S1 to S2S2. The
immediate effect will be surplus and this will force the producer to lower
their prices in order to get rid of excess stock. This fall will lead to an
increase in quantity demanded until a new equilibrium is established at
Pe.

A fall in supply Consider the Figure 2.19 which illustrates the effect of a
fall in supply on the market equilibrium. A fall in supply is represented
by a shift of supply curve to the left from S1S1 to S2S2. The immediate
effect will be shortage and thus will force the prices to go up leading to a
fall in quantity demanded until a new equilibrium is established at Pe1,
Qe2.
Price Control

This refers to a deliberate action by the government to artificially

impose through legislation the prices of certain goods and services. Such
imposed prices are referred to as flat prices. These flat prices may be a
maximum or a minimum price. A maximum price refers to that price
above which a good or a service cannot be sold. A minimum price refers
to that price below which a good/service cannot be sold.

A minimum price refers to that price below which a good/service cannot

be sold. The government may find it necessary to control the prices of
certain good/service because:
1.Cheapness It may be objective of the government to keep price of
certain goods and services at a level at which they can be afforded by
most people hence protecting the consumer being exploited by
producers

2.Maintenance of income. The government may want to keep the income

of certain producers at a higher level than that which would be supplied
by market forces demand and supply. Thus the government is able to
maintain the low income producers in the market.

3. Price stability if there is a wide variation in the price of product year to

year the government may wish to iron out these variations for the
interests of both producers and consumers. This price control will act as
one of the methods to curb inflation

4.Rise of black market where goods are sold above legal price even above
the equilibrium price.

Shortages are likely to become chronic as producers move away from

production of price controlled goods.

5.Research and development will be encouraged as the producers move

from the price controlled industry.

6. increased costs efficiency in production by firms as profits can only be

increased by reducing costs.

Advantages of price control

(a) Protects consumers, especially the low income consumers from price
increases by producers.

(b) Ensures that producers have a reasonable income which is subject to

inflation

(c) Contributes to industrial peace especially if they constitute part of

the comprehensive income policy and a maximum price is fixed on some
basic goods.

(d) It may be associated with a decrease in price and an increase in

output such as the case of a monopolist overcharging for its products
and is forced to lower prices. In this case the monopolist may accompany
the fall in price with an increase in output in order to compensate for
loss in revenue.

(e) It may be used as one of the several counters of inflation

Price elasticity of supply

It is the measure of responses of quality supplied of a commodity to

change in its two prices. It is abbreviated as ES and calculated as:

ES will have appositive value because of the direct relationship between

the price of the product and quality supplied.
If ES is greater than 1, then the supply is said to be price elastic

If Es <1 then supply is price

f Es =1 then supply is unit elastic.

Type of price elasticity of supply

1. Perfectly elastic supply

2. Elastic supply

3. Unit elastic supply

4. Inelastic supply

5. Perfectly inelastic supply.

Factors affecting price elasticity of supply

a) Mobility of factors of production If they are highly mobile then supply

will be price elastic since more factors can be employed quickly when
the prices increase thus increase in supply
b) The level of employment of resources It refers to the utilization and
allocation of resources. If the factors are fully utilized supply will be
price inelastic due to the fact that all the facts are occupied and thus can
not be mobilized in order to increase supply. However if they are under
employed, supply will be price elastic.

c) Production period for product that take short period of time to

produce their supply tend to be price elastic. While thus that take a
longer period will be price inelastic because it will take a while before
the products can reach the market.

d) Nature of the commodity Price elasticity of supply for perishable goods

tend to be inelastic due to the fact that the goods do not respond to price
fall as they can not be easily stored. On the other hand supply for
durable goods tend to be price elastic since they can be store when the
price falls thus contracting supply.

e) Risk taking If the entrepreneurs are willing to take risk then supply of
the products will be price elastic. Risk taking will in return be
determined by the prevailing conditions in the economy. E.g. Political
stability, security, government incentives, infrastructure, etc.

f) Level of stock If it‟s high supply will be price elastic because if the
price of a good increases more of the good will is supplied from the stock

g) Time period Supply for most goods and services will tend to be more
elastic in the long run than in the short run because producer need more
time to reorganize factors of production so that they can increase supply
of the products.
CHAPTER TWO
 THE THEORY OFPRODUCTION

Production comprises all activities that provide goods and services

which people want and for which they are prepared to pay a price. The
composition of the total output can be classified into consumer goods
and produce goods and services.

Consumer goods are commodities that satisfy human needs

directly .They can be:

Durable consumers’ goods, Non- durable consumer goods and Producer

goods .

Services are intangible economic goods e.g. banking, transport, tourism

and administration. Services are non transferable i.e. they can not be
purchased and then resold at a different price Production can be
categorized into three:

Extractive industries, examples are farming, fishing and forestry.

Primary products result from such industries

Manufacturing industries these include engineering, vehicle

manufacture, chemical and food processing.

Distribution industries; these incorporate the activities of wholesaling

and retailing.

Stages of production/levels

Primary production stage

This is also referred to as extractive production. It is the process through
which the producer avails the commodities in their natural raw form as
provided by nature. The outcome of this stage is referred to as primary
products.

This includes the process of farming, fishing, mining etc.

Secondary production

This is processing stage of production through which value is added to

the products of the primary production stage. In this stage, the producer
refines or adds value to what has already been produced in primary
stage. It is known as industrial products.

Tertiary production

This is production that involves the creation and provision of services to

the consumers. It is the last stage of production that enables the
produced commodity to reach the consumer.

Factors of Production

This refers to the inputs or resources from the society that are used in
the process of production .They include land, labour, capital and
entrepreneurship
Land It refers to all natural recourses over which people have power of
disposal and which may be used to yield income. It includes farming
land, forest, river, lakes, building land, and mineral deposit. The total
supply of land in the world is limited although the supply of land for
some particular use is not fixed. Thus for example, more maize can be
planted at the expense of potatoes. Alternatively, more land can be
allocated to buildings at the expense of farming land, drainage,
irrigation and fertilizers can increase the area of agricultural land.

Characteristics of land

1. It is a free gift of nature

2. Have a zero production cost always/zero prices

3. It has perfect inelastic supply/does not change in supply

4. It is geographically immobile and at times occupationally immobile in

the short run.

5. Production of land is subject to the law of diminishing returns

Labour refers to the exercise of human mental and physical effort in the
production of goods and services. The supply of labour in an economy is
measured by the number of hours of work which is offered at a given
wage rate at a given period of time.
Capital is a manmade input. It can be classified as working capital or
circulating capital referring to stocks or raw materials, partly finished
goods and goods held by producers. Alternatively, capital can be
classified as fixed capital which consists of equipment used in
production such as machinery and buildings.

Entrepreneurship the organizational of the factors of production with a

view to make a profit It involves hiring and combining other production
factors making decision on what to produce how and what and where to
produce. It in involves risk taking which arises because most production
is undertaken in expectation of demand and in most cases the future is
uncertain. Entrepreneurs make payments to cover their costs without
any certainty that the cost will be covered by revenue

Functions of the Entrepreneur

1. Makes economic decisions on resource allocation i.e. he/she decides

on what to produce and how much to produce.

2. Determines the methods of production i.e. determines the techniques

the techniques of production to be adopted in the production process.

3. Bears the uncertainty of investments

4. Undertakes risks which cannot be insured by the insurance

companies.

5. Undertakes the management of business i.e. organizes the other

factors of production in their right proportions so as to enable
production take place.
6. Hires the other factors of production needed in the production
process i.e. acquires and pays for the other factors of production.

7. Markets the products of the production process by selling in the most

profitable way possible i.e. he/she looks for the markets for the
products.

Mobility of Factors of Production

Mobility of Factors of Production has two main aspects

a) Occupational mobility refers to the ease of movement of factors of

production from one job or task to another.

b) Geographical mobility refers to the movement factors of production

from one location to another.

Individual mobility of factors of production

Land is not mobile geographically but has a high degree of occupation

mobility i.e. land can be put into different uses of farming building roads
etc Capital is mobile in both cases e.g. a vehicle and tools are
geographical and occupational mobile. Some capital are immobile e.g.
railways. Other form of capital has occupational mobility e.g. a building

Labour is mobile both geographical and occupation. However there are

barriers to geographical and occupation mobility.

Barriers to Mobility of Labour

1) Reluctance of the family to move

2) Cost involves in labour mobility

3) Language barriers

4) Adverse climatic condition

5) Insecurity and political instability

6) Ignorance of job opportunities

Specialization

This refers to the concentration of activity in those lines of production

where the individual, firm or country has natural or acquired an
advantage. Adam Smith drew attention to the importance of division of
labour in his book, the wealth of nations. He was fundamentally
concerned with division of labour of a particular industry where the
manufacture of products was broken down into many specialized
activities. Adam Smith observed that the making of pins required 18
distinct operations, estimating that the production per day in the factory
was about 5,000 pins per person employed. If however the whole
operation was undertaken from first to finish by each employee, Smith
estimated that he would have been able to make only a few dozen pins
per day. Apart from specialization in particular industries the following
other forms of specialization can be identified:

a) International specialization – refers to the concentrating of a country

of its resources on a specific area of production for example, the
concentration by Kenya in the production of coffee and tea or the
production of copper by Zambia.
b) Regional specialization within a country where factor endowments
and economic history have led industries to concentrate in certain areas
because it is difficult for competitive plants to be established elsewhere.
Thus for example, in Kenya the production of tea is concentrated in the
highlands.

c) Specialization between Industries since each economy includes many

industries an example; it is possible to speak of the motor
manufacturing industry, the steel industry and so on.

d) Specializations between firms- since industries are composed of firms

that can be regarded as units of production. Thus for example different
firms can specialize in the manufacture of different components of a
product. Thus for example, in the car industry certain firms specialize in
the provision of spare parts.

e) Specialization within factories which arises because one firm will often
control a number of factories, and these are usually referred to as plants
and are units of production. For example, a manufacturer might find it
economical to build engines in one plant, axles in another, car bodies in
a third and so on, and subsequently transport all the parts of another
plant for final assembly.

Advantages of specialization

- It help individual development by exploring their talent

- It is possible to use machines to do specific/ particular task

- Increase in skills result in increased expertise and performance

- Time saving as a worker will accomplish more by doing a particular
task.

Disadvantages

- Leads to loss of craftsmanship. Extensive specialization leads to

increased use of machines which are more automated leading to loss of
basic skills

- Production of standardized goods limiting the range of goods

consumers can choice from. It does not cater for different tastes and
preferences.

- Monotony and boredom due to repetitions of the same work. This leads
increased accidents, absenteeism which is associated with lack of
motivation.

- Increased inter-dependence as a specialized system of production

increases the extent to which different sectors of the economy rely on
each other. If mistakes are made in one production unit it may cause the
fall of all or other organization which depend on items from that
production unit.

- Increase in risk of unemployment if ones skills are no longer required

in the market they may get an alternative employment.
CHAPTER THREE: MARKET STRUCTURES
The term market is usually used to mean the place where buyers and
sellers meet to transact business.

Markets can be divided into imperfect market and perfect market

(a)Perfect Markets

Perfect market is a market with many buyers and sellers where nobody
can determine the price of goods or services.

Characteristics of perfect market

1. Large number of buyer and sells where each individual firm supplies
part of total quality supplied. Buyers are many such that no monopolistic
powers can affect the working of the markets. Under this condition no
individual firm or buyer can affect the market

2. Free entry and free exist there are no barriers to entry or exit to the
industries. Entry and exit from the industries may take time but firms
have the freedom of movement in and out of the industry.

3. Product homogeneity The industry is defined as group of firms

producing homogenous product i.e. the technical characteristic as well
as the service associated with product sold are identical. There is no why
is which buyer can differentiate among the products of different firms.

N/B: Under perfect competition firms are price takers. Meaning the
demand curve of an individual firm will be perfectly elastic showing that
the firm can sell any quantity of output at a given or prevailing market
price. The concept of price taking is illustrated in Figure 5.1
4. Profit maximization The goal of the firm is profit maximization both is
the short run and in the long run. No other goal is pursued.

5. No government regulation. There is no government intervention in

the operation of this market.

6. Perfect mobility of factors of production. Factors are free to move from

one firm to another throughout the economy. It is assumed that there is
perfect competition on the factor market.

7. Perfect knowledge All sellers and buyers are assumed to have

complete knowledge about the conditions in the market. This knowledge
refers not only to prevailing condition in current but also for future
periods.
The revenue position of a perfectly competitive firm

In perfect competition since each unit of out is sold at the same price
both the average and marginal revenue are constant. This is illustrated
in Table 5.1

Price(ksh Qty Total Marginal

) demand demand revenue

20 1 20 20

20 2 40 20

20 3 60 20

20 4 80 20

20 5 100 20

20 6 120 20

Table5.1 illustrates
20 7 40 20
that as the quality
demand increases
20 8 160 20 the price remains
unchanged. This implies that each additional unit sold increases the
total revenue by in amount equal to its price. This relationship is
illustrated graphically as shown in Figure 5.2
The short run -Recall that the short run is the context the theory of the
firm is the period in which the quality of at least one factor of production
is fixed. The level of output during this period of time can alter the
utilization of variable factors. In the short run is the perfect competition
can make normal profit, abnormal profits or losses

Normal profit- This refers to the minimum level of profit which a firm
must make in order to induce it to remain in operation. The level of
normal profit varies from one industry to the other this because of
different level of risk and nature of the production process involved in
different industries.

Normal profits may be considered be just past cost of production line

since production will not continue unless at least this level of profit is
attained
In the Figure 5.2 the firm is earning normal profit because price is equal
to the average cost. The profit maximizing level of output is Q1 where
the necessary sufficient conditions are satisfied. Since normal profit are
made where the price is equal to average cost it implies that when price
exceeds average cost the firm is said to be earning normal or super-
normal profits.

Supernormal profit (P>AC) Categories all those firms which are earning a
return which exceeds the minimum necessary to induce them to remain
the industry they currently occupy. Figure 5.3 shows a firm making
super-normal profits.
 Figure 5.3 when the level of output is Q2 the cost for unit is EQ2 and the
price DQ2 supernormal profit is equal to CPDE which is represented by
the scheduled area.

Types of market structures

1. Monopoly
Monopolies are usually associated with economies of scale because of
the large size of the market controlled by the firm. Economies of scale
imply lower unit‟s costs of production. It is likely that the consumer will
benefit from this cost effectiveness through lower prices from a
monopoly supplier. A monopolist like any other firm finds profit
maximizing level of output where the marginal revenue is equal to
marginal cost as shown in Figure 5.4. Monopoly firm maximizes profit at
the level of output Q where the necessary and sufficient conditions of
profit maximization are satisfied. The super normal profits earned by
the monopolist are represented by the shaded area PCBX. This
monopolist profit will persist in the long run since the are barriers to the
entry in the industry. In the long run the monopoly can expand or use
the existing plants at any level that will maximize profit. Owing to the
existence of barriers it is unnecessary for the monopolist to reach the
optimum scale of production which corresponds to the minimum point
of the long run average curve.

Sources of monopoly power

1. Legal barriers This takes the form of statutory monopolies or patents
i.e. monopolies established by an Act of parliament and patent meaning
that a firm is protected from competition of new firms.

2.Products differentiation barrier This may be in form of product

uniqueness, advertisements and branding where an existing monopolist
may exploit his position as a supplier of an established products which
the customer is persuaded to believe that it is the best.

3. Economies of scale barriers could arise where existing firms are

already operating on a vast scale production and enjoying technical
economies of sale.

4. Transport cost and tariff barriers Some firms may enjoy local
monopoly position arising from the ability to sell more cheaply in their
own localities than other firm. Such firms can therefore rise prices in
their local markets above the production cost by an amount that does
not exceed transport cost close of firm in other localities with similar
production cost

Advantages of monopolies

a) Economies scale

b) No wastage of resources

c) Price stability since monopolists are price makers

d) Ability to carry out research and development to improve on their

product
Disadvantages

(a) Diseconomies of scale arise in case the firm grows in a very large size,
exploits the economies of scale and fails to achieve the targeted
economies of scale.

(b) Inefficiency since there is no competition

(c) Lack of motivation though the firm is in a better financial position to

research and develop there product the monopoly may fail to do so since
there is no competition or a challenging firm.

(d) Consumers‟ exploitation .This is the most notorious practice of

monopoly. This is done through overpricing and price discrimination of
their products.

Price Discrimination

This exists where the same product is sold at different prices to

different buyers. This depends on the tastes and preferences of the
consumers, different periods of the firm, consumers‟ income etc. These
factors will give rise to a demand curve with different elasticities in
different areas in the markets for the firms. Price discriminates is easily
implemental by a monopolists since he controls the whole supply of a
given good.

There are two necessary conduction for price discrimination to take

place:

1. The monopolist must effectively separate markets. If he has not

separated the market the customers in the low price market will buy and
sell the commodities those consumers in the higher price market.
2. The price elasticity of demand for the two markets must be different
so that profitability will be realized. At every price the demand in any
market must be elastic than the other where the low priced market have
a more elastic demand than the high priced market. By selling the
quality dined by the equation MC and MR at different price the
monopolist realizes a higher total revenue and profits, the monopolists
realizes a higher total revenue and profits as compound to charging
uniform prices.

N/B: suppose that a monopolist has two markets M1 and M2 the profit in
each market maximized by equating marginal cost to the corresponding
marginal revenue i.e. In the first market; MR1=MC1 In the second
market; MR2=MC2 That mean monopolist will maximize profit by
equating the common market cost with the individual market revenues
as MC=MR1=MR2

2. Monopolistic Competition

This is a form of imperfect competition which lies between the extremes

of perfect competition and monopoly and includes elements from both
markets. Examples include: restaurants, hair dressers etc Characteristics

1 There are many buyers and sellers in the market

2 The product of the sellers is differential yet very close substitute for
each other

3 There is freedom of entry and exist of firms

4 The goal of the firms is profit maximization both in the short run and
in the long run.

5 The prices of factors of production and technology are given. Under

this competition, each producer sells a product which is to slightly
different from that of the competitor and attempts to emphasize on
differences like packaging and advertisements. This process of creating
the differences is called product differentiation which is aimed at
creating brand loyalty. The firm demand curve will be relatively elastic
since the products sold by the competition will be relatively close
substitutes. Monopolistic firm sells differentiated products therefore
have limited control over the price. They are prices makers since they
can raise their prices without loosing their customers and have to
reduce the prices in order to sell more

Short run equilibrium in monopolistic competition

In Figure 5.5 a firm operating under monopolistic competition makes

supernormal profit in the short run as shown by PCAB. The supernormal
profit will attract new firms into the industry and the surplus profit will
be reduced to normal profit in the along-run as shown in Figure 5.6
A firm in monopolistic competition in the long run will make normal
profit since average revenue will be equal to average cost. The existence
of many brands enhances the consumer choice and ability. However it is
considered wasteful because of existence of excess capacity shown by
(Q2-Q1) which is carried (borne) by the consumer through prices. It is
also in wasteful since the resources that could have been used in
expansions and exploitation of economies of scale are used in
advertising.

3. Oligopoly

This refers to the market structure dominates by large few firms. The
number of sellers (firms) is small enough for other sellers to take
account of each other i.e. if one seller changes his prices or uses non-
price strategies his/her rivals would react. This is called oligopolistic
dependency. Characteristics

1. Contains few firms who produce goods that are substitute but need to
be perfect substitutes.

2 Lies somewhere between extreme of perfect competition are

monopoly.

3 There are barriers to the entry.

4 Decision of the firms are strictly interdependent

5 Sellers agrees on the price or the market share

Forms of oligopoly

(i) Duopoly where market is dominated by two firms

(ii) Pure oligopoly where the products of the few sellers are identical.

(iii) Differentiated oligopoly where products are differentiated in term

of quality packaging etc.

(iv) Collusive oligopoly where the few sellers in the market come
together and make decisions to control the prices, quality and quantity
to be produced.

(v) Non collusive oligopoly where the few sellers determine their prices,
quality and quantity without colluding.

Kinked Demand Curve The interdependence in oligopolistic firms

explains the price rigidity among the firms. The theory of kinked
demanded curve suggests that firms in oligopoly face two sets of demand
curves.

(i) Price increase

(ii) Price reduction which is slightly inelastic

For price increases the firm is an elastic demand curve dd. For price
decreases it is on the inelastic demand curve DD. This means the actual
demand curve for firms is represented by dED. The demand is said to
have a kink at point E associated with the price P1 and quantity Q1. All
firms in the industry are assumed to be in a similar position which
implies that if a firm raises its prices and its competitor fails to follow
suits then, it will loss large sales of revenue. This firm is on the elastic
portion of the demand curve if one firm reduces prices then, its
competitors will have to reduce their price by at least a much or even
more to retain the market share. When the price is lower each firm has
the same market share which implies that the firms are on the inelastic
portion of the demand curve. Collusion will take the form of agreeing the
prices for each market share. This is done in order for the oligopolistic
firms to maximize their joint profits and reduce uncertainty. A form of
open collision is known as a cartel whereby firms produce differently
but act like determinants of price and output. Figure 5.8 shows the
Equilibrium of an oligopolistic firm facing kinked demand curve. The
marginal revenue is discontinuous at the output level where there is a
kink in the demand curve. The kink in the demand curve explains the
nature of the marginal revenue curve. Where at point E and output Q the
marginal revenue curve falls vertically since at the higher price the
marginal revenue curve correspond to less elastic demand curve. The
firm maximizes its profit where the marginal cost is equal to marginal
revenue. It is very likely that the marginal cost curve will cut the
marginal revenue curve between point X and Y which corresponds to the
discontinuous part of marginal revenue curve.
CHAPTER FOUR NATIONAL INCOME ANALYSIS

Definition of National Income

National Income is a measure of the money value of goods and services

becoming available to a nation from economic activities.

It can also be defined as the total money value of all final goods and
services produced by the nationals of a country during some specific
period of time – usually a year – and to the total of all incomes earned
over the same period of time by the nationals.

Different Concepts of National Income

Gross Domestic Product

The money value of all goods and services produced within the country
but excluding net income from abroad.

Gross National Product

The sum of the values of all final goods and services produced by the
nationals or citizens of a country during the year, both within and
outside the country

Net National Product

The money value of the total volume of production (that is, the gross
national product) after allowance has been made for depreciation
(capital consumption allowance).

Nominal Gross National Product

The value, at current market prices, of all final goods and services
produced within some period by a nation without any deduction for
depreciation of capital goods.

Real Gross National Product

This is the national output valued at the prices during some base year or
nominal GNP corrected for inflation.

National Income Accounting

This refers to the measuring of the total flow of output (goods and
services) and of the total flow of inputs (factors of production) that pass
through all of the markets in the economy during the same period. To
see exactly what national income includes, how it is measured, and what
it can tell us, we start with economic models: By economic models we
mean:

‘A simplification of a real world or a practical situation aimed at

explaining that situation within a set of assumptions’

The Circular Flow of Income and Expenditure

This is an economic model illustrating the flow of payments and receipts

between domestic firms and domestic households. The households
supply factor services to the firms. In return, they get factor incomes.
With factor incomes, they buy goods and services from the firms. These
flows can be illustrated diagrammatically as shown in Figure 1.1.

The points at which flows from one sector meets the other sector and
generate other flows are called critical points. In the above diagram, the
critical points are A, B and C. At A, the flow of factor services from the
households sector meets the firm sector and generates the flow of factors
incomes from the firms to the households. At B, the flow of factor
incomes meets the household sector and generates the flow of consumer
spending. At C, the flow of consumer spending meets the firms sector and
generates the flow of goods and services.

Approaches to Measuring National Income

The compilation of national income statistics is a very laborious task.
The total wealth of a nation has to be added up and there are millions of
nationals. Moreover, in order to double check and triple check the
statistics, the national income statistician has to work out the figures out
in three different ways, each way being based on a different aspect. The
three aspects are:

a. The national output: - The creation of wealth by the nation’s industries.

This is valued at factor cost, so it must be the same as b) below.

b. The national income: - The incomes of all the citizens.

c .The national expenditure because whatever we receive we spend, or

lend to the banks to invest it, so that the addition of all the expenditure
should come to the same as the other two figures. Put in its simplest
form we can express this as an identity:

National output = National Income =National Expenditure.

The Circular Flow of Income and Expenditure

i) Using Total Expenditure for Calculating National Income

The expenditure approach centres on the components of final demand
which generate production. It thus measures GDP as the total sum of
expenditure on final goods and services produced in an economy. It
includes all consumers’ expenditure on goods and services, except for
the purchase of new houses which is included in gross fixed capital
formulation. Secondly we included all general government final
consumption. This includes all current expenditure by central and local
government on goods and services, including wages and salaries of
government employees. To these we add gross fixed capital formation or
expenditure on fixed assets (buildings, machinery, vehicles etc) either for
replacing or adding to the stock of existing fixed assets. This is the major
part of the investment which takes place in the economy. In addition we
add the value of physical increases in the stocks, or inventories, during the
course of the year. The total of all this gives us Total domestic
expenditure (TDE). We then add expenditure on exports to the TDE and
arrive at a measure known as Total Final Expenditure. It is so called
because it represents the total of all spending on final goods. However,
much of the final expenditure is on imported goods and we therefore
subtract spending on imports. Having done this we arrive at a measure
known as gross domestic product at market prices. To gross domestic
product at market price we subtract the taxes on expenditure levied by
the government and add on the amount of subsidy. When this has been
done we arrive at a figure known as Gross Domestic Product at factor
cost. National Income however is affected by rent, profit interest and
dividends paid to, or received from, overseas. This is added to GDP as
net property income from abroad. This figure may be either positive or
negative. When this has been taken into account we arrive at the gross
national product at factor cost. As production takes place, the capital
stock of a country wears out. Part of the gross fixed capital formation is
therefore, to replace worn out capital and is referred to as Capital
Consumption. When this has been subtracted we arrive at a figure known
as the net national product. Thus, summarizing the above, we can say:
Y = C + I + G + (X – M)

Calculating national income from total expenditure

Expenditure of Consumers 1999

Food 27,148

Alcoholic drink 13,372

Tobacco 6,208

Housing 27,326

Fuel and light 9,395

Clothing 12,114

Household goods and services 12,274

Transport and communications 31,475

Recreation 16,541

Other goods and services 23,356

Total 179,209

Less: Adjustment of non-profit (443)

making bodies

178,766
Add: Expenditure of non-profit 3,661
making bodies

182,427

Central Government expenditure 40,623

Local Government expenditure 25,236

Capital formation 49,559

Growth in stocks 267

Total Domestic expenditure at 298,112

market prices

Deduct: Taxes on expenditure 49,865

 248,247

Add: Net result exports-imports 3,186

Subsidies 1,948 11,190

259,437

Less: Estimated depreciation on 36,490

capital assets

222,947m
(ii) Using Factor Incomes for Calculating National Income

A second method is to sum up all the incomes to individuals in the form

of wages, rents, interests and profits to get domestic incomes. This is
because each time something is produced and sold someone obtains
income from producing it. It follows that if we add up all incomes we
should get the value of total expenditure, or output. Incomes earned for
purposes other than rewards for producing goods and services are
ignored. Such incomes are gifts, unemployment or relief benefits, lottery,
pensions, and grants for students etc. These payments are known as
transfer income (payments) and including them will lead to double
counting. The test for inclusion in the national income calculation is
therefore that there should be a “quid pro quo” that the money should
have been paid against the exchange of a good or service. Alternatively,
we can say that there should be a “real” flow in the opposite direction to
the money flow. We must also include income obtained from subsistence
output. This is the opposite case from transfer payments since there is a
flow of real goods and services, but no corresponding money flow. It
becomes necessary to “impute’’ values for the income that would have
been received. Similarly workers may, in addition to cash income,
receive income in kind; if employees are provided with rent free housing,
the rent which they would have to pay for those houses on the open
market should, in principle, be “imputed” as part of their income from
employment. The sum of these incomes gives gross domestic product
GDP. This includes incomes earned by foreigners at home and excludes
incomes earned by nationals abroad. Thus, to Gross Domestic Income we
add Net property Income from abroad. This gives Gross National Income.
From this we deduct depreciation to give Net National Income.
Country Y National Income rewards to 1999
factors (in £ millions)

Incomes from employment

Wages and salaries 143,348

Pay in cash and kind of HM Forces 3,121

Employers’ contribution to National Health 10,632

Insurance

Employers’ contribution to other funds 12,971

170,072

Income from self-employment 23,123

Other Incomes

Profits of companies 41,530

Surpluses of public corporations 9,661

Surpluses of other public enterprises (-) (109)

Rent 17,424
Imputed charge for consumption of capital 2,456

264,157

Less: Stock appreciation (4,326)

259,831

Add: net property income from abroad 1,948

261,779

Less: Residual error 2,342

Estimated depreciation on capital assets 36,490 (38,832)

222,947m
Note: The residual error is a small error (about 1%) in the collection of
these figures.

(iii) Using the National Output for Calculating National Income

A final method which is more direct is the “output method” or the value
added approach. This involves adding up the total contributions made by
the various sectors of the economy. “Value Added” is the value added by
each industry to the raw materials or processed products that it has
bought from other industries before passing on the product to the next
stage in the production process. This approach therefore centres on final
products. Final products will include capital goods as well as consumer
goods since while intermediate goods are used up during the period in
producing other goods; capital goods are not used up (apart from “wear
and tear” or depreciation) during the period and may be thought of as
consumer goods “stored up” for future periods. Final output will include
“subsistence output”, which is simply the output produced and consumed
by households themselves. Because subsistence output is not sold in the
market, some assumption has to be made to value them at some price.
We also take into account the final output of government, which provides
services such as education, medical care and general administrative
services. However, since state education and other governmental
services are not sold on the market we shall not have market prices at
which to value them. The only obvious means of doing this is to value
public services at what it costs the government to supply them that is, by
the wages bill spent on teachers, doctors, and the like. When calculating
the GDP in this matter it is necessary to avoid double counting.
Country Y National Product by 1999
industry (£ millions)

Agriculture 5,535

Energy and water supply 29,645

Manufacturing 2,258

Construction 5,319

Distribution, hotels, catering, repairs 35,002

Transport 1,543

Communications 7,092

Insurance, banking and finance 31,067

Ownership of dwellings 15,761

Public administration, defence and 8,027

social security

Public health and education services 24,021

Other services 16,415

Total domestic output 271,685

Deduct: Residual error 2,342

Adjustment for financial services 11,854

Estimated depreciation on capital 36,490 - 50,686

assets

Add: Net property income from abroad 220,990

1,948

Aggregate net national product 222,947 m

Difficulties in Measuring National Income

National income accounting is faced with several difficulties. These are:

a. What goods and services to include

Although the general principle is to take into account only those

products which change hands for money, the application of this principle
involves some arbitrary decisions and distortions. For example, unpaid
services such as those performed by a housewife are not included but
the same services if provided by a paid housekeeper would be.

Many farmers regularly consume part of their produce with no money

changing hands. An imputed value is usually assigned to this income.
Many durable consumer goods render services over a period of time. It
would be impossible to estimate this value and hence these goods are
included when they are first bought and subsequent services ignored.
Furthermore, there are a number of governmental services such as
medical care and education, which are provided either 'free' or for a
small charge. All these provide a service and are included in the national
income at cost. Finally, there are many illegal activities, which are
ordinary business and produce goods and services that are sold on the
market and generate factor incomes.

b. Danger of Double Counting

The problem of double counting arises because of the inter-relationships
between industries and sectors. Thus we find that the output of one
sector is the input of another. If the values of the outputs of all the
sectors were added, some would be added more than once, giving an
erroneously large figure of national income. This may be avoided either
by only including the value of the final product or alternatively by
summing the values added at each stage which will give the same result.

Some incomes such as social security benefits are received without any
corresponding contribution to production. These are transfer payments
from the taxpayer to the recipient and are not included. Taxes and
subsidies on goods will distort the true value of goods. To give the
correct figure, the former should not be counted as an increase in
national income for it does not represent any growth in real output.

c. Inadequate Information

The sources from which information is obtained are not designed

specifically to enable national income to be calculated. Income tax
returns are likely to err on the side of understatement. There are also
some incomes that have to be estimated. Also, some income is not
recorded, as for example when a joiner, electrician or plumber does a
job in his spare time for a friend or neighbour. Also information on
foreign payments or receipts may not all be recorded.

Factors affecting the size of a National Income

The size of a nation’s income depends upon the quantity and quality of
the factor endowments at its disposal. A nation will be rich if its
endowments of natural resources are large, its people are skilled, and it
has a useful accumulation of capital assets. The following points are of
interest:
a) Natural Resources These include the minerals of the earth; the
timber, shrubs and pasturage available; the agricultural potential
(fertile soil, regular rainfall, temperature or tropical climate); the fauna
and flora; the fish; crustacea etc of the rivers and sea; the energy
resources, including oil, gas, hydro-electric, geothermal, wind and wave
power.

b) Human Resources

A country is likely to prosper if it has a large population; literate and

numerate sophisticated and knowledgeable about wealth creating
processes. It should be well educated and skilled, with a nice mixture of
theory and practice. It should show enterprise, being inventive,
energetic and determined in the pursuit of a better standard of living.

c) Capital Resources

A nation must create and then conserve capital resources. This includes
not only tools, plant and machinery, factories, mines, domestic
dwellings, schools, colleges, etc, but a widespread infrastructure of
roads, railways, airports and ports. Transport creates the utility of
space. It makes remote resources accessible and high-cost goods into
low-cost goods by opening up remote areas and bringing them into
production.

d) Self-sufficiency

A nation cannot enjoy a large national income if its citizens are not
mainly self-supporting. If the majority of the enterprises are foreign –
owned there will be a withdrawal of wealth in the form of profits or
goods transferred to the investing nation.
e)Political Stability

Uses of national income figures

We need national income statistics to measure the size of the "National

cake' of goods and services available for competing uses of private
consumers, government, capital formation and exports (less imports).

National Income statistics are also used in comparing the standard of

living of a country over time

And also the standards of living between countries.

National Income Statistics provide information on the stability of

performance of the economy over time e.g. a steadily increasing income
would be indicative of increasing national income.

If National Income Statistics are disaggregated it would enable us to

assess the relative importance of the various sectors in the economy.
This is done by considering the contribution of the various sectors to
Gross National Product over time. Such information is crucial for
planning purposes for it reveals to planners where constraints to
economic development lie. It therefore becomes possible to design a
development strategy that eventually would overcome these problems.
This central contribution could be in the form of employment or the
production of goods and services

National Income Statistics also help in estimating the saving potential

and hence investment potential of a country.
By assessing exports and imports as a percentage of Gross national
Product i.e. using national statistics, it is possible to determine the
extent to which a country depends on external trade.

National Income and Standards of Living

Standard of living refers to the quantity of goods and services enjoyed by

a person. These goods may be provided publicly, such as in the case of
health care or education or they may be acquired by direct purchase. It
also includes the less easily quantifiable aspects of living such as terms
and conditions of employment and general living environment.

National Income figures can be used to measure the standard of living at

a particular point of time and over time. This is done by working out the
per capita income of the country. By per capita income we mean: the
value of goods and services received by the average man. Per capita
income is obtained by dividing the National Income by the Total
population. If the per capita income is high, it can be deduced that the
standard of living is high.

Problems of using per capita income to compare standard of living over

time

1) The composition of output may change. e.g. more defence-related

goods may be produced and less spent on social services, more producer
goods may be made and less consumer goods, and there may be a
surplus of exports over imports representing investment overseas.
Standards of living depend on the quantity of consumer goods enjoyed.

2) Over time prices will change. The index of retail prices may be used to
express the GNP in real terms but there are well known problems in the
use of such methods.
3) National Income may grow but this says nothing about the
distribution of that income. A small group may be much better off. Other
groups may have a static standard of living or be worse off.

4) Any increase in GNP per capita may be accompanied by a decline in

the general quality of life. Working conditions may have deteriorated.
The environment may have suffered from various forms of pollution.
These non-monetary aspects are not taken into account in the estimates
of the GNP.

5) Finally the national income increases when people pay for services
which they previously carried out themselves. If a housewife takes an
office job and pays someone to do her housework, national income will
increase to the extent of both persons' wages. Similarly a reduction in
national income would occur if a man painted his house rather than
paying a professional painter to do the same. Changes of the above type
mean that changes in the GNP per capita will only imperfectly reflect
changes in the standard of living.

Per Capita income and International Comparisons

Per capita income figures can also be used to compare the standards of
living of different countries. Thus if the per capita income of one country
is higher than that of another country, the living standard in the first
country can be said to be higher. Such comparisons are made by aid
giving international agencies like the United Nations and they indicate
the relevant aid requirements of different countries.

But there are major problems in using real income per head (per capita
income) to measure the standard of living in different countries. First
there is the whole set of statistical problems and, secondly, there are a
number of difficult conceptual problems or problems of interpretation.
i. Inaccurate estimates of population: The first statistical problem in
calculating income per head particularly in less developed countries is
that we do not have very accurate population figures with which to
divide total income.

ii. Specific items which are difficult to estimate: Another data problem, as
already mentioned, is that data for depreciation and for net factor
income from abroad are generally unreliable. Hence although we should
prefer figures for “the’ national income, we are likely to fall back on GDP,
which is much less meaningful figure for measuring income per head.
Inventory investment and work-in-progress are also difficult items to
calculate.

iii. Non-marketed subsistence output and output of government: some

output like subsistence farming and output of government are not sold
in the market. These are measured by taking the cost of the inputs. In
one country, however, salary of doctors for instance, might be higher
and their quality low compared to another country. Although the
medical wage bill will be high, the "real consumption” of medical care in
the former might be lower. Since “public consumption” is an important
element in national income, this could affect comparisons considerably.

Also in making international comparisons it is assumed that the

complied national income figures of the countries being compared are
equally accurate. This is not necessarily the case. If, for example, in one
country there is a large subsistence sector, a lot of estimates have to be
made for self-provided commodities. The national figures of such a
country will, therefore, be less accurate than those of a country whose
economy is largely monetary or cash economy.
iv. Different degrees of income distribution: If the income of one country
is evenly distributed, the per capita income of such a country may be
higher than that of another country with a more evenly distributed
income, but this does not necessarily mean that most of its people are at
a higher living standard.

v. Different Types of Production: If one country devotes a large

proportion of its resources in producing non-consumer goods e.g.
military hardware, its per capita income may be higher than that of
another country producing largely consumer goods, but the standard of
living of its people will not necessarily be higher.

vi. Different forms of Published National Income figures: The per capita
income figures used in international comparisons are calculated using
the published figures of national income and population by each
country. For meaningful comparisons, both sets of national income
figures should be in the same form i.e. both in real terms or both in
money terms, the latter may give higher per capita income figures due to
inflation, and thus give the wrong picture of a higher living standard. On
the other hand, if both sets are in money terms the countries being
compared should have the same level of inflation. In practice, this is not
necessarily the case.

vii. Exchange Rates: Every country records its national income figures in
its own currency. To make international comparisons, therefore, the
national income figures of different countries must have been converted
into one uniform currency. Using the official exchange rates does this.
Strictly speaking, these apply to internationally traded commodities,
which normally form a small proportion of the national production. The
difficulty is that these values may not be equivalent in terms of the goods
they buy in their respective commodities i.e. the purchasing power of the
currencies may not be the same as those reflected in the exchange rate.
viii. Difference in Price Structures: Differences in the relative prices of
different kinds of goods, due to differences in their availability, mean
that people can increase their welfare if they are willing to alter their
consumption in the direction of cheaper goods. The people in poor
countries probably are not nearly as badly off as national income
statistics would suggest, because the basic foodstuffs, which form an
important part of their total consumption, are actually priced very low.

ix. Income in relation to Effort: The first conceptual problem in

calculating income per head is to look at goods and services produced in
relation to the human effort that has gone into producing them.
Obviously if people work harder, they will be able to get more goods; but
they may prefer the extra leisure. Indeed, the amount of leisure that
people want depends in part on their level of income. Strictly, therefore,
we should take income per unit of labour applied. It is largely because
this would be statistically awkward that economists prefer to take real
income per head.

x. Differences in size: A problem which is both conceptual and statistical

is due to the transport factor. If two countries are of different sizes, the
large country may devote a large proportion of its resources in
developing transport and communication facilities to connect the
different parts of the country. This will be reflected in its national
income, but the standard of living of its people will not necessarily be
higher than that of smaller country, which does not need these facilities
to the same extent.
xi. Differences in Taste: Another formidable difficulty is that tastes are
not the same in all countries. Also in different countries the society and
the culture may be completely different thus complicating comparisons
of material welfare in two countries. Expensive tastes are to some extent
artificial and their absence in poor countries need not mean a
corresponding lack of welfare. Tastes also differ as regards the emphasis
on leisure as against the employment of the fruit of labour: if in some
societies people prefer leisure and contemplation, who is to say this
reduces their welfare as compared to those involved in the hurly-burly
of life and labour in modern industry?

xii. Different climatic zones: If one country is in a cold climate, it will

devote a substantial proportion of its resources to providing warming
facilities, e.g. warm clothing and central heating. These will be reflected
in its national income, but this does not necessarily mean that its people
are better off than those in a country with a warm climate.

xiii. Income per head as index of economic welfare: We cannot measure

material welfare on an arithmetic scale in the same way as we measure
real income per head. For instance, if per capita income increases,
material welfare will increase; but we cannot say by how much it has
increased, and certainly that it has increased in proportion.

Consumption, Saving and Investment

Aggregate Demand

This refers to the total planned or desired spending in the economy as a

whole in a given period. It is made up of consumption demand by
individuals, planned investment demand, government demand and
demand by foreigners of the nations output.
The Consumption Function

The consumption function is the relationship expressed in mathematical

or diagrammatic form] between planned consumption and other
independent variables, particularly income.

The consumption function is one of the most important relations in

Macro-economics. Consumption is the largest single component of
aggregate expenditure and if we are to predict the effects of income and
employment of variations in private investment and in government
spending, we must know how consumption varies in response to
changes in income. Thus it is important to take a closer look at the
consumption.

Other Determinants

1. Rate of Interest Is contained in the argument of the classified

economists who argued that rational consumers will save more and
consume less if the rate of interest is high.

2. Relative Prices Influences the aggregate consumption. If relative prices

are high, the level of consumption will be low

3. Capital Gains Keynes observed that there is a possibility of windfall

gains or losses influencing consumption. He says consumption of the
wealth owning group may be extremely susceptible to unforeseen
changes in the money value of their wealth. This is true of the stock
minded speculative economy.

4. Wealth The possession of liquid assets influences the amount that you
have to save.
It stems from the Diminishing Marginal Utility of Wealth.The larger the
stock of wealth, the lower its Marginal Utility and consequently the
weaker the desire to add to future wealth by curtailing present
consumption. In this case, the more wealth an individual has, the weaker
will be the desire to accumulate still more savings at that particular
time.

5. Money Stock or Liquid Assets: Possession of liquid assets boosts

consumption in that they can be changed into cash and thus consumed.

6. Availability of Consumer Credit: Normally influences spending of the

consumer of durables.

7. Attitudes and Expectations of the Consumer A change in the consumer

attitudes will affect consumer behavior. The expectations attained by the
consumer about income increases will affect the consumer behaviour. If
in the face of price increases they expect further price increases; they
shall increase their purchases further.

N/B. These things might be true of an individual, but not the [aggregate]
society.

8. The money Illusion Some people look at money at the face value.
Consumption will be affected if customers are subject to money illusion.
The phenomenon of Money illusion occurs when despite proportional
changes in the prices of goods and services and then their money
incomes which keeps real incomes unchanged; consumers make a
change in their real consumption pattern. It is known as Pigou Effect
which talks of real balance. With a change in nominal income, people
behave in the same way as though their real income has gone up.
Suppose price and Money Income increases by 10%, for the families
which regard their real income unchanged and do not suffer from money
illusion they would take their real incomes as unchanged and would only
increase their consumption by 10%.

9. Distribution of Income If the Marginal Propensity to consume among

the poor is high, then redistribution of wealth from the rich to the poor
leads to higher consumption.

10. Composition of the Population: In sex and age.

Determination of Equilibrium National Income

National income is said to be in equilibrium when there is no tendency

for it either to increase or for it to decrease. The actual National Income
achieved at that point is referred to as the equilibrium National Income.

For there to be equilibrium, firm spending must be equal to firm’s

receipts. If this were not the case, the firms will receive less and lose
money until there is no more money in the system. Hence, for there to be
equilibrium:

Factor Incomes = Consumer Spending

A mathematical approach to national income equilibrium

Equilibrium analysis also has applications in the area of national

income. A simple Keynesian national income model may be expressed as
follows:

Y = C + IO + GO …………………………………………………… (i)
C = a + bY ……………………………………….ii)

(a > o, o < b < 1)

Y and C are both endogenous variables since they are determined within
the model. Io

And Go, on the other hand, represent exogenously determined

investment and government expenditure respectively. Exogenously
determined variables are those whose values are not determined within
the model. C = a + b Y represents a consumption function where a and b
stand for autonomous consumption and the marginal propensity to
consume, respectively.

If we substitute equation (ii) into (i) we obtain:

Y = a + bY + Io + Go

(1 – b ) Y = a + Io + G

Equilibrium national income is represented by Y.

Y = a + Io + Go ………………………….. (iii)

1–b
The equilibrium level of consumption can be obtained by substituting
equation (iii) into equation (ii).

A numerical example

Assume a simple two sector model where Y = C + I C = a + bY and I = Io.

Assume in addition, that a = 85, b = 0.45 and Io = 55. This implies that Y =
a + bY + Io = 85 + 0.45Y + 55

Y – 0.45Y = 140

0.55Y = 140

Y = 255

This simple model can be extended to include government expenditure

and foreign trade. It may take the following general form:

Y = C +I + G+ (X – M)

Where C = a +bY

And M = mo + mY

Mo represents autonomous imports and m represents induced imports

(imports dependent on _the level of income). Equilibrium national
income in this case is represented by
Y = a + Io + Go+ Xo - Mo

1 – b + mo

Numerical example

Assume that Io = 360, Go= 260, Xo= 320, Mo = 120, a = 210, b = 0.8 and m
= 0.2

The equilibrium level of national income can be computed as follows:

Y = 360 + 260 + 320 + 210 – 120 = 2,575

1 – 0.8 + 0.2

Fluctuations in National Income and the Business Cycles

Business Cycles The business cycle is the tendency for output and
employment to fluctuate around their long-term trends. The figure
below presents a stylised description of the business cycle. The
continuous line shows the steady growth in trend output over time,
while the broken line indicate the actual output over the time period.
Point A represents a slump, the bottom of a business cycle while point B
suggests the economy has entered the recovery phase of the cycle. As
recovery proceeds the output rises to a point C above the trend path; we
call this a boom. Then as the line dips via D towards the trend line with
output growing less quickly during the recovery and least quickly
(perhaps even falling), during a recession.
Causes: There are a number of explanations of the business cycle but
changes in the level of investment seem to be the most likely. In the
simplest Keynesian model an increase in investment leads to a larger
increase in income and output in the short run. Higher investment not
only adds directly to aggregate demand but by increasing income adds
indirectly to consumption demand. A process known as the multiplier.
The reasons for change in investment may be explained as follows. Firms
invest when their existing capital stock is smaller than the capital stock
they would like to hold. When they are holding the optimal capital stock,
the marginal cost of another unit of capital just equals its marginal
benefit, this is the present operating profits to which it is expected to
give rise over its lifetime. This present value can be increased either by a
fall in interest rates at which the stream of expected profits is
discounted or by an increase in the future profit expected. In practice, it
is generally believed that changes in expectations about future profits
are more important than interest rate changes. If real interest rates and
real wages change only slowly, the most important source of short term
changes in beliefs about future profits is likely to be beliefs about future
levels of sales and real output. Other things being equal, higher expected
future output is likely to raise expected future profits and increase the
benefits from a marginal addition to the current capital stock. This kind
of explanation is known as the accelerator model of investment. In this
theory it is assumed that firms estimate future profits by extrapolation of
past growth of output. While constant output growth leads to a constant
rate of growth of capital stock, it takes accelerating output growth to
increase the desired level of investment. Though the accelerator model
is acknowledged to be a simplification of a complex process its
usefulness has been confirmed by empirical research.

Just how firms respond to changes in output will depend on a number of

things including the extent to which firms believe that current growth in
output will be maintained in the future and the cost of quickly adjusting
investment plans. The more costly it is to adjust quickly; the more likely
are firms to spread investment over a long time period.
The underlying idea of the multiplier-accelerator model is that it takes
an accelerating output growth to keep increasing investment, but it must
be noted that once output growth settles to a constant level investment
also becomes constant. Finally if output falls then the level of investment
must fall also.

The limits of the fluctuations around the trend path of output are
referred to as ceilings and floors. If we assume that the circular flow of
income is in equilibrium at less than full employment and there is an
increase in investment, the effect of this will be to raise national income
by more than an equivalent amount because of the effect of the
multiplier. This will in turn produce a more than proportionate increase
in investment because of the effect of the accelerator which will produce
a more than proportionate rise in incomes and so on. This cumulative
growth of income will continue until the economy’s full employment
ceiling is reached. The process then goes into reverse with an
accelerated decline in the absolute level of net investment, followed by a
multiplied reduction in income and so on. The bottom of ‘floor’, of the
recession will come when withdrawals once more equal the reduced
level of injections.
It is argued that modern economies do not fluctuate as much as they did
in the past because of built in stabilizers which operate automatically
and the use of discretionary measures which are available to
governments. The taxation system is said to act as a stabilizer that
operates automatically and the use of discretionary measures which are
available to governments. The taxation system is said to act as a
stabilizer in the following way: As income rises a progressive taxation
system takes larger and larger proportions of that increased income;
when income falls revenue drops more than proportionately. Other
built-in stabilizers are unemployment benefits and welfare payments
because expenditures on these rise and fall with the unemployment rate.
Despite these built-in stabilizers and the actions of government in their
use of discretionary measures to stabilize the economy, the cycle is still
with us as recent experience has demonstrated.

In conclusion, it must be added that the causation of business cycles is a

complex matter and the above is only one of a number of possible
explanations.
CHAPTER FIVE MONEY AND BANKING

Meaning of Money
A standard definition of money is anything generally accepted for
payment of a debt. A debt is an obligation incurred when a business
transaction takes place. Money is a medium of exchange sought for the
purpose of transacting exchange of commodities / services / goods. A
commodity chosen as money cannot be used for other purposes rather
ensuring that business transaction takes place. This then implies that a
commodity taken as money must be universally accepted by the users if
it has to retain its value.

The Historical development of money

For the early forms of money, the intrinsic value of the commodities
provided the basis for general acceptability: For instance, corn, salt,
tobacco, or cloth was widely used because they had obvious value
themselves. These could be regarded as commodity money.

Commodity money had uses other than as a medium of exchange (e.g.

salt could be used to preserve meat, as well as in exchange). But money
commodities were not particularly convenient to use as money. Some
were difficult to transport, some deteriorated overtime, some could not
be easily divided and some were valued differently by different cultures.

As the trade developed between different cultures, many chose precious

metal’s mainly gold or silver as their commodity money. These had the
advantage of being easily recognizable, portable, indestructible and
scarce (which meant it preserved its value over time).
The value of the metal was in terms of weight. Thus each time a
transaction was made, the metal was weighed and payment made. Due to
the inconvenience of weighing each time a transaction was made, this
led to the development of coin money. The state took over the minting of
coins by stamping each as being a particular weight and purity (e.g. one
pound of silver). They were later given a rough edge so that people could
guard against being cheated by an unscrupulous trade filling the edge
down.

It became readily apparent, however, that what was important was

public confidence in the “currency” of money, its ability to run from hand
to hand and circulate freely, rather than its intrinsic value. As a result
there was deliberately reduced below the face value of the coinage.

Any person receiving such a coin could afford not to mind, so long as he
was confident that anyone to whom he passed on the coin would also
“not mind”. Debasement represents an early form of fiduciary issue, i.e.
issuing of money dependent on the “faith of the public” and was resorted
to because it permitted the extension of the supply of money beyond the
availability of gold and silver.

Paper Money

Due to the risk of theft, members of the public who owned such metal
money would deposit them for safe keeping with goldsmiths and other
reliable merchants who would issue a receipt to the depositor. The metal
could not be withdrawn without production of the receipt signed by the
depositor. Each time a transaction was made, the required amount of the
metal would be withdrawn and payment made.
It was later discovered that as long as the person being paid was
convinced the person paying had gold and the reputation of the
goldsmith was sufficient to ensure acceptability of his promise to pay, it
became convenient for the depositor to pass on the goldsmith’s receipt
and the person being paid will withdraw the gold himself. Initially, the
gold would be withdrawn immediately after the transaction was made.
But eventually it was discovered that so long as each time a transaction
was made the person being paid was convinced that there was gold, the
signed receipt could change hands more than once. Eventually, the
receipts were made payable to the bearer (rather than the depositor)
and started to circulate as a means of payment themselves, without the
coins having to leave the vaults. This led to the development of paper
money, which had the added advantage of lightness.

Initially, paper money was backed by precious metal and convertible

into precious metal on demand. However, the goldsmiths or early
bankers discovered that not all the gold they held was claimed at the
same time and that more gold kept on coming in (gold later became the
only accepted form of money). Consequently they started to issue more
bank notes than they had gold to back them, and the extra money
created was lent out as loans on which interest was charged. This
became lucrative business, so much so that in the 18th and 19th
centuries there was a bank crisis in England when the banks failed to
honour their obligations to their depositors, i.e. there were more
demands than there was gold to meet them. This caused the government
to intervene into the baking system so as to restore confidence. Initially
each bank was allowed to issue its own currency and to issue more
currency than it had gold to back it. This is called fractional backing, but
the Bank of England put restrictions on how much money could be
issued.
Eventually, the role of issuing currency was completely taken over by the
Central Bank for effective control. Initially, the money issued by the
Central Bank was backed by gold (fractionally), i.e. the holder had the
right to claim gold from the Central Bank. However, since money is
essentially needed for purchase of goods and services, present day
money is not backed by gold, but it is based on the level of production,
the higher the output, the higher is the money supply. Thus, present day
money is called token money i.e. money backed by the level of output.

The development of money was necessitated by specialization and

exchange. Money was needed to overcome the shortcomings and
frustrations of the barter system which is system where goods and
services are exchanged for other goods and services.

Disadvantages of Barter Trade

1. It is impossible to barter unless A has what B wants, and A wants what

B has. This is called double coincidence of wants and is difficult to fulfill
in practice.

2. Even when each party wants what the other has, it does not follow
they can agree on a fair exchange. A good deal of time can be wasted
sorting out equations of value.

3. The indivisibility of large items is another problem. For instance if a

cow is worth two sacks of wheat, what is one sack of wheat worth? Once
again we may need to carry over part of the transaction to a later period
of time.

4. It is possible to confuse the use value and exchange value of goods and
services in a barter economy. Such confusion precludes a rational
allocation of resources and promotion of economic efficiency.
5. When exchange takes place over time in an economy, it is necessary to
store goods for future exchange. If such goods are perishable by nature,
then the system will break down.

6. The development of industrial economies usually depends on a

division of labour, specialization and allocation of resources on the basis
of choices and preferences. Economic efficiency is achieved by
economizing on the use of the scarcest resources. Without a common
medium of exchange and a common unit of account which is acceptable
to both consumers and producers, it is very difficult to achieve an
efficient allocation of resources to satisfy consumer preferences.

For these reasons the barter system is discarded by societies which

develop beyond autarky to more specialized methods of production. For
such peoples a money system is essential.

Money may be defined as anything generally acceptable in the

settlement of debts.

Types of Money

An incredible diversity of items have served as money at various times

and in various places. However all of these moneys can be classified as
either:

a) Commodity money

b) Flat money
The simplest differentiation between these types of money is that
commodity money has substantial value a part from what it will buy
while flat money is important only because of its uses as money (legal
tender). Ultimately the use of flat money is driven by faith and
acceptability of the item being used. Flat money also depends on
stability of the government that issues it. One can further classify money
into 3 major categories.

a) Real money – full bodied money

b) Token money

c) Representative money

Real money Comprises of items that have intrinsic value. This includes
gold and other precious metals and stones. Even today‟s modern world
settlement of indebtedness between countries is frequently done in gold.
Full bodied money or real money tends to have its monetary value equal
to its component stuff. Its value as a coin is the same as its value as a
metal. Full bodied money is either metallic or represents money.

Token money is an item which is accepted for value in excess of its real /
intrinsic value. This implies that its base is higher that its market value.
It‟s made up of cheap material and its official purchasing power is
higher than the value of its metallic contents. Due to relatively scarce
supply of gold and difficult in dividing into very small units, other coins
of inferior value emerged. Gradually the metal content value of these
coins reduced far below their printed face value e.g. the metal content of
a 5 shilling coin is much less than 5 shilling. These coins however
remains acceptable by the general public because laws have been
enacted making it legally binding for people to accept it for face value.
Token money is said to be a real tender – value of a token money is at the
discretion of currency authority that issues it.
 Representative or optional money Besides currently notes and coins
there are other forms of paper performing the function of money e.g.
cheques, bill of exchange, bank draft, travelers cheques or IOU
documents. These instruments however, not being legal tender can be
refused. They infact represent money lying elsewhere e.g. cheques
represent bank deposit.

Monetary Standards

Refers to the characteristics which must be possessed by money in order

to carry out its functions

There also called the attributes of good money materials. Many

materials in the past have been used as money e.g. cattle/goat skins,
copper, gold, silver, cowry shells etc., but with time those materials have
lost their usefulness as monetary standards. For a material to be used as
a monetary standard it must possess the following characteristics.

1. General acceptability - The material must be acceptable by the public.

This general acceptability should not be tied to alternate uses.

2. Portability material should be portable so that one can transport it

from one point to another without loss or depreciation.

3. Durability - Material should be capable of storage without

depreciation.

4. Homogeneity – Item used should be of the same type and uniform in

quality. It should be capable of being standardized.
5. Divisibility – money material should be capable of being divided
without losing value. The sum of the parts should be equal to the
undivided whole.

6. Cognoscibility – capable of being recognized and not confused with

other materials by touch, hear and see.

7. Stability of value – the money material should be stable in order to

ensure stable prices. The money material should not fluctuate with time.
It should remain constant in terms of value in order to ensure a stable
micro-economic growth.

The Functions of Money

In any society / economy money has five main functions which must be
fully accepted these are: medium of exchange, unit of account, store of
value credit standard and influence to economic activities.

1. Medium of exchange the existence of money gives the consumer

greater freedom of choice that could never ever exist under barter
system. Provided money is generally accepted a person would take in
exchange for goods / services he/she sells since no difficulty will be
encouraged in the use of the money to purchase other goods / services.
Money thus facilitates trade and specializations two key conditions for
economic advancement of any society / nations.

2. Unit of account it is used as a common denominator in which the value

of things can be expressed in the market. It enables a price system to
operate and facilitate the production and exchange of goods. Without
money some other means to measure the value of goods against each
other would have to be used. This may introduce many relative prices
which will be hard to determine.
3. Store of value In a non monetary economy, wealth is measured in
terms of persons tangible possessions e.g. how many cattle one has. Such
wealth may be acceptable to others in return for goods / services.
However things like jeweler may be stolen, cattle may die and grains
deteriorate in quality due to passage of time. Thus wealth in these forms
is inherently risky and to a certain extend illiquid i.e. not suitable for
instant transfer or use. In modern economy liquid wealth is held in the
form of money by the use of banks notes and more importantly bank
deposits. This provides a temporarily certainty of purchasing power for
the holder which it is both convenient and certain. It facilitates savings
which is essential for economic progress of any nation. Before money is
accepted as a store of value two conditions must be satisfied.

a) Money must retain its value otherwise people will get rid of it in
exchange of real commodities.

b) Goods and services must be available in the future. If there is no

guarantee of goods and services in the future individuals will want to
acquire these now instead thus money will loose its function as store of
value.
4. Credit standard The existence of money is essential to the modern
systems of production which depends upon the granting of credit to
those who undertake the manufacturing of goods in expectation of sales.
It enable capital investment (acquisition of plant and machinery) to take
place. A manufacturer can thus borrow funds to purchase raw materials,
machinery and hire labour to produce in order to sale later in the
market. The resultant receipt (money) being used to repay the loans.
Thus where a person borrows or enters a contract involving some future
form of payments this will be expressed in money terms. Thus the
effective and efficient use of money as a credit standard requires it not to
loose its value due to inflation. When money is falling in value
borrowers‟ gain at the expense of lenders because this money is worth
more than tomorrow‟s money. Consequently borrowing cannot be
encouraged unless savers in the economy demand high interest rates for
the use

of their funds. Otherwise savers could spent or invest in commodities

less likely to loose value than money. Such actions tend to make inflation
worse. During deflation the opposite occurs, prices fall and the value of
money rises and as a result there is reluctance to borrow and spent
which accelerates the price fall and lowers the levels of economic
activity to a country.
5. Influence on economic activity Money has a dynamic function in that a
government by controlling its supply may influence the level of
economic activity (employment, output and prices). The dynamic
function of money arises from the fact that it represents purchasing
power which when exercised stimulates producing of goods / services.
The regulation of money supply may be used by government to achieve
specific economic objectives e.g. full employment and price stability. It‟s
important to appreciate that money markets and price mechanism
determine the allocation and utilization of resources in both developed
and developing economies. Money also facilitates the payment of taxes
implying it‟s an indispensable tool for a modern state / nation.

Gresham’s Law

It states that “bad money drives out good money”. People tend to hold
new money as they spend the old one. They consider the new money to
have some form of utilities by having it. This because the old money is
either mutilated or debased to an extend that individuals start lacking
confidence in the old money. Hence central monetary authority is
expected to ensure that the dirty money is removed from circulation.
Gresham law is applicable majorly in the cross border trade where old
coins and notes tend to be scarcely used for facilitating exchange. The
old notes seize to be acceptable for international payment. A major
reason why people then hold new coins is to use the new money to pay
for foreign indebtedness. This then makes new money to disappear from
the domestic markets leaving the old money.

i. Demand for money The demand for money is a more difficult concept
than the demand for goods and services. It refers to the desire to hold
one’s assets as money rather than as income-earning assets (or stocks).
Holding money therefore involves a loss of the interest it might
otherwise have earned. There are two schools of thought to explain the
demand for money, namely the Keynesian Theory and the Monetarist
Theory.

The demand for money and saving The demand for money and saving are
quite different things. Saving is simply that part of income which is not
spent. It adds to a person’s wealth. Liquidity preference is concerned
with the form in which that wealth is held. The motives for liquidity
preference explain why there is desire to hold some wealth in the form
of cash rather than in goods affording utility or in securities. (See pp 18 –
26)

ii. The supply of money Refers to the total amount of money in the
economy.

Most countries of the world have two measures of the money stock –
broad money supply and narrow money supply. Narrow money supply
consists of all the purchasing power that is immediately available for
spending. Two narrow measures are recognized by many countries. The
first, M0 (or monetary base), consists of notes and coins in circulation
and the commercial banks’ deposits of cash with the central banks.

The other measure is M2 which consists of notes and coins in circulation

and the NIB (non-interest-bearing) bank deposits – particularly current
accounts. Also in the M2 definition are the other interest-bearing retail
deposits of building societies. Retail deposits are the deposits of the
private sector which can be withdrawn easily. Since all this money is
readily available for spending it is sometimes referred to as the
“transaction balance”.
Any bank deposit which can be withdrawn without incurring (a loss of)
interest penalty is referred to as a “sight deposit”.

The broad measure of the money supply includes most of bank deposits
(both sight and time), most building society deposits and some money-
market deposits such as CDs (certificates of deposit).

Legal Tender Legal tender is anything which must be by law accepted in

settlement of a debt. Determinants of the money supply Two extreme
situations are imaginable. In the first situation, the money supply can be
determined at exactly the amount decided on by the Central Bank. In
such a case, economists say that the money supply is exogenous and
speak of an exogenous money supply.

In the other extreme situation, the money supply is completely

determined by things that are happening in the economy such as the
level of business activity and rates of interest and is wholly out of the
control of the Central Bank. In such a case economists would say that
there was an Endogenous money supply, which means that the size of
the money supply is not imposed from outside by the decisions of the
Central Bank, but is determined by what is happening within the
economy.

In practice, the money supply is partly endogenous, because commercial

banks are able to change it in response to economic incentives, and
partly exogenous, because the Central Bank is able to set limits beyond
which the commercial banks are unable to increase the money supply.

Measurement of changes in the value of money

Goods and services are valued in terms of money. Their prices indicate
their relative value. When prices go up, the amount which can be bought
with a given sum of money goes down; when prices fall, the value of
money rises; and when prices rise, the value of money falls. The
economist is interested in measuring these changes in the value of
money.

The usual method adapted to measure changes in the value of money is

by means of an index number of prices i.e. a statistical device used to
express price changes as percentage of prices in a base year or at a base
date.

Preparation of Index Numbers

A group of commodities is selected, their prices noted in some particular

year which becomes the base year for the index number and to which
the number 100 is given. If the prices of these commodities rise by 1 per
cent during the ensuing twelve months the index number next year will
be 101. Examples of Index Number are Cost-of Living-Index, Retail Price
Index, Wholesale Price Index, Export Prices Index, etc.

Problems of Index Numbers

The construction of Index Numbers presents some very serious

problems and, as they cannot be ideally solved, the index numbers by
themselves are limited in their value and reliability as a measurement of
changes in the level of prices. The problems are:

a) The problems of weighting

The greatest difficulty facing the compiler of index number is to decide
on how much of each commodity to select. This is the problem of
weighting. Different “weights” will yield different results.

b) The next problem is to decide what grades and quantities to take into
account. By including more than one grade an attempt is made to make a
representative selection. An even greater difficulty occurs when the
prices of a commodity remain unchanged, although the quantity has
declined.

c) The choice of the base year. This would preferably be a year when
prices are reasonably steady, and so years during periods either of
severe inflation or deflation are to be avoided.

d) Index numbers are of limited value for comparisons over long periods
of time because:

-New commodities come on the market.

-Changes in taste or fashion reduce the demand for some commodities

and increase the demand for others.

-The composition of the community is likely to change.

-Changes may occur in the distribution of the population among the

various age groups.

- The rise in the Standard of living.

e) Changes in the taxation of goods and services affect the index.

The Banking System

Consists of all those institutions which determine the supply of money

The main element of the Banking System is the Commercial Bank (in
Kenya). The second main element of Banking System is the Central Bank
and finally most Banking Systems also have a variety of other specialized
institutions often called Financial Intermediaries.

Commercial Banks

These are financial are financial institutions that accept deposits of

money from the general public, safeguard the deposits and make them
available to their owners when need arises. Commercial banks operate
under the Banking Act 1968 Functions of Commercial Banks

1. Accepting deposits for safe keeping and for interest

2. Collecting money on behalf of customers and credit this money in

customers’ accounts

3. Transferring of money from individual to another person’s accounts

through credit transfer.

4. Supply of foreign currency are obtainable at commercial banks

5. Lending money, banks lend loans to customers from which they earn
interest

6. Facilitate international trade by issuing letter of credit and undertake

foreign exchange transactions on behalf of their customers
7. Act as trustees and executives of wills if one wants to make a will
he/she writes and appoints a commercial bank as the trustee and
executor of the will

8. Provision of safer keeping of valuables like title deeds, gold

certificates etc

9. Making decision affecting development. Before advancing loans to

prospective customer, commercial banks are very careful and strict so as
to give loans to investment in viable sector of the economy

Role of commercial banks in a country’s economy

i) Exchange and trade: commercial banks facilitate the process of

exchange through lending; commercial banks create additional deposits,
which form part of the total money supplies in the economy. By use of
cheques, holders of demand deposits accounts are able to transact
business and exchange goods and services. By providing overdraft
facilities, and letters of credit, commercial banks facilitate and increase
the speed of commercial and industrial activities. International
exchange is similarly enhanced.

ii) Intermediaries: commercial banks connect savers of surplus funds to

borrowers. They (banks) play the role of “middlemen” in the lending-
borrowing cycle. By so doing, commercial banks relieve savers of the
risk of loss, which may result when borrowers default in paying their
loans. If savers were to lend individually and directly to borrowers, they
would have to carry the risk of possible loss personally.
iii) Economies if scale: Commercial banks provide the necessary savings
and investment economies of scale. By aggregating individual savings
into commercial banks. Large enterprises like hotels, heavy machinery,
like shipping lines, oil drilling and many more would have been very
difficult if investors were to rely on personal savings. It can be said
therefore, that commercial banks play an important role in the process
of capital formation. It can be said that commercial banks harness
society‟s saving potential and direct these savings to infrastructure and
capital assets, they become key agents of capital formation and
economic development.

iv) Safety: Commercial banks are also used as “strong boxes” for keeping
valuable assets in safety. Many rich people deposit jewellery, documents
and other valuables with commercial banks for safety. Money is
sometimes deposited into banks for no other objective than safekeeping.
Sometimes, it is the main consideration in the minds of users of banks.

(v)They lend money to borrowers partly because they charge interest on

the loans, which is a source of income for them, and partly because they
usually lend to commercial enterprises and help in bringing about
development

(vi)They provide safe and non-inflationary means for debt settlements

through the use of cheques, in that no cash is actually handled. This is
particularly important where large amounts of money are involved.

(vii)They act as agents of the central banks in dealings involving foreign

exchange on behalf of the central bank and issue travelers’ cheques on
instructions from the central bank.

(viii)They offer management advisory services especially to enterprises

which borrow from them to ensure that their loans are properly utilized.
The Central Bank

It was established by Central Bank Act 1966 and the Banking Act 1968.
The management and policy decisions are entrusted to the Board of
Directors, comprising of seven members including the governor, deputy
governor, and permanent secretary to treasury. The governor is the
executive head of the bank. The Central Bank is entrusted with the
responsibility of maintaining economic stability and financial soundness
of a country. It is therefore entrusted with two objectives:

a) Responsibility of maintaining financial soundness of the economy.

The bank has therefore to identify gaps in financial markets and seek
solutions to these gaps. The central bank is the governing authority of
the financial system of any country. It is the apex of financial system and
is responsible for ensuring the smooth working of the banking sector
and other financial institutions.

b) To act as a commercial bank. It therefore has to operate profitably

when offering services to different parties. The Central Bank acts as a
lender of last resort to commercial banks.

c) Issuer of currency notes and coins. The central Bank is the only legal
institution that is authorized to issue legal tender.
d) Implementation of the monetary policy. The monetary policy is the
regulation of the economy through changes in money supply, interest
rates and exchange rate. Lower interest rates resulting from increased
money supply, will encourage investment and consumption. Lower
interest rates will however, result in capital outflows hence depreciation
of the currency. The fall in external value of the country‟s currency
makes exports more competitive and imports more expensive. On the
whole consumption, investments and net exports will raise hence
promoting employment. Higher interest rates resulting from a reduction
in money supply will produce opposite effects; fall in consumption,
investment and net exports.

e) Government banker. The central Bank acts as bank and custodian of

the government.

(f) Lender of last resort: Commercial banks often have sudden needs for
cash and one way of getting it is to borrow from the central bank. If all
other sources failed, the central bank would lend money to commercial
banks with good investments but in temporary need of cash. To
discourage banks from over-lending, the central bank will normally lend
to the commercial banks at a high rate of interest which the commercial
bank passes on to the borrowers at an even higher rate. For this reason,
commercial banks borrow from the central bank as the lender of the last
resort.

(g)Managing national debt: It is responsible for the sale of Government

Securities or Treasury Bills, (h) Banking supervision: In liberalized
economy, central banks usually have a major role to play in policing the
economy. he payment of interests on them and their redeeming when
they mature.
(i)Operating monetary policy: Monetary policy is the regulation of the
economy through the control of the quantity of money available and
through the price of money i.e. the rate of interest borrowers will have to
pay. Expanding the quantity of money and lowering the rate of interest
should stimulate spending in the economy and is thus expansionary, or
inflationary. Conversely, restricting the quantity of money and raising
the rate of interest should have a restraining, or deflationary effect upon
the economy.

Non - Banking Institutions

These includes insurance firms, hire purchase companies, building

societies, microfinance institutions etc The Functions of non-bank
financial institutions in the economy

a) They stimulate competition with commercial banks over deposits and

credit markets which lead to enhanced efficiency of services to savers
and borrowers.

b) Enhance the development of the financial markets through the

introduction of a great variety of financial services.

c) Offer credit facilities to risky borrowers at higher rate of interest

whom commercial banks have denied credit

d) Offer financial services which are beyond the scope of commercial

banks such as purchase finance

e) Through the development of the non-bank financial institutions the

government can use them as an additional vehicle for the more effective
execution of monetary policy.
CHAPTER SIX INTERNATIONAL TRADE

Definition: It is the exchange of goods and services between one country

and another. International Trade can be in goods, termed visibles or in
services, termed invisibles e.g. trade in services such as tourism,
shipping and insurance.

Reasons for the Development of International Trade

a. Some goods cannot be produced by the country at all. The country may
simply not possess the raw materials that it requires; thus it has to buy
them from other countries. The same would apply to many foodstuffs,
where a different climate prevents their cultivation.
b. Some goods cannot be produced as efficiently as elsewhere. In many
cases, a country could produce a particular good, but it would be much
less efficient at it than another country.

c. It may be better for the country to give up the production of a good

(and import it instead) in order to specialize in something else. This is in
line with the principle of comparative advantage.

d. In a free market economy, a consumer is free to choose which goods to

buy. A foreign good may be more to his or her liking. This is in line with
the principle of competitive forces and the exercise of choice.

e. Shortages: At a time of high domestic demand for a particular good,

production may not meet this demand. In such a situation, imports tend
to be bought to overcome the shortage.

Advantages and disadvantages of international trade

Theory of Comparative Advantage

In his theory put forward in a book published in 1817, David Ricardo

argued that what was needed for two countries to engage in
international trade was comparative advantage. He believed that 2
countries can still gain, even if one country is more productive then the
other in all lines of production. Using the Labour Theory Value, Ricardo’s
contribution was to show that a sufficient basis for trade was a
difference, not in absolute costs. He illustrated his theory with 2
countries and two commodities, I and II and A and B respectively.

Country Cost of Producing One Unit

(in manhours)
A B

I 8 9

II 12 10

We can observe that country I has complete absolute advantage in the

production of both commodities since it can produce them with a lower
level of resources. Country I is more efficient than country II.

Ricardo believed that even then there could still be a basis for trade, so
long as country II is not equally less productive, in all lines of
production. It still pays both countries to trade. What is important is the
Comparative Advantage. A country is said to have comparative
advantage in the production of a commodity if it can produce at
relatively lower opportunity costs than another country. (The law of
comparative advantage states that a nation should specialize in
producing and exporting those commodities which it can produce at
relatively lower costs, and that it should import those goods in which it is
a relatively high cost producer). Ricardo demonstrated this by
introducing the concept of opportunity cost.

The opportunity Cost of good A is the amount of other goods which have
to be given up in order to produce one unit of the good. To produce a
unit of good A in country I, you need 8 man hours and 9 man hours to
produce good B in the same country. It is thus more expensive to
produce good B then A. The opportunity costs of producing a unit of A is
equivalent to 8/9 units of good B. One unit of B is equal to 9/8 units of A.

In country II, one unit of A is equal to 12/10 of B and one unit of B =

10/12 units of A. Therefore he felt that: -
Opportunity cost of producing one unit of:

A B

Country

I 9/8 (1.25) B 8/9 (0.89) A

II 10/12 (0.83) B 12/10 (1.2) A

B is cheaper to produce in country II in terms of resources as opposed to

producing it in country I. The opportunity costs are thus lower in
country II than in country I.

Consider commodity A valued in terms of B. A cheaper in country I than

country II.

A country has comparative advantage in producing commodity if the

opportunity cost of producing it is lower than in other counties. Country
I has a lower opportunity cost in producing A than B and II has a lower
opportunity cost in the production of B than A. In country I, they should
specialize in the production of A and Import

Limitations of Comparative advantage

This doctrine is valid in the case of a classical competitive market

characterized by a large number of informed buyers and sellers and
homogenous products in each market, with world market places serving
as efficiency determinants for global allocation of resources to their
most suitable uses. Unfortunately, world markets and their prices are
largely inefficient showing influences of trade barriers, discrimination
and market distortions.
Individual countries systematically aim at maximizing their potential
gains from trade rather than with optimizing the allocation of world
resources.

By pursuing gains from trade in the short run young nations may
jeopardize long term development prospects because:

i) It is important to protect infant industries to acquire new skills,

technology and home markets that are necessary in the early years of
industrial development;

ii) Concentrating on short term comparative advantage may lead to

internalizing wrong externalities e.g. promoting use of illiterate
peasants and primary sector production;

iii) Long term movements in commodity terms of trade disfavour

primary commodities as their prices rise more slowly than those of
industrial manufactures (income elasticity of demand for primary
commodities is lower than for manufactures and as world incomes rise
demand for the latter rises more rapidly affecting their relative world
prices).

Gains from International Trade/Advantages

The gains from International trade are to make the participating

countries better of than they would have otherwise been. This will be the
result of a number of advantages which a country can derive from
international trade, namely:

1.The vent-for-“surplus” product

Many countries have products which are surplus to their own
requirements and it is only by exporting these that they have value at all.
Thus, the plantations of coffee in Kenya are only of value because of the
existence of international trade. Without it, the coffee would mainly be
unused and remain unpicked.

Many of the primary products that are exported would be of no use to

the country. Without trade, the land and the labour used for their
production would be idle. Trade therefore gives the country the
opportunity to sell these products and to make use of the available land
and labour.

2.Importation of what cannot be produced

A country has to import what it cannot produce. Certain countries like

Japan and Britain could not manufacture goods without the importation
of most of the raw materials. There is thus necessity for international
trade in respect of these essential materials.

3.Specialization according to absolute advantage

International trade allows a country to specialize in the production of

commodities where it more efficient than other countries. For instance,
if we take a situation in which each country in a simple two country
model has an absolute advantage in producing either fruits or beef but is
able to produce the other commodity only if required (for simplicity we
assume constant returns to scale and full utilization of resources).
Suppose that each country has equal resources and devotes half its
limited resources to citrus fruit and half to beef and the production
totals are:

Units of Citrus fruits Units of beef

Country X 10 5

Country Y 5 10

World total 15 15

The relative or comparative costs of citrus production is lower in

country X than in country Y, but the situation is reserved in the case of
beef production. Country X has an absolute advantage in citrus fruit
production and Y has an absolute advantage in beef production. If each
country specializes in the production of the commodity in which it is
most efficient and possesses absolute advantage, we get:

Units of Citrus fruits Units of Beef

Country X 20 0

Country Y 0 20

World total 20 20

The gains from trade are obvious with five units m ore of fruit and five
more of beef – provided we assume that transport costs are not so
enormous as to rule out gains made.

4.Specialization according to comparative advantage

Even if one country can produce the two goods more efficiently at a
lower comparative cost than the other country, there could be gains to
be made from International Trade. This possibility is explained by the
theory of comparative advantage. Suppose that country X is more
efficient in both citrus fruit and beef production. If each country devoted
half its resources to each, let us imagine the production totals are:

Units of Citrus fruits Units of Beef

Country X 30 60

Country Y 20 10

World total 50 70

Country X possesses an absolute advantage in both industries but

whereas X is only 50% more efficient in the citrus fruit production, it is
six times more efficient in beef production. Even so, if country Y
produces an extra unit of citrus fruit it need give up only half a unit of
beef. In contrast, country X must give up two units of beef to increase
production of citrus fruits by one unit. It is evident from this example
that although a country may have absolute advantage in the production
of all products, it is possible for a country such as Y to produce some
products relatively cheaply at lower opportunity cost than its trading
partner X. When this occurs as in the simple example above then
economists describe X as possessing a comparative advantage in the
production of citrus fruit.

If each country specializes completely in the activity in which it

possesses a comparative advantage, the production totals are:

Units of Citrus fruits Units of Beef

Country X 0 120

Country Y 40 0

World total 40 120

What is evident from these last calculations is that although the overall
production of beef has increased, the output of citrus fruit has fallen by
ten units. Thus we cannot be sure without some knowledge of demand
and the value placed on the consumption of citrus fruit and beef that a
welfare system gain will result from specialization.

4.Competition

Trade stimulates competition. If foreign goods are coming into a

country, this puts home producers on their toes and will force them to
become more efficient.

5.Introduction of new ideas

International trade can introduce new ideas into a participating country;

it can stimulate entrepreneurship and generate social change. This is
especially the case in developing countries where the development of
expert industries can lead to the emergence of a commercial class
desirous of change and opposed to any practice that hold back economic
advancement.

Technological advances can also be introduced into a country as

companies start to base their production in overseas countries.

6.Widening of choice to the consumer

It is undoubtedly a great benefit to be able to buy a wide range of goods
that would not otherwise be available. International trade offers to the
consumer a wider choice. This greater availability of goods may indeed
prove to be of economic advantage. For in a country, producers may only
be prepared to take risks and invest their time and money in a business
if they can spend the resultant income on consumer goods. These may be
imported, especially if the country lacks consumer goods industries – as
in may developing countries. Thus, these imports of consumer goods
provide the incentive for productive effort within the country.

7.Creation and maintenance of employment

Once a pattern of international trade has developed, and countries

specialize in the production of certain goods for export, it follows not
only has that trade created employment in those sectors, but that the
maintenance of that trade is necessary to preserve that employment. In
the modern world with its high degree of interdependence, a vast
number of jobs depend upon international trade.

Restrictions on International Trade

Despite the arguments of the “classical” theory of free trade, the

twentieth century has seen the gradual movement away from free trade,
with governments increasingly imposing restrictions on trade and
capital flows. All have adopted, to varying extents, various forms of
restrictions to protect some of their industries or agriculture.

Reasons for Protection

1. Cheap Labour
It is often argued that the economy must be protected from imports
which are produced with cheap, or ‘sweated”, labour. Some people argue
that buying foreign imports from low wage countries amounts not only
to unfair competition, but continues to encourage the exploitation of
cheap labour in those countries as well as undermining the standard of
living of those in high wage economies.

2. Infant Industry Argument

Advocates of this maintain that if an industry is just developing, with a

good chance of success once it is established and reaping economies of
sale, then is it necessary to protect it from competition temporarily until
it reaches levels of producdton and cost which allow it to compete with
established industries elsewhere, until it can “stand on its own feet”. The
argument is most commonly used to justify the high level of protection
that surrounds the manufacturing industry in developing countries, as
they attempt to replace foreign goods with those made in their own
country (“import substitution”).

3. Structural Unemployment

The decline of the highly localized industry due to international trade

causes great problems of regional (structural) unemployment. If it
would take a long time to re-locate the labour to other jobs, then this can
put the government, under considerable political and humanitarian
pressure, to restrict the imports that are causing the industry to decline.

4. Dumping
If goods are sold on a foreign market below their cost of production this
is referred to as dumping. This may be undertaken either by a foreign
monopolist, using high profits at home to subsidize exports for political
or strategic reasons. Countries in which such products are “dumped” feel
justified in protecting themselves. This is because dumping could result
in the elimination of the home industry, and the country then becomes
dependent on foreign goods which are not as cheap as they had
appeared.

5. Balance of Payments

Perhaps the most immediate reason for bringing in protection is a

balance of payment deficit. If a country had a persistent deficit in its
balance of payments, it is unlikely to be able to finance these deficits
from its limited reserves. If therefore becomes necessary for it adopt
some form of restriction on imports (e.g. tariffs, quotas, foreign exchange
restrictions) or some means of boosting its exports (e.g. export subsidies).

6. Danger of over-specialising

A country may feel that in its long-term interests it should not be too
specialized.
A country may not wish to abandon production of certain key
commodities even though the foreign product is more competitive,
because it is then too dependent on imports of that good. In the future,
its price or supplies may diminish. It is for this reason that countries
wish to remain largely self-sufficient in food. An exporting country may
not wish to become overspecialized in a particular product. Such over
specialization may make sense now, but in the future, demand may fall
and the country will suffer disproportionally. It is for this reason that
many developing countries choose not to rely solely on their
comparative advantage; they wish to diversify into other goods as an:
insurance policy”.

7. Strategic Reasons

For political or strategic reasons, a country may not wish to be

dependent upon imports and so may protect a home industry even if it is
inefficient. Many countries maintain industries for strategic reasons.
The steel industry, energy industries, shipping, agriculture and others
have used this strategic defence argument.

8. Bargaining

Even when a country can see no economic benefit in protection, it may

find it useful to have tariffs and restrictions bargaining gambits in
negotiating better terms with other nations.

Ways of Restricting International Trade

The most common means of restricting international trade is through

import restrictions. The main forms are:
The most common means of restricting international trade is through
import restrictions. The main forms are:

1. Tariffs

This is a tax on each unit imported. The effect of the tax is to raise the
price of imported varieties of a product in relation to the domestically
produced, so that the consumers are discouraged from buying foreign
goods by means of the price mechanism. Such a tax may be ad valorem,
representing a certain percentage of the import price, or specific that is,
an absolute charge on the physical amount imported as, for example, five
shillings a ton.

2. Quotas

The most direct way of offering protection is by limiting the physical

quantity of a good which may be imported. This can be done by giving
only a limited number of import licenses and fixing a quota on the total
amount which may be brought in during the period. The quota may be
imposed in terms of physical quantities or in terms of the value of
foreign currency, so that a maximum of so many “shillings-worth” may
be imported.

3. Foreign exchange restriction

Exchange controls work much the same way as physical controls.
Foreign exchange is not made available for all desired imports. It can be
severely restricted to whatever the government decides it wants to see
imported. Alternatively, the exchange rate may be fixed in such a way as
to “overprice” foreign currency (compared to what would have been the
free market price), so that importers have to pay more for foreign
currency (in terms of domestic currency). This makes all imports dearer
and thus gives protection “across the board” to all domestic production
for the home market.

4. Procurement policies by government

The government itself, together with state corporations, is an important

purchaser of goods; in its “procurement” policies, therefore, it can either
buy goods from the cheapest source, whether domestic or foreign, or it
can give preference to domestic producers. This could amount to a
substantial advantage, or protection.

5. Other restrictions

Governments can devise health or safety requirements that effectively

discriminate against the foreign good. Also where the country has state
import agencies they can choose not to import as much as their citizens
would require. The government can also introduce cumbersome
administrative procedures that make it almost impossible to import.

Arguments against protectionism

Most of the arguments for protectionism may be met with counter

arguments, but underlying the economic arguments as opposed to the
social, moral, political, strategic, etc, is the free trade argument.
1. Free trade argument

This, in brief, maintains that free trade allows all countries to specialize
producing commodities in which they have a comparative advantage.
They can then produce and consume more of all commodities than
would be available if specialization had not taken place. By implication,
any quotas, tariffs, other forms of import control and/or export
subsidies all interfere with the overall advantages from free trade and so
make less efficient use of world resources than would otherwise be the
case.

2. Reduced output argument

It has been said that import controls will protect jobs initially, but not in
the longer run. If we in the home country limit imports, then other
countries will have less of our currency with which to buy our exports.

This will lead to a decline in sales and a loss of jobs in export industries.
The overall effect is likely to be a redistribution of jobs from those
industries in which the country has a comparative advantage to those in
which it has a comparative disadvantage. The net result will be that total
employment is unchanged but total output is reduced.

3. The infant industries seldom grow up

The infant industry argument is sometimes met with the claim that
infant industries seldom admit to growing up and cling to their
protection when they are fully grown up. Most economists, however,
appear to accept the infant industry argument as a valid case for
protection provided it is temporary.

4. Gains from comparative advantage

The argument for protection against low wage foreign labour is partly a
moral argument which is outside the scope of positive economics, but
even the economic part of the argument that it will drag down the living
standards of high wage economies can be shown to be invalid. It is true
as noted above that the payment of low wages will allow a country to
export their goods cheaply and so possibly undercut those of high wage
countries. However, it must be noted that countries importing these
cheap goods gain by virtue of their low cost in terms of the goods
required to be exported in return. This again is another use of the
comparative advantage argument.

5. No Validity in economics

The other arguments such as the need to avoid over dependence on

particular industries and the defence argument are really strategic
arguments which are valid in their own terms and for which economic
science is largely irrelevant.

6. Retaliation

Advocates of free trade also believe that if one country imposes import
restrictions, then those countries adversely affected will impose
retaliatory restrictions on its exports, so it will not end up any better off.
This could lead to a “beggar-my-neighbour” tariff war, which no one can
benefit from, and which contracts the volume of world trade on which
every country’s international prosperity depends.

8. Inflation

If key foreign goods are not free to enter the country (or cost more), this
will raise their prices and worsen the rate of inflation in the country
8. Inefficiency

It is argued that if home industries are sheltered from foreign

competition there is no guarantee that they will become more efficient
and be able to compete in world markets.

Economic integration

It refers to the merging to various degrees of the economies and

economic policies of two or more countries in a given region

1. Free Trade Area:

Exist when a number of countries agree to abolish tariffs, quotas and any
other physical barriers to trade between them, while retaining the right
to impose unilaterally their own level of customs duty, etc, on trade with
the rest of the world.

2. Customs Market

Exists where a number of countries decide to permit free trade among

themselves without tariff or other trade barriers, while establishing a
common external tariff against imports from the rest of the world

3. Common Market

Exists when the countries, in addition to forming a custom union, decide

to permit factors of production full mobility between them, so that
citizens of one country are free to take up employment in the other, and
capitalist are free to invest and to move their capital from one country to
another.
4. Economic union

Is where the countries set up joint economic institutions, involving a

degree of supranational economic decision-making

5. Common Monetary System

Is where countries share a common currency, or ensure that each

national currency can be exchanged freely at a fixed rate of exchange,
and agree to keep any separate monetary policies roughly in line, to
make these possible?

Benefits of integration

The formation of an economic integration could be beneficial in the light

of the following aspects:

1. Enlarged market size: Regional economic blocks provide larger

markets than individual countries. Such increase in size of the market
permits economies of scale, resulting in lower production costs and
expansion of output. In fact, member countries are better placed to
bargaining for better terms of trade with non-member countries.

2. Industrialization: the size of the domestic market of one member

country may not be sufficiently large to justify the setting up of an
industry, whereas the market provided by many countries (regional
market) is much more likely to be an incentive for establishment of new
manufacturing industries, thus what economists consider as potentially
derived industrial development.
3. Infrastructural facilities: Jointly financed infrastructural facilities such
as in the field of transport (e.g. railway systems, ports and habours, and
airlines. The East African Co-operation (EAC), for instance, would reduce
costs by setting up one Development Bank to serve all the three
countries rather than each country maintaining its own.

4. Specialization: Each member country concentrates on production of

those goods which it can produce more efficiently. Surpluses are
exchanged and resources utilization is increased - comparative
advantage.

5. Increased employment opportunities and subsequent reduction in

income inequalities: Free mobility of labour leads to people moving from
areas where incomes are low to areas of high labour incomes. This
becomes even more beneficial if such incomes are invested back in
respective countries. Furthermore, firms will have to pay highly in order
to retain factor services (economic rent), thereby enhancing
productivity.

6. Improvement of balance of payments (BOP): increased market implies

more exports than before and given fairly low priced imports (from
member countries) relative to imports from non-member countries,
balance of payments position is most likely to improve. Foreign
exchange savings also arise from this situation i.e. hard currencies such
as the US dollar will only be required to import what cannot be produced
from within the region.
7. Competitive business environment: Absence of trade barriers allows
for free flow of goods and services which develops an upward pressure
on competition and the driving force for relatively lower prices for
higher quality products. This helps reduce or even eliminate monopoly
practices, since firms can only acquire and maintain a market base by
producing as efficiently as possible. Overall, there is increased variety of
goods and services their consumption of which enhances living
standards/development.

8. Indigenization of economies: Regional governments play their part by

creating the right incentives for the growth of the private sector which is
the prime-mover of economic activities in liberalized situations. The
private sector participation should not be limited to business activities
but should extend to the formation of regional professional and business
associations in order to advise on the influence future co-operation
policies (e.g. the East African Business Council.) This creates more
awareness among potential investors to take advantage of investment
opportunities available within the region to create wealth. This way,
over-reliance on private foreign investments and other forms of capital
inflows (such as conditional Aid from IMF and World Banks) tends to be
reduced.

The African continent regional integrations have not gone far in

realizing the intended objectives due to:
1. Minimal or lack of practical commitment hence the low
implementation of policies and agreements. Policy-induced factors such
as inward looking policies of individual countries could result in the
protection of less or uncompetitive domestic producers against imports
irrespective of resources, and stringent trade and payments controls
instituted to deal with the persistent balance of payments problems
have adversely affected the volume of trade among African countries.

2. Indispensable high capital import content: Most African countries are

not in a position to sufficiently produce capital goods and other inputs
for the production of goods hence continued vulnerability to foreign
influence and dominance. This is traced to widespread poverty and
minimal technical progress.

3. Neo-colonialism and dependence mentality: The psychological

influence arising from massive and persuasive advertising by the
developed world has largely role modeled the consumption pattern
(tastes and preferences) of the African People. Preference has been
given to products which do not originate from within the region. This
then forces regional member countries to import such products in order
to meet their domestic demand.

4. Trade-diversion: countries previously importing cheap goods from

outside the region switch to importing the same goods from other
member countries. This is brought about by the removal of tariffs and
other trade restrictions on the movement of goods between member
states, while the tariffs on goods from outside remain. Depending on
price/cost difference(s) such expenditure –switching may increase
production cost accompanied by negative welfare implications.
5. Government loss of tax revenue: Removal of tariffs (import duties)
leads to reduced tax revenue to the government. With free trade, in
countries where import duties constituted a high proportion of tax
revenue; the government’s spending programmers’ will be distorted.

6. Unequal distribution of trade benefits/gains: Although all countries

gain to a certain extent, one member country may benefit more than the
others. This often arises due to high subsidization of production so that
one country may succeed in attracting a more than proportionate share
of new industrial development. In particular, incomes and employment
opportunities will increase more than proportionately due to the
multiplier effect.

7. Product similarity and duplication: Because of product similarity

(especially primary products), regional member countries have not lived
to substantial benefits as would be required; what one country produces
is equally produced by others so that the overall relative market share
remains distinctively small.

8. Widespread internal conflicts and general political instabilities: the

most immediate result of such an atmosphere is suspicion and increase
of protectionist strategies which no doubt hinders the free movement of
goods and people. This then negates the intention of an economic
integration. Owing to the current political and economic reforms
sweeping across the economies of the developing world, it’s quite
evident that much cannot be done without any form of collective effort.
Economic integration aspect(s) could receive the seriousness deserved
now or in the immediate future. In fact, some which had collapsed or
remained insensitive are getting revived e.g. the East African Co-
operation.

The disadvantages of economic integration

i. The “trade-diversion” effect has already been mentioned. Countries
previously importing cheap goods from outside the free trade area
switch to importing the same goods from other member countries; this
is brought about by the removal of tariffs on goods moving between
member states, while the tariffs on goods from outside remain. The
result is a less efficient use of resources. Furthermore, the goods
produced in the other member states are often of inferior quality to
those formerly imported from outside.

ii. Government suffers a loss of tax revenue from the setting up of a free
trade area. Before a lot of tax revenue was received from import duties
on goods brought into the country from overseas. If goods are imported
from other member states when the free trade area is up, import duties
are no longer payable and tax revenue, the effect on a government’s
spending programme will be substantial.

iii. The benefits arising from a free trade area may be unequally
distributed. Even though all countries gain to a certain extent, one may
benefit more than the others. If one country succeeds in attracting a
more than proportionate share of new industrial development, it will
enjoy more than proportionate economic benefits. In particular, incomes
and employment opportunities will increase more than proportionately
because of the multiplier effect.

Balance of Payments

The Balance of Payments of a country is a record of all financial

transactions between residents of that country and residents of foreign
countries. (Residents in this sense do not just refer to individuals, but
would also include companies, corporations and the government). Thus
all transactions are recorded whether they derive from trade in goods
and services or transfer of capital.
Like all balance sheets, the balance of payments is bound to balance. For
if the country has “overspent”, then it must have acquired the finance for
this “overspending” from somewhere (either by running up debts or
using its reserves), and when this item is included in the accounts they
will balance. It follows therefore that when reference is made to a
balance of payments “deficit” or “surplus”, this only looks at a part of the
total transactions, e.g. that part involving trade in goods and services,
which is termed the “Balance of Payments on the current account”

If the values of exports exceed the value of imports the balance of

payments is said to be in Trade Surplus. This is regarded as a favorable
position because a persistent trade surplus means lower international
debts. Also, a trade surplus is regarded as a sign of success in the
country’s trade with other countries and is, therefore, politically
desirable.

On the other hand, if the values of imports exceed the value of exports,
the balance of payments is in trade deficit. This is an unfavorable
position because a persistent balance of payment trade deficit means the
country’s foreign exchange reserves are being run down and so is its
ability to pay for its imports and settle its international debt. Also
persistent balance of payments trade deficit is regarded as a sign of
failure in the country’s trade with other countries and is therefore
politically undesirable Structure of the Balance of Payments

The balance of payments is divided into three accounts:

a. The Current Account

This records all transactions involving the exchange of currently

produced goods and services and is subdivided into
i Visible:

A record of all receipts from abroad the export of goods and all
expenditures abroad on the import of goods. When these are compared,
this is known as the “balance of trade” (though it would be properly
called the “balance of visible trade”).

ii. Invisibles:

A record of all receipts from abroad in return for services rendered and
all expenditure abroad for foreign services. It also includes receipts of
profits and interest earned by investments abroad, and similarly profits
and interest paid abroad to foreign owners of capital in the country are
included in Expenditure. The comparison of all the debits (Expenditure
abroad) and credits (receipts from abroad) arising from visibles and
invisibles is known as the “balance of payments on current account” and
is the best indicator of the country’s trading position.

If the value of exports exceeds the value of imports the balance of

payments is said to be in trade surplus. This is regarded as a favourable
position because a persistent trade surplus means the country’s foreign
exchange reserves are rising and so its ability to pay for its imports and
settle its international debts. Also a trade surplus is regarded as a sign of
success in the country’s trade with other countries and is, therefore,
politically desirable.
On the other hand, if the value of imports exceeds the value of exports,
the balance of payments is in trade deficit. This is an unfavourable
position because a persistent balance of payments trade deficit means
that the country’s foreign exchange reserves are being run down and so
is its ability to pay for its imports and settle its international debts. Also
a persistent balance of payments trade deficit is regarded as a sign of
failure in the country’s trade with other countries and is therefore
politically undesirable.

b. Capital account

This records all transactions arising from capital movements into and
out of the country. There are a variety of such capital flows recorded,
namely:

Long term capital: is consists of:

(a)Government to Government borrowing and lending

(b)Government borrowing from international organizations

(c) Investment by foreigners at home in such projects as factories, mines

and plantations and by nationals abroad in similar projects.

(d) The buying of shares by foreigners in home companies and by

nationals in foreign companies.
ii. Short term capital (“hot money”)

Refers to changes in bank balances held by foreigners in home banks

and by nationals in foreign banks

If money comes into the country (e.g. deliberate borrowing abroad by a

domestic company or foreign investment in the country), it is recorded
as a credit item, while investments abroad etc is recorded as a debit
item.

When the current account and the capital account are combined, and we
compare the total debits and credits, this is termed the balance for
official financing (it used to be termed the “total currency flow”). This
shows the final net outflow, or inflow arising from current and capital
transactions.

c. The Monetary account

Also called official financing, this comprises the financial transactions of

the government (handled by the central bank) needed to offset any net
outflow of money on the current and capital accounts i.e. total currency
flow. It comprises of:

i. Use of the foreign exchange reserves, i.e. increasing or decreasing

them.

ii. Borrowing from the IMF i.e. borrowing or paying back.

iii. Central bank transactions with other countries central banks i.e.
borrowing or lending.

d. The balancing item

Since forever position entry in the current and capital accounts there is a
corresponding negative entry in the monetary account, and for every
negative entry in the first two accounts there is a corresponding positive
entry in the monetary account, it follows that the balance of payments
must balance i.e. the sum of the balances of all the three accounts must
add up to zero.

In practice, this is usually not the case because there are so many
transactions that take place, and due to human errors some may be
recorded correctly in one account but incorrect in another account with
the result that the sum of the tree balances may not be zero. The actual
discrepancy in the records can be calculated. The balancing item
represents the sum of all errors and omissions. If it is positive, it means
that there have been unrecorded net exports while a negative entry
means that there have been unrecorded net imports.

Equilibrium and disequilibrium in the balance of payments

If on the current account, the value of exports is equal to the value of

imports, the balance of payments is said to be equilibrium. If the two
values are not equal, the balance of payments is in disequilibrium. This
could be due to a trade surplus with the value of exports exceeding that
of imports or due to a trade deficit with the value of imports exceeding
that of exports.

In either case, balance of payments disequilibrium cannot last

indefinitely. For if this is due to a trade deficit, the country will try and
move it. This is because a persistent trade deficit i.e. a fundamental
disequilibrium poses several problems for an economy, namely:
1. In short run a deficit allows a country’s peoples to enjoy higher
standard of living form the additional imports that would not be possible
from that country’s output alone in the longer term the decline of the
country’s industries in the face of international competition will
inevitably result in lower living standards.

2. A persistent trade deficit means that the country’s foreign exchange

reserves are being run down and so it its ability to pay for its imports
and settle international debts.

3. Also, a persistent balance of payments trade deficit is regarded as a

sign of failure in the country’s trade with other countries, and is
therefore not politically desirable.

Policies to cure balance of payment deficits

The measures available to tackle balance of payments deficits include

short term measures such as deflation, import controls, devaluation of a
fixed exchange rate or a managed downward float of the exchange rate
in the short-run and foreign exchange controls and long term measures
such as Export promotion and Import Substitution.

Short-term policies
1. Deflation is a policy of reducing expenditure with the intention of
curing a deficit by reducing the demand for imports. This reduction of
expenditure may be achieved by the use of either fiscal or 2.monetary
policy. In addition to reducing demand for imports however,
deflationary measures may also have expenditure switching effect upon
the balance of payments. The depression of demand may cause the
domestic inflation rate to fall relative to that of competitor countries and
thus increase the price competitiveness of exports. Consumers in other
countries may then switch their demand towards the country’s exports,
whilst its own residents switch away from imports, preferring instead to
buy home produced substitutes. The difficulty posed by deflation is that
it not only reduces demand for imports but also reduces demand for
domestically produced goods. This in turn can have a knock on effect in
the form of lower output and higher unemployment.

3. Import controls have immediate effect on the balance of payments.

Quotas and embargos directly prevent or reduce expenditure on
imports, while import duties or tariffs discourage expenditure by raising
the price of imports, while import duties or tariffs discourage
expenditure by raising the price of imports. Import controls also have
their limitations and problems. They do not tackle the underlying cause
of this disequilibrium i.e. the lack of competitiveness of a country’s
industry and what is more they are likely to invite retaliation to the
long-term detriment of themselves as well as their trading partners. It is
also the case that trade agreements such as GATT limit the opportunities
for member countries to make use of import controls and the use of
subsidies to encourage exports.
4. Devaluation. Devaluation of a fixed exchange rate or the downward
float of a managed exchange rate is mainly expenditure switching in its
effect. The cure works in a similar manner to the freely floating
adjustment mechanism under a floating exchange rate system. In the
case of a fixed exchange rate system devaluation consists of an
administered reduction in the value of the currency against other
currencies. In a managed system the authorities can engineer a
downward float by temporarily reducing their support. In both cases the
effect is to increase the price of imports relative to the price of exports
and so switch domestic demand away from imports and towards home
produced goods.

Certain conditions have to be met for devaluation to have this effect on

boosting exports/curbing imports. They are:

a. Competing countries must not devalue at the same time, otherwise

there would be no competitive advantage gained (exports would not
become any cheaper in comparison with products of those countries).

b. The demand for exports (or for imports) must be price elastic, i.e. the
sales must be affected by the change in price. Thus, when the domestic
currency falls in value, the demand for exports should rise by a larger
proportion in order to earn more foreign exchange.

c. There must be appropriate domestic policy.

i. The extra exports must be available. If there were full employment in

the economy, the home demand would have to be curbed to make room
for the extra export production.
ii. Inflation must not be allowed to erode the competitive advantage
secured by devaluation. A devaluation of the currency is not a soft
option. There are a number of problems that will be involved, and these
must be outlined:

a. To the extent that home demand has to be cured to make room for the
extra exports, the domestic standard of living is reduced. This is only
because, before it took place, the country was “living beyond its means”,
but it does come as a shock to find the domestic “squeeze” accompanying
devaluation. Yet if it does not take place, then the strategy will not have
worked; the exports may not rise to meet the higher demand from
abroad.

b. The larger cost of importing goods raises the domestic cost of living.
This is not just inflationary in itself, but can trigger off pay claims which
if settled will further worsen inflation.

c. It does not boost exports immediately. There is a period during which

the balance of payments gets worse as the country faces a higher import
bill. It is only when exports start rising (and there is a considerable time
lag involved) that the situation improves.

d. It does not tackle the long-run problem of why exports were not doing
well. The problem may be more in inefficiency and other non-price
factors than in the price of the exports themselves. In which case
devaluation would make little difference to the basic problem.
A fourth option is to use exchange control. When this is used to deny
foreign exchange to would be importers, its effects are identical to those
of the various import restricdtions already discussed. There are various
forms of exchange control that can be imposed by a government and
enforced by legislation. They all involve restrictions on the actions of
holders of its currencies and residents of the country who may hold
foreign currency.

ii. Long-term policies

One long term option of tackling balance of payments deficit is export

promotion. In the long run this is the best method of improving a balance
of payments. If the general level of efficiency in an economy can be
raised, then exports will benefit. Efficiency can be promoted by mergers
in exporting firms (thereby reaping economies of scale), research and
economic growth – for it is felt that once an economy is growing it is
generating the necessary dynamism and technological improvement
that will feed through into a better export performance.

A second long-term option is import substitution. The replacement of

imports by home products can be achieved by economic planning. If the
defects of home products can be analysed, and the likely future trends in
demand can be forecast, then domestic firms can take the necessary
action both to improve their product and to expand their capacity.
Government support for certain industries can also be helpful here.

International Financial Institutions

In July 1944, a conference took place at Bretton Woods in New

Hampshire to try to establish the pattern of post-war international
monetary transactions. The aim was to try to achieve free convertibility,
improve international liquidity and avoid the economic nationalism
which had characterized the inter war period.
The result was that two institutions were established: in 1946, the
International Bank for Reconstruction and Development (IBRD); and in
1947 the International Monetary Fund.

The International Monetary Fund

The International Monetary Fund is a kind of an embryo World Central

Bank. Its objectives are:

i. To work towards the full convertibility of currencies by encouraging

the growth of world trade.

ii. To stabilize exchange rates between currencies.

iii. To give short-term assistance to countries having balance of

payments problems.

To achieve these objectives, the following conditions would have to be

fulfilled: -

i. Countries should not impose restrictions in their trade with each

other. This should encourage the growth of world trade and lead to full
convertibility of currencies.

ii. Countries should adopt the peg system of exchange rates, in which
each country quotes the exchange rate of its currency in gold and thus
the exchange rates between currencies can be determined. The quoted
exchanged rate is allowed to fluctuate to within 1% up and down, and
the country can devalue or revalue its currency by up to 10%. This was
meant to stabilize exchange rates between currencies.
iii. Each member state of the I.M.F should contribute to a fund to enable
the I.M.F to give short-term assistance to countries having balance of
payments problems. The quota contribution of the member state
depends on the size of its G.D.P and its share of world trade. The member
state contributed 25% of its quota in gold or convertible currency and
the remaining 75% in its own currency.

vi. A member state in balance of payments problems can borrow from

the I.M.F on a short-term basis. 25% of the country’s quota contribution
is automatically available to it as stand-by credits. Beyond this the
country can borrow on terms dictated by the I. M. F. the country borrows
by purchasing gold or convertible currency using it own currency. The
country’s borrowing facility expires when the I.M.F. holds the country’s
currency twice the value of its quota contribution. In paying back to the
I.M.F. the country will repurchase back its currency using gold or
convertible currency until the I.M.F holds 75% of the country’s quota
contribution in the country’s currency.

v. The I.M.F. reserves the right to dictate to the country borrowing from
it how to govern its economy.

To what extent has the IMF achieved its objectives?

The objective of achieving full convertibility of currencies has not been

achieved. In the first place countries impose restrictions in their trade
with each other, and this has not helped the growth of world trade.
Secondly, the export capabilities of different countries are different and
it is difficult for all currencies to be convertible in particular the range of
exports for developing countries very limited and so is the demand for
them. This makes their currencies weak and unconvertible.
The objective of stabilizing exchange rates has not been achieved. This is
because outside the stated limits the adjustable peg system of exchange
rates has the same limitations as the gold standard in that it is
deflationary and can put strains on the country’s foreign exchange
reserves in times of a trade deficit and it is inflationary in times of a
trade surplus.

While the IMF does give short-term assistance to member states in

balance of payments problems, it is strictly on a short-term basis and it
does not go to the root cause of the deficit. A more useful form of
assistance would be one that would go into projects that would increase
the productive potential of the country, making it less dependent on
imports and increasing its export potential. Such assistance would have
to be on long-term basis, but this is not within the objectives of the I.M.F.,
which gives assistance to finance a prevailing deficit.

External Debt Problem

External debt refers to debt owing by one country to another. External

debt is a more serious problem than internal debt because the payment
of interest and repayment of the capital sum form debit items in the
balance of payments.

The cause of third world debt is the unwise borrowing and lending
during the 1970s. The oil crisis made conditions extremely difficult for
many third world countries. For the same reason the Euro currency
markets were awash with money and real interest rates were low.
Therefore poor countries need to borrow and banks were anxious to
lend where they could get better return than on the domestic market.
The bulk of this lending was by commercial banks and not by
international institutions such as the IMF and World Bank. This has the
consequence that, while the international institutions could write-off the
debt, it is very difficult for commercial ones to do so.
The problem turned into a crisis in the early 1980s. As the world fell into
recession this hit the debtor nations particularly hard. Many developing
economies are highly dependent on the export of primary products and
the price of these dropped dramatically. At the same time real interest
rates rose sharply and most of the debt was at variable interest. The
debtor nations were caught in a vice between falling income and rising
costs. When this happened the banks which had been so anxious to lend
in the 1970s were no longer willing to do so.

This meant that the debtor nations had to turn to international agencies
for help. However, the international agencies do not have sufficient
funds to substantially affect the situation. For such help as they were
able to give, they demanded very stringent conditions. These
deflationary conditions have often impoverished further the debtor
nations. Much of the money that was borrowed was not used for
development purposes but simply balance the books for the nations’
overseas payments. Little found its way into the sort of projects which
development economies would suggest.

Many measures have been suggested for instance by the World Bank.
Among them has been suggestion for reducing interest rates on non-
concessional debt, rescheduling with longer grace periods and
maturities or outright conversion of bilateral loans to grants.
International Development Association (IDA) has converted its
repayments to be used to reduce International Bank for Reconstruction
and Development (IBRD) debt owed by low income third world
countries.
CHAPTER SEVEN PUBLIC FINANCE

Public finance is related to financing of the state activities and a narrow

definition of public finance is a subject which discusses the financial
operations of the public treasury.

Objectives of Government

Government policies are required in market economies to achieve

certain goals. There are broadly two types of government policies viz;

Microeconomic policy objectives And macroeconomic policy objectives.

a. The Microeconomic objectives of government

These are the policies which are concerned with the allocation and
distribution of resources to maximize social welfare.

i. Allocation policies

The major objective of government is to achieve pareto efficiency in

resource allocation. An economy is said to be Pareto efficient when it
must be impossible to increase the production of another, or to increase
the consumption of one household without reducing the consumption of
another. Such situation results when the following three conditions are
satisfied:

a) The given stock of resources must be allocated in the production of

goods and services in such a way that no re-location can increase the
output of one good without decreasing the output of any other.
b) The combination of goods and the proportions in which they are
produced must be in response to tastes and preferences of the
community – i.e. the goods produced must be the ones that the
community wants.

c) The distribution of goods and services must be in conformity with

consumers’ preferences, given their tastes and incomes.

ii. The distribution function /policy

The overriding aim of the strategy is to promote equity – that is to

achieve a “fair” distribution of income and wealth. For this purpose,
budgets are usually designed to impose higher rates of taxation on
higher incomes and to try and secure a fair distribution of tax burdens in
the community.

On the expenditure side of the budget, spending can be channelled into

areas (such as health, education, and social security benefits), which
directly benefit the lower income groups.

b. Macro-economic policy objectives

The major macro-economic policy objectives which the governments

strive to achieve are:

i. Full employment

One of the main objectives of all governments is the control of

employment or full employment.
However economists are not agreed on what constitutes full
employment. But we can say full employment exists when everyone who
wants a job and is capable of doing a job is able to find one.

ii. The control of inflation

Since most monetarists believe that inflation has a negative effect upon
economic growth as it increases uncertainty and discourages savings,
maintaining stable prices usually is a major objective of most
governments.

These two foregoing objectives can be regarded as “good housekeeping”.

iii. High Growth rates

For most people, economic growth remains the prime objective of policy
as it allows everyone to enjoy a better standard of living.

iv. Balance of payments equilibrium

Most governments like to have an equilibrium position in the BOP

accounts as there are problems associated with both sides of
disequilibrium.

v. Equitable distribution of income

The Budget
The budget is a summary statement indicating the estimated amount of
revenue that the government requires and hopes to raise. It also
indicates the various sources from which the revenue will be raised and
the projects on which the government intends to spend the revenue in a
particular financial year. The budget in Kenya is presented to
parliament by the Minister of Finance around mid June. In the budget the
Minister REVIEW s government revenue and expenditure in the previous
financial year. The minister presents tax proposals i.e. how he intends to
raise the proposed revenue from taxation for parliament to approve.

Functions of the Budget

The budget fulfils three main functions:

1. To raise revenue to meet government expenditure

The government of a country provides certain services such as

administration, defence, law and order, environmental services and
economic services. Also it must meet the public debt. Sufficient revenue
must be raised to pay for this.

2. It is a means of redistributing wealth

In many countries, a situation has arisen where a small proportion of the

population own a more than proportionate share of the nations wealth,
while the majority of the population own only a small proportion of it.
One method of redressing such inequalities of wealth is through a
progressive system of taxation on income and capital. A progressive
system is one whereby the wealthy people do not only pay more tax than
the poor, but also pay a greater proportion of their income or wealth.
3. To control the level of economic activity

The government uses the budget to implement fiscal policy, i.e. the
regulation of the economy through government’s expenditure and taxes.

Types of Budgets

1. Deficit budget If the proposed expenditure is greater than the planned

revenue from taxation and miscellaneous receipts, this is a budget
deficit. The excess of expenditure over revenue will be met through
borrowing both internally through the sale of Treasury Bills and
externally from other organizations.

2. Balanced budget If the proposed expenditure is equal to the planned

revenue from taxation and other miscellaneous receipts, this is a
balanced budget. Usually, balanced budgets are not presented, unless
the expenditure is very limited. It would mean the government would
have to over-tax the population which can create disincentives. It is to
avoid this that the tax revenue is supplemented by borrowing.

3. Surplus budgets

If the proposed expenditure is less than the planned revenue from

taxation and other miscellaneous receipts, this is a surplus budget.
Usually, surplus budgets are not presented for they are deflationary and
can create unemployment as the government takes out of the economy
more than it puts back.

Public Revenue Sources

Public revenue is all the amounts which are received by the government
from different sources.
The main sources of public revenue are as follows:

(a)Taxes-Taxes are the most important source of public revenue. Any tax
can be defined as an involuntary payment by a tax payer without
involving a direct repayment of goods and services (as a "quid pro quo")
in return. In other words, there are no direct goods or services given to a
tax payer in return for the tax paid. The tax payer can, however enjoy
goods or services provided by the government like any other citizen
without any preference or discrimination.

(b) Land rent and rates

These are levies imposed on property. Rent is paid to the Central

Government on some land leases while rates are paid to the Local
Authority based on the value of property..

(c) Fees

Fees is an amount which is received for any direct services rendered by

the Central or Local Authority e.g. television and radio fees, national
park fees, airport departure fee, airport landing and parking fee, port fee
by ships, university fee, etc.

(d) Prices

Prices are those amounts which are received by the central or local
authority for commercial services e.g. railway fare, postage and revenue
stamps, telephone charges, radio and television advertisement etc.
PURPOSE AND C(e) External borrowing

This is done from foreign governments and international financial

institutions such as World Bank and International Monetary Fund (IMF).
(f) Fines and Penalties

If individuals and firms do not obey the laws of the country, fines and
penalties are imposed on them. Such fines and penalties are also the
income of the government.

(f) State Property

Some land, forests, mines, national parks, etc. are government property.
The income that arises from such property is also another source of
public revenue. The income will arise from payment of rents, royalties,
or sale of produce.

(g) Internal Borrowing

The government usually raises revenue through issue of treasury bills

and treasury bonds in the local market.

TAXATION

Definition of tax
Tax is a compulsory charge levied on the qualified category of the
citizens of a country. It is compulsory in that it is not optional for anyone
who attains a certain threshold and failure to remit taxes is a criminal
offense. It is a compulsory payment for which a government is not bound
to offer a specific service in return. This is the main distinguishing
characteristic of taxes, the lack of a defined benefit that is expected from
the tax paid. This differentiates it from the other sources of funds which
are levied for specific purposes and one can enforce the benefits
expected from such funds. The government has discretion to decide how
they are going to make use of funds collected from taxes and individual
citizens cannot direct for specific services from their portion of
contribution, however it is expected that the government will utilize the
funds for activities beneficial to the general public.

Taxation is the process of imposing compulsory contribution on the

private sector to meet the expenses which are incurred for a common
good.

Functions or Purposes of Taxation

The functions of taxation can be discussed from the activities of the

government it is meant to achieve.

These are:
a. Raise revenue The revenue is required to pay for the goods and
services which the government provides. These goods are of two types –
public and merit goods. Public goods, such as defence and police are
consumed collectively and no one can be prevented from enjoying them
if he wishes to do so. These goods have to be provided by governments.
Merit goods, such as education and medical care, could be, and often are,
provided privately but not necessarily in the amounts considered
socially desirable and hence governments may subsidize the production
of certain goods. This may be done for a variety of reasons but mainly
because the market may not reflect the real costs and benefits of the
production of a good. Thus, the public may be subsidized because the
market does not take account of all the costs and benefits of the public
transport system.

b. Economic stability These are imposed to maintain economic stability

in the country. During inflation, the government imposes more taxes in
order to discourage the unnecessary expenditure of the individuals.
During deflation, taxes are reduced in order to enable the individuals to
spend more money. In this way, the increase or decrease helps to check
the big fluctuations in the prices and maintain economic stability.

c. Fair redistribution of income A major function of taxation is to bring

about some redistribution of income. First, tax revenue provides the
lower income groups with benefits in cash and kind. Second, the higher
income groups, through a system of progressive taxation, pay a higher
proportion of their income in tax than the less well-off members of the
society.

d. Pay interest on National debt Taxes are also levied by the government
to pay interest on national debt.
e. Optimum allocation of resources Taxes are also imposed to allocate
resources of the country for optimum use of these resources. The
amounts collected by the Government from taxes are spent on more
productive projects. It means the resources are allocated to achieve the
maximum possible output in the given circumstances.

f. Protection policy Taxes are also imposed to give protection to those

commodities which are produced in the country. The government thus
imposes heavy taxes on the import of such commodities from the other
countries. In the view of these taxes, the individuals are induced to buy
local products.

g. Social welfare The government imposes taxes on the production of

those commodities which are harmful to human health e.g. excise duty
on wines, cigarettes, etc.

Principles of an Optimal Tax System

When taxes are imposed certain conditions must be fulfilled. These

conditions are known as Principles or canons of taxation. According to
Adam Smith who first studied the principles of taxation, these are equity,
certainty, economy and convenience.

1. Equity
This means that the tax levied should be fair to all. The fairness may take
various forms depending on the considerations at hand. Fairness may be
interpreted to mean that those perceived to be the users of the service
should pay for it as is the case with the road levies that are taxed on
motorists per liter of fuel. This however is not practical due to the fact
that it is not always possible to link the benefits enjoyable by the
individual taxpayer and since some benefits are universal there may not
be a good way of collecting taxes on basis of use.

The other approach to equity is the ability to pay. This means that one
should pay in line with their level of income meaning that people with
the same level of income pay the same amount of tax while people with
less income pay less tax. For this reasons progressive taxation is
preferred where the rate of taxation rises with the level of income.

2. Economic viability

A tax system should be viable economically in that it should not have

negative impact on the economic growth of the country. Punitive tax
regimes tend to push investors away meaning that the investors would
prefer relocating or setting their businesses in other areas. A tax system
should encourage economic growth and this is usually done by giving tax
holiday for new investments and for exports and punishing unnecessary
imports which might hurt the economy.

3 Low administration costs

A tax system should be easy to administer and to enforce. Complex tax

systems are difficult to enforce and end up being costly hence not
productive. In addition complex tax system tends to increase compliance
costs hence encouraging the tax payers to evade taxes.
4. Productivity

Another key principle is to have a tax system is that it should be

productive. This means that there should not be duplicity of taxes each
bringing a small portion of tax but the adopted tax system should be able
to net a huge proportion of tax and this will mean that only a few taxes
will be needed to get the needed tax.

In addition to productivity a tax should be elastic meaning that it should

be able to grow as the financial needs of the government grow. The
growth may be due to growth in the number of contributors or growth in
the economy meaning growth in business profitability or the ability to
attract new businesses and investment. Failure of the tax net to grow
with growth in financial needs would mean that the government has to
increasingly look elsewhere for financing of the recurrent and
development expenditure and this may have negative effects.

5. Certainty

The tax system should be certain as relates to the amount expected and
the timing. This is necessary for the purpose of government budgeting to
avoid timing differences between expected revenues and planned
expenditure. In addition the government needs to have certainty as
relates to the impact and incidence of the tax.

When introducing a tax to encourage or inhibit a certain activity the

government needs to know the incidence of the tax otherwise some
taxes may be counterproductive or hurt those it is not intended to hurt.
For example when the government is increasing beer taxes the belief is
that the beer drinkers will not be able to shift the incidence to the beer
manufacturers by boycotting the beer. This is because the habit is
addictive. However in the cases where the targeted population is able to
shift the incidence then the effect may not be the expected one.
The tax payers also need to have certainty as regards the tax liability
otherwise there would be discomfort when the rates keep on shifting
meaning one cannot establish tax payable beforehand. Hence the tax
payers need certainty for their planning needs and also to do away with
any unclear issues on tax liability as this might encourage evasion or
encourage corruption.

6 .Simplicity

A tax system should be simple to understand and to compete. This

simplicity usually leads to acceptability hence higher levels of
compliance. The tax payer should be in a position to determine their tax
liability as this reduces costs related to compliance which are likely to
encourage non compliance.

Classification of Taxes

Taxes can be classified on the basis of:

Impact of the taxes It means on whom the tax is imposed. On the other
hand, incidence of the tax refers to who had to bear the burden of the tax.
In this case the taxes may be:

Direct or

Indirect
b. Rates of tax The rate of tax is the percentage of the tax base to be taken
in each situation. In this case the taxes may be:

progressive or

proportional or

regressive or

(iv) Digestive

Direct Taxes A direct tax is one where the impact and incidence of the Tax
is on the same person e.g. Income Tax, death or estate duty, corporation
taxes and capital gains taxes. It can also be defined as the tax paid by the
person on whom it is legally imposed.

- Impact of tax This means on whom the tax is imposed.

- Incidence of tax This means who has to bear the burden of the tax, i.e.
who finally pays the tax.
Merits of direct taxes

a. They satisfy the principle of equity as they are easily matched to the
tax payers capacity to pay once assessed.

b. They satisfy the principles of certainty and convenience to tax payers

as they know the time and manner of payment, and the amount to be
paid in the case of these taxes. Similarly, the government is also certain
as to the amount of money it shall receive from these taxes.

c. They satisfy the Canon Simplicity as they are easy to understand.

d. Because most of them are progressive, they tend to reduce income

inequalities as the rich are taxed heavily through income tax, wealth tax,
expenditure tax, excess profit, gift tax, etc. so long as they are alive; and
through inheritance taxes or death duties when they die. The poor and
the income groups which are below the minimum tax limit are exempted
form these taxes. These taxes thus reduce income and wealth
inequalities because of their progressive nature.

e. Because the public are paying taxes to the government, they take an
interest in the activities of the state as to whether the public expenditure
is incurred on public welfare or not. Such civic consciousness puts a
check on the wastage of the public expenditure in a democratic country.

Demerits of direct taxes

a. Heavy direct taxation, especially when closely linked to current

earnings, can act as a serious check to productivity by encouraging
absenteeism and making men disinclined to work.
b. Heavy direct taxation will clearly reduce people’s ability to save since
it leaves them with less money to spend. Taxation may, therefore, act as
a deterrent to saving. Heavy taxation of profits makes it more difficult
for business to build up reserves to cover replacement of obsolete or
worn-out capital and thus investment.

c. Direct taxes possess an element of arbitrariness in them. They leave

much to the discretion of the taxation authorities in fixing the rates and
in interpreting them.

d. They are not imposed on all as incomes earned on subsistence and non
legal activities are left out.

e. Cost of collection is generally high.

f. These taxes are easily evaded either by understating the source of

income or by any other means. Such taxes thus cultivate dishonesty and
there is loss of revenue to the state.

Indirect Taxes These are imposed on an individual mostly producers or

traders but they can be passed on to be borne by others usually the final
consumers. They can also be defined as taxes where the incidence is not
on the person on whom it’s legally imposed. They include excise duties,
sales tax, Value Added Tax and others.

Advantages

a. They are less costly to administer because the producers and sellers
themselves deposit them with the government.

b. If levied on goods with inelastic demand with respect to price rises, it

will result in high revenue collection.
c. Indirect taxes reach the pockets of all income groups. Thus, they have a
wide coverage, and every consumer pays to the state exchequer
according to his ability to pay.

d. They can check on the consumption of harmful goods like wine,

cigarettes and other toxicants.

e. Can be used as a powerful tool for implementing economic policies by

the government. If the government wants to protect domestic industries
from foreign competition, it can levy heavy import duties. This will help
to develop domestic industries. If the government wants to encourage
one industry on a priority basis, it may not levy any taxes on its products
but continue the taxes imposed on other industries. The government
may do so in order to encourage, a particular technology or employment
in a particular industry.

Disadvantages

a. Most indirect taxes are regressive as they are based are not based on
ability to pay. The rich and the poor are required to pay the same
amount of tax on such commodities as matches, kerosene, toilet soap,
washing soap, toothpaste, blades, shoes, etc.

b. They may lead to inflation as their imposition tends to raise the prices
of commodities, thereby leading to higher costs, to higher wages, and
again to higher prices. Thus a price-wage cost spiral sets in the economy

c. They sometimes have adverse effects on production of commodities,

and even employment. When the price of a commodity increases with
the levy of a tax, its demand falls. As a result, its production falls, and so
employment.
d. The revenue from indirect taxes is uncertain because it is not possible
to accurately estimate the effect of such taxes on the demand for
products.

Progressive Tax A progressive income tax system is one where the higher
the income, the greater the proportion paid in taxes. This is effected by
dividing the taxpayers’ incomes into bands (brackets) upon which
different rates of tax are paid – the rates being higher and the band of
income. For example, in Kenya, the bands are as follows:

Monthly Tax Rates

Income Bracket Tax

(K£ per month) (Kshs per Kshs 20)

1 – 325 2

326 – 650 3

651 – 975 4

976 – 1300 7

1301 – 1625 7

Excess over 1625 7.50

Source: Income Tax Department, 1996

Examples of Progressive taxes in Kenya are Income Tax, Estate Duty,
Wealth Tax and Gift Tax.

Advantages

a. It is more equitable. The broader shoulders are asked to carry the

heavier burden.

b. It satisfies the canon of productivity as it yields much more than it

would under proportional taxation.

c. It satisfies the canon of equity as it brings about an equality of sacrifice

among the taxpayers.

d. To some extent it reduces inequalities of wealth distribution.

Disadvantages

1. The effect on incentives High progressive tax makes work and extra
effort become less valuable.

2. The effect on the willingness to accept risk High marginal rates of tax
are likely to make entrepreneurs less willing to undertake risks.

3. Effects on mobility Some financial inducement is usually required if

people are to be asked to change their location, or undergo training, or
accept promotion.
Progressive taxation by reducing differentials is likely to have some
effect on a person’s willingness to any of the above.

4. Encourages tax avoidance and evasion.

5. Outflow of high achievers to other countries with lower Marginal tax

rates.

6. It can lead to fiscal-drag where wage and price inflation cause people
to pay higher proportion of income as tax.

Proportional Tax Is where whatever the size of income, the same rate or
same percentage is charged. Examples are commodity taxes like
customs, excise duties and sales tax.

Its advantage is that it’s much simpler than progressive taxation.

Regressive Tax A tax is said to be regressive when its burden falls more
heavily on the poor than on the rich. No civilized government imposes a
tax like this.

Digressive Tax A tax is called digressive when the higher incomes do not
make a due contribution or when the burden imposed on them is
relatively less.

Another way in which digressive tax may occur is when the highest
percentage is set for that given type of income one which it is intended to
exert most pressure; and from this point onwards, the rate is applied
proportionally on higher incomes and decreasing on lower incomes,
falling to zero on the lowest incomes.

Economic Effects of Taxation

a. A deterrent to work Heavy direct taxation, especially when closely
linked to current earnings, can act as a serious check to production by
encouraging absenteeism, and making men disinclined to work.
However, indirect taxation may actually increase the incentive to work,
since the more money is then required to satisfy the same wants,
indirect taxes having made goods dearer than they were before.

b. A deterrent to saving

Taxation will clearly reduce people’s ability to save since it leaves them
with less money to spend. Taxation may, therefore, act as a deterrent to
saving. However, this will not always be the case, as it will depend on the
purpose for which people are saving.

c. A deterrent to enterprise

It is argued that entrepreneurs will embark upon risky undertakings

only when there is a possibility of earning large profits if they are
successful. Heavy taxation of profits, it is said, robs them of their
possible reward without providing any compensation in the case of
failure. As a result, production is checked and economic progress
hindered. It may be, too, that full employment provides conditions under
which even the less efficient firms cannot fail to make profits, and so
there may be greater justification for taxation of profits, and so there
may be greater justification for taxation of profits under such conditions.

d. Taxation may encourage inflation

Under full employment increased indirect taxation will lead to demand

for higher wages, thereby encouraging inflation. A general increase in
purchase taxes pushes up the Index of Retail Prices, and so brings in its
train demands for wage increase.
e. Diversion of economic resources Only if there are no hindrances to the
free play of economic forces will resources is distributed among
occupations in such a way as to yield that assortment of goods and
services desired by consumers. Taxation of commodities is similar in
effect to an increase in their cost of production. Thus, the influence of a
change of supply has to be considered, effect depending on their
elasticity of demand. In consequence of taxation, resources will more
from heavily taxed to more lightly taxed forms of production. This result
may, of course, be desired on Non-economic grounds.

Public Expenditure/government expenditure

The accounts of the central government are centered on two funds, the
Consolidated Fund, which handles the revenues from taxation and other
miscellaneous receipts such as broadcasting license fees, interest and
dividends, and the National Loans Fund which conducts the bulk of the
governments domestic borrowing and lending.

Each government ministry works out how much money it wants to spend
in the coming Financial Year which, in Kenya starts on 1st July in each
year and ends on 30th June on the following year. This is known as
preparing estimates. There are two types of estimates, -estimates of
Capital Expenditure and estimates of Recurrent Expenditure.

Capital Expenditure refers to the money spent on government projects

such as the construction of roads, bridges, health facilities, educational
institutions and other infrastructure facilities. Recurrent expenditure
refers to money spent by the government on a regular basis throughout
the Financial Year e.g. the salaries of all civil servants, or the cost of
lighting a government building.
Government departments also have to prepare estimates for the next
financial year for presentation to parliament. Any department which
earns revenue for sales of goods or services to the public shows this as
an appropriations-in aid, which is deducted from its estimated gross
expenditure to show net expenditure, that is, the actual amount required
of the Exchequer.

The estimates also include Grants-in aid i.e. grants made by the central
government to local authorities to supplement their revenue from their
levying of rates.

National Debt/public borrowing

Taxation does not often raise sufficient revenue for the Government
Expenditure. So, governments resort to borrowing. This government
borrowing is called Public debt or National debt; it thus refers to the
government total outstanding debt. This debt increases whenever the
government runs a deficit for then it has to borrow to pay for the excess
of expenditure over taxes and other receipts.

Public Debt is undertaken basically for two reasons:

a. Given the scarcity of our resources, it is necessary for the government

to borrow funds in order to speed up the process of economic
development.

b. Export earnings of foreign exchange usually fall short of the needed

outlays for imports. In order to cover this foreign exchange deficit on
transactions, it is necessary for the government to borrow from abroad.
In the short-run therefore, the external debt is incurred to finance
balance of payment deficits. These deficits are incurred in the course of
importing vital consumers and producer goods and services.
Types of Public Debt

Public debts can be classified according to the purpose for which the
money was borrowed into;

a. Reproductive Debt: where a loan has been obtained to enable a

government to purchase some real assets, or Deadweight Debt where
the debt is not covered by any real assets.

b. National Debt: can also be classified into marketable and non-

marketable debt. Marketable debt can be bought and sold on the money
market or stock exchange. It can be divided into two types, short and
long-term. The former consists of Treasury Bills and the latter of
Government Bonds (Stocks). Non-marketable debt cannot be sold on the
money market or stock exchange and includes such items as National
Savings certificates, various types of Bonds, and deposits at the National
Savings Bank.

Finally, National debt can also be classified into Domestic and external
debt. Domestic public debt is owed by the state mainly to its citizens or
to domestic institutions such as commercial companies, etc. It includes
interest payments on domestic institutions such as commercial
companies, etc. Interest payments on domestic debt are raised from the
taxation of the community. Such interest payments are transfer
payments since the total wealth is not affected, irrespective of the size of
the debt. External debt is owed to foreign institutions and governments.
Kenya’s external debt is incurred with two types of lenders:

i. Bilateral Lenders

This is official lending between two governments. Chief among the

lenders of Kenya in this category are the U. S. A., Britain and Japan.
ii. Multi-lateral Lenders

This is lending from organizations comprising of many governments. By

for the leading lender is the World Bank (IBRD) – with two main lending
affiliate bodies - the International Development Association (IDA) – the
international Finance Corporation (IFC); and the International Monetary
Fund, and since 1983, the African Development Bank (ABD).

Burden of the national debt

The extent of the burden on a nation of public debt, depends in the first
place on whether it is an external or an internal debt. The burden of the
national debt to the community can be approximated by the cost of
serving it. The cost of servicing the public debt can be calculated:

Per head of the population, or

As a percentage of government revenue, or

As a percentage of the national income.

Whichever method used, the National debt shall have the following
burden on society:
1. If higher taxation is required to service a debt which might have
disincentive effects resulting in a lower level of output, then this is a
burden.

2. If the debt is held by foreigners, goods will need to be exported to pay

the interest and possible repayment of capital. This part of the debt will
involve a great burden.

Public Sector Borrowing Requirement (PSBR)

Public Sector Borrowing Requirement (PSBR) is the amount which the

government needs to borrow in any one year to finance an excess
expenditure over income.

Effects of Government Borrowing on the Economy

If the government borrows from the general public, this may divert
funds from more productive uses.

Firms also require finance and it may be that individuals and financial
institutions prefer to lend to the government where the risk is less and
possibly the returns are greater. Thus the public sector may “crowd out”
the private sector. This is known as the “crowding out” effect.

A further harmful effect may occur. Government borrowing will tend to

raise the rate of interest. This increase in interest rates will make certain
capital investments less profitable resulting in a fall in investment,
slower economic growth and a reduction in the competitiveness of
industries.
The increase in interest rates will also raise the cost of borrowing money
for the purchase of houses and other goods hence an increase in the cost
of living leading to inflationary wage pressure.

To avoid the above adverse effects, the government would borrow from
the banking system the use of Treasury Bills; But this would raise eligible
reserve assets in the banking system and thereby the money supply and
the resultant inflation: This puts the government in a dilemma.

The above pattern could be alleviated if the size of the PSBR was
reduced. This could be done by: Reducing government expenditures
and/or increasing taxation: The first option is the trend in recent years
but increased taxation is said to have the effect of reducing initiative and
incentives.

Of late, employment has been put in the control of PSBR and ensuring
that the growth of money did not exceed the growth of output

i. Fiscal policy refers to the manipulation of government revenue and

expenditure to achieve policy objectives associated with:

1.Moderating resources allocation and adjusting price mechanisms in

favour of the satisfaction of public wants by encouraging socially optimal
investments as well as increasing rate of investments;

2. Redistributing wealth income;

3. Guiding the national economy in terms of growth and stability;

4. Increasing employment opportunities;

5. Counteracting inflation; and

6. Improving the balance of payments.

The usefulness of fiscal policies if often limited by:

1. Structural constraints in the economies; and

2. Observed conflicts of objectives between long term growth and short

term stability; social welfare and economic growth; income distribution
and growth and personal freedom and social control.

Basically, fiscal policy can be applied in many ways to influence the

economy. For example the government can increase its own expenditure
which it can influence by raising taxes, by borrowing from non bank
members of the public and/or borrowing from the Central and
Commercial bank. Borrowing from non - bank members of the public
often raises interest rates and reduces availability of credit to the
private sector forcing a reduction in the sectors of consumption and
investment expenditures. Borrowing from the Central Bank increases
money supply and may give rise to inflation and balance of payments
problems.
Taxes can be used to change the consumption of demand in the economy
and to affect consumption of certain commodities.

ii. Monetary policies This is the direction of the economy through the
variables of money supply and the price of money. Expanding the supply
of money and lowering the rate of interest should have the effect of
stimulating the economy, while a policy designed to reduce price and
wage inflation by requesting voluntary restraint or by imposing
statutory controls contracting the supply and raising the rate of interest
should have a restraining effect upon the economy. (See Lesson 5)

iii. Direct intervention The government can also intervene directly in the
economy to see that its wishes are carried out. This can be achieved
thorough:

a. Price and incomes policy This is where the government takes measures
to restrict the increase in wages (incomes) and prices thus can be
statutory or voluntary.

b. Supply-side policies These are policies to influence the economy by the

prod Liquidity activity of the free market economy. For instance
unemployment can be controlled through supply side measures such as
skills training, reducing social security payments, lessening the
disincentives presented by taxation, facilitating the easier flow of
finance to firms, removing firms, removing restrictive practices etc.

c. Regional policies

These are policies designed to help the less prosperous regions.

Difficulties in using fiscal policy

There are several problems involved in implementing fiscal policy. They
include:

1. Theoretical problems

Monetarists and the Keynesians do not seem to agree on the efficacy of

fiscal policy. Monetarists claim that budget deficits (or surpluses) will
have little or no effect upon real national income while having adverse
effect upon real national income while having adverse effects upon the
interest rates and upon prices.

2. The net effects of the budget

Unlike the simple Keynesian view that various types of budgets have
different effects, the empirical evidence is that the net effects of taxes
and government expenditure are influenced by the marginal
propensities to consume of those being taxed and governments
expenditure.

The Inflexibility of government finances

Much of the government’s finances are inflexible. One of the reasons for
this is that the major portion of almost any departments budget is wages
and salaries, and it is not possible to play around with these to suit the
short-run needs of the government.

3. Discretionary and automatic changes

Discretionary changes are those which come about as a result of some

conscious decision taken by the government, e.g. changes in tax rates or
a change in the pattern of expenditure.
Automatic changes come about as a result of some changes in the
economy, e.g. an increase in unemployment automatically increases
government expenditure on unemployment benefits.

In fact it is the case that deficits tend to increase automatically in times

of recession and decrease in times of recovery. (These fiscal weapons
which automatically increase in times of recession and decrease in times
of recovery are referred to as brick stabilizers). It is possible for a
government to compound the effects of a recession by raising taxes in
order to recover lost revenues. This, according to Keynesians, would
cause a multiplier effect downwards on the level of economic activity.

4. Policy conflicts

When devising its fiscal policy, the government must attempt to

reconcile conflicting objectives of policy. For example, there is
commonly supposed to be a conflict between full employment and
inflation, i.e. that the attainment of full employment may cause inflation.

5. Information

It is very difficult to assemble accurate information about the economy

sufficiently quickly for it to be of use in the short-run management of the
economy.

6. Time lag

It normally takes time for a government to appreciate the economic

situation, to formulate a policy and them implement it. This leads to
lagged responses some of which may be long and difficult to predict.
For instance, there is an inside lag which is the time interval between the
recognition of an economic problem or the shock and the
implementation of appropriate policy measures. This is the time it takes
to recognize that the shock has taken place and then to formulate and
implement an appropriate policy. In general, fiscal policy is thought to
have a longer inside lag than monetary policy.

Finally, there is an outside lag when the time interval between the
implementation of policy measures and the resultant effects on the
intended targets.

CHAPTER EIGHT TYPES AND CAUSES OF INFLATION

Meaning of inflation

The word inflation has at least four meanings.

- A persistent rise in the general level of prices, or alternatively a

persistent falls in the value of money.

- Any increase in the quantity of money, however small can be regarded

as inflationary.
-Inflation can also be regarded to refer to a situation where the volume
of purchasing power is persistently running ahead of the output of goods
and services, so that there is a continuous tendency of prices – both of
commodities and factors of production – to rise because the supply of
goods and services and factors of production fails to keep pace with
demand for them. This type of inflation can, therefore, be described as
persistent/creeping inflation.

- Finally inflation can also mean runaway inflation or hyper-inflation or

galloping inflation where a persistent inflation gets out of control and
the value of money declines rapidly to a tiny fraction of its former value
and eventually to almost nothing, so that a new currency has to be
adopted.

Measurement of Inflation

Causes of Inflation

At present three main explanations are put forward: cost-push, demand-

pull, and monetary.

Cost-push inflation occurs when he increasing costs of production push

up the general level of prices. It is therefore inflation from the supply
side of the economy. It occurs as a result of increase in:

a. Wage costs: Powerful trade unions will demand higher wages without
corresponding increases in productivity. Since wages are usually one of
the most important costs of production, this has an important effect
upon the price. The employers generally accede to these demands and
pass the increased wage cost on to the consumer in terms of higher
prices.
b. Import prices: A country carrying out foreign trade with another is
likely to import theinflation of that country in the form of intermediate
goods.

c. Exchange rates: It is estimated that each time a country devalues it‟s

currency by 4 per cent, this will lead to a rise of 1 per cent in domestic
inflation.

d. Mark-up pricing: Many large firms fix their prices on unit cost plus
profit basis. This makes prices more sensitive to supply than to demand
influences and can mean that they tend to go up automatically with
rising costs, whatever the state of economy.

e. Structural rigidity: The theory assumes that resources do not move

quickly from one use to another and that wages and prices can increase
but not decrease. Given these conditions, when patterns of demand and
cost change, real adjustments occur only very slowly.

Shortages appear in potentially expanding sectors and prices rise

because slow movement of resources prevent the sector and prices rise
because of slow sectors keep factors of production on part-time
employment or even full time employment because mobility is low in the
economy. Because their prices are rigid, there is no deflation in these
potentially contracting sectors. Thus the process of expanding sectors
leads to price rises, and prices in contracting sectors stay the same. On
average, therefore, prices rise.

f. Expectational theory: This depends on a general set of expectations of

price and wage increases. Such expectations may have been generated
by continuing demand inflation.

Wage contracts may be made on a cost plus basis.

Demand-pull inflation is when aggregate demand exceeds the value of
output (measured in constant prices) at full employment. The excess
demand of goods and services cannot be met in real terms and therefore
is met by rises in the prices of goods. Demand-pull inflation could be
caused by:

1.Increases in general level of demand of goods and services. A rise in

aggregate demand in a situation of nearly full employment will create
excess demand in may individual markets, and prices will be bid
upward. The rise in demand for goods and services will cause a rise in
demand for factors and their prices will be bid upward as will. Thus,
inflation in the pries of both consumer goods and factors of production is
caused by a rise in aggregate demand.

2. General shortage of goods and services. If there is a general shortage

of commodities e.g. in times of disasters like earthquakes, floods or
wars, the general level of prices will rise because of excess demand over
supply.

3. Government spending: Hyper-inflation certainly rises as a result of

government action.

Government may finance spending though budget deficits; either

resorting to the printing press to print money with which to pay bills or,
what amounts to the same thing, borrowing from the central bank for
this purpose. Many economists believe that all inflation is caused by
increases in money supply.

Monetarist economists believe that “inflation is always and everywhere

a monetary phenomenon in the sense that it can only be produced by a
more rapid increase in the quantity of money than in output” as
Friedman wrote in 1970.
Measurement of Inflation

The rate of inflation is measured using the Retail Price Index. A retail
Price Index aims to measure the change in the average price of a basket
of goods and services that represents the consumption pattern of a
typical household. It estimates the change in the cost to consumers of a
range of commodities that they typically buy. It is usually prepared for
different classes of consumers and for different areas.

The calculation of the index requires:

-Selection of commodities to be included in the consumers basket

-Selection of the base period weights for each commodity

-Date on prices of the commodities in the current period and in the base
period such an index then estimates the cost of living or the purchasing
power of incomes. If the index increases by 10% in a given period, wages
would need to rise by 10% for purchasing power to remain constant. It is
in this regard that trade unions and workers demand that wages should
increase pari-assu with the cost of living index.

THE IMPACT OF INFLATION AND ITS CONTROL MEASURES

Inflation has different effects on different economic activities on both

micro and macro levels.

Some of these problems are considered below:

i. During inflation money loses value. This implies that in the lending-
borrowing process, lenders will be losing and borrowers will be gaining,
at least to the extent of the time value of money. Cost of capital/credit
will increase and the demand for funds is discouraged in the economy,
limiting the availability of investable funds. Moreover, the limited funds
available will be invested in physical facilities which appreciate in value
over time. It’s also impossible the diversion of investment portfolio into
speculative activities away from directly productive ventures.

ii. Other things constant, during inflation more disposable incomes will
be allocated to consumption since prices will be high and real incomes
very low. In this way, marginal propensity to save will decline
culminating in inadequate saved funds. This hinders the process of
capital formation and thus the economic prosperity to the country.

iii. The effects of inflation on economic growth have inconclusive

evidence. Some scholars and researchers have contended that inflation
leads to an expansion in economic growth while others associate
inflation to economic stagnation. Such kind of inflation if mild, will act as
an incentive to producers to expand output and if the reverse happened,
there will be a fall in production resulting into stagflation i.e. a situation
where there is inflation and stagnation in production activities.

iv. When inflation implies that domestic commodity prices are higher
than the world market prices, a country’s exports fall while the import
bill expands. This basically due to the increased domestic demand for
imports much more than the foreign demand for domestic produced
goods (exports). The effect is a deficit in international trade account
causing balance of payment problems for the country that suffers
inflation.
v. During inflation, income distribution in a country worsens. The low
income strata get more affected especially where the basic line
sustaining commodities‟ prices rise persistently. In fact such
persistence accelerates the loss of purchasing power and the vicious
cycle of poverty.

vi. Increased production

It is argued that if inflation is of the demand-pull type, this can lead to

increased production if the high demand stimulates further investment.
This is a positive effect of inflation as it will lead to increased
employment.

vii. Political instability

When inflation progresses to hyper-inflation, the unit of currency is

destroyed and with it basis of a free contractual society.

viii. Inflation and Unemployment

For many years, it was believed that there was a trade-off between
inflation and unemployment i.e. reducing inflation would cause more
unemployment and vice versa.

Measures to control inflation

An inflationary situation can effectively be addressed/tackled if the

cause is first and foremost identified. Governments have basically three
policy measures to adopt in order to control inflation, namely:
Fiscal Policy: This policy is based on demand management in terms of
either raising or lowering the level of aggregate demand. The
government could attempt to influence one of the components C + I + G
(X – M) of the aggregate demand by reducing government expenditure
and raising taxes. This policy is effective only against demand-pull
inflation.

Monetary Policy: For many years monetary policy was seen as only
supplementary to fiscal policy. Neo-Keynesians contend that monetary
policy works through the rate of interest while monetarists‟ viewpoint
is to control money supply through setting targets for monetary growth.

This could be achieved through what is known s medium term financial

strategy (MTFs) which aims to gradually reducing the growth of money
in line with the growth of real economy – the use of monetary policy
instruments such as the bank rate, open market operations (OMO) and
variable reserve requirement (cash & liquidity ratios).

Direct Intervention: Prices and incomes policy: Direct intervention

involves fixing wages and prices to ensure there is almost equal rise in
wages and other incomes alongside the improvements in productivity in
the economy. Nevertheless, these policies become successful for a short
period as they end up storing trouble further, once relaxed will lead to
frequent price rises and wage fluctuations. Like direct intervention,
fiscal and monetary policies may fail if they are relied upon as the only
method of controlling inflation, and what is needed is a combination of
policies.
CHAPTER NINE

ECONOMIC GROWTH AND DEVELOPMENT

Economic growth

Refers to the changes (increases/decreases) in the level of output

(amount of goods and services produced) in an economy within a period
of one year i.e

It is an increase/increased in real Gross Domestic Product (GDP) and

real income in a nation over a given period.

Thus it is a quantative change in the volume of goods and services

produced and the production capacity of a country over a given period of
time.

N/B: An increase would be realized when the demand of amount of

goods and services in a particular country increases more steadily than
the number of population growth and vice versa.

Economic Development

Refers to multi-dimensional process of transformation/change involving

accumulated qualitative and quantitative changes in an economy leading
to better standards of living, cultural changes, economic transformation,
education reforms, and political revolutions e.t.c
It is a continuous process covering a long period; economic development
involves economic growth which eventually lead to change in people’
ways of life, fair distribution of wealth and provision of essential goods
and services thus improvement of living standards.

Differences between Economic Growth and Economic DEVELOPMENT

Economic Growth Economic Development

Involves only changes in the Involves both qualitative and

quality of goods and services. quantitative changes.

Is a rapid process that occurs Is a slow and gradual period

within a short since it involves several
qualitative and quantitative
Period. changes in several sectors in an
economy

May involve only changes in only Is a multi disciplinary change

one sector of the economy. involving many sectors

May be achieved through There must be a change in

changing the technology by technology to achieve economic
extensive use of available development.
resources.

May not transform people’s way Must bring about transformation

of life. in people’s way of life through
improvement of people’s living,
cultural changes.
The concept of under development

There are a number of ways through which countries are categorized

according to their levels of development. The level of categorization is
first world, second world and third world.

1st world

This refers to the advanced industrialized economy including the

western, Europe, Canada, Japan and USA.

2nd world

This comprises mainly the eastern community of former communist

countries e.g. Europe, China etc.

3rd world/less developed countries

This comprises of all the remaining countries of African, Asian and

American.

The term less developed countries is mainly used to refer to the 3rd
world countries however, this term is no les used in preference to
developing countries to describe the poor nations.

A developing country is one where real precipitin income is low when

compared with that of industrialized nations.

Characteristics of a Developing nation/low developing country (LCD)

Low standards of living

It’s characterized by low standards of living as noted by poor nutrition,

medical care, sanitary services, poor transport and education.

Low levels of income

Low income leading to low purchasing power and limited market, it is

because much of labour force is engaged in Agriculture which is the
dominant sector.

Pre-dominancy of peasant agriculture

The majority of the populations are engaged in agriculture which is the

dominant sector.

Agriculture is unproductive since primitive tools and methods of

production are at subsistence level.

Weak industrial sector

The industrial sector is small, weak and undeveloped due t capital

concept and poor entrepreneurial abilities.

Underutilization of resources

Most of natural resources of low developing countries are unutilized,

underutilized or misutilized.

This is due to lack of knowledge, skills, capital and market.

High population growth rate

Demographically, low developing countries have high population growth

rate due to high birth rates and declining death rates. They are
associated with the problems of dependency, unemployment and
balance of payment process.

Low life expectancy

This is due to general poor living conditions e.g. poor medical care, poor
food balance diet e.t.c.

Conservation

Culturally, the behaviour of the majority is based on traditional beliefs

and superstition.

The culture prohibits economic development and acceptance of new

ideas.

Women are generally underprivileged as they are considered inferior to

man.

Poor technology

The developing countries use backward technology with little use of

scientific in production.

Low literacy level: there is abundant of unskilled labour due to high rate
of illiteracy.
High degree of independence: there is over dependence on external
resources and trade.

Shortage of entrepreneurial abilities.

Dualism: there exist contradictory sectors i.e. traditional and modern

sectors.

Low productivity: is associated by labour efficiency and low technology.

Poor infrastructure: infrastructure is poorly developed i.e. poor roads,

poor transports.

Factors influencing economic growth and Development of a country

Availability of natural resources

When natural resources are available and properly exploited then

economic growth will be registered i.e. there will be an increase of the
output and vice versa.

Availability of capital stock and capital accumulation

Increased level of capital stock may result in capital widening and

capital accumulation but may eventually lead to increase in level of
output and vice versa.

Technological changes
Advancement of technology significantly raises the productivity of the
economy as it enables work to work to be one faster. It also led to
prediction of improved quality of goods and services.

Political stability

A stable political condition is good for production to take place in an

economy thus may result in increase of output.

Instances of political instability however would discourage production

activities to be taken.

Increase in level of investment

Investments increase the productive capacity of an economy thus

leading to high growth and vice versa.

Government policies/interventions

If government policies are those that encourage active economic

growth/production as well as promotes the private sector (reduced legal
requirement, low taxes e.t.c.) the rate of economic growth is likely to be
high and vice versa.

Availability of market

When market is available and expanding i.e. both domestic and external
market, the output of production will expand leading to economic
growth and vice versa.

Improvement in terms of trade

Favorable terms of trade increases the productive capacity of the
economy due to high growth leading to high production and vice versa.

Existence of good infrastructure

Existence of roads, power supply, and storage facilities e.t.c. enables

production to take place leading to output increase.

Ideal population

When the population size of a country is ideal, resource exploitation

increase with increasing marginal productivity thereby leading to
economic growth and vice versa

Industrialization

As the standard of living imposes, spending on goods, agricultural or

manufactured goods increase. Since the opportunity for employing more
capital and technology are greatest manufacturing, the growth rate thus
increases as the country hence industries. TEN

NEED FOR DEVELOPMENT PLANS

CHAPTER TEN

POPULATION AND UNEMPLOYMENT

Population: refers to number of people living in a particular area at a

specific period of time.

It includes both permanent and temporary residence of a place or

region. A region could be part of a country, the all country a number of
countries or the entire world.

Basic concepts in population

Demography: refers to population composition, patterns and structures

in terms of age, sex, occupation and settlement.

Population growth rate: refers to the changes in population size that can
be brought about due to changes in migration, births and death rates
and other factors.

The difference between the birth rate and death rate in a country gives
as the National population growth rate.

Population explosion: refers to the rapid increase in population in a

given area relative to the available resources such that the resources
cannot adequately satisfy the needs of people.
Optimum population: It is the population size and structure which is
most suitable and conclusive for exploitation of available resources of
the economy.

It is the population size that provide the labour force that when
combined with other factors of production e.g. capital, land e.t.c yields
the maximum output per work/average.

It occurs at a level where the output average per head of population is at

the maximum.

Under population: this is the population size which is too small to

effectively use the available resources in an area such that the average
product of labour.

This population size falls below the optimum level where there is
insufficient lab our to fully exploit the existing resources.

Over population: is a situation where the size of the population exceeds

the optimum and available resources is not sufficient to sustain
population size such that the average product of labour declines with the
increase in population size.

It implies that population size is too large to be sustained by the existing

resources and it happens when the population size exceeds the capacity
of existing resources at given particular technology.

An aging population: this is the population structure in which a bigger

percentage is made up of older people. May be caused by the fall in the
birth and rise in the life expectancy
Declining population: is a situation where population trend is towards a
smaller family and people try to keep families as small as possible. This
leads to the fall of the size of population.

Population census: refers to the enumeration of people living in area in

given period of time in order to establish the various aspects and
structure of the population for planning purposes.

Importance of population census

To establish the correct size of the population.

To discover the distribution of the population and also to establish

population densities which help in planning of distribution of social
services and other resources?
Helps to establish both birth and death rates that are useful in
formulation of population policies.

To establish the size of labour force, the middle age or economically

active and number of dependants (the old, the middle age, the young).

To establish the quality of the population by establishing the level of

education of people.

To establish rate of migration i.e. immigrants.

To discover the sex composition in a given population in a country (male

and female).

To establish the rate of unemployment in a country.

To establish Declining population: is a situation where population trend

is towards a smaller family and people try to keep families as small as
possible. This leads to the fall of the size of population.

Population census: refers to the enumeration of people living in area in

given period of time in order to establish the various aspects and
structure of the population for planning purposes.

Importance of population census

To establish the correct size of the population.

To discover the distribution of the population and also to establish

population densities which help in planning of distribution of social
services and other resources
Helps to establish both birth and death rates that are useful in
formulation of population policies.

To establish the size of lab our force, the middle age or economically
active and number of dependants (the old, the middle age, the young).

To establish the quality of the population by establishing the level of

education of people.

To establish rate of migration i.e. immigrants.

To discover the sex composition in a given population in a country (male

and female).

To establish the rate of unemployment in a country.

To establish extend of population variables such as divorce, separation,

migration e.t.c. for various purposes.

Effects of population growth

Population size and structure may have various implications on the

development of a country and it can be positive or negative

Positive effects

1. Increase in market demand

2. Enough lab our supply

3. Technological advancement
4. Export promotion

5. Source of cheap lab our

Negative impacts

1. Effect on per capita income

2. Increased dependency ratio

3. Effects on savings and investment

4. Effects on employment

5. Effects on provision of social amenities’

6. Effects on distribution of incomes

7. Effect on environment.

UNEMPLOYMENT

Unemployment generally refers to a state/situation where factors of

production (resources) are readily available and capable of being
utilized at the ruling market returns/rewards but they are either
underemployed or completely unengaged.
When referring to labour, unemployment is considered to be a situation
where there are people ready, willing and able to work at the going
market wage rate but they cannot get jobs. This definition focuses only
on those who are involuntarily not employed. It is noteworthy to
mention here that all countries suffer unemployment but most
developing countries experience it at relatively higher degree, and the
following can be some of the causes.

Types of Unemployment

Transitional unemployment: Transitional unemployment is that

situation which prevails due to some temporary reasons. The main
reasons for this type of unemployment are:

Turnover unemployment: Some individuals leave their present jobs and

make efforts to secure better ones and in this way, they remain
unemployed for some time.

Casual unemployment: Casual workers are employed for a specific job

and when the job is completed, such workers become eventually
unemployed. E.g. shipping or building construction workers.

Seasonal unemployment: Some industries, for instance have seasonal

demand and their produce is manufactured for a specific period of time
(a specific period of the year). The workers of such industries remain
unemployed for that time e.g. ice factories may remain closed during
winter.

Structural unemployment: Caused by structural changes such that there

exist:
Cyclical unemployment: During depression, prices are too low and profit
margins remain distinctively low. In this case, investment decreases and
unemployment increases.

Technological unemployment: Due to inappropriate technology.

Technology is not inappropriate per se but in relation to the
environment in which it is applied.

In most developing countries, most production structures tend to be

labour saving (capital-intensive), which is not appropriate as these
countries experience high labour supply. Capital – labour ratios tend to
be high in these countries implying that less labour is absorbed
compared to capital in production undertakings causing unemployment.

Industrial change: The establishment of new industries decreases the

demand for the products of existing industries e.g. the rapid increase in
the demand for Japanese industrial products is one reason for greater
unemployment in some European countries.

Keynesian unemployment: According to Keynesian theory of income and

employment, unemployment occurs due to lack of effective demand. If
effective demand is less, production of goods and services will fall which
will further result in the unemployment of labour. Another feature of
Keynesian unemployment is that unemployment of labour is associated
with unemployed capital such as plant and machinery which tend to be
idle during depression.

Urban unemployment: Due to availability of more facilities in urban

areas, more and more people tend to move to these areas. The
employment opportunities are not sufficient to absorb all those people
who settled in the urban areas. This kind of unemployment is therefore
due to rural-urban migration.
Disguised unemployment: Situation where some people are employed
apparently, but if they are withdrawn form this job, total production
remains the same. In most developing countries this type of
unemployment is estimated at 20 to 30% and measures should be taken
to employ such people in other sectors of the economy.

Causes of unemployment

1. Insufficient Capital: Shortage of capital is a hindrance in the

establishment of more industries and other productive installations, and
due to this reason, more employment opportunities are not created.

2. Nature of education system: Education systems for most developing

countries are white-collar oriented, yet the nature of productive
capacities of these economies are not sufficiently supportive. Moreover,
inadequate education and training facilities render(s) most people
unable to secure those job opportunities that require high skills and
specialized training.

3. Rapidly increasing population: The rate of growth in population

exceeds the amount of job opportunities that the economy can generate.

Thus in summary, of the causes of unemployment in developing

countries can be said to include:

Rapidly increasing population

Inappropriate technology

Insufficient capital base

Demand deficiency/structural changes

Presence of expatriates

Education Systems – white-collar orientation

Rural-urban migration

One person for more than one job

Corruption and general mismanagement

Inadequate knowledge on market opportunities

Cost of Unemployment

Unemployment is a problem because it imposes costs on society and the

individual. The cost of unemployment to a nation can be categorized
under three headings: the social costs, the cost to the exchequer and the
economic cost.

The Social Cost of Unemployment

i. For the individual, there is the demoralizing effect which can be

devastating particularly when they are old. This is because as some job
seekers become more and more pessimistic about their chances of
finding a job, so their motivation is reduced and their chances of
succeeding in finding jobs become even more remote.

ii. Many of the longer-term unemployed become bored, idle, lose their
friends and suffer from depression
iii. There is also evidence of increased family tension leading in some
cases to violence, infidelity, divorce and family breakups.

iv. Unemployment may also lead to homelessness, as in some

circumstances building societies may foreclose on a mortgage if the
repayments are not kept up.

v. Long-term unemployment may also lead to vandalism, football,

hooliganism and increases in the crime rate and insecurity in general.

The cost to the exchequer (Ministry of Finance)

There is increasing dependency ratio on the few who are employed in

the form of:

The loss of tax revenues which would otherwise have been received:
This consists mostly of lost income tax but also includes lost indirect
taxes because of the reduction in Spending.

The loss of national insurance contributions which would otherwise

have been received.

The economic cost

Unemployment represents a terrible waste of resources and means that

the economy is producing a lower rate of output than it could do if there
were full employment. This leads to an output gap or the loss of the
output of goods and services as a result of unemployment.
REMEDIES FOR UNEMPLOYMENT

The measures appropriate as remedies for unemployment will clearly

depend on the type and cause of unemployment.

Supporting declining industries with public funds

Instituting proper demand management policies that increase aggregate

demand including exploiting foreign and regional export markets this
can be done by increasing government expenditure, cutting taxation or
expanding the money supply.

Promoting the location of new industries in rural areas which will

require an improvement of rural infrastructure

Increasing information dissemination on market opportunities

Reversing rural-urban migration by making rural areas more attractive

and capable of providing jobs This particularly is the case in developing
countries where rural-non-farm opportunities offer the longest
employment opportunities.

Changing attitude towards work i.e. eliminating the white-collar

mentality and creating positive attitudes towards agriculture and other
technical vocational jobs

Provision of retraining schemes to keep workers who want to acquire

new skills to improve their mobility
Assistance with family relocation to reduce structural unemployment
this is done by giving recreational facilities, schools, and the quality of
life in general in other parts of the country even the provision of
financial help to cover moving costs and assist with home purchase.

Special employment assistance for teenagers many of them leave school

without having studied work-related subjects and with little or no work
experience.

Subsidies to firms which reduce working hours rather than the size of
the workforce

Reducing welfare payments to the unemployed there are many

economists who believe that welfare payments have artificially
increased the level of unemployment.

Reduction of employee and trade union rights

CHAPTER ELEVEN

LABOUR MARKET

Labour is a factor of production. It is a different factor of production

since it’s not a substitute for land in overpopulated countries labour is
‘abundant’ while land is scarce.
 One needs to make a distinction between physical or unskilled labour
and skilled labour. Some countries have an abundant supply of unskilled
labour but an acute shortage of skilled labour of all types a major
hindrance to economic growth.

Supply and Demand for Labour

Demand for a factor is known as derived demand, i.e. it s derived from

the demand for the product it can produce. E.g. if demand for sugar
increases, the demand for sugar increases, the demand for workers in
the sugar estates will increase. It therefore follows that labour is in
abundant supply where derived demand is high.

Derived
demand

Demand for labour

Supply of labour can be seen from the entire economy point of view the
size of the national workforce. Determinants affecting the size of the
economically active population or national workforce include; the size of
the population itself, the age structure, ratio of men to women, the
average working day and efficiency of quality of the labour effort. A
developing nation is characterized by unlimited supply of labour form
the rural areas – consisting of underemployed workers. The supply
curve of labour to an industry or economy slopes up form left to right. If
the price of labour (wage rate) goes up, the amount of labour supplied
will increase.

Wage rate

Supply of labour
However in developing countries, the supply curve of labour is
“backward sloping” – the supply curve of labour is “backward sloping”.
The supply curve slopes down form left to right, so that an increase in
wage results in a decrease in the amount. People prefer leisure to money
to an extent that an increase in money earnings is more likely to lead to
a decrease in the amount of work done.

Backward bending
Wage
supply curve
rate

Hours worked

Income and Substitution Effects

With any form of labour anywhere, there must be some point at which
the amount of labour supplied by an individual ceases to increase or
decrease, as the wage rate increases. This is because money income is
not desired for its own sake, but for the goods it can buy. And the
enjoyment of these goods will be impossible without at least a minimum
amount of leisure; as one sets better off he is likely at some point to take
at least part of the increased standard of living n the form of more
leisure – and thus work fewer hours. The increase in real income is
therefore an incentive to work less hard, to consume more leisure. This
is known as the income effect (rise in income leading to more leisure)
and the substitution effect caused by the change in the price of the
leisure (less income taken).
Hours worked
daily
Income

Leisure Hours

Daily

The Downward Sloping Demand Curve

Firms need workers to produce goods and services. The demand curve
for labour shows how many workers will be hired at any given wage rate
over a particular time period. Economic theory suggests that the higher
the price of labour, the less labour firms will hire. The higher the wage
rate, the more likely it s that firms will substitute machines for workers
and hence the lower the demand for labour.

Labour
 Capital

In the third world, where labour is cheap relative to capital, firms tend
to choose labour intensive methods of production. In the first world,
labour is relatively expensive and hence more capital-intensive
techniques of production are chosen.

The Supply Curve of Labour

A rise in real wage rates may or may not increase the supply of labour by
individual workers in the industry. However, it is likely to attract new
workers in the industry. The supply curve of labour is likely to be
upward sloping. The higher the wages the more workers will want to
enter the particular industry.

Key Terms

Activity or participation rates – the percentage or proportion of any

given population in the labour force.

Economically active – the number of workers in the workforce who are

in a job or are unemployed.

Net migration – immigration minus emigration.

Workforce/labour force – those economically active and therefore in

work or seeking work.
Workforce jobs – the number of workers in employment. It excludes the
unemployed.

Factors influencing the labour market in Kenya:

Supply and demand for labour

Production techniques/technology

Quality of labour/education levels

Cost of labour/wage rates

Population dynamics – migration, age etc

Government – legislation EEO, wage guidance, age requirements,

entertainment, culture

Socio cultural factors

Environment and climate

1. The Supply of Labour

Supply may be taken to mean the total number of people of working age.
It may also mean the supply of labour service available. The total supply
of labour in an economy depends upon: -Size of the population. Size of
population: - this sets an obvious limit to the total supply of labour.
The proportion of the population which works/available for
employment. This is determined chiefly by age distribution, social
institutions, customs, participation rate of married women and the
wages offered.

The amount of work offered by each individual labourer. Number of

hours worked by each person per year. Higher rates of pay usually
induce a person to work overtime, the increased reward encouraging
him to substitute work for leisure. But this is not always so.

2. Production Techniques and Technology

In the developing world where technology is not extensively applied the

demand for labour is high. This s as compared to the developed world
where machines are used to replace people. Our production techniques
are labour intensive and as such demand for labour is high.

3. Quality of labour

There is an important difference between low wages and cheap labour.

Despite low wages in labour – abundant countries, labour is not nearly
as cheap as it appears since low wages are to a great extent offset by low
productivity. This is attributed to the poor education levels among the
labour force. The higher the levels of education, the scarcer the unskilled
labourers become.

4. Wage rates
High relative wages outside Kenya have attracted highly skilled
professional in such countries as Botswana and South Africa. High
labour costs may also make a company resort to technology. High wage
rates are also known to attract and hold labour in most unattractive
areas of the country. Unpleasant but unskilled jobs are often poorly paid
because anyone can do them. Shifts in earnings may create substantial
inflows of workers into an expanding occupation, industry or area and
an outflow of workers from a depressed occupation, industry or area.

5. Population Dynamics

The number of people searching for work in a developing country

depend primarily on the size and age composition of the population. The
age structure of the population also affects the labour market. An aging
population has fewer workforces and therefore few people are available
for work.

The rapid reductions in death rates experienced by most developing

economies have expanded the size of their present labour force while
continuous high birth-rates create high dependency ratios and rapidly
expanding future labour force.

6. Government Legislation

Governments may affect the labour market through various legislations

such as; equal employment opportunity, age limit for employment and
retirement and minimum wage limits. The trade union movement
activities may also have an impact on the labour market.

PRODUCTIVITY OF LABOUR
There are two main factors, which reduce the supply of labour – the
longer period of education and the shorter workweek. Efficiency of
labour is the ability to achieve a greater output in a shorter time without
any falling off in the quality of the work – increased productivity per
man employed. The efficacy of the labour force depends on a number of
influences: -

Climate – this can be an important influence on the willingness to work,

for extremes of temperature or humidity are not conducive to
concentration on tasks.

Health of the worker – workers must be adequately fed, clothed and

housed. Attention to the employee’s physical welfare reduces time lost
from sickness and improves general efficiency. The cost of a health
service might be offset to some extent by increased production

Peace of mind – anxiety is detrimental to efficacy. A social security

scheme relives people from worry about the future by providing form
them in times of sickness, unemployment and old age

Working conditions – the general conditions under which people work

can affect their output. Workplace health and safety is an important
consideration here. Heating, lighting, ventilation, noise, provision of rest
pauses and tea breaks help reduce fatigue and increase output.
Provision of recreation facilities and canteens has the same objective

Education and training – this factor has 3 aspects general education,

technical education, and training with industry. General education is a
foundation upon which more specialized vocational training can be
based. Training within industry is offered by each firm that opts to train
its own employees, in the correct manner that it desires work to be done.
Efficiency of the factors – the productivity of labour will be increased if
the quality of the other factors of production is high. Fertile land,
sufficient capital and division of labour all increase the efficiency of
labour.

Education and Manpower

Governments have expanded educational budgets in part because they

have seen education as an investment in human capital and the training
of manpower needed for development.

Education may have important labour market effects, accelerating rural

– urban migration and increasing the amount of labour force and even
wastage of manpower.

Education may through its effects on the wage and salary structure effect
income distribution and equality of opportunity to jobs.

The type of education offered could influence attitudes, attitudes to

manual or agricultural work, interest in business and risk taking.

Due to the importance of education to manpower, governments are now

formulating HRD programmes, which make explicit the role of education
in labour force development. This can be seen in provision of formal or
informal education, and in manpower planning

Formally educated manpower is always in abundance in the developing

world, taking up the rates of unemployment and labour wastage.
A different approach towards planning educational investment is the
method of manpower planning. The approach here is to make a demand
projection or forecast of the economy’s requirements of different
categories of labour in future time periods, and a supply projection for
the same categories and periods, comparing them and determining
which categories of manpower will be short supply. Training
programmes can then be adjusted to alleviate the shortages.

The key to mobility among occupations is education. Many skills are

learned rather than inherited. This is the stock of personal capital
acquired by each worker. Since investment in labour skills is similar to
investment in physical capital, acquired skills are called HUMAN
CAPITAL. The supply of some particular skill increases when more
people find it worthwhile to acquire the necessary human capital and
decreases when fewer do so. Because acquiring human capital is costly,
the more highly skilled the job, the more it must pay if enough people
are to be attracted to train for it.

WAGES AND EMPLOYMENT GROWTH

There is a relatively slow growth of employment in the developing

countries due to low wage levels. However, on the other hand increases
in real wages re a significant factor restraining growth in employment.
Rapid increases in real wages retard paid employment opportunities.

FACTORS DETERMINING THE LEVEL OF PRODUCTIVITY

The stock of capital available; money, machinery and other capital

equipment used in the organisation.

The nature of the human resources available in the organisation; skilled

and experienced manpower.
Conducive working environment; encouraging workers through
motivation, team work etc.

Level of technology; on the machines and tools used at the places of work
e.g. latest technology would contribute to higher productivity.

Effective organisational procedures, policies, rules and regulations.

Motivational measures adopted by the organisation. It includes job

enlargement and enrichment.

Strength of the management team. A strong management team will

improve employee morale leading to high work performance and
productivity.

INCREASING LABOUR PRODUCTIVITY

Providing training and development programmes to employees to

improve their skills and level of performance, hence a high level of
productivity.

Improving working facilities and equipment e.g. installation of modern

equipment, machinery and computers.

Effective organisational structures e.g. departmentation, delegation of

authority etc.

Effective job design i.e. the level of job enlargement or job enrichment in
the organisation.
Improve working conditions; fair and appropriate rules and regulations;
democratic leadership approaches to management.

Conducive working environment and god organisational climate; level of

cleanliness, sanitary conditions of the organisation; friendly working
environment; employee health and safety measures.

Motivation or incentive measures provided by the organisation;

attractive employment packages, wages and salaries, medical, housing
etc; opportunity for promotions through internal recruitment.

Provision of social amenities to staff; sports, club membership. These

enable workers to reduce stress and strain of the workplace.

Provision of rest breaks at places of work; tea break, lunch break etc.

Provision of leave; annual, sick off etc.

Friendly work environment; team spirit, knowing employees in great

detail, concept of shared fate (that the company belongs to everyone and
if it goes down all will suffer; and if it succeeds all will benefit)

Client/service chain concept; all employees must understand that all

their activities are meant to serve the “customer” – the person who uses
the product of their work.

METHODS OF CONTROLLING LABOUR COSTS

The total cost of production TC= Fixed cost (FC) + Variable costs (VC)
Where

TC = the total cost of production

FC = Fixed cost (FC) {Machinery, plant, salaries, taxes, rent}

VC = Variable costs (VC) {wages, materials, transport)

The term labour costs refer to additions to the total cost of production
contributed by or associated with units of labour (employees). Methods
of controlling labour costs are concerned with measures to reduce the
cost of labour and improve efficiency. The following measures should be
undertaken to control the labour costs:

Effective recruitment and selection processes. Scientific recruitment and

selection should be conducted to hire the right persons for the right jobs;
placement should be carried out to ensure that individuals are matched
with jobs in line with their experience and qualifications.

Training and Development. The management should provide their

employees with adequate training and development programmes to
improve their efficiency. This should reduce poor performance,
resulting in a reduction in labour costs.
Retrenchment/Downsizing. Most organisations are trying to restructure
by cutting down the size of their labour force in order to reduce the cost
of labour and improve their profit margin. This is due to the recognition
that labour cost contributes the greatest amount to the cost structures of
organisations. Layoffs or redundancies may therefore be carried out
due to poor business performance. Layoffs of employees may be
temporary or permanent.

Discharge or dismissal. This action may be taken to stop employment of

less productive workers by discharging or dismissing them. As a result,
the labour costs will reduce.

Improving work equipment and tools. Outmoded equipment and tools

may contribute to labour inefficiencies and therefore high cost of
production. Improvement on equipment and tools at the workplace may
therefore reduce inefficiencies associated with working using such
equipment. An organisation may also install new technology in order to
reduce the labour cost.

Training on effective use of time. Labour costs resulting from poor time
management may be reduced by training employees on effective use of
time. For instance reporting to work, reporting for meetings,
monitoring production activities etc requires effective time
management.
Improving organisational structures, Job design and job description.
Efficient organisational structures, job design and job description may
reduce labour costs associated with inefficiency of such structures. Poor
organisational design may affect coordination and control.

Improving physical work environments and well-being of employees.

This will reduce the stress in the work environment and lead to
improvement in productivity and reduction in the labour costs.