'A' Level Economics Study Pack

‘A’ LEVEL
ECONOMICS
Publication staff
Publishing Director
Sam Madzingira.
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Curriculum Development Unit Zimbabwe
General Editor
Edson Madzingira
Contributor
STUDY PACK S. Madzingira
THIRD EDITION Text Printers

Chiedza Muchena; Crystabell Mudzingwa
‘A’ Level Economics Study Pack
Page 2
Foreword
I had the opportunity of discussing this book with several educationists, teachers and
students when it was in the process of making, and I felt at once that it was likely to prove
unusually useful. It gathers together a great deal of information which must otherwise be
delved for in many books and all this is arranged judiciously and on practical lines. The
authors’ outlook might be described as one of liberal commonsense clarity, simplicity of
expression, and examination - skills - focused. Our study packs are there to offer a canvas
for Zimbabweans to showcase their best ideas to help transform the country into a
knowledge- based society where citizens are free to express their creativity, knowledge and
ingenuity. We have set challenging objectives, but we believe that only by striving to
achieve the highest, can we elevate ourselves above the elements which tend to hold our
country back. However, if your see anything where you feel we may have failed to deliver,
and where we may have failed on issues such as content, depth, relevance and usability,
please let us know by using the contact numbers (09) 61226/61247, 0773 247 358; or Box
2759 Byo; email at turnupcollege@yahoo.com. We are here to listen and improve.
In my days as a teacher and as a student I should have welcomed this book warmly because:
(i) It approaches the syllabus wholistically
(ii) It uses simplified expression
(iii) It has an in-depth coverage of content
(iv) It provides examination skills at the earliest stage of studying
(v) It provides local, international and commonplace examples; illustrations and case studies.
(vi) It provides intelligent questions and answers of the examination type on a chapter by chapter
basis
(vii) Last but not least, it provides a clear platform for self-evaluation as one prepares for the
final examinations.
I have no doubt that learners and educators would as well find this book to be the best. It is
certainly a manual for success. Every one would find it worthy to have his own copy. I
should not be surprised if the Turn-up College Study Pack became the best resource in
school and out of school.
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TABLE OF CONTENTS
CHAPTER PAGE
ACKNOWLEDGEMENTS........................................................................................................................................ 12
PREFACE .......................................................................................................................................................... 13
STATISTICS.......................................................................................................................................................... 13
GRAPHICAL DATA ............................................................................................................................................... 13
STIMULUS RESPONSE QUESTIONS ........................................................................................................................ 13
MARK ALLOCATION ............................................................................................................................................ 14
OBJECTIVES OF THE EXAMINATION ..................................................................................................................... 14
EXPRESSION ........................................................................................................................................................ 15
CHAPTER 1 ........................................................................................................................................... 16
THE SCOPE OF ECONOMICS ............................................................................................................. 16
CHAPTER OBJECTIVES ...................................................................................................................... 16

INTRODUCTION ................................................................................................................................................... 16
NORMATIVISM VERSUS POSITIVISM .................................................................................................................... 17
PROBLEMS OF NORMATIVE ECONOMICS ............................................................................................................. 17
THE NATURE AND METHODOLOGY OF ECONOMICS .............................................................................................. 17
ECONOMIC PROBLEM .......................................................................................................................................... 17
NEEDS AND WANTS ............................................................................................................................................. 17
PUBLIC GOODS .................................................................................................................................................... 18
THE ROLE OF THE PRICE ..................................................................................................................................... 19
DIVISIONS OF ECONOMICS ................................................................................................................ 20
DIFFERENCES BETWEEN MICRO AND MACRO - ECONOMICS................................................... 20

GENERALIZATIONS.............................................................................................................................................. 21
THE FALLACY OF COMPOSITION .......................................................................................................................... 21
CAUSE AND EFFECT FALLACY ............................................................................................................................ 21
LAND 21
LABOUR .............................................................................................................................................................. 21
CAPITAL .............................................................................................................................................................. 22
ENTREPRENEURSHIP............................................................................................................................................ 22
GOODS AND SERVICES ........................................................................................................................................ 22
EXAMINATIONS TYPE QUESTIONS....................................................................................................................... 22
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MULTIPLE CHOICE ............................................................................................................................................... 22

ESSAYS ............................................................................................................................................................... 22
CHAPTER 2 ........................................................................................................................................... 23
GRAPHS AND THEIR MEANING ......................................................................................................... 23

PURPOSE OF GRAPHS ........................................................................................................................................... 23
DEPENDENT AND INDEPENDENT VARIABLES ....................................................................................................... 23
PLOTTING POINTS ................................................................................................................................................ 25
DIRECT AND INVERSE RELATIONSHIPS ................................................................................................................ 25
THE SLOPE OF THE LINE ....................................................................................................................................... 25
EQUATION FORM ................................................................................................................................................. 27
THE SAVINGS FUNCTION ..................................................................................................................................... 27
THE SLOPE OF A NON – LINEAR CURVE ................................................................................................................ 29
EXAMINATION TYPE QUESTIONS ........................................................................................................................ 31
ESSAY 31
CHAPTER 3 ........................................................................................................................................... 32
THE ECONOMIZING PROBLEM .......................................................................................................... 32
NEEDS AND WANTS RESOURCES ............................................................................................. 32

SCARCITY ........................................................................................................................................................... 32
OPPORTUNITY COSTS .......................................................................................................................................... 33
WE CAN NOW HIGHLIGHT THE THREE CONCEPT BY THE FOLLOWING EXAMPLE ................................................... 33
EXAMINATIONS TYPE QUESTIONS....................................................................................................................... 36
ESSAY 36
CHAPTER 4 ........................................................................................................................................... 37
THE ECONOMIC SYSTEMS ................................................................................................................. 37

SIX BASIC COMPONENTS OF AN ECONOMIC SYSTEM ............................................................................................ 37
OWNERSHIP OF RESOURCES................................................................................................................................. 37
1. THE FREE MARKET SYSTEM ............................................................................................................................. 37
FEATURES OF A FREE MARKET ............................................................................................................................ 38
ADVANTAGES OF THE FREE MARKET ECONOMY ................................................................................................ 38
INVESTMENT AND EMPLOYMENT ........................................................................................................................ 38
STANDARD OF LIVING ......................................................................................................................................... 38
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EFFICIENCY ......................................................................................................................................................... 38
DISADVANTAGES ................................................................................................................................................ 38
INSTABILITY ........................................................................................................................................................ 38
MARKET FAILURE ............................................................................................................................................... 38
INEQUALITY IN INCOME DISTRIBUTION ............................................................................................................... 39
CENTRALLY PLANNED/COMMAND ECONOMIES .................................................................................................. 39
ADVANTAGES OF THE COMMAND BASED ECONOMY ............................................................................................ 39
CONSUMER PROTECTION .................................................................................................................................... 40
DISADVANTAGES OF THE COMMAND ECONOMY .................................................................................................. 40
INEFFICIENCY ...................................................................................................................................................... 40
LOW LEVELS OF INVESTMENT AND EMPLOYMENT ............................................................................................... 40
BUREAUCRACY ................................................................................................................................................... 40
THE MIXED ECONOMY ........................................................................................................................................ 40
EXAMINATION TYPE QUESTIONS ......................................................................................................................... 41
ESSAYS ............................................................................................................................................................... 41
CHAPTER 5 ........................................................................................................................................... 42
THE THEORY OF SUPPLY AND DEMAND ......................................................................................... 42

THEORY OF DEMAND .......................................................................................................................................... 42
THE LAW OF DEMAND ......................................................................................................................................... 42
INDIVIDUAL AND MARKET DEMAND .................................................................................................................... 43
DEMAND SCHEDULE ............................................................................................................................................ 43
DEMAND CURVE.................................................................................................................................................. 44
DETERMINANTS OF DEMAND ............................................................................................................................... 44
DISPOSABLE INCOME .......................................................................................................................................... 44
POPULATION ....................................................................................................................................................... 44
CHANGES IN TASTES AND PREFERENCES ............................................................................................................. 44
GOVERNMENT POLICY......................................................................................................................................... 45
EXPECTATIONS ................................................................................................................................................... 45
CHANGES IN PRICES OF OTHER GOODS ................................................................................................................ 45
DIFFERENCES BETWEEN A CHANGE IN DEMAND AND CHANGES IN QUANTITY DEMANDED. ................................. 46
LAW OF SUPPLY .................................................................................................................................................. 48
INDIVIDUAL FIRMS AND MARKET SUPPLY CURVES .............................................................................................. 48
SUPPLY SCHEDULE (MARKET) ............................................................................................................................. 49
SUPPLY CURVE .................................................................................................................................................... 49
THE SUPPLY CURVE ............................................................................................................................................. 49
DETERMINANTS OF SUPPLY ................................................................................................................................. 50
CLIMATIC CONDITIONS ....................................................................................................................................... 50
GOVERNMENT POLICY......................................................................................................................................... 50
TECHNOLOGY ..................................................................................................................................................... 50
NEW DISCOVERIES .............................................................................................................................................. 50
A CHANGE IN QUANTITY SUPPLIED ..................................................................................................................... 51
CHANGE IN SUPPLY ............................................................................................................................................. 51
EQUILIBRIUM PRICE (MARKET PRICE) ................................................................................................................. 52
PRICE FLOOR....................................................................................................................................................... 52
PRICE CEILING .................................................................................................................................................... 53
THE ELASTICITY CONCEPT.................................................................................................................................. 53
ELASTICITY OF DEMAND ..................................................................................................................................... 53
THE NATURE OF DEMAND CURVE ........................................................................................................................ 54
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PERFECTLY ELASTIC DEMAND CURVE ................................................................................................................ 55

UNITARY ELASTIC DEMAND CURVE ..................................................................................................................... 55
TIME PERIOD ....................................................................................................................................................... 56
AVAILABILITY OF SUBSTITUTES .......................................................................................................................... 56
THE NATURE OF THE PRODUCT ............................................................................................................................ 56
HABIT 56
IMPORTANCE OF ELASTICITIES ............................................................................................................................ 57
THE GOVERNMENT ............................................................................................................................................. 57
PRICE ELASTICITY OF SUPPLY.............................................................................................................................. 58
TYPES OF ELASTICITY OF SUPPLY ........................................................................................................................ 58
C) UNITARY ELASTICITY OF SUPPLY CURVE ................................................................................................. 59
E) PERFECTLY ELASTIC SUPPLY CURVE ....................................................................................................... 60
DETERMINANTS OF ELASTICITY OF SUPPLY ......................................................................................................... 61
TIME PERIOD ....................................................................................................................................................... 61
CAPACITY UTILISATION ...................................................................................................................................... 61
AVAILABILITY OF STOCK .................................................................................................................................... 61
FACTOR MOBILITY .............................................................................................................................................. 61
DETERMINANTS OF DEMAND ............................................................................................................ 62

DETERMINANTS OF SUPPLY ................................................................................................................................. 62
EXAMINATION TYPE QUESTIONS ......................................................................................................................... 63
MULTIPLE CHOICE .............................................................................................................................................. 63
ESSAYS ............................................................................................................................................................... 66
1. (A) EXPLAIN THE FACTORS THAT INFLUENCE PRICE ELASTICITY OF DEMAND FOR PUBLIC URBAN
TRANSPORT [10] ................................................................................................................................................ 66
(B) GOVERNMENT HAS IMPOSED PRESUMPTION TAX IN ORDER TO AVOID TAX EVASION BY PUBIC TRANSPORT
OPERATORS. DISCUSS THE RELEVANCE OF PRIZE ELASTICITY OF DEMAND OF THIS TAX[15] 66
DATA RESPONSE QUESTIONS .............................................................................................................................. 66
CHAPTER 6 ........................................................................................................................................... 69
CONSUMER BEHAVIOUR .................................................................................................................... 69

UTILITY............................................................................................................................................................... 69
THE LAW OF DIMINISHING MARGINAL UTILITY ................................................................................................. 69
UTILITY MAXIMIZATION BY THE RATIONAL CONSUMER .................................................................................... 69
INDIFFERENCE CURVE ......................................................................................................................................... 70
INDIFFERENCE MAP ............................................................................................................................................. 71
SUBSTITUTION AND INCOME EFFECT FOLLOWING A PRICE DECREASE ................................................................. 75
EXAMINATION TYPE QUESTIONS ........................................................................................................................ 77
ESSAYS ............................................................................................................................................................... 77
CHAPTER 7 ........................................................................................................................................... 80
THE SHORT RUN ................................................................................................................................................. 80
THE LONG RUN ................................................................................................................................................... 81
TOTAL REVENUE................................................................................................................................................. 81
AVERAGE REVENUE ............................................................................................................................................ 81
MARGINAL REVENUE .......................................................................................................................................... 81
TOTAL COST ....................................................................................................................................................... 81
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TOTAL VARIABLE COSTS .................................................................................................................................... 81

AVERAGE COST .................................................................................................................................................. 82
AVERAGE VARIABLE COST ................................................................................................................................. 82
FIXED COSTS ....................................................................................................................................................... 82
AVERAGE FIXED COSTS....................................................................................................................................... 82
MARGINAL COST ................................................................................................................................................ 82
INDIVIDUAL FIRM’S DEMAND CURVE................................................................................................................... 83
CONDITIONS OF PROFIT AND OUTPUT MAXIMISATION ......................................................................................... 83
THE LONG RUN OF FIRMS IN PERFECT COMPETITION ............................................................................................ 87
THE FIRMS SHORT-RUN SUPPLY IN PERFECT COMPETITION.................................................................................. 88
ECONOMIC EVALUATION OF PERFECT COMPETITION ........................................................................................... 89
REASONS FOR MONOPOLY ................................................................................................................................... 90
MONOPOLY AND PROFIT MAXIMISATION IN THE SHORT-RUN .............................................................................. 90
CONDITIONS NECESSARY FOR PRICE DISCRIMINATION ........................................................................................ 91
CONSUMER SURPLUS .......................................................................................................................................... 92
CHAPTER 2 CONSUMER SURPLUS ............................................................................................... 93
CHAPTER 1 CONSUMER SURPLUS ............................................................................................... 93

ECONOMIC EVALUATION OF MONOPOLY ............................................................................................................ 94
THE SHORT RUN OF MONOPOLISTIC COMPETITION ............................................................................................... 94
THE LONG EQUILIBRIUM OF MONOPOLISTIC COMPETITION .................................................................................. 96
THE KINKED DEMAND CURVE OF AN OLIGOPOLIST ............................................................................................. 98
OLIGOPOLIES....................................................................................................................................... 99
STANDARDIZED OR DIFFERENTIATED PRODUCTS ..................................................................... 100
NON – PRICE COMPETITION ............................................................................................................ 100

EXAMINATION TYPE QUESTIONS ...................................................................................................................... 101
ESSAYS ............................................................................................................................................................. 101
DATA RESPONSE QUESTIONS ............................................................................................................................ 102
CHAPTER 8 ......................................................................................................................................... 104

THEORY OF PRODUCTION .................................................................................................................................. 104
CHAPTER OBJECTIVES ....................................................................................................................................... 104
DEFINITION OF A FIRM....................................................................................................................................... 104
ECONOMIES OF SCALE ....................................................................................................................................... 105
MANAGERIAL ECONOMIES ................................................................................................................................ 105
THEORY OF PRODUCTION .................................................................................................................................. 107
PRODUCTION IN THE SHORT-RUN ...................................................................................................................... 108
THE LAW OF VARIABLE PROPORTIONS ............................................................................................................... 108
WIDE SHAPE ...................................................................................................................................................... 112
VERTICAL AND HORIZONTAL INTEGRATION....................................................................................... 117
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CHAPTER 9 ......................................................................................................................................... 122
.................................................................................................................. 122
DETERMINATION OF WAGES ............................................................................................................................. 123
MARGINAL REVENUE PRODUCT........................................................................................................................ 123
DETERMINANTS OF DEMAND FOR LABOUR ........................................................................................................ 123
DETERMINANTS OF THE SUPPLY OF LABOUR .................................................................................................... 124
THE ELASTICITY OF DEMAND FOR LABOUR. ...................................................................................................... 128
TRANSFER EARNINGS AND ECONOMIC RENT...................................................................................................... 129
WAGE DIFFERENTIALS ............................................................................................................................... 130
MULTIPLE CHOICE ............................................................................................................................................. 131
ESSAYS ............................................................................................................................................................. 133
DATA RESPONSE................................................................................................................................................ 133
CHAPTER 10 ....................................................................................................................................... 135
FISCAL POLICY AND PUBLIC FINANCE ......................................................................................... 135

FISCAL POLICY .................................................................................................................................................. 135
TYPES OF FISCAL POLICY................................................................................................................................... 135
BUILT – IN – STABILISERS ................................................................................................................................. 136
THE NATURE OF FISCIAL POLICY ....................................................................................................................... 136
EXPANSIONARY FISCAL POLICY ........................................................................................................................ 136
CONTRACTIONARY FISCAL POLICY .................................................................................................................... 137
PUBLIC FINANCE ............................................................................................................................................... 137
REASONS FOR GOVERNMENT PENDING .............................................................................................................. 138
FISCAL POLICY TOOLS ....................................................................................................................................... 138
TYPES OF TAXES................................................................................................................................................ 139
MULTIPLE CHOICE ............................................................................................................................................. 144
ESSAYS ............................................................................................................................................................. 144
CHAPTER 11 ....................................................................................................................................... 147
MONEY AND BANKING ..................................................................................................................... 147

THE HISTORY OF MONEY .................................................................................................................................. 147
GRESHAM’S LAW .............................................................................................................................................. 148
FUNCTIONS OF MONEY. .................................................................................................................................... 148
MONEY CREATION BY COMMERCIAL BANKS .................................................................................................... 151
FORMULAE FOR MONEY SUPPLY DETERMINATION ........................................................................................... 152
THE QUANTITY THEORY OF MONEY ................................................................................................................. 153
MONEY DEMAND .............................................................................................................................................. 154
THE SUPPLY OF FUNDS DEPENDS ON VARIOUS FACTORS. THESE INCLUDE: ....................................................... 157
FINANCIAL INSTITUTIONS ................................................................................................................................. 158
MERCHANT BANKS ........................................................................................................................................... 161
MULTIPLE CHOICE ............................................................................................................................................ 162
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CHAPTER 12 ....................................................................................................................................... 163
THE MONETARY POLICY .................................................................................................................. 163

REASONS FOR USING A MONETARY POLICY. ...................................................................................................... 163
HOW MONETARY POLICY WORKS ...................................................................................................................... 163
ESSAYS ............................................................................................................................................................. 165
CHAPTER 13 ....................................................................................................................................... 168
UNEMPLOYMENT ............................................................................................................................... 168

TYPES OF UNEMPLOYMENT ............................................................................................................................... 168
STRUCTURAL UNEMPLOYMENT. ........................................................................................................................ 168
FRICTIONAL UNEMPLOYMENT ........................................................................................................................... 168
DEMAND DEFICIENT UNEMPLOYMENT / CYCLICAL UNEMPLOYMENT .............................................................. 168
VOLUNTARY UNEMPLOYMENT .......................................................................................................................... 169
SEASONAL UNEMPLOYMENT............................................................................................................................. 169
TECHNOLOGICAL UNEMPLOYMENT .................................................................................................................. 169
BENEFITS OF UNEMPLOYMENT .......................................................................................................................... 169
THE RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT ....................................................................... 169
EXAMINATIONS TYPED QUESTIONS .................................................................................................................. 172
ESSAYS ............................................................................................................................................................. 172
CHAPTER 14 ....................................................................................................................................... 176
INFLATION .......................................................................................................................................... 176

DEMAND PULL INFLATION ................................................................................................................................ 176
COST PUSH INFLATION ...................................................................................................................................... 177
STRUCTURAL INFLATION .................................................................................................................................. 178
IMPORTED INFLATION ....................................................................................................................................... 179
EFFECTS OF INFLATION ..................................................................................................................................... 179
DEFLATIONARY POLICIES ................................................................................................................................. 180
EXAMINATIONS TYPED QUESTIONS .................................................................................................................. 181
MULTIPLE CHOICE ............................................................................................................................................. 181
ESSAYS ............................................................................................................................................................. 182
CHAPTER 15 ....................................................................................................................................... 184
ECONOMIC GROWTH ........................................................................................................................ 184

MEASURING ECONOMIC GROWTH...................................................................................................................... 185
ESSAYS ............................................................................................................................................................. 189
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CHAPTER 16 ....................................................................................................................................... 190
NATIONAL INCOME ACCOUNTING .................................................................................................. 190

PRINCIPLES OF NATIONAL INCOME ACCOUNTING ............................................................................. 191
MEASURES OF NATIONAL INCOME ......................................................................................................... 191
GROSS DOMESTIC PRODUCT: ............................................................................................................................ 191
GROSS NATIONAL PRODUCT ............................................................................................................................. 191
NET NATIONAL PRODUCT ................................................................................................................................. 192
DISPOSABLE INCOME ........................................................................................................................................ 192
METHODS OF NATIONAL INCOME ACCOUNTING ................................................................................ 192
THE EXPENDITURE APPROACH.......................................................................................................................... 193
THE OUTPUT APPROACH ................................................................................................................................... 194
NATIONAL INCOME DETERMINATION ................................................................................................... 198
MULTIPLE CHOICE ............................................................................................................................................. 201
ESSAYS ............................................................................................................................................................. 201
CHAPTER 17 ....................................................................................................................................... 202
ECONOMICS FOR DEVELOPING COUNTRIES ............................................................................... 202

CHARACTERISTICS OF DEVELOPING COUNTRIES ................................................................................................ 202
HOW TO MEASURE AN UNDER DEVELOPED COUNTRY ........................................................................................ 204
MULTIPLE CHOICE ............................................................................................................................................. 205
ESSAYS ............................................................................................................................................................. 205
CHAPTER 18 ....................................................................................................................................... 206
MARKET FAILURE AND EXTERNALITIES ....................................................................................... 206

MARKET FAILURE ............................................................................................................................................. 206
PUBLIC GOODS .................................................................................................................................................. 206
EXAMINATIONS TYPE QUESTIONS..................................................................................................................... 207
MULTIPLE CHOICE ............................................................................................................................................. 207
ESSAYS ............................................................................................................................................................. 208
CHAPTER 19 ....................................................................................................................................... 209
ECONOMIC POLICIES ........................................................................................................................ 209

INSTRUMENTS OF POLICY ......................................................................................................................... 210
SUPPLY SIDE POLICIES ...................................................................................................................................... 212
EXCHANGE RATE REGIMES ...................................................................................................................... 212
EXCHANGE RATE DETERMINATION.................................................................................................................... 213
GREATER FREEDOM TO PURSUE DOMESTIC GOALS .......................................................................................... 215
DISADVANTAGES OF FREE FLOATING EXCHANGE RATES ................................................................................. 215
ESSAYS ............................................................................................................................................................. 216
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CHAPTER 20 ....................................................................................................................................... 219
INTERNATIONAL TRADE .................................................................................................................. 219

MUTUAL GAINS FROM SPECIALIZATION AND TRADE ........................................................................................ 219
BARRIERS TO INTERNATIONAL TRADE .............................................................................................................. 223
SUBSIDIES ......................................................................................................................................................... 224
EMBARGOES...................................................................................................................................................... 224
TERMS OF TRADE .............................................................................................................................................. 224
CAUSES OF CHANGES IN THE TERMS OF TRADE ................................................................................................ 225
THE BALANCE OF PAYMENT (BOP)................................................................................................................... 225
OFFICIAL FINANCING/ CHANGES IN RESERVES ................................................................................................. 226
MULTIPLE CHOICE ............................................................................................................................................. 228
ESSAYS ............................................................................................................................................................. 229
CHAPTER 21 ....................................................................................................................................... 231
DEVELOPMENT PROGRAMMES IN ZIMBABWE ............................................................................. 231

ECONOMIC STRUCTURAL ADJUSTMENT PROGRAMME ....................................................................................... 231
MAIN GOALS OF SAPS ...................................................................................................................................... 231
THE SAP POLICY PACKAGE ............................................................................................................................... 231
REDUCING GOVERNMENT EXPENDITURE ........................................................................................................... 232
DEVALUATION .................................................................................................................................................. 232
INTEREST RATE POLICY ..................................................................................................................................... 233
PRIVATISATION ................................................................................................................................................. 233
GOOD GOVERNANCE AND HUMAN RIGHTS ........................................................................................................ 233
OBJECTIVES OF ESAP ....................................................................................................................................... 234
REFORMS UNDER ESAP .................................................................................................................................... 234
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ACKNOWLEDGEMENTS
I must express great thanks to teachers and other employees at Turn-Up College who
worked faithfully to build up this resource. My gratitude is also extended to all outsiders
contributors, particularly Mr. N. Masiyandima (a former lecturer at the National University
of Science and Technology who later joined the Economic Research Department of the
Reserve Bank of Zimbabwe) for his crucial effort to standardize the material in this
resource. In a similar honour, I am grateful to Mr. C. Ronney, Mr Peresu and E Madzingira,
veteran Economics teachers, who worked out the final nitty-gritties of the study pack.
We have taken every effort to try and get hold of the copyright holders of any information
we have reproduced without acknowledgement. We will appreciate the help from anyone to
enable us contact the copyright holders whose permission we have not yet obtained.
Page 13
PREFACE
The vision of the Turn-Up Study Packs Project is to create a self-sufficient information base
for the student. With this aim in mind, this Study Pack provides all the necessary topical
material in a simplified manner. Thereafter, the Study Pack provides a wide range of
examination-type questions at the end of each topic area.
.
Course Outline
This study pack is designed to cover the ‘A’ level syllabus 9158/1/2/3. The content has been
synthesised and is tailor made to suite ‘A’ level candidates.
Paper 1 of the examination covers 40 multiple-choice questions
Paper 2 covers the data response questions. These are compulsory questions, each carrying
20-marks. A data response question can be based on any of the following aspects:
1. Comprehension
2. Statistics
3. Graphical data
4. Or a combination of the above
Comprehension
- This relates to a passage and candidates are asked to read and answer the questions
based on the passage.
STATISTICS
This relates to quantifiable data on tables where candidates are asked to do computations
based on these comprehension questions and are expected to make deductions and
generalisations.
GRAPHICAL DATA
Graphs are given which picture an economic situation. Candidates are required to read and
interpret such graphs, make comparisons and match economic theory interpretations where
necessary.
The questions set can either be on:

a) Data given
b) Stimulus response
c) Or a combination of the above.
Data response questions

These questions are mainly based on data given where one has to write evidence from the
given data to support one argument.
STIMULUS RESPONSE QUESTIONS

The data given stimulates one to think of other relevant information after being stimulated
by what is given. This should be readable economics. This encourages the candidate to bring
Page 14
in further ideas from different parts of the syllabus rather than viewing each topic as an
isolated component.
Normally the last part of the question on data response requires judgment and is open ended.
MARK ALLOCATION
The mark allocation in a data response question gives a clue of how much content both
quality and quantity is injected. The solutions given should be developmental and to the
point.
OBJECTIVES OF THE EXAMINATION

1. Knowledge
a) Knowledge of the terminology of economics
b) Knowledge of specific facts relating to economics and economics situations.
c) Knowledge of general and specific methods of inquiring and of the main sources of
information about economic matters and ways of presenting economic information.
d) Knowledge of the main concepts of particular principles and formulae applied within
the field of economic and of the more economics theories held.
2. Comprehension
a) The ability to understand and interpret economic information presented in verbal,
numerical, and graphical form and to translate such information from one point to
another.
b) The ability to explain familiar phenomena in terms of the relevant principle.
c) The ability to apply known laws and principles to problems of a routine type.
d) The ability to make decisions about economic knowledge or about given data.
3. The ability to apply selected known laws and principles to problems which are
unfamiliar or are prevented in a moral manner.
4. Analysis and synthetics

a) The ability to distinguish between statements of fact, statements of value and hypothesis
statements.
b) The ability to recognize unstated consumption.
c) The ability to make valued references from material provided.
d) The ability to examine the implication of a hypothesis
e) The ability to recognise ideas into a new unity and to present them in an appropriate
manner.
f) The ability to make valid generalisations.
5a) Evaluation
The ability to evaluate the reliability of the material.
b. The ability to check that conclusions drawn are consistent with given information and to
discriminate between alternative explanations.
a) The ability to detect logical fallacies in arguments.
b) The ability to appreciate the role of the main concepts and models in the analysis of
economic problems.
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EXPRESSION
The ability to organise and present economic ideas and statements in a logical for and
appropriate manner.
(Source: Joint Matriculation Board Exams, Council, General Certificate of Education
Regulations and Syllabus, 1979).
Paper 3 cover essays. There are 12 questions of which the candidate has to answer only 4
questions.
Maile and Jerkin s summarised good habits which should be accommodated and practiced
throughout the ‘A’ level; course:
 Relevance
 Or familiarisation
 Style
 Presentation
 Accuracy
(Questions and answers in ‘A’ level Economics, 9).
Relevance.
It is important for one to brain-storm any given question and it is proper for one to answer the
question set rather than twist the question to what one thinks is meant by the question. It would
be proper to underline key terms and phrases to group the content of the question.
Organisation.
The next stage is to make a formal plan, which is developmental. One’s brain stormed ideas are
now arranged in a logical and coherent manner.
Style
Roger Jenkins says this involves writing an answer, which is:
a) Precise
b) concise and
c) Identifiably economics.
d) Presentation
This calls for good English and logical developmental essays.
Accuracy
One has to present identifiably economics rather than waffle on unfounded matters. Diagrams
must be properly drawn and labelled.
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CHAPTER 1
THE SCOPE OF ECONOMICS
Chapter objectives
After reading and retaining comprehension of the contents of this chapter you should be able
to:
1. Define the term Economics” and explain its major classes

2. Explain the relevance of the following terms to Economics; public goods, private
goods merit goods, demerit goods and free goods.
3. Describe the crucial roles played by price in Economics.
4. Distinguish between Macro Economics and Micro Economics
5. Explain all the factors of production.
INTRODUCTION
We can define economics as:
- Economics is a science of scarcity. It is the study of mankind behaviour in

processes of production, exchange, distribution and consumption that seek to
maximize material well-being from the limited resources available.
- It is the study of how people behave when faced with the problem of scarcity.
- It is a social science that deals with the allocation of scarce resources. It is closely
related to such social sciences as ethics, politics, sociology and others in that it deals
with human behaviour.
The study of economics can be classified into normative and positive economics, depending
on whether one is looking at proven facts or subjective statement. Alternatively, the study of
economics can be at micro or macro level. Both aspects are going to be looked into in this
book.
Page 17
NORMATIVISM VERSUS POSITIVISM
Economics of positivism deals with economic principles, laws and facts that can be
objectively verified. These include issues such as the law of demand and supply. Normative
economics deals with subjective statements such as what ought to be done or what is good
or bad in a society. Normative economics involve individual opinion and unsubstantiated
value judgments or insights. These include issues on fairness, equality, etc
PROBLEMS OF NORMATIVE ECONOMICS
1. It cannot be experimented as it deals with human behaviour rather than with physical
properties;
2. Any measurements used or applied are only approximate and even so take time to collect;
3. It deals with human behaviour, which can change from time to time;
4. Economic studies are rarely distinct from those of other sciences - as state planning of the
economy increases, so that area which economics overlaps with politics increases.
5. It cannot directly measure welfare, as it is impossible to measure satisfaction because it is
a personal feeling, which cannot be measured objectively.
THE NATURE AND METHODOLOGY OF ECONOMICS
Economics is a social science. This means that an economist attempts to understand

economic problems rationally and systematically by collecting and sifting facts before
coming to any conclusions or theories. In this case economists used a method very similar to
that of scientists but their job is made more difficult by the fact that he cannot set up
controlled laboratory experiments. Instead of studying objects, the economist has to study
man and his economic decisions. Economic study, like any other social science, moves from
abstraction to generalization. Economists collect data from many economic agents. In the
data there are always outliers and inconsistent behaviours!, but the economist reads general
or average behaviours or trends to come up with widely predictable conclusions, laws,
theories and principles.
ECONOMIC PROBLEM
Resources are scarce. Scarce resources are used to make goods and services. Resources that
are not scarce are free goods, which do not have value. These include free air that we
breathe or desert sand.
NEEDS AND WANTS
All people have the same basic needs. People usually want more than they need and human
wants are without limit. This is because the resources needed to make goods and services
are scarce as compared with people’s wants and this is the centre of the economic problem.
Nobody can have sufficient goods to satisfy all their needs and wants, so people must
choose which wants they will satisfy. Scarce resources have alternative uses.
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Ceteris paribus
This refers to the “other things being equal” assumption. Only the variables under
investigation are investigated while the rest will be held constant. This assumption is
necessitated by the inevitable fact that when one tries to investigate a relationship in
economics, other variables will be changing such that it is always difficult to ascertain cause
and effect in economics. In making conclusions, therefore, economists have to assume that
other factors are kept constant.
PUBLIC GOODS
These are goods whose consumption by one party does not reduce the amount available to
others. Public goods are also referred to as collective consumption goods. These goods have
two main characteristics, that is, they are non- rivalry in consumption and secondly are non-
excludable in consumption.
Non- rivalry. Non - rivalry in consumptions means that consumption by one part does not
reduce the amount available to others.
Non-exclusive. Non- exclusive implies that one cannot be excluded from consuming the
good by any other party. Even if one pays for them, once they are produced it would be very
difficulty to prevent non-payers from enjoying the good. This is often referred to as the free
rider problem.
Largely because of the feature of non- exclusivity, it means the price mechanism fails to
play its signalling and rationing role. Since the price mechanism is non- functional, there is
no incentive to produce public goods. Thus, if left to the price mechanism to decide on the
amount to produce there will be under or none production of public good. The marginal cost
of producing public goods is zero and thus, they cannot be priced. In order to correct the
market failure to produce public goods, the government in the majority of cases intervenes
and produce them on behalf of the general public because they are desirable for their social
benefits. Consumers pay indirectly for the production of public goods through taxations,
which is the major source of finance of public goods. Example of public goods include
defence, police, roads, street-lighting, public parks just to mention but a few.
Private Goods
These are goods whose consumption by one party reduces the amount available to others.
They can be priced and hence there are incentives for producers to produce them since the
scope for profit maximisation is wide. They include, bread, cars shoes just to mention but a
few. Thus whenever it is possible to put a price on the product then the product in question
is a private good. Private goods also have two defining features: they are rivalry in
consumption and also excludable in consumption.
Rivalry in consumption implies that consumption by one party reduces the amount available
to others. The feature of exclusivity means that owners of a private goods can prevent none
payers from their consumption. This is usually enforced through property rights.
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N.B. One can convert public goods into private goods by assigning property rights -
copy rights, trade marks or even brand name.
Merit Goods
These are goods that when consumed their social benefits outweigh private benefits. They
are desired for their positive externalities. Examples includes education and health care just
to mention but a few. It is possible to price merit goods. However, if left to the market
mechanism they will be under consumed and hence the government has to intervene through
the construction of public schools, public hospital, etc or by subsidising their production.
Demerit Goods
These are goods whose consumption by an individual results in greater social costs
compared to private costs. If left to the price mechanism demerit goods will be
overproduced and hence the government has to intervene through the tax instrument and
direct regulation to reduce or stop their consumption. Examples include pollution, public
smoking, noise etc.
Free Goods
These are goods, which are produced at zero cost of production, for example, air. It follows
that free goods are not economic goods because their supply is unlimited and we cannot
charge a price on them.
THE ROLE OF THE PRICE
Price is the value of good or service expressed in monetary terms. The price plays three
crucial roles in economics. These can be stated as (i) signalling, (ii) rationing and (iii)
rewarding.
We have already come across the term scarcity in this chapter and it would be crucial at this
juncture to put into perspective how the price mechanism attempts to deal with the issue of
scarcity.
Signalling Role
Factors of production are scarce and hence have to be distributed and allocated amongst
competing ends. The role of the price is to signal to factor owners in which sector of the
economy they should employ their scarce resource and fulfil their profit maximising
objective. Given for instance two alternatives maize and brick making production with each
fetching $35m and $2m respectively per tonne, a rational producer will employ more of its
resources in maize production where returns per tonne are high. Thus, the price has
signalled the sector where scarce resources should be employed.
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Rationing
The price can ration scarce resources amongst competing ends. If for example two firms
want to employ an engineer and there is only for simplicity one engineer on the market, the
firm which offers the highest salary will most likely attract our engineer, ceteris paribus. If
firm A offers our engineer $20 000 per month and firm B offers, $12 000, firm A is most
likely to employ the engineer and hence we have managed to deal with the issue of scarcity
through the price mechanism. This analysis can be extended to any range of economic
goods that we come across.
Rewarding
As already encountered elsewhere factors of production have factor payments that come
along with them. There is nothing for free. Land receives rent, capital, interest, labour,
wages and enterprise profits or losses, all these have to be expressed in monetary terms. For
example, you can decide that your labour will cost you $3m in payments, the $3m is the
reward that we are talking about. This can also be extended to the remaining factors of
production. One can only attract scarce resource if he or she is prepared to part away with
money (our price in this case).
Divisions of Economics
The term economics was derived from the Greek word Oikonomikos, meaning the study of
how households use scarce resources to provide for their endless needs and wants.
Economics was divided into two major groups as follows:
Oikonomikos (Economics)
Makros (macro)
Micros (micro)
- A small picture - A study of large economics

- A study of small economies - A large picture
- Study of individuality - Study of aggregates, totality or the
whole
Differences between micro and macro - economics
Micro Macro
- Study individual units - The study of totality of the economy

- For example price of bananas - For example Consumer price index (CPI/
RPI)
- Supply of bananas etc - Aggregate demand
- Aggregate supply etc
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GENERALIZATIONS
These are the principles, theories, laws or models made by economists. The derivation of
these principles is the task of economic theory.
THE FALLACY OF COMPOSITION
The fallacy observes that what is true or correct for an individual part may not be true for
the whole. For example if a farmer makes a bumper harvests in his 2 hectare in Matopo this
does not necessarily mean that there has been a bumper harvest in Zimbabwe. A single
spectator increases his visibility of a soccer match by standing up, but if all spectators stand
up they will not necessarily improve their visibility.
CAUSE AND EFFECT FALLACY
This is the fallacy of cause and effect. Because many factors change simultaneously in
reality, one can not easily ascertain that A has happened because of B, ie it’s not necessarily
true that when one event proceeds another, the first event necessarily caused the second for
example a bird crows before dawn but this does not mean that it is responsible for the sun
rise.
The Factors of Production
These are scarce resources available for use in the production of goods and services to
satisfy wants. These resources are the inputs into a production process from which an output
of goods and services emerges.
Factors of production can be grouped under four headings.
LAND
Land is all the natural resources given to man by nature and can be used in the process of
production. This includes the fertile soil vital to the growth of plants, minerals such as gold
and oil and animals for their meat and skins are known as material resources. It also
represents all gifts of nature in the productive system for example farmland, rivers and
woodlands.
LABOUR
Labour is the physical and mental effort provide by individuals to make goods and services. This
effort is necessary in the production process. The greater the number of workers and the better
educated and skilled they are, the more a country can produce.
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CAPITAL
Capital consists of all man made factors in the production process for example dams, equipment,
machinery. These resources which help to produce many other goods and services are known as
capital.
ENTREPRENEURSHIP
This involves the ability to organize all the other factors of production and willingness to take risks
in order to undertake production. Business know–how, or the ability to run a production process is
known as entrepreneurship. The people with entrepreneurship skills are called entrepreneurs. They
are the people who undertake the risks and decisions to make a firm run successfully.
GOODS AND SERVICES

A consumer good is any good that satisfies consumers’ wants. These are usually tangible
commodities classified as durable for example cars, computers and non-durable for example food,
petrol.
Sometimes our wants are satisfied by someone doing something for us. These are called consumer
services. Examples include services of a doctor, teacher, policemen, etc.
EXAMINATIONS TYPE QUESTIONS
MULTIPLE CHOICE
1. Which one is not a normative statement?
A. The government should be more worried about unemployment as compared to inflation in
the economy.
B. The inflation rate in Zimbabwe in November 2005 is above 400%.
C. Equitable distribution of income and wealth leads to economic growth in an economy.
D. Should the government increase the interest rate in order to reduce the problem of inflation?
2. What is a merit good?
A Good that is provided by the government.
B A good with extensive external benefits to society.
C A good whose private benefits to the consumer exceed the social benefits of consumption to
the whole society.
D A good whose social costs to the society exceed the private costs incurred by the consumer.
ESSAYS
1 (a) With illustrative examples; explain the differences between normative
statements and positive statements. [10]
(b) Discuss the benefits of equitable distribution of income and wealth in an

economy. [15]
2 The basic economic problem is not so much the amount of production from scarce resources
but rather how the resulting products are distributed. You are required to:
(a) Explain the statement [5]
(b) Show how different economies have tried to resolve the problem. [10]
(c) Consider the difficulties they face in so doing. [10]
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CHAPTER 2
GRAPHS AND THEIR MEANING
Chapter objectives
After reading and retaining comprehension of the contents of this chapter you should be able
to:
1. Differentiate between dependent variables and independent variables giving
examples of each.
2. Distinguish between direct and inverse relationships and represent these on a straight
line linear equation.
3. Account for the shape of a firm’s average total cost curve in both the short and long
run.
PURPOSE OF GRAPHS
Graphs or functional relationships are not necessarily economic theory or an explanation of

any unknown theory. They are simply a simplification of reality. The discipline of
economics, therefore, starts from known facts and theories to graphical or functional
representation of such information. Graphical representation of facts has several advantages,
which include the following:
1. To visualize and understand important economic relationships.

2. Summarise important economic relationships.
DEPENDENT AND INDEPENDENT VARIABLES
Dependent variable
Is the outcome, which changes due to a change in the independent variable. A variable is a
measure that can change from time to time or from observation to observation.
For example - Price = f (Income, Season, Population, Price of substitutes, etc……)
Price is the dependent variable.
Independent variable
It is a variable, which causes the change in the dependent variable. In the above
representation, income, season, population and price of substitutes are all independent
variables, which determine the price level. In graphical representations, price and cost data
are always placed on the vertical axis while quantities in relation to price and cost data are
on the horizontal axis.
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Other examples
VARIABLE DEPENDENT INDEPENDENT

1. Income Consumption Income
Consumption
2. Ticket price a Attendance Ticket price
Attendance
3. Savings Savings Income
Income
4. Study time Exam score Study time
Exam score
Graphic representation of a dependent and an independent variable
y- axis
Dependent
Variable
0 Independent variable x – axis

Page 25
PLOTTING POINTS
The points are plotted by drawing perpendiculars from the appropriate points on the vertical
and horizontal axes. These perpendiculars intersect at a focal point which locates the
particular dependent – independent combination. Then the general relationship between
dependent and independent variables exists for all graphs.
DIRECT AND INVERSE RELATIONSHIPS

These are represented by a straight line with a general equation denoted by y = mx +c
Where m = is the slope of the line

C = is the intercept, the y – axis
Y = dependent variable
X = independent variable
By a direct relationship means that the two variables change in the same directions ie when
one quantity increases the other also increases in the same direction. This relationship is
shown by an upward sloping line. An example is that of demand and income.
By an inverse or negative relationship means that the two variables change in the opposite
direction i.e. when one quantity increases the other quantity decreases. This relationship is
shown by a downward sloping line. An example is that of price and quantity demanded.
THE SLOPE OF THE LINE

This is the gradient of the line. This is the ratio of the vertical change to the horizontal
change involved in moving between two points
Slope = Vertical change

Horizontal change
For a positive slope, the gradient will be positive and the line slopes upwards despite its
position in the 4 quadrants.
For a negative slope the gradient will be negative and the line slopes down wards despite its
position in any of the four quadrants
POSITIVE SLOPE
y2 B Change in Y = y2 – y1
Change Change in X x2 – x1
inY
y1 A
0
Change in x
Page 26
NEGATIVE SLOPE
Change y1 A
in Y
y2 B
0 x1 x2
Change in x
Change in Y = y2 – y1
Change in X x2 – x1
2nd Quadrant 1st Quadrant

+ ve Slope
- ve slope
+ ve slope - ve gradient
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3rd Quadrant 4th Quadrant

+ ve slope + Slope
- ve slope
- ve slope
EQUATION FORM
The equation y = mx +c explained earlier allows one to determine the independent at any
level of the dependent.
The following table contains data on the relationship between saving and income
INCOME SAVINGS
$ $
20 000 1 500
15 000 1 000
10 000 500
5000 0
0 - 500
THE SAVINGS FUNCTION

Savings depend on income. As a result savings is the dependent while income is the
independent. The graph would appear as follows:
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2 000
1 500
Y
1 000
Saving $
500
0 x 0
5 000 10 000 15 000 20 000 25 000 X
- 500
The slope of the line is determined by finding the distance y/x = 1 500 – 1 000
2 000 – 15 000
= 500
5 000
= 0.1
The intercept is –500
The equation of the line is s = 0.1 Y – 500
Where S = savings; Y= income
The slope shows how much savings will go up for every $ 1 increase in income while the
intercept shows the amount of savings occurring when income is zero.
When income is $ 12 500 savings will be
S = 0.1 x $ 12 500-500
= $ 1 250 – 500
= $ 750
The problem of accommodating three variables in a graph can be resolved through the use
of contour or iso-lines as depicted in geography ‘contour maps’. Each contour line shows
different combinations of capital and labour which yield the same output O.
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A
C
Units of B
capital C1 O
ve O1
O2
Q Q1
Units of Labour
In the diagram above C + Q = O is the combination of capital and labour at A that produce
output O. C1 and Q1 is another combination of capital and labour that produce output O.
The entrepreneur will have to choose between the two combinations, depending on their
relative prices. Higher levels of output imply greater amounts of both labour and capital.
Conversely different combinations will be achieved with O1 and O2 respectively.
THE SLOPE OF A NON – LINEAR CURVE
The slope of a curve can only be measured at some point on the curve. This is the slope of a
tangent to the curve at a point :-
(6,25)
a c (8,25)
Dependent (20.0) (4,20) b (10,20)
a (1,5) c (13,5)
0
i) slope of aa = 25 – 5 (ii) Slope of bb = 20 – 20 (iii) slope of cc =
25 – 5
6-1 10 – 4 8 – 13
= 20 =0 = 20
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5 -5
= +4 = -5
The slope of a line depends on the choice of units denominating the variables and are
specially relevant for economics because they measure marginal changes
The slope of a horizontal line is zero.
The slope of vertical line is infinite.
Changing slope along curves
a) Positive and decreasing b) Positive and increasing
y y
x x
0 0
c) Negative and increasing d) Negative and decreasing
y y
0 0
x x
e) Positive and then negative f) Negative then positive
y A y
x 0 x
0
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EXAMINATION TYPE QUESTIONS

ESSAY
1. (a) Explain what is meant by diminishing returns?

[10]
(b) How do diminishing returns relate to the shape of the firm’s cost curves?
[15]
2. How does the determination of short-run costs differ from costs in the long- run?
[25]
3. For what reasons might the long-run average cost curve eventually rise and how
might
firms try to avoid this?
[25]
4. Account for the shape of a firm’s average total cost curve in both the short and
long run. [25]
Page 32
CHAPTER 3
THE ECONOMIZING PROBLEM
Chapter objectives
After Reading and retaining comprehension of this chapter you should be able to:
1.Understand the importance and scope of the economic problems.
2.Explain the fundamentals of Economics.
3.Illustrate diagrammatically opportunity costs, choice and scarcity.
4.Outline the factors which account for the shift in the production possibility frontier.
Economic Problems
The central economic problem that faces human kind and is the problem of scarcity of
resources amongst competing ends or alternatives. Factors of production are not just
sufficient to meet unlimited human wants.
- Needs and wants are unlimited – they are endless or infinite

- Resources are scarce; they are limited in supply or are finite.
- Hence individuals or societies must make rational decisions in order to satisfy their
needs and wants.
This can be shown as follows:
Needs and wants Resources

- Money -Land
- Clothes -Capital
- Food -Labour
- Shelter -Enterprise
- Education
- Entertainment
- Textbooks
[Unlimited] [Limited]
SCARCITY
This is defined, as the availability of limited resources to meet unlimited nature of human
wants that the resources are meant to satisfy. Scarce goods are referred to as economic
goods because supply is always less than demand.
Choice
Scarcity of resources gives birth to choice. Choices have to be made anywhere scarce
resources should be employed. Choices made, however, are not random or by chance, they
are premised instead on rational behaviour by economic agents to maximise their desired
Page 33
goals. These could include profit or utility maximisation for firms and individuals
respectively.
OPPORTUNITY COSTS
Choices made by economic agents in pursuit of their goals result in sacrifices being made.
This sacrifice is referred to as opportunity cost. It follows from the rationale that given
limited scope for choice as a result of constraints on resources some alternatives have to be
forgone in order to arrive at the attainment of other alternatives. Thus in some way,
opportunity costs refers to the forgone alternative. The concept of opportunity costs implies
that there is no free lunch in economics.
WE CAN NOW HIGHLIGHT THE THREE CONCEPT BY THE FOLLOWING

EXAMPLE
A student may have to decide on the use of available time (time is a scarce resource). A
student presented with two options, to go for a movie or study is expected to decide on the
optimum use of this resource called time. If the student decides to go for study instead of
movie, the opportunity cost the student faces is the forgone alternative, that is, failure to go
to the movie. We can extend this analysis to a macro-economic level where the government
faced with scarce resource may have to decide on the best alternative use of its resources. A
government may have $40m available to meet the following priority needs –road and
hospital construction. If the government decides to build a road, the opportunity costs to the
country is the forgone alternative, that is, the hospital that could have been constructed.
Opportunity cost is thus not expressed in monetary terms, but instead refers to the next best
alternative forgone. Due to scarcity of resources economic agents are called to prioritise on
the best use of available resources.
The Production Possibility Frontier (PPF)
This is a curve, which joints different combinations that an economy is able to produce at a
given time given its scarce resources, ceteris paribus. This concept is used to explain the
concepts of scarcity, choice and opportunity cost.
In order to explain the concepts of scarcity, choice and opportunity cost using the PPF we
shall hold the following assumptions to be true.
(i) There are only two goods being produced in the economy (good x and good y).
(ii) The state of technology is constant.
(iii) Resources are fixed both in terms of quantity and quality.
We can now illustrate diagrammatically opportunity costs, choice and scarcity as below.
Page 34
3.1.1 The Production Possibility Frontier
A
D unattainable
Good Y
Y1 C
Under employment
E
Y2 F PPF
0 X1 X2 B good X
Given fixed resources, an economy may decide to allocate its resources to the production of
good Y i.e. at A and this will result in zero production of good X. Thus the alternative
forgone, the none production of good X represents opportunity cost. Alternatively, the
economy may decide to allocate its scarce resources to the production only of good X as
represented by B. This will result in the opportunity costs of good Y that could have been
produced. Ideally, however, economies do not operate at the extremes but seek to strike a
balance in the production of both goods X and Y.
Given resources, limited resources as defined by the PPF ‘AB’, an economy may produce at
or inside the PPF. Producing at any point along the PPF such as at C means that there is full
utilisation of resources or full employment of resources. There are no resources lying idle.
There is thus, full employment of resources. It is not possible to produce at D because of
limited resources. The economy can only produce at D if there are changes in, for example,
factor inputs, changes in population, discovery of new materials, changes in technology just
to mention but a few. Production at D is only possible thus when there is economic growth.
Producing at point E or within the PPF implies under utilization of resources or inefficient
utilization of resources. Moving form E to the boundary “AB” does not mean economic
growth but rather mean that there is full utilization of resources.
We have already highlighted somewhere that scarcity of resources implies that choices have
to be made on the employment of the same and this ultimately results in opportunity cost.
From the above illustration, we can decide to produce at F instead at C. However,
production at F which represents an increase in good X is only possible when we reduce the
production of Good Y. Thus for production of good X to increase from X1 to X2, good Y has
to be reduced from Y1 to Y2. It follows that this sacrifice Y1 Y2 represents our opportunity
cost. We can extend this analysis to any point on the PPF and the results are the same. More
has to be given up of one good in order to increase production of the other. It is possible to
deduce that as long as resources are scarce opportunity cost is always increasing.
N.B. Producing at any point on the PPF implies efficient utilisation of resources whilst
producing within the PPF implies inefficient utilisation of resources.
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Shift in the PPF

The PPF may shift inwards or outwards depending on factors of production. An outward
shift of the PPF is referred to as economic growth and may be as a result of the following
factors.
Investment
Increase in investment has the effect of increasing the output of both goods, ceteris paribus.
It also implies that workers have the purchasing power to buy more of the output being
produced.
Population
Growth in population, ceteris paribus, results in increased demand for output. It also means
a large pool of the workforce, which contributes to increased output.
Discovery of new resources

The discovery of new resources may lead to increased investment and hence output.
Technology
Advanced technology may enable a country to increase the production of both goods.
If the factors are treated in the reverse mode, the result is a shift inwards of the PPF which is
referred to as economic decline. It should be noted that moving from producing at a point
inside the PPF to a point at the PPF will not result in economic growth. It only implies that
there is now efficient utilization of resources.
Economic growth and economic decline may be represented as below.
Shift in the PPF
Good Y
A1
A0
Outward
2
shift (economic
A
growth)
Inward shift (economic

decline)
0 B2 B0 B1
Good X
Exceptional PPF
Whilst the PPF is used to illustrate in most case the concept of increasing opportunity cost,
it is possible to encounter cases of decreasing and constant opportunity cost.
Page 36
These scenarios are depicted below.

Decreasing Opportunity Cost
Good Y
A
PPF
B
0 Good X
Constant Opportunity Cost
Good Y
PPF
0 B Good X
N.B. Increasing opportunity costs are depicted by a PPF that is convex to the origin,
decreasing opportunity costs by PPF that is concave to the origin whereas constant
opportunity costs are depicted by a straight line.

ESSAY
1. Illustrate the practical importance of the concept of opportunity cost.
[25]
2. A firm may expand horizontally, vertically or by diversification.

(a)What advantages might a firm hope to gain if it were able to grow in each of
these ways? [10]
(b) What disadvantages might result? [15]
Page 37
CHAPTER 4
The Economic Systems
Chapter objectives
After reading and understanding the contents of this chapter, considering some of the
examination type questions, you should be able to:
1. Define the term, “Economic systems” and explain its basic components.
2. Explain the features, advantages and disadvantages of a free market command economy
and mixed economy.
3. Discuss the efficiency implications on how the basic economic questions are answered in
a command economy.
4. Account for the reasons why most countries are changing from the command to market
economies.
Economic systems are the institutional arrangements in various countries that assist in
solving the fundamental economic problems faced by societies.
The system must find answers to the following problems

1. What to produce?
2. What quantities to produce?
3. How and where to be produced?
4. For whom to produce?
5. How to produce more?
SIX BASIC COMPONENTS OF AN ECONOMIC SYSTEM
OWNERSHIP OF RESOURCES
1. The role of private sector
2. Allocation of resources
3. Ownership of means of production
4. Degree of freedom of choice
5. The role of the government.
1. THE FREE MARKET SYSTEM

In a free market system, the price system plays a critical role of allocating and distributing
resources and final commodities. The price performs the following functions:
a) Signals to customers the cost of purchasing a good or service, hence what to buy and
what not buy; and
b) Signals to producers the revenue they will receive from selling the goods or services;
hence what to produce and what not to produce.
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FEATURES OF A FREE MARKET

1. The resources are allocated by the workings of the price mechanism;
2. Resources are privately owned;
3. Factories are privately owned;
4. Producers are motivated by the need to earn private profits; and
5. Government has very limited part to play.
ADVANTAGES OF THE FREE MARKET ECONOMY
Consumer sovereignty
Consumers are able to tell producers what to produce through the price mechanisms. Since
there are many producers in the market, consumers are able to exercise their freedom of
choice, that is, decide which producers to deal with without any decisions being made on
their behalf by another economic agents.
Quality products and low prices
Producers are likely to improve on the quality of their products in order to attract a quality
conscious consumer. This increased competition results in improved product quality. In
addition, increased competition results in low prices being charged as producers compete
amongst themselves to attract additional custom.
INVESTMENT AND EMPLOYMENT

The free reign that is given to firms on the fundamental question of how, when and what to
produce promotes enterprise amongst the country’s citizens. This results in increased
investments which opens up employment opportunities. In addition to this, increased
investment results in economic growth.
STANDARD OF LIVING
Standard of living is likely to be high in a free market economy because of increased
product quality and accompanying low prices which results in low levels of inflation. Low
levels of inflation imply high purchasing power for the consumer. High purchasing power
translates into a large consumer basket.
EFFICIENCY
The free market economy is said to be more efficient in the allocation and distribution of
scarce resources. Producers produce goods which have high demand, and this means scarce
resources are employed where they are likely to be fully utilized.
DISADVANTAGES
INSTABILITY
The free market economy is associated with price instability. Prices change according to the
dictates of consumer tastes and preferences.
MARKET FAILURE
Market failure refers to the inability of the price mechanism to produce goods that have a
zero price, that is, public goods and to regulate the production of negative externalities such
as pollution. Public goods will not be produced by profit maximizing firms because they
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cannot be ‘sold’, producers are unable to prevent free riders from their consumption.
Negative externalities such as pollution will be overproduced, as a firm has no incentive to
internalise them. Social costs are therefore, very high under free market enterprise economy.
INEQUALITY IN INCOME DISTRIBUTION

The free market promotes inequalities in the distribution of income. The rich, that is, those
with factors of production become rich and those without become increasingly poor.
Consumer exploitation
Consumers are only able to exercise their freedom of choice if firms remain competitive.
However, since there is no government regulation small firms may be swallowed by large
firms culminating in monopolies. Once this situation obtains consumers can be exploited,
that is, charged high prices or face poor quality products since there are no longer
alternatives on the market.
CENTRALLY PLANNED/COMMAND ECONOMIES
Planned economies are characterized by the existence of central planning with regard to
resource allocation as well as the allocation of finally produced goods and services.
Features
1. Resources are allocated by a central planning authority.

2. Resources are owned and run by the state
3. Factories are owned and run by the state
4. Prices are controlled and regulated by the central planning authority.
ADVANTAGES OF THE COMMAND BASED ECONOMY
Low levels of inflation

Low prices can be maintained through the use of price controls. This results in low levels of
inflation. Low levels of inflation translates into high levels of standard of living.
Provision of public goods

The government through the imposition of tax can raise funds to provide public goods.
These would have been under produced or not produced at all under free market based
economy. The government can also subsidies the provision of merit goods.
Externalities
The government can also regulate the production through the manipulation of the taxation
tool. Social costs are therefore, are likely be low ceteris paribus.
Income Equality
The government seeks to bridge the gap between the rich and the poor. This can be done by
imposing high taxes on high-income groups and low tax on low-income groups. This is
known as progress tax system. The government can also promote through various initiative
programmes by the marginalised group (read poor) that seek to promote wealth generation.
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CONSUMER PROTECTION
Consumers enjoy high degree of protection from the government. The government ensures
low prices by setting price benchmarks (price controls) and regulates the standard of
products produced through its various acts. Monopoly power is restricted through anti-
monopoly legislation.
DISADVANTAGES OF THE COMMAND ECONOMY
INEFFICIENCY
The economic system is characterised by high levels of inefficiency. The ‘visible hand’ of
the government can lead to misallocation of resources. This results when the government
orders the production of product even though there is no demand for it.
Poor quality products

There is no incentive for firms in a command-based economy to be innovative, hence,
products produced are likely to be poor. Moreover, production is undertaken by monopolies.
Monopolies are well known for their abuse of the consumer since the consumer has no
alternatives.
LOW LEVELS OF INVESTMENT AND EMPLOYMENT
Government regulation can stifle innovation resulting in low levels of investments. No one
firm is comfortable with being dictated to on how to run its operations and hence local and
foreign investors will opt for other investment destinations where there is freedom of
enterprise. It follows therefore from low level of investments that employment opportunities
are low.
BUREAUCRACY
Several layers of decision-making will delay decisions being arrived at. This has the cost of
losing out business to competitors from other countries with free decision-making room. It
also contributes to high levels of corruption, which can destroy the social fabric.
Shortages and rationing

Shortages can also result especially if the government imposes price controls on private
enterprise. This is because producers may feel that the price controls erode their profit
margins and hence to protest this action, they can withdraw their products from the market.
N.B. Advantages and disadvantages treated here are not exhaustive; the reader is
advised to research more on these.
THE MIXED ECONOMY
This represents a blend of the command and free enterprise economy. It borrows features
from both economic systems in order to minimize the negative aspects of the two. The price
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system is to some extent allowed to allocate resources. The Government plays the crucial
role of producing and providing public and merit goods and services as well as providing a
legal framework within which private institutions conduct their business operations. Almost
all countries follow this economic system.
In Zimbabwe, for example, whilst individuals are free to participate in the production of
goods, the state still has a role in providing public goods and merit goods. It also regulates
the operation of private companies through the use of laws. The financial resources from
taxation for example individual tax, corporate tax and others normally fund these public
goods.
The rational behind mixed economic systems is to reduce the demerits of both command
and market economies. Otherwise the blend allows for competition to take place while the
government provides public and merit goods
Multiple Choice
1. Which one is not a characteristic of a pure command economy?

A All decisions are made by the central planning authority.
B Shadow prices are used to ration scarce goods and services.
C The price mechanism alone allocates resources.
D Goods are produced for everyone in the society.
2. A mixed economy is an economy:

A Which is partly run by government and partly run by individuals.
B In which prices are determined by forces of demand and supply.
C Whose assets are owned by both locals and foreigners?
D Which is made up of agriculture and manufacturing industries?

ESSAYS
1 Discuss the efficiency implications on how the basic economic questions are
answered in a command economy. [25]
2. (a)How are resources allocated in a command economy? [10]
(b) Discuss why most countries are changing from the command to market
economies.15]
3 Why may a ‘black market’ exist in tickets for a special event such as a football cup
final? Illustrate your answer with a diagram.
[25]
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CHAPTER 5
THE THEORY OF SUPPLY AND DEMAND
Chapter objectives
After reading this data and understanding the contents of this chapter considering some of the
data response questions you should be able to:
1. Define the term “demand” and describe its law.
2. Using the demand schedule, draw up the demand curve.
3. Explain the determinants of demand and supply and show how they are represented
on the demand curve and of the supply curve respectively.
4. Differentiate between a change in demand and changes in quantity demanded.
5. Understand the low of supply and use it to draw the supply curve.
6. Distinguish between a change in supply and changes in quantity supplied.
7. Define the terms, “Elasticity of demand” and “Elasticity of supply.”
8. Understand the differences between the price elasticity of demand. Income elasticity
of demand and cross elasticity of demand.
9. Describe the types of elasticity of demand and supply showing these on the graph.
10. Outline the determinants of price elasticity of demand and elasticity of supply.
11. Explain the relevance of the concept of elasticity to economies.
THEORY OF DEMAND
Demand refers to the willingness and ability of consumers to buy goods and services at a
given price in a given period of time.
THE LAW OF DEMAND
The law of demand stipulates that there is a negative relationship between quantity
demanded and price of the commodity. All factors being equal, an increase in price results
in less quantity being demanded. However there are exceptional cases to this law, for
example jewellery is more demanded the higher the price.
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INDIVIDUAL AND MARKET DEMAND
Individual demand schedules when summed up will give a market schedule. Graphically
this would be illustrated as follows:
Market 1 Market 2 Market 3 Overall
Demand
Price D1 Price D2 Price D3 Price Dm
P1 P1 P1 P1
D1 D2 D3 Dm
=
0 Q1 Qty 0 Q2 Qty 0 Q3 Qty 0 Qt
Qty
Theoretically, the market demand curve is the sum of the individual demand curves at the
same price P1. The quantity demanded Qt is the sum of the individual quantities demanded
i.e Q1+ Q2 + Q3 = Qt
DEMAND SCHEDULE
It is the illustration of the relationship between quantity demanded and price using a table.
Illustration
The following table relates the quantity demanded of oranges at different price levels.
Price of oranges ( $ ) Quantity demanded per day
500 100
1000 80
1500 60
2000 40
2500 30
3000 25
3500 20
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DEMAND CURVE
It is a graphical presentation of the relationship between quantity demanded and price. It is

extracted from the demand schedule. Ceteris Paribus, the demand curve is downward
sloping from left to right.
4 000
PRICE
3 000
2 000
D
1 000
0 20 60 80 100 120 140 QUANTITY
DETERMINANTS OF DEMAND
These are factors that may result in changes in demand holding the price of the product to be
constant. Determinants of demand result in the parallel shift either outwards or inwards of
the demand curve depending on the direction of changes in the determinants.
Commodity’s own price

The product’s own price as a determinant of demand is based on the law of demand.
Holding other factors constant, an increase in the price of the product results in a decrease in
the quantity demanded.
DISPOSABLE INCOME
An increase in disposable income will lead to more being demanded at constant prices. This
has the effect of shifting the demand curve outwards, to the right. A decrease in disposable
income will induce consumer to demand less at constant prices of a given product. This will
result in an inward shift in the demand curve.
POPULATION
If there is an increase in population, demand for a product may also increase in response at
constant prices. This will shift the demand curve outwards. A decrease in population results
in the opposite.
CHANGES IN TASTES AND PREFERENCES

Changes in fashion (tastes and preferences) in favour of a good will lead to an increase in
demand at constant prices whilst the opposite is true.
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GOVERNMENT POLICY
A government policy can also affect the demand of a particular product. If for instance, the
government imposes a sales tax on a product, the demand for the product may be reduced,
ceteris paribus in response to this government action. The opposite is true.
EXPECTATIONS
Future expectations can also affect demand for a particular product. If consumers anticipate
that the product is going to be scarce in the future, they may ‘hoard’, that is, buy in advance
even though the price has not been reduced to cushion themselves against these future
shortages. The opposite is true.
CHANGES IN PRICES OF OTHER GOODS

Relationships between products may also affect demand for respective goods. If products
are substitute or complements, changes in their prices can affect demand for the related
product. For instance, if the price for beef increases, we expect demand for substitutes, say
pork, to increase even when the price of pork remains constant. This is the case of
substitutes. We can also include complementary goods in our analysis. If the price for cars is
reduced, for instance we anticipate demand for petrol, ceteris paribus, to increase. The
opposite is true.
Changes in weather conditions or seasons

Some goods are more demanded in winter for example blankets, heaters, and tea as
compared to summer seasons.
N.B. The list for determinants presented here is not exhaustive and readers are kindly
recommended to look for others. Also in our treatment the statement ‘ the opposite is true’
has featured prominently. It is, however, not advisable for examination candidate to use it.
Rather the candidates are expected to tell the examiner what the ‘opposite’ is.
Changes in quantity demand

This is the movement along the same demand curve as covered by price changes.
Price D
P2
P1 D
Q2 Q1 Quantity
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The above diagram shows a change in demand as caused by varying price. If the price is
increased from P1 to P2, quantity demanded decrease from Q1 to Q2.
Change in demand
It is the shift of the entire demand curve either to the left or right. A right shift signifies an
increase in demand while a shift to the left shows a decrease in demand.
As illustrated by the
above diagram a
shift of demand
curve from D to D1
shows an increase in
demand while a shift
from D to D2 shows
a decrease in
demand.
DIFFERENCES BETWEEN A CHANGE IN DEMAND AND CHANGES IN

QUANTITY DEMANDED.
A change in quantity demanded is caused by a product’s own price, while a change in

demand is caused by all other determinants of demand for the product except its own price.
Exceptional demand curves
These are demand curves that slope upwards from the left to the right, showing that more is
demanded at higher prices.
Example: -
a) Goods of snob effect

These are goods which are bought for prestigious purposes. Examples include luxurious
goods such as jewellery. More of these goods are demanded at higher price.
b) Giffen goods
These are inferior goods. The demand for them falls as price falls.
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c) Fear of a future rise in price

If consumers anticipate an increase in the prices of goods, this results in the increase in
quantity demanded for these goods in the short run.
Exceptional demand curve
D
Price
$
0 Qty
Inferior goods – these are also known as Giffen Goods from Sir Robert Giffen’s studies,
such goods demand falls as income increase and falls as the price falls. This can be shown
as follows:
Y D
Income Fall in demand
Inferior goods have a

0 quantity
negative relationship with
price and income.
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Superior goods – these are also known as normal goods, goods of ostentation, superior
goods or goods of prestige or status whose demand increases as price and income increases.
Hence they have a positive relationship with both price and income. Diagrammatically they
are shown as follows:
y
D
Income
superior goods
0 quantity
THEORY OF SUPPLY
Supply refers to the quantity that suppliers are willing and able to offer for sale at a given
price in a given time.
LAW OF SUPPLY
The law of supply states that more is supplied the higher the price i.e. there is a positive
relationship between quantity supplied and price. The rationale behind increased supply at
higher prices is the aim to maximize profits.
INDIVIDUAL FIRMS AND MARKET SUPPLY CURVES

Individual supply schedules when summed up will give a market supply schedule.
Graphically, this would be illustrated as follows:
Price S1 Price Price

S2
St
P1 P1 P1
St
S1 S2
0 Q1 0 Q2 0 Qt
Theoretically, the market supply curve is the sum of the individual firm’s supply curves at
the price P1. The quantity supplied Qt is the sum of the individual quantities supplied Q 1 +
Q2 = Qt.
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SUPPLY SCHEDULE (MARKET)
A supply schedule shows the relationship between quantity supplied and price in the form of
a table.
The following supply schedule relates to the quantity supplied of apples at different prices
per day.
Price ($) Quantity Supplied in Units

500 50
1000 80
1500 100
2000 140
2500 160
3000 200
3500 250
400 300
4500 350
5000 450
5500 580
SUPPLY CURVE
It shows the relationship between price and quantity supplied in the form of a graph. The
typical supply curve slopes upward from left to right showing a positive relationship
between quantity supplied and price.
THE SUPPLY CURVE

S
Price
P2
P1
0 Q1 Q2 Qty
The above diagram illustrates the supply curve. It shows that more is supplied the higher the
price. If price is increased from P1 to P2, quantity supplied increases from Q1 to Q2
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DETERMINANTS OF SUPPLY
Determinants of supply refers to factors that might affect supply at given prices. As the case
with determinants of demand, determinants of supply affect the position of the supply curve
in the price- output space.
Product’s own price (Change in quantity supplied)
A change in a commodity’s own price results in changes in quantity supplied. An increase in

price increases quantity supplied and vice versa. Own price, therefore, explains the law of
supply.
CLIMATIC CONDITIONS
Climatic conditions may affect supply on to the market. This is especially true when firms
produce seasonal goods. We expect supply to be high during the ‘season’ for the respective
good and to be low during off-season. In addition, supply for agricultural products is
expected to be high during a bumper harvest and low during a drought.
GOVERNMENT POLICY
Government can formulate a policy that hinder or encourage supply. If the government
reduces corporate tax for instance, firms are able to increase capacity and supply more to the
market whereas, the opposite would result if tax is increased. The government can also give
firms subsidies to cover part of their production costs. This will lead to more being produced
at constant prices. The opposite would result if subsidies are removed.
TECHNOLOGY
State of the art technology results in more being produced at constant prices than when the
firm uses manually labour. The opposite is true. In addition to the above, new advanced
technology may also result in low production costs encouraging the firm to produce more at
constant prices.
NEW DISCOVERIES
Discoveries of new sources of cheap raw materials may lead to more being supplied at
constant prices, whilst the exhaustion of sources of raw materials may lead to reduced
supply.
New firm Entries
The entrants into the market may shift supply inwards due to reduced market share whereas,
the exit of firms may lead to more being supplied. If looked from another angle, entrance by
new firms may increase the supply of the product in the market. Exit of firms from the
market may reduce supply.
N.B. Determinants of supply lead to a parallel shift in the supply curve depending on
whether the factors have moved in favour or against the product in question. The reader is
also encouraged to add to the list above.
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A CHANGE IN QUANTITY SUPPLIED
A change in quantity supplied is depicted by movements along the same supply curve. It is
caused by adjustments in the commodity’s price.
S
Price P2
P1
0
Q1 Q2 Quantity
The arrow above shows movements along the same supply curve. If price is increased from
P1 to P2 quantity supplied increases from Q1 to Q2.
CHANGE IN SUPPLY
Changes in supply results from changes in the determinants of supply. These changes have
the effect of shifting the supply curve either outwards or inwards depending on the direction
of changes in the determinants.
We depict the changes through a parallel shift in the supply curve as below.
Changes in supply
S2
S0
S1supply
Decrease in
Price Increase in supply
S2
S0
S1
0 q2 q0 q1
Quantity
Page 52
From the above illustration price of own good P, remains constant whereas it is possible for
quantity supplied to shift from for instance S0 to S2 or from S0 to S1..A shift from S0 to S2 is
interpreted as a decrease in supply and occurs when the determinants of supply move
against the product. The supply can also alternatively shift from S0 S1 which is interpreted as
an increase in supply. This is brought about by changes in the determinants of supply, which
are in favour of the good in question.
Please note that the price of the good remains constant even when changes in supply occur.
EQUILIBRIUM PRICE (MARKET PRICE)
The equilibrium or market price is the price that is determined by the interaction of demand
of and supply (market forces). At equilibrium price, quantity demanded is equal to quantity
supplied.
Equilibrium Price
From the above diagram, if the price is P2 there is surplus on the market. This is because
consumers are demanding q2 whereas suppliers are supplying q3. In order to eliminate this
surplus, suppliers are forced to compete amongst themselves by reducing their prices until
they reach Pe which is the equilibrium or market price. If the price is P1 , only q1 is supplied
on to the market but at the same price, consumers are demanding q4 of the good resulting in
scarcity. Consumers will have to compete amongst themselves by offering a higher price to
suppliers in order to obtain the scarce good. This competition will continue until a price is
reached where suppliers and demanders are in agreement, that is, the equilibrium price. At
the equilibrium price, in this case, Pe quantity supplied and demanded is qe, which is the
equilibrium quantity. Thus any price below or above Pe will result in disequilibrium in the
market.
PRICE FLOOR
It is the setting of a minimum price above the equilibrium level to prevent prices from
dropping. Floor prices or minimum prices are usually put by Governments to protect the
incomes of producers, such as farmers. This is shown by P2 in diagram above. Floor prices
always create surpluses in commodity markets.
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PRICE CEILING
A price ceiling exists when the price is fixed below its market level. The aim is to protect
customers from price increases. P1 on the above diagram shows the price ceiling which
leads to an increase in quantity demanded, and a decrease in quantity supplied and thus
causing shortages. Price ceilings are usually associated with black or parallel markets.
THE ELASTICITY CONCEPT

ELASTICITY OF DEMAND
Elasticity of demand is the sensitivity of demand to changes in the determinants of demand.

There are as many elasticities of demand as there are the determinants of demand. There are,
however, three types of elasticities of demand that are commonly of practical importance.
These are:
a) Price elasticity of demand;

b) Income elasticity of demand;
c) Cross elasticity of demand;
Price elasticity of demand (PED)

This refers to the response of quantity demanded to changes in the price of a product. It can
be calculated from the following formula: -
PED = % Change in quantity demanded

% change in price
If the statistic calculated is less than one (PED < 1), it means PED is inelastic. Inelastic
PED is usually associated with necessities, that is, goods with no close substitutes. PED of
less than one means that a higher than proportionate change in the price is followed by a less
than proportionate change in quantity demanded as consumers do not have a wider scope for
substitutes.
Price elasticity of demand of greater than one (PED>1) means that a less than proportionate
change in price is followed by a higher than proportionate change in quantity demanded.
This is usually the case with luxury goods. A slight change in the price is followed by a
large change in quantity demanded because consumers have immediate substitutes.
If the results from the calculation give a PED of one (PED = 1), then we are dealing with
unitary elasticity of demand. A slight change or higher change in price results in
proportionate change in quantity demanded. Please note that there is no definite category of
goods or service for this PED that are known. What is known definitely is that goods can
have price elasticity of demand from less than one (inelastic), equal to one (unitary) to
greater than one (elastic). We also have to ignore the sign (+) in the statistic because the
law of demand postulates that there is a negative relationship between price and quantity
demanded.
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Income Elasticity of Demand (YED)

Income elasticity of demand refers to the response in quantity demanded to changes income.
It is calculated using the formula below:
YED = % change in quantity demanded

% change in income
If the results obtained are positive it means we are dealing with normal goods and if they are
negative then we are dealing with inferior goods. Unlike the case with PED where the sign
is not important or is ignored totally, with YED the sign is equally important, as is the
statistic. It shows the direction of our relationship, that is, whether we are dealing with
normal or inferior goods. The statistic measures the degree or strength or weakness of the
relationship. Thus, YED splits goods into two broad categories – normal and inferior goods.
Cross Elasticity of Demand (CED)

Cross elasticity of demand measures the responsiveness of quantity demanded to changes in
the price of another good, say good X. It is calculated from the following formula.
CED = % change in quantity demanded of Y

% change in price of X
The statistic helps us to classify goods into either complementary or substitute goods. As is
the case with the YED, the sign as well as the statistic is equally important in this
classification. If the results obtained are positive, it means we are dealing with substitutes
goods whereas negative result is associated with complementary goods. Thus, the sign gives
the direction of the relationship, that is, whether we are dealing substitute or complementary
goods. The statistic measures the strength or weakness of the relationship.
THE NATURE OF DEMAND CURVE
Price elastic demand
Price
P2
P1
0 Q2 Q1 Quantity
This demand curve is highly responsive (assuming same scaling on both axis) to price a
change that is if price is increased from P1 to P2, quantity demanded decreases from Q1 to
Q2.
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Perfectly inelastic demand curve

This demand curve shows that quantity demanded does not change as price changes.
Elasticity of demand = 0
Price
P2
P1
0 Q Quantity
If the price is increased from P1 to P2 quantity demanded does not change, it remains static
at Q.
PERFECTLY ELASTIC DEMAND CURVE
It is a demand curve which is fixed at a certain price level.
UNITARY ELASTIC DEMAND CURVE

This is when there is an equi-proportionate change in quantity demanded to changes in
price.
Price
0 Quantity
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With this demand curve, elasticity of demand is equal to 1.
Determinants of price elasticity of demand
TIME PERIOD
Price elasticity of demand is inelastic in the short run because of limited scope for choice
(alternatives). If the price of good changes consumers take long to adjust their expenditure.
In the long run as the scope for substitute increases, price elasticity of demand becomes
elastic.
AVAILABILITY OF SUBSTITUTES
The price elasticity of demand of goods that have close substitutes is likely to be elastic
compared with goods which have no close substitutes.
THE NATURE OF THE PRODUCT
If the good in question is a necessity, price elasticity of demand is inelastic. Luxury goods
are on the other hand, associated with elastic price elasticity of demand.
HABIT
There are some habit-forming goods such as smoking or alcohol drinking which exhibit
inelastic price elasticity of demand. Habit-forming goods are treated as ‘necessities’ –
quantity demanded responds marginally to a significant change in the price.
Proportion of Income
If a consumer spends a small proportion of his or her income on a good, the PED for the
good will be inelastic. Changes in price does not affect greatly consumption of the good. If
the consumer spends a larger proportion of his or her income on a good. PED is elastic.
Changes in the price of the good affects the consumer’s budget and hence the budget should
be realigned to take into account these changes.
Number of uses to which a commodity can be put

The demand curve and elasticity of demand
The price elasticity of demand changes as one moves along the demand curve. The
difference elasticities are shown by the following demand curve.
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Demand curve and price elasticity of demand
Price
PED = -∞
PED >1
PED = 1
PED < 1
PED = 0
0 Quantity demanded
IMPORTANCE OF ELASTICITIES
The business world
- Firms analyze the demand of their products and this will help them price their products
- Price elasticity of demand analysis is the key to success of an organisation
- Firms charge high prices on in elastic goods in order to maximise revenue and low
prices on elastic goods.
Segmentation
The produce can segment (divide) the market according to different price elasticities of
demand. A producer can successfully charge a higher price in a market with a low PED and
a low price in a market with a high PED to maximise revenue.
THE GOVERNMENT
- There is need for the Government to analyse the elasticities of goods if they need to
raise income.
- Indirect and direct taxes can be charged on goods and income. The government can
maximise revenue from taxation if it imposes tax on a good or service with a low
PED than on a good with PED since with the former consumers do not have
alternatives and are unlikely to reduce the expenditure on the good or service
significantly.
- Government can subsides products, which have an elastic demand.
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To raise income
This is normally used by Trade Unions when bargaining wage increases for their members.
This now depends on the elasticity of demand for the products they produce as demand for
labour is a derived demand. Trade unions can successfully negotiate a wage increase if the
demand for the final product is price insensitivity since a wage increase can be
accommodated by increasing the price of the final product.
Correction of the balance of payment (BOP)

The BOP can be corrected by manipulating the exchange rate. A devaluation of the
exchange rate is likely to increase exports on one hand and reduce imports on the other hand
ceteris paribus. This should go a long way in reducing the BOP deficit however if exports
and imports exhibit inelastic PED the results of this policy prescription is likely to be less
than desirable. Thus a devaluation of the exchange rate is likely to yield desirable results if
the price elasticity of exports and imports respectively is elastic.
PRICE ELASTICITY OF SUPPLY

Price elasticity of supply is the measure of the responsiveness of quantity supplied to
changes in price.
PES = % change in quantity supplied

% change in price
TYPES OF ELASTICITY OF SUPPLY
a) Elastic supply curve
Supply is said to be elastic if a small change in price yield a greater change in quantity
supplied.
S
Price P2
P1
Q1 Q2 Quantity
If the price is increased from P1 to P2, quantity supplied is also increased by a greater
margin from Q1 to Q2.
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b) Inelastic supply curve
Supply is inelastic if a greater change in price yields a smaller change in quantity supplied.
Price
S
P2
P1
Q1 Q2 Quantity
Inelastic supply has a smaller percentage change in quantity supplied compared to a
percentage change in price, i.e. PES is between 0 and 1.
C) UNITARY ELASTICITY OF SUPPLY CURVE
Elasticity of supply is unitary if the percentage in quantity supplied is equal to the

percentage change in price.
Price P2
P1
Q1 Q2 Quantity
Price elasticity of supply is equal to one.

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d) Perfectly inelastic supply curve
Supply is perfectly inelastic if the percentage change in price does not have any effect on
quantity supplied.
S
Price
P2
P1
0 Q QUANTITY
The above diagram illustrates perfectly inelastic supply, where a price increase does not
affect the quantity supplied. It therefore follows that PES = 0
E) PERFECTLY ELASTIC SUPPLY CURVE
Perfectly supply curve shows that suppliers are prepared to offer different quantities of their
goods at the same price.
Price
P S
0
Q1 Q quantity
Price elasticity of supply is infinite at large.

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DETERMINANTS OF ELASTICITY OF SUPPLY
TIME PERIOD
In the short run period supply is likely to be inelastic, as production cannot be increased due
to constrained capacity. Supply becomes elastic in the long run as producers can increase
capacity and hence output.
CAPACITY UTILISATION
Supply is inelastic at full capacity as there is no way production can be increased in
response to changes in prices. However, when operating at below capacity, it is possible to
respond to changes in the price by increasing production.
AVAILABILITY OF STOCK
Where a product can be stored without loss of quality or undue expense, supply will tend to
be elastic, at least while stocks last.
FACTOR MOBILITY
The greater the mobility of the factors of production, the greater the elasticity of supply.
The level of trade barriers
An open economy can have elastic supply if goods can be imported, however, this may lead
to balance of payment problems.
Price elasticity of demand and total revenue

The total revenue that a firm earns by varying its price is dependent on the price elasticity of
demand. If faced with elastic price elasticity of demand for its product, a firm can maximise
total revenue by reducing the price than increasing it. Faced with inelastic demand, a firm
can maximise its total revenue by increasing than decreasing its price. Changes in the price
when the firm is faced with unitary price elasticity will not change total revenue. Thus the
resulting total revenue is the same whether there is a decrease or increase in total revenue.
We can illustrate the different scenario as below in summary
PED Changes in price Effect on TR

Inelastic Increase Increase
decrease decrease
Elastic Increase Decrease
decrease increase
Unitary Decrease No change
increase no change
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The theory of demand and supply at a glance
Determinants of demand
These are variables or factors which can shift the demand curve other than the price of the
good and can be shown in the equation.
QD = f(Pg; Y, A, M, E, C)
Where
Pg – prices of other goods for example complementary and substitute.
Y – changes in disposable income
A – advertising / consumer awareness
M – market size / number of consumers
E - consumer exploitations
C – climatic/ weather changes
DETERMINANTS OF SUPPLY
These are factors which cause shifts in the supply curve or those factors which create a
change in supply.
These can be summarized in the mnemonic COWPING
CO – Cost of production
W – weather/ climatic changes
P – prices of other goods
I – innovation / technology
N – number of suppliers/ firms
G – government policies for example taxes, prices, subsidies price ceilings and
price floors.
Price ceiling – this is the maximum price below the market / equilibrium price whose
effects are as follows:
 Protects consumers
 Reduces price
 Increases demand
 Increases consumption
 Has an income effect on the consumers
 Improves consumers’ living standards

 Reduce supply
 Leads to artificial shortages
 Leads to grey, underground as black market hence an increase in price that’s fueling
inflation.
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Price floor – this is the minimum price above the market price.
 The price is set to promote investments and competition among producers or

suppliers.
Its general effects are as follows:
 Protects infant / new industries
 Increases the price
 Creates inflation
 Reduces demand
 Increases supply leading to surplus
MULTIPLE CHOICE
1. All other factors shift the demand curve for an Economic textbooks, except:
A Increase in the number of people studying Economics.
B An increase in the price of a substitute textbook.
C A change in people’s incomes.
D A change in the price of an Economics textbooks.
2. When can the demand for a product be said to be price inelastic?

A An increase in the price of a product raises its quantity demanded.
B An increase in the price of a product increases expenditure on it.
C A fall in price increases quantity demanded of a product.
D A fall in the price of a product reduces expenditure on it.
3. What is effective demand?

A Amount of a good a consumer is willing to buy at a given price.
B Quantity of a good a producer is willing to sell at a given price.
C Desire to buy a good backed by the ability to do so.
D Desire to buy a good through credit purchase.
4. Which diagram shows unit elasticity of demand at all points of the demand curve.
Price A Price P B
0 Quantity demanded 0 Quantity

demanded
D
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D C
Price Price
0 Quantity demanded 0 Quantity

demanded
2. What will increase the price elasticity of demand for a product?

A Availability of perfect substitutes for a product.
B Expenditure on a product takes a small fraction of the household’s total expenditure.
C Consumers are becoming addicted to the product.
D Demand for a product considered in the short-run.
3. The diagram below shows supply curves with different degrees of price elasticity of
supply.
Which curve A, B, C, or D is inelastic at all points on the supply curve?
Price S A B
S
C
S
D
S
0 Quantity demanded
4. Goods X and Y are related. Cross elasticity of demand for X and Y has a large positive
co efficient. When income increases demand for both goods also increases.
What type of goods are X and Y?
A Substitutes and normal goods
B Substitutes and inferior goods
C Complements and normal goods.
D Complements and inferior goods.
5. Which statement on applicability of elasticity of demand is correct?
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A The greater the elasticity of demand for the agricultural product, the greater will be
the fluctuations in price from period to period.
B The more inelastic the demand curve, the lower is the firm’s ability to shift the
incidence of a tax to consumers.
C An import duty is most effective in improving the balance of payments when
domestic demand is price inelastic.
D Devaluation is most effective in improving the country’s balance of payments when
local demand for imported goods and foreign demand for the country’s exports are
both price inelastic.
6. The diagram below shows the interaction of demand and supply curves.
Following a shift of the supply curve from S1 to S2, which area represents the loss in
consumer surplus.
Price S2
A S1
P2 B
C
P1 E
0 Q2 Q1 Quantity
A ABA
B ADE
C CEQ1Q2
D BCED
7. The consumer has a choice of three goods X, Y and Z to consumer in order to maximise
her utility.
The condition of equi-marginal utility will be:
A Mux = Muy = MUz
Px Pz Py
B MUx = Muy = MUz

Py Pz Px
C MUx = MUy = MUz

Px Py Pz
D MUx = MUy = MUz

Pz Px Py
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8. Demand for factors of production is said to be derived demand. Derived demand means:
A A factor is not demanded for its sake, but for the goods and services it produces.
B Demand for factors of production is perfectly elastic.
C Demand for an individual factor of production is the market demand.
D Demand for a factor of production is the same as demand for the goods and
services it produces.
ESSAYS
1. (A) EXPLAIN THE FACTORS THAT INFLUENCE PRICE ELASTICITY OF
DEMAND FOR PUBLIC URBAN TRANSPORT [10]
(B) GOVERNMENT HAS IMPOSED PRESUMPTION TAX IN ORDER TO AVOID
TAX EVASION BY PUBIC TRANSPORT OPERATORS. DISCUSS THE RELEVANCE
OF PRIZE ELASTICITY OF DEMAND OF THIS TAX.
[15]
2. (a) Using illustrations, explain the derivation of the short-run supply curve.
[12]
(b) Analyse the factors which lead to a shift in the short-run supply curve of
a product.
2. (a) Explain the factors that influence market supply of a product.

[10]
(b) Discuss the effects of an increase in an indirect tax on:
(i) The production of asbestos
(ii) The road transport.
[15]
DATA RESPONSE QUESTIONS
1. KENYA EYES BIODIESEL AS COST OF FUEL RISES
NAIROBI
The prevailing high cost of fossil diesel in Kenya has spurred renewed interest in biodiesel
as an alternative source of energy.
Private sector firms and organisations have upped the stakes in producing biodiesel from
methylester, a vegetable- based derivative obtained from jatropha, croton, palm oil and
coconut among other plants. Interest in biodiesel globally has been attributed to its non-
offensive exhaust fumes. The fuel does not cause irritation in the eyes and is
environmentally friendly and more biode gradable.
The rising cost of petroleum products and electricity has created an immediate need for new
thinking towards alternative fuels. Biodiesel can be used in any diesel engines in the same
way as conventional diesel fuel. Energy for Sustainable Development Africa (ESDA), an
interest group, reckons that interest in biodiesel is riding on the back of the high cost of
diesel (automotive gas oil).
Page 67
(a) (i) What has led Kenya to look for an alternative source of energy.
[2]
(ii) Give any two advantages to society of using this source of energy.
[2]
(b) State possible reasons for a rise in the cost of fuel.
[4]
(c) (i) What is the likely effect on the price elasticity of demand of petroleum products
after the development of a new product?
[2]
(ii) Explain any two advantages of the production of this new product to society.
[4]
(d) Discuss the benefits of competition in production to society.
[6]
BOOK PUBLISHERS FACE HARD TIMES
By Japhet Dube
WRITERS in Zimbabwe are going through tough times, as book publishers no longer
publish books due to lack of customers.
This emerged during a monthly meeting of the Bulawayo chapter of the Zimbabwe Writers’
Union (ZWU) held recently at Amakhosi Township Centre.
The chairman of the Bulawayo branch, Philbert Khumalo, said because of the economic
difficulties that the country was presently going through, many people could not afford to
buy books as they considered them a luxury.
“The book industry is depressed as witnessed by the fact that writers have written a lot of
manuscripts, but publishers are saying they have suspended publishing because its
‘unprofitable,” said Khumalo.
Tapiwa Muchechemere of Longman Publishers confirmed to Chronicle that the going was
tough for both the book publishers and authors as people were only buying textbooks and
not fiction.
“We are currently not publishing fiction because there are no customers. I believe the
economic hardships are making people concentrate on basic necessities rather than buy
books, which many feel, are a luxury. The only books that are being bought are the school
text books,” he said Khumalo appealed to the Government to subsides the cost of books in
order to sustain the writers and the whole book industry
“Book reading is critical in any society as it develops the mind and creativity in society, so
we as writers feel the Government should make the books cheaper and easily accessible to
all for the benefit of both the writers and the general public,” he said.
The writers also complained about the royalties being offered by book publishers, saying
they were too little. Authors only get 10 percent of the price of the book.
“The percentage of royalties is very small and you have to sell large quantities to receive a
reasonable figure. However, as authors we also sympathize with publishers as they are also
in a tight situation because, the cost of the paper has increased tremendously,” said
Khumalo.
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A t the same meeting, a new executive committee- was elected for the Bulawayo branch.
The new members of the executive are Khumalo (chairman), Bernard Ndlovu (vice), the
position of secretary went to Sibongile Mnkandla, while veteran writer, Ndabazinhle
Sigogo, was elected treasurer.
Ishmael Penyai and Mihla Sitsha were elected as committee members. Khumalo said the
new committee has set up a programme to run workshops on writing skills for upcoming
writers.
(a) From the extract, explain why the book industry is depressed.
[2]
(b) (i) What is meant by the term ‘royalties?’
[2]
(ii) How may subsides from government increase royalties received by writers?
[2]
(c) (i) Identify the factors that influence demand for books, as outlined in the
extract. [4]
(ii) Suggest the price elasticity of demand for school textbooks and books for
fiction. Justify your answer.
[4]
(d) Examine the effects of a decline in the demand for a product such as a textbook.
[6]
Page 69
CHAPTER 6
CONSUMER BEHAVIOUR
Chapter objectives
After reading and retaining comprehension of this chapter you should be able to:
1. Define the term “Utility” and explain the low of diminishing marginal utility.
2. Explain the properties of indifference curves and represent it on the diagram.
3. Describe the concept of Consumer Equilibrium and show it on the diagram.
4. Illustrate the substitution and income effect of a price change on the indifference
curve.
The theory of consumer behaviour is about how the consumer with a limited income
determines his expenditure and consumption pattern with a view to maximize his utility or
satisfaction. The rational consumer strives to get the most satisfaction from every dollar or
cent spent on any commodity that he buys.
UTILITY
Utility is the satisfaction a consumer obtains when he consumes a commodity. It depends on

the circumstances of the consumer, preference, taste and expectations.
THE LAW OF DIMINISHING MARGINAL UTILITY
Marginal utility (MU) is the extra satisfaction that a consumer derives from consuming an
extra unit of a commodity. The law of diminishing marginal utility states that as the
consumer consumes more and more of a commodity, the extra utility derived from the
successive units falls continuously. An example is often given of a thirsty person. The first
glass of cold water will definitely gives her the highest satisfaction. As she takes the second
glass, the third and so on of the glass, they will provide her with declining satisfaction.
UTILITY MAXIMIZATION BY THE RATIONAL CONSUMER
A rational consumer who seeks to maximize satisfaction from a limited (inadequate) income
should, at the margin, consume a commodity up to a point where marginal utility from the
last dollar spent on the commodity is equal to the price (P) of the commodity.
i.e. P = MU
If MU is greater than the price paid, then the consumer obtains more total satisfaction by
buying and consuming more of the commodity. As he does that MU will converge to the
commodity’s price (the law of diminishing marginal utility). If MU is less than P, then the
consumer will be making a ‘loss’ on the last unity consumed, so there will be need to reduce
quantity consumed until MU equals P.
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When consuming more than one commodity, the consumer will maximize utility when
consuming where utility per dollar spent on the last unit of each of the commodities is equal
across all the commodities.
ie MUx = MUy =……….= MUz

Px Py Pz
Preferences and demand / Indifference curve analysis

This section presents the basic theory of consumer choice. The individual consumer is
assumed to have fixed preferences and to be consistent in his behaviour. A fixed amount of
money, called the budget, is allocated among available choices and the theory examines the
most efficient allocation.
Definition of terms
INDIFFERENCE CURVE
This is a curve that joints a combination of two goods that yield the same level of
satisfaction, ceteris paribus. We can illustrate by way of diagram below:
Indifference Curve
Good Y a
0 Good X
From the above indifference curve I, points a, b and c and other various points which lay on
the indifference curve yield the same level of utility.
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INDIFFERENCE MAP
GOOD Y
IC4
IC³
IC²
IC¹
0 IC° GOOD X
Along each indifference curve the consumer is indifferent to alternative combination of

goods X and Y. The higher the difference curve, the higher the level of satisfaction. From
the indifference map above, IC4 yields the highest level of satisfaction whilst IC0 yields the
lowest level of satisfaction. In other words, the consumer derives the highest level of
satisfaction as he moves from the origin. Thus, the highest indifference curve is preferred to
a lower one.
The slope of IC indicates the amount by which consumption of one good must be given up
or decreased, in order to increase consumption of the other good for the individual to remain
indifferent (same level of satisfaction). This slope is called the marginal rate of substitution
in consumption. It is assumed that this decreases as consumption of good X increases, so
that indifference curves are convex.
Properties of indifference curves
1. No two indifference curves may cross each other

2. The slope always downwards i.e. they are convex, ceteris paribus.
3. The higher to the origin the indifference curve, the higher the level of satisfaction,
ceteris paribus.
Choice with a limited budget
The consumer is assumed to be faced with market prices of different consumer goods,
which are beyond his control. A constraint is then imposed on the amount of money at his
disposal- budget constraint. Only a limited number of combinations of purchases, therefore,
is possible and these alternatives can be represented diagrammatically as below.
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The budget constraint
Good Y
Feasible region
0 N
Good X
The consumer from the above diagram has a fixed amount of money (income) represented
by MN, which we shall refer to, as the budget line. Any purchases of goods X and Y
respectively is only possible if it lies on the budget line MN or below. This means that a
consumer cannot purchase a combination of goods X and Y that lies on any position above
MN. Thus MN represents our budget constraint.
The budget constraint
Faced with two alternative goods X and Y, our consumer can purchase any quantity of good
X (Qx) at given market prices (PX) and quantity of good Y (Qy) at given market prices for
good Y (Py). Assuming that our income is β, our budget constraint would be represented as
follows.
BC = Qx Px + QyP y≤ β
Consumer Equilibrium
It is now possible to provide a description of the efficient consumption choice (consumer

equilibrium). The budget constraint specifies the feasible range of alternatives. An
individual with insatiable desires will prefer to reach the highest indifference curve
consistent with this constraint. We can represent this position as in the diagram below.
Page 73
Consumer Equilibrium
Good Y M
a
d
b
IC2
IC1
c
IC0
0 N
Good X
From the diagram above our budget constraint is MN. Given the budget constraint, the
consumer is capable of operating on either IC0 or IC1.. Indifference curve IC2 is unattainable
given our budget constraint. Thus restricting our analysis to ICO and IC1, we can determine
our equilibrium position (efficient consumption).
Positions a, b, and c lie on the same budget constraint MN meaning that the consumer is
able to consume at either of the positions. Positions a and c lie on the same indifference
curve IC0 and derive the same level of satisfaction. If, however, our consumer wishes to
maximize his utility given the budget constraint, he is best advised to consume at position b
because it is on a higher indifference curve and this derives higher satisfaction than
positions a and c even though the three uses the same level of income (MN). Thus, our
consumer reaches consumer equilibrium only when he consumes at a position where the
budget constraint and the indifference curve are tangent, in our analysis at b. At b the slope
of indifference curve equal the slope of the budget constraint. Thus, the marginal rate of
substitution is equal to the rate of exchange (the price ratio). In the event that the consumer
moves from position b, the results are that he will yield less and less levels of satisfaction
because he ends up consuming at lower indifference curves.
N.B. At the level of equilibrium, MR Sxy.
Where MRSxy is the marginal rate of substitution, Px and Py are the respective prices for
goods X and Y, When this equality does not hold, the individual can increase utility by
moving to a higher indifferent curve.
Page 74
Changes in the budget

The slope of the budget line (constraint) depends only on relative prices (price ratio). Thus
an increase in the budget line causes a parallel shift outward in the budget line. This is
shown in the diagram below.
The effect of a change in the budget
Good Y
M3
M2
e3
M1 e2
e1
IC3
IC2
IC1
0 N1 N2 N3
Good X
For a given set of prices, a higher money budget shifts the budget line upwards. The points
e1 e2 e3
trace out a budget consumption curve as the budget constraint shifts from MN1, MN2 and
MN3. Thus, with a higher level of income the consumer is able to increase the consumption
of both goods, X and Y and moves from a lower indifferences curve to a higher indifferent
curve.
N.B. The budget constraint can either move upwards or downwards depending on whether
income has increased (upward shift) or has decreased (downward shift).
Changes in the prices
Changes in prices of one of the goods will result in a pivotal shift of the budget line.
Assuming that there is a decrease in price of good X or an increase the effect of these
changes would result in the following budget constraints.
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A decrease in price
Good Y
M
A price decrease, ceteris paribus, will result in a pivotal shift of the
Budget line from MN to a new budget line MN1.
0 N N1
Good X
An increase in price
Good Y An increase in the price has the effect of shifting the budget
line from MN1 to MN, ceteris paribus.
0 N N1 Good X
SUBSTITUTION AND INCOME EFFECT FOLLOWING A PRICE DECREASE

We can now analyze the substitution and income effect of a price change. Though it is an
established fact that price changes swing in both directions, we shall restrict our analysis to
a situation where there is a price decrease in good X.
Substitution and income effect of a price change

In order to analyze the effect of a price decrease on quantity demanded, we need to make the
following assumptions.
1. There are only two goods, goods X and Y.

2. Consumer tastes and preferences are constant.
3. Consumers are faced with market prices they can hardly influence.
4. Consumers have limited income.
Page 76
The last two assumptions mean that consumers are faced with a budget constraint.
It is postulated that a price decrease should lead to an increase in quantity demanded
according to the law of demand. The increase in quantity demanded is largely due to the
income and substitution effect. We can establish the two effects through diagrammatical
expositions as below.
Substitution and income effect of a price decrease
Good Y
M2
C2 A
C4 C
B IC¹
C3
IC0
Q2 Q3 Q4 N N² N¹
Substitution Good X
Income
effect
effect
From the above illustration the initial equilibrium position is at A where the budget line MN
is tangential to the indifference curve IC0 . Following a decrease in price of good X
consumers move to a higher indifference curve IC, and establish consumer equilibrium at C.
As expected a price decrease in good X increases quantity demanded from q1 to q2. This
increase in quantity demanded is however, brought about by two effects, substitution of the
relatively expensive good, good Y with a cheap good, good X as well as the income effect
which is a rise in real income due to a fall in prices which enables the consumer to consume
more of both goods that is operating at C.
However, in order to distinguish these two effects we will have to draw an additional
imaginary budget line M2N2 sometimes referred to as compensating budget line drawn
parallel to the new budget line MN1. This compensating budget line has the same level of
income as the new budget line MN1 and is drawn such that it is tangential to the initial
indifference curve, IC0. The essence is to analyse on would happen given the same level of
income at C if the consumer was to operate at the initial indifference curve with this level of
income. From the illustration above, it can be seen that given the level of income M2 N2.,
consumers would move from A to B. This is due to substitution effect. Consumers are
substituting good Y for X, i.e. reducing consumption of good Y and increasing consumption
of good X. Thus, the substitution effect is positive. However, due to increased real income
brought about by falling prices, consumers are able to demand more of both good X and Y.
This is illustrated by the difference between B and C. Thus the income effect is positive.
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The substitution and income effect work in opposite direction. In the case of normal goods,
that is goods whose demand increases with increases in income vice versa, the substitution
effect and income effect reinforce each other. As a result demand increases as price
decreases.
N.B. We can also extend the analysis of a price decrease and the substitution and income
effect to the case of inferior goods. Inferior goods are goods whose demand decreases as
income increases, vice versa. In the case of inferior goods the substitution effect is so large
that it offset the income effect leading to a decrease in quantity demanded as price
decreases. The relationship between income and substitution effects explains why a demand
curve may slope upwards (the case of inferior goods) or downward (the case of normal
goods. In the case of normal goods the income effect and substitution effect reinforce each
other resulting in a downward sloping demand curve. However, in the case of inferior goods
the substitution effect is so strong that it offsets the income effect.
Multiple choice
1. Good X has a downward sloping demand curve, the income effect of the price change
works in the opposite direction to the substitution effect and the income effect is
smaller than the substitution effect.
This is a description of:
A A normal good
B An inferior good
C A given good
D Veblen good.
2. The slope of the budget line shows:
A The marginal rate of substitution between the two goods.
B The diminishing marginal utility as the consumer, consumes more of one
good.
C The marginal rate of transformation
D The relative prices of the two goods.
2. Which one is not a property of an indifference curve?
A An indifference curve is made up of combinations of goods which yield the
same level of satisfaction to the consumer.
B A higher indifference curve yield a greater level of satisfaction than the one
below it.
C An indifference curve is concave to the origin.
D Indifference curves never cross.
ESSAYS
1. (a) Using the substitution and income effect, explain the downward sloping
demand curve for bread.
[12]
(b) Discuss the factors, which influence demand for a good such as bread. [13]
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2. To what extent can the Marginal Utility theory explain consumer behaviour. [25]
Clothing industry hit by poor demand
Business Reporter
The local clothing industry has been hit by poor demand in the first quarter of this year as a
result of falling incomes and proliferation of second hand imports, industry officials have
said.
The Zimbabwe Textiles and Manufacturers Association (Zitma) said in submissions to the
Government that some companies may have to reduce operations to cut costs.
“There is a decline in demand for the locally produced goods. In the event that the situation
remains unchanged there is a likelihood that some companies will be forced to shut down,”
said Zitma at the official commissioning of the Clothing Industry Pension Fund Complex
last week. While the production capacity of the industry had increased to 30 percent in the
first quarter from 10 percent at the end of last year, industry officials warned that profits
would be hit hard as a result of depressed demand.
Zitma warned that local and foreign direct investments in the industry would decline
because of poor performance of the sector.
“Investment levels will continue to decline as both the local and foreign investors stay away
from the industry because of (the) depressed demand and competition from some Asian
countries,” said Zitma.
It said that most companies were exploring markets in the Southern Africa Development
Community.
However, analysts said the clothing and textile industry was slow to respond to the changing
trade environment.
“There is the need for clothing industry firms to match their products with international
standards to increase earnings,” said Mr. Edward Potsiwa, an economic analyst.
He said that the industry should add value to products to capture export market. Mr. Potsiwa
said that the drop in local demand could improve if clothing industry firms can surpass the
quality of imported products.
“Most local people are buying the imported commodities owing to quality therefore the
textile industry can address the challenges by producing high class products,” he said.
Another economic commentator with Kingdom Financial Holdings Limited, Mr. Witness
Chinyama said that the recovery of the clothing industry required adequate funding from
economic stakeholders.
“Both the private sector and the Government should play a leading role in funding
developmental programmes,” he said. The clothing industry has the capacity of creating 5
000 jobs yearly.
Page 79
(a) From the extract, identity factors that led to a decline in demand for locally produced
clothing.
[4]
(b) Explain how companies cut costs by reducing operations.
[2]
(c) (i) Suggest and explain ways in which the local companies can fight competition
from foreign produced products.
[4]
(ii) Suggest and explain ways in which the government can help local textiles
industry from depressed demand for their products.
[4]
(d) Discuss the benefits of competition in an industry.

[6]
Page 80
CHAPTER 7
MARKET STRUCTURES
Chapter objectives
After reading and retaining comprehension of this chapter, you should be able to:
1. Distinguish between the short run and the long-run.
2. Understand the differences between total costs, average costs, variable costs and
marginal costs.
3. Explain the features of perfect competition monopoly, monopolistic competition and
oligopolies.
4. Illustrate abnormal profits in the short-run of perfect competition and monopolistic
competition.
5. Compare and contrast the long run of firms in perfect competition and monopolistic
competition.
6. Appreciate the economic evaluation of perfect competition monopoly, monopolistic
competition and oligopoly
7. Describe the conditions necessary for price discrimination by a monopolist.
8. Understand the “concept of cartels” by oligopoly competition.
In making their strategic decisions, firms must take into account the nature of markets they
are operating in. This will assist them in selecting the factors of production to be used and
the techniques to be used.
Market Structures
Competitive Markets Imperfect competition

(Perfect competition) Monopoly
Oligopoly
Monopolistic
Competition
THE SHORT RUN

This describes the time period in which at least one factor of production is constant, usually
capital and other factors can be varied, in most cases labour. Thus in order to increase
production in the short-run where the capacity is limited, increase in factor costs can only be
attributed to variable factors for example, labour and raw materials to mention but a few.
Page 81
THE LONG RUN
This is the time period in which all factors of production are variable. Increasing the
capacity, i.e., capital can thus increase production.
N.B. It is only in the short run that costs can be categorised into variable and fixed costs. In
the long-run all production costs become variable.
TOTAL REVENUE
This is the revenue obtained from selling a product. It is obtained by multiplying the selling
price and the quantity sold. (TR = P x Q) where TR is total revenue, P is the selling price
and Q is the quantity sold.
AVERAGE REVENUE
This is the selling price obtained by dividing the total revenue and the quantity sold. (AR =
TR/ Q.)
MARGINAL REVENUE
This is the additional revenue obtained from selling an additional unit of production. In
order to obtain the marginal revenue the following calculation should be done: (TR – TR) /
Q
EXERCISE 1
Calculate total revenue, average revenue and marginal revenue from the following
information. Webstrations Trans International is involved in the production and selling of
personal computers. It sells its products at $100 each. In a 5 day, week period it managed to
sell 9 PCs. However, due to increased demand, it opened shop on the 6th day and said 3 pc.
Using any or all of the above information answer the above question.
TOTAL COST
This is total production cost incurred from producing all products available for sale. It is
calculated by multiplying the cost of producing a single unit by the quantity produced (TC =
C x Q) where TC is the total cost, c = cost per unit and Q = quantity produced.
TOTAL VARIABLE COSTS

This is calculated by multiplying the variable cost per unit by the quantity produced (TC =
AVC x Q).
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AVERAGE COST
This is the cost per unit of production calculated by dividing total cost by the units of
production produced (TC/ Q).
AVERAGE VARIABLE COST
FIXED COSTS
These costs do not vary with the level of production. They remain the same despite the level
of production. This, therefore means that they are incurred even when, production is at zero.
AVERAGE FIXED COSTS
These are fixed costs per unit of production obtained by dividing total fixed costs (TFC) by
quantity produced (Q) . AFC = TFC /Q
MARGINAL COST
This is the additional cost that one incurs from producing an additional unit of production.
N.B. In order to arrive at the total cost of production one has to sum up the total fixed cost
and the total variable costs. (TC = TFC + TVC). It follows, therefore, that average total cost
(ATC) is the summation of average variable cost (AVC) and average fixed costs (AFC).
ATC = AVC + AFC
EXERCISE 2
From the following information, calculate the following TC, TVC, ATC and AFC.
Webstration Trans International has produced 100 personal computers, incurring fixed costs
of $1 200 and average variable costs of $6. Using any or all the information above attempt
the question above.
N.B. Fixed costs are incurred irrespective of whether the firm is producing or not whereas
variable costs vary with the level of output. At zero output, they are also zero and fixed
costs equal total cost at this level. As output increases total costs begin to rise in response
to a rise in variable costs.
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INDIVIDUAL FIRM’S DEMAND CURVE

The demand curve of a perfectly competitive firm is perfectly elastic i.e. it is horizontal and
at a constant price level.
Price
P D = AR = MR
0 Quantity
The demand curve is horizontal. If the firm’s price is below P, the firm will be making
losses and if it is above P, the demand for the firm’s product will be zero.
Since the firms sell all units at the same price, marginal revenue is always equal to price
which is also equal to average revenue
CONDITIONS OF PROFIT AND OUTPUT MAXIMISATION
In order to maximise profits and output, firms are expected to produce at a level of output
where marginal revenue (MR) is equal to marginal cost (MC).
MR = MC, this condition implies that the firms is operating at an equilibrium output and
there is no incentive to move from this position as operating at any other level the firm will
be worse off.
Where marginal revenue is less than marginal cost, rational behavior will force firms to
reduce out put until the equilibrium position is arrived at thus when MR < MC, in order to
maximise profits firms should reduce output.
Where on the other hand, marginal revenue is greater than marginal cost (MR >MC) rational
profit maximising behavior dictates that the firm should increase production until the
equilibrium position is attained.
Thus when MR > MC, profit maximising behavior will result in more output being
produced.
In summary, the following conditions hold.

When: MR >MC - Increase output
MR =MC - equilibrium output
MR <MC - reduce output
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Whereas the marginal revenue and marginal cost functions are used to determine output, in
order to determine profits and losses we use the average revenue (AR) and average total cost
(ATC).
Normal profits or the break- even point, a point where neither profits or losses are made
occurs when AR = ATC.
Abnormal profits a position where total costs equal total revenue occurs when average
revenue is greater than average costs. (AR > ATC).
On the other hand, in order to establish when a firm is making losses, the following
conditions should obtain. Average revenue should be less than average costs (AR < AC).
In summary when; AR >ATC, the firm is earning supernormal or abnormal profits.

AR = ATC, normal profits are earned
AR <ATC, losses are incurred.
Given the forgoing information it is now possible to describe the short- run and long- run of
our market structures, perfect competition, monopoly, monopolistic competition and
oligopoly all inclusive.
Perfect Competition
This is a market structure where the price and output are by and large determined by what
was termed the ‘invisible hand’ by Adam Smith in simpler terms, the market forces of
demand and supply.
We shall illustrate the conditions of perfect competition in the short and long run. The
objective is to distinguish abnormal profits from normal profit positions of a perfectly
competitive firm as well as the position of loss making.
Perfect competition in the short run
Perfectly competitive firms earn abnormal profits in the short run. However we need to state
the underlying assumptions of perfect competition. We shall assume the following:
(i) There are many buyers and sellers of the product, that is, firms are price takers.
(ii) Firms are producing a homogenous product, that is one cannot differentiate one
product made by one firm from the other.
(iii) There are no barriers to entry and exit, firms can enter or exit the market whenever
they are comfortable.
(iv) There is perfect information in the market that is consumers are fully conscious of
product prices obtaining in the market.
(v) There are no transport costs involved
(vi) Firms seek to maximise profits by producing where marginal revenue (MR) equal
marginal costs (MC).(MR = MC)
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As already mentioned somewhere else, the short-run of perfect competition is characterised

by abnormal or supernormal profits and firms produce at a level of output where MR = MC
and average revenue (AR ) is greater than average total cost (ATC). (AR > ATC). This
scenario of supernormal profits can be illustrated through diagrammatical expositions as
below.
Abnormal profits in the short-run of perfect competition
MC
ATC
Price/cost
P MR=AR=D
Q Output
From the above illustration, a profit maximising firm in a perfectly competitive market
produces output Q where MR = MC. Abnormal profits on the other hand are represented by
the rectangle C1P ab. How abnormal profits or supernormal profits are arrived at is as
follows: From the above total revenue equal Opa Q or (P x Q) whilst total cost equal OC b
Q or (C1 x Q).
Thus supernormal profits equal total revenue minus total costs, in other words, (OPa Q) –
(OC b Q).
The condition of maximising profits can be analysed using the total revenue – total cost
method and the marginal cost – marginal revenue approach.
a) Total Revenue – total cost approach
The total revenue - total cost approach considers profit maximisation where total
revenue exceeds total costs by the greater margin i.e. where TR > TC by the widest
margin
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Cost TC
TR
Q Quantity
As shown by the diagram above, TR > TC by the greatest margin (a –b) at quantity Q.
 Any level of output above Q or below it generates less profits as compared to Q. At Q
the slope of TC is equal to the slope of TR.
Perfect competition and the long-run
Whereas a perfectly competitive firm earns abnormal profits in the short-run, the scenario
differs in the long-run. The long-run of a perfectly competitive firm is characterised by
normal profit. This is due to the assumption of free entry and exit that we have made
previously. Abnormal profits earned in the short-run are likely to attract new firms into the
market who also want to enjoy these profits. Abnormal profits thus act as a magnet that
attracts new firms into the market since there are no barriers to entry. New firms coming
into the market will lead to a rise in production costs such that firms end up incurring
abnormal losses initially, but since this is not an equilibrium position other firms that cannot
sustain these losses will exit the market forcing costs to fall down as competition eases. This
will lead to a scenario where average revenue equal average total cost (AR = ATC), normal
profits and opportunity cost is zero, in other words, there are no incentives to enter or exit
the market.
It would not be prudent, therefore to describe the normal profits in the perfect competition
without describing the disequilibrium scenario of abnormal losses.
Abnormal losses in Perfect competition
The entrance of new firms into the market attracted by the supernormal profits in the short-
run will drive factor costs upwards as firms increase factor rewards to attract scarce
resources. This competition for factors of production will tend to raise the average total cost
to a position where average costs are above average revenue. This can be illustrated
diagrammatically as below.
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Abnormal losses in perfect competition

revenue
Cost /
MC ATC
C d
P e MR = AR
0 Q
Output
As can be deduced from the above diagram, equilibrium output produced is Q where MR =
MC. However, unlike in the short- run position where supernormal profits are being earned,
the above illustration depicts a position where firms are making abnormal losses as
represented by the rectangle PCde (The reader can refer back to the short-run diagram on
how profits or losses are determined). This is so because intense competition amongst firms
for scarce factors of production has driven costs or average costs upwards. This, however, is
a disequilibrium condition as losses will force some firms to exit the market as they cannot
absorb them. Firms will continue to exit the industry until such time that average revenue is
to equal average total costs. In other words until only normal profits are being earned.
THE LONG RUN OF FIRMS IN PERFECT COMPETITION

The long run of perfect competition is strictly associated with normal profits. As already
mentioned above, abnormal losses resulting from new entrants into the market are a
disequilibrium phenomenon. Hence, already we should expect firms to exit the market until
the average revenue of each firm is tangential to its long- run average cost. This is the point
where the marginal cost curve cuts the average total cost curve at its lowest point. The
diagrammatical exposition below describes this process.
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a) Long-run equilibrium in perfect competition
ATC
Revenue
Cost MC
P
MR = AR = D
0 Q
Output
In the long- run, supernormal profits are eliminated by new entrants. Firms produce profit
maximising output Q where MR= MC. However, new entrants eliminate supernormal by
pushing average total costs so that they equal average revenue. Note also from the diagram
that for normal profits to occur average revenue (AR) equal average total cost (ATC) and
the marginal cost curve cuts the average total cost curve from below. This positions means
that opportunity cost is zero or that firms are earning a return that is equivalent to any from
other alternative employment of its resources. The long-run equilibrium position means
there are no incentives for new entrants into the market on one hand and there are no
rational reasons for disengagement or exit from the market.
N.B. In the long run all firms produce the same output at the minimum average cost and
have access to the same information, including technology and factor prices remain
constant.
THE FIRMS SHORT-RUN SUPPLY IN PERFECT COMPETITION

The firm’s short run supply curve is the relationship between the market price and the
amount the individual firm supplies at that price. The supply curve is given by that portion
of the short run marginal cost curve that is above the short run average variable cost curve.
This is can best be captured diagrammatically as below.
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The Supply curve of perfect competition in the short-run
P3 MC
Revenue
Cost
ATC
P2
AVC
P1
0 Q1 Q2 Q3
Output
From the illustration above, the firm does not produce when price is below P1, where
average revenue does not cover average variable costs. As long as the price is above P1,
even if it is below ATC, the firm still produces in the short-run. P1 is, therefore, referred to
as the shut down point and that portion of the MC curve above AVC curve is the firm’s
supply curve. The market’s supply curve, however is obtained by adding at each price, the
outputs of all the firms in the market. In other words, it is the horizontal summation of the
supply curves of all the firms in the market.
ECONOMIC EVALUATION OF PERFECT COMPETITION
- Perfect competition is blamed for its external cost contribution like water and air
pollution. This causes discomfort and other health problems to the nation.
- Lack of public goods provision as there may not be incentives to do so.
- It is only based on assumption and it lacks practical application
Monopoly
A monopoly refers to a market structure where there is a single producer of a product. Thus
the producer is not faced with competition from any quarter and has the liberty to decide on
the output or price to produce or charge respectively. However, a monopolist is faced with
many buyers of its products. Given this, it means it can either decide on the output to
produce and the price is determined by the market or it can decide on the price and the
output is determined by the market. Thus, it cannot decide on the price and output
simultaneously.
Since a monopolist is faced by many buyers for its products, it means it has the freedom to
charge different prices to different consumers or buyers for its products. This freedom to
charge different prices to respective buyers results in a downward sloping demand curve.
This demand curve is also the average revenue for the monopolist. Unlike perfect
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competition where marginal and average revenue are the same, the average revenue for a
monopolist is always above its marginal revenue. This is because for a monopolist to sell an
additional unit of production, it has to reduce its price to attract buyers. However, it still has
to produce at a level of output where the marginal revenue equal marginal cost.
N.B. The supply curve for a monopolist is the market supply curve since it is the sole
producer or seller of a product.
REASONS FOR MONOPOLY
1. Source of raw materials
Any company that controls the source of raw materials will end up being monopoly for
example control of coal deposits by Hwange Colliery.
2. Licenses
The Government can create monopoly through giving issuing patents, copyrights and
licenses for example parastatals like NRZ, ZBH etc.
3. Economics of Scale
Some investments or projects are capital intensive and requires a lot of money to invest in
machinery. These advanced technology results in economies of scale, which reduces the
cost price per unit thereby locking out competitors.
MONOPOLY AND PROFIT MAXIMISATION IN THE SHORT-RUN

The short run of a monopolist is characterised by abnormal profits, as is the case with
perfect competition. The monopolist has to produce at a level where marginal revenue equal
marginal cost (MR = MC). Supernormal profit is on the other hand determined where
average revenue is greater than average cost (AR >ATC). To illustrate this scenario we use
the following diagrammatical exposition as below:
Abnormal profits in the short-run of a monopolist.

Revenue
MC
Cost
ATC
a
P1
b
C1
AR= D
MR
0 Qe Output
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From the above diagram, in order to maximise its profits, a monopolist has to produce
output Qe where MR = MC. Abnormal profits on the other hand occur because total revenue
represented by OP1 a Qe is greater than total costs represented by OC1bQe Thus the
rectangle C1 P1 ab represents abnormal profits of a monopolist.
Normal profits and monopoly

The above scenario of abnormal profits in the short- run can also prevail in the long run if
there are barriers to entry and exit. However, if we relax this assumption, we can end up
with a situation where supernormal profits are competed away by new entrants. This will
result in normal profits being earned in the long-run. Normal profits will result when new
entrants force the average total costs to rise to a new level where they are equal to average
revenue. This is shown by the dotted average total cost curve (ATC1) below
Revenue
MC From the above diagram, profit

maximizing firms produce
Cost
ATC1 output Qe, the output at which

MR = MC. However, due to
intense competition for factors
a of production, average costs
P1 have been pushed upwards to
b ATC, as represented by the
C1
dotted ATC curve since ATC is
greater than AR, it follows that
AR= D the firm is incurring losses of C1
P1ab
MR
From the above illustration, a
0 Qe Output profit maximizing monopolist
produces output Qe where MR
= MC. Normal profit occur because ATC equal AR.
Price Discrimination by the Monopolist
Price discrimination refers to a situation where the firm charges different prices for reasons
not justified by differences in cost of production, for example charging different rates to low
density suburbs and high density suburbs by most municipalities.
CONDITIONS NECESSARY FOR PRICE DISCRIMINATION
For price discrimination to be successful, certain conditions must be met.
1. It only works when it is not possible to buy a good from one market and resale it in
another market. Thus there should be heterogeneous markets.
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2. The markets should have different elasticities of demand. There should thus, be two
markets. One whose demand for the good is elastic and the second one whose
demand is inelastic.
3. Transport costs should be prohibitively high. This is meant to prevent seepage or

arbitrage, a situation where one buys a product in one market at a lower price and
resale it a higher price in another market.
Given the foregoing, profit maximisation requires that the monopolist equals marginal
revenue in these two markets whose demand curves are shown below.
(a) Market 1 (b) Market 2 (c) Total
Revenue,
Revenue,
Revenue,
MC
Cost
Cost
Cost
P1
P2
AR1 + AR2
MR1 MR1 + MR2
0 Q1 AR1 0 Q2 MR2 AR2 0 Q3 AR2

Output Output Output
If two markets are separate and have different demand curves, AR1 and AR2, a monopolist
maximise profits by selling at different prices in the two markets. The profit maximising
output of the firm in the long run occurs where long run marginal cost (MC) equals marginal
revenue (MR). MR = MR1 + MR2 shown in C above. Total output is divided between the
two markets. In market 1, Q1 is sold at P1, and in market 2, Q2 is sold at P2. Marginal
revenue in both markets is the same. The steeper the (inelastic) demand curve in a market,
the higher the price.
NB: If the elasticities in the two markets are the same, there is no advantage from applying
price
discrimination.
CONSUMER SURPLUS
Having examined price discrimination between markets by a monopolist, it is useful to

consider the case of a perfectly discriminating monopolist. A perfectly discriminating
monopolist is able to charge a separate price to each consumer. This means that each
consumer can be charged the maximum amount he is willing to pay for each unit of the
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good, and it is able to sell to the highest ‘bidder’ first. It can in this way obtain the
maximum revenue from the sale of any given quantity.
Consumer surplus under monopoly
CHAPTER 1 C
Price
B o
n
A C
s
u
E G H
m
Market demand curve
e
0 D F r
Quantity
From the above diagram, if all units are sold at the same price A, then an amount D is sold
and total revenue is equal to OACD. If the ssame amount is sold by a perfectly
discriminating monopolist, then a different price is charged for each unit, and the total
revenue is OBCD. The difference ABC, measuresuthe consumers’ surplus. If the price is
raised from E to A, the total loss of consumers’ surplus is EACH of which EACG is
transferred to producers, and GCH represents the deadweight
r loss of consumers’ surplus.
p is the difference between the market

In a perfectly competitive market consumer surplus
price and the highest price the consumer is prepared to pay. We can illustrate this
diagrammatically l
as below: -
u
s CHAPTER 2 C
Price
S
a o
n
b s
Pe
u
m
Market demand curve
e
0 Qe r
Quantity
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Given market price of Pe, the consumer is prepared to pay as much as price a. Thus Peab
represents our consumer surplus.
ECONOMIC EVALUATION OF MONOPOLY
1. Since a monopolist is a price setter and is the only supplier it can charge exorbitant
prices if its operations are not monitored.
2. Monopoly offers incentive for research and development as the firm can earn super –
normal profits.
3. A big monopolist can acquire advanced technology that may result in falling costs of
production due to greater efficiency.
4. Monopoly results in poor distribution of income as it transfer it from the majority to
owners of a monopolistic firm.
Monopolistic Competition
Monopolistic competition is an intermediary market structure which has features of perfect
competition and monopoly respectively. It tries to strike a balance between the two-market
structures. Monopolistic competition derives its monopoly from the fact that each firm has a
monopoly on the price or output of its products.
In order to appreciate monopolistic competition, the following underlying assumptions have

to be made:-
(i) There are many sellers and buyers of a product

(ii) Firms are selling a differentiated or heterogeneous product
(iii) There free entry and exit by firms, that is, there are no barriers to entry and exit a
firm can enter or exit the market at any time
(iv) There is imperfect information, that is a firm is not aware of the activities of other
competing firms on one hand, and consumers do not have full knowledge of prices
and products obtaining in other markets
(v) Firms are profit maximisers, that is, the objectives of the firms is to maximise profits
and in pursuit of this objective, firms produce where marginal revenue equal
marginal cost (MR = MC).
THE SHORT RUN OF MONOPOLISTIC COMPETITION

There is not much difference between the short run of a monopolist and monopolistic
competition. A firm in monopolistic competition faces a downward sloping demand curve
from the underlying fact that each firm though faced with competition from other
differentiated products, it has a monopoly hold on the price it can charge or the output it can
produce at a particular time. However, because the firm is facing competition from other
firms, its demand curve is relatively elastic compared to that which faces a monopolist. In
terms of output determination, each firm in pursuit of its profit maximising objective
produces at a level where marginal revenue equal marginal cost (MR = MC). Abnormal
profits are earned in the short run because in most cases the average costs of production are
less than average revenue (AR > ATC). This can best be captured through diagrammatical
expositions as below: -
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Short run of monopolistic competition: Abnormal Profits

MC
Revenue ATC
Cost
a
Pe
C1 b
AR= D
MR
0 Qe Output
The diagram above depicts a scenario where a firm is earning abnormal profits represented
by the shaded rectangle, C1 Peab. At output Qe which is the equilibrium output because
MR= MC, total costs (OC1bQe) is less than total revenue, (OPeaQe). In other words, at
output Qe, average revenue (AR) is greater than average total costs (ATC), hence the
abnormal profits.
Monopolistic competition and abnormal losses ATC

Revenue
MC
Cost
b
C²
a
Pe
AR= D
MR
0 Qe Output
Whereas it is normal to experience abnormal or supernormal profits in the short run,

abnormal losses cannot be ruled out altogether. Abnormal losses occurs when average
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revenue fall below average total costs as a result of competition for factors of production.
From the diagram above, this is represented by the dotted average total cost (ATC).
Abnormal losses will be equal to the rectangle PeC2ba. Equilibrium output remains Qe ,
where MR = MC.
THE LONG EQUILIBRIUM OF MONOPOLISTIC COMPETITION
The long-run equilibrium of monopolistic competition is characterized by normal profits.

There is also excess capacity. Normal profits are attained because new entrants producing a
similar but not identical product are attracted into the market by short-run supernormal
profits. The demand curve of monopolistic competition in the long run is relative elastic
compared to the short-run demand curve. This is brought about by increased competition
(substitutes are available more and more) which divides the demand for the industry’s
output among competing firms. We can use diagrammatically exposition such as below to
show the equilibrium position.
Long-run equilibrium of monopolistic competition
MC
Revenue, cost
Excess ATC
Capacity
Pmc a
Ppc
AR= D
MR
Output
0 qmc qpc
From the above illustration a firm in monopolistic competition produces output qmc and
charges a price of Ppc. Normal profits are being earned because the long run average cost
equal the average revenue – the ATC is tangential to the AR curve at a. However, it is
argued that producing output qmc is not the best given the fact that the firm is not producing
at its lowest point of the average total cost curve. In perfect competition, efficient output
production occurs in the long run because firms would be producing at its lowest on the
ATC, in this case qpc where the marginal cost curve cuts the ATC from below the excess
capacity results because ideally the firm is producing at qmc when it is possible to produce at
qpc. This results in what is called X-inefficiency. Opponents of this market structure also
argue that apart from the fact that the market structure is inefficient in the utilization of
scarce resources, it also results in unnecessarily high prices to consumers. Under perfect
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competition, Ppc would be the price whereas Pmc is the price in monopolistic competition.
The
consumer in monopolistic competition is thus being exploited, getting less, qmc at a higher
price Pmc than would be possible under perfect competition.
Though the market structure has its critics, it is without its own supporters. Arguments
advanced for maintaining excess capacity are premised on two reasons: excess capacity
results because of reduced demand for the individual firm’s product and second, it is
maintained to fend off competition. Instead of exiting the market when faced with
competition the firm can increase output to qpc and reduce the price to Ppc. This will result
in lower profits to new entrants, as they are not in a position to charge this price due to
diseconomies of scale. Thus instead of entering the industry, faced with this situation
potential entrants are kept at bay.
Economic evaluation of Monopolistic Competition
1. Monopolistic competition is wasteful, as many firms involved are not producing up to

their optimal levels.
2. Wide choice for goods and services due to many firms and various products.
3. Other countries have blamed advertising for its brain washing, that is, forcing customers
to buy products that they do not want.
4. There is also relatively equal distribution of income as they are many firms producing.
5. Free entrance and exit results in firms realising normal profits thereby charging fairly
low prices. Competition also improves product quality.
Oligopolies
An oligopolistic market is comprised of few giant sellers. The firms are usually selling
similar products for example Organisation of Petroleum Exporting Countries (OPEC) which
include BP, Shell, mobile etc or differentiated products for example cellular phone
producers. If there are only two firms selling, then the term duopoly is used. The small
number of firms operating under the oligopoly market forces them to strategically inter
depend on each other’s actions and policies.
The methods used by oligopolists in defending their market positions take various forms,
such as advertising, product differentiation, and price competition. Production
differentiation is often combined with a search for new goods or product improvement in
specifications of the existing product.
The oligopolist is comfortable in using non- price competition which may include
advertising, after sales services, product differentiation than price competition. This is partly
due to the fear that variations in the price may lead to ‘price wars’, which worsens the
position of everyone in the market.
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THE KINKED DEMAND CURVE OF AN OLIGOPOLIST
An oligopolist has an elastic demand curve when it is assumed that it is likely to face
reaction from rival firms. The demand curve is inelastic if assumed that competing firms
will not respond to price changes.
In the diagram below Z signifies the link, where the price is D and output is Q. Above this
price, the firm will lose customers to competitors and below P, the firm will be operating at
a loss. It will therefore be forced by the market to sell at price, P. This explains why prices
in an oligopoly competition are relatively stable for a long time.
Any increase in the marginal cost at Z does not affect price as long as it falls within points
ab below.
Price
MC1
Z MC2
P
MR1
MR
DY
0 Q Output
Economic evaluation of oligopoly

1. Advertising undertaken by oligopolist may result in it contributing to abnormal profits.
2. Oligopoly is not efficient
3. The possibility of abnormal profits encourage firms to engage in research and
development programs.
Market structures at a glance
Criteria for identifying whether a market is competitive or not or perfect or not the
following characteristics can be used.
Characteristics Perfect Imperfect

1. Number of firms Many Few
2. Product Homogeneous Heterogeneous
3. Prize Takers Setters/ Makers
4. Competition Stiff Less/ no
5. Barriers No barriers Exist
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Type of monopolizes
i) Natural monopoly – owns and controls natural resources for example Hwange
Colliery, ZINWA, Rio Tinto etc.
ii) Artificial monopoly – enjoys a patent exclusive rights or franchise on a specific
product for example Nandos, KFC etc.
iii) Government monopoly – formed by an out of Parliament to provide essential
services such as ZIMPOST, ZESA, NRZ etc.
Oligopolies
There are also other types of oligopolies besides the Kinked – Demand curve such as:
i) Oligopolies with price leadership where large firms in the market out as those in
monopoly. They are leaders because of the following:
 They are large
 They control large market share
 They have been in the market for a long time.
The small firms in the market at like those in the perfect competition market.
They are followers because of the following reasons: -
 They are small

 They are new in the market or industry
 They control a small market share
(ii) Oligopoly with cartels
A cartel is a conglomerate, an integration or a collusion of oligopoly firms after realizing the

domestics of the Kinked demand concept. Hence oligopolies collide because of the
following reasons.
 To avoid stiff competition
 To avoid cut – throat techniques
 To avoid firms being worse – off etc.
Oligopolies with cartels can be explained in two groups:
(a) Explicit collusion – this is where there is a written down agreement using the firms
to produce the same output and charge the same price for example OPEC.
(b) Implicit collusion
This is where there is no written down agreement among the firms but they behave
the same to reduce competition among themselves.
Consumer sovereignty – the process of allowing the people vote with their dollars for the
goods and services they want most. Those items that receive the most votes are produced in
large quantities those that receive for votes are discontinued or produced in minimal
amounts.
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Oligopoly has the following characteristics:
i) A few sellers
ii) Substantial barriers to entry
iii) Standardized or differentiated product
iv) Substantial non – price competition
A few Sellers
Economists usually define oligopoly as few enough firms so that there is mutual
interdependence among the firms. Thee actions of any one firm in the market will affect the
other firms in the market and vice – versa. A firm-operating no a market characterized by
oligopoly would not change the price of its products, the quality of its product, or its
advertising without first taking into consideration the possible reaction of its competitors.
Barriers to entry – these are usually substantial. In the care of national oligopolies such as
the automobile and steel industries the primary barriers may be high cost of acquiring the
resources necessary to establish of new firm and the inability to begin producing on a
sufficiently large scale that the established firms are experiencing. Further more, a new firm
would be unlikely to experience large enough sales in its few years of existence to enable it
to take advantage of the economies of scale that result from mass production. Also control
of important raw materials can be strong barriers to entry.
In the case of local oligopolies, market size may be the primary barrier to entry. Also
customer loyalty to establish firms may be a very difficult obstacle for new firms to
overcome, in the case of both local and national oligopolies.
Standardized or differentiated products

The product produced may be either standardized or differentiated, depending on the
industry. In industries such as steel, aluminum, and light bulbs, the products are almost
identical. In other industries such as breakfast cereals, laundry detergents and automobiles,
the products are differentiated.
Non – price competition

In differentiated products sellers engage in vigorous non prize competition. This involves
efforts to persuade consumers to buy all particular products for reasons other than price.
Firms operating in oligopolistic markets seldom engage in price wars. If a firm operating in
an oligopolistic market powers its price, its competitors will be forced to match the price
cut. As a result, all firms will suffer a reduction in profits. Prices lend to remain relatively
stable in oligopolistic markets, with most of the competition being of a monopoly nature.
Page 101
Multiple Choice Questions
1. The main difference between oligopoly and monopolistic competition is

A On the nature of the product produced.
B On the number and size of the firms.
C Amount of profits enjoyed in the short-run.
D On the determination of equilibrium price and output.
2. The characteristic which differentiates monopolistic competition from perfect
competition is that
A There are strong barriers to entry and exit of firms.
B There is production of differentiated products.
C There are few firms in the industry.
D Firms enjoy abnormal profits in the long run.
3. Monopsony can be defined as:

A A sole supplier
B A single buyer
C A situation where there is one trade union in the economy.
D A situation where the country specialises in the production of one good.
4. Monopolistically competitive firms are said to be allocatively inefficient because:

A Of a large number of firms in an industry.
B Of abnormal profits they enjoy in the short run.
C Of prevalence of excess capacity.
D Of production of differentiated products.
ESSAYS
1. Analyse the differences and similarities between the main features of a perfectly
competitive firm and a monopoly firm.
[25]
2. Discuss whether monopoly is always a disadvantage to society.
[25]
3. All firms in business seek to maximise profit. Discuss.
[25]
4. (a)What are the conditions necessary for price discrimination?
[12]
(b) Assess the benefits of price discrimination to the society.
[13]
Page 102
Kingdom eyeing Zambia market

US $1 million set aside for a new retail bank
Staff Reporter
DIVERSIFIED financial services group, Kingdom Financial Holdings Limited (KFHL),

which is still itching for a return to the Zambia market, has set aside US$1 million for a new
retail bank in Zambia if granted approval by the monetary authorities.
It has emerged that KFHL, which ditched Investrust of Zambia early this year following a
frustrating failure to increase its shareholding from 25 percent to a controlling 51 percent,
was now targeting a greenfield investment into Zambia.
Nigel Chanakira, KFHL deputy chairman said the group was waiting for regulatory
approval from the Reserve Bank of Zimbabwe (RBZ) to set up a fully-fledged bank in
Zambia that would operate as Kingdom Bank of Zambia. The group’s forays into the region
have so far resulted in KFHL establishing a wholly-owned subsidiary, Kingdom Botswana (
Private) Limited, whose main activities include distribution of American Express credit
cards in the region outside South Africa. KFHL has been mulling plans to apply for a
commercial banking license in Botswana since 2002. Chanakira said Kingdom Zambia, if
granted approval, would be offering a full product range of all banking facilities being
offered in its Zimbabwean operation. The US$ 1 million was raised when the RBZ granted
KFHL approval to commence offshore investment management services with a private bank
domiciled in the Channel Islands, but with specific focus on the United Kingdom market.
SOURCE: The Financial Gazette September 30 October 6, 2004
(a) (i) From the extract which other countries apart from Zimbabwe does KFHL
want to invest in?
[2]
(ii) With reference to question (a) (i) , what type of company KFHL is going to
be? [2]
(b) (i) Suggest reasons why a firm, such as KFHL, sets up subsidiaries in various
countries.
[4]
(ii) What are the main advantages of investing in different countries.
[2]
(c) (i) With reference to data given, explain what is meant by:
- Diversification
[2]
- Investment
[2]
(d) Discuss the benefits and costs of diversification in production by a firm.
[6]
Page 103
‘Supply of soft drinks to improve’
Harare- Delta Corporation, the country’s biggest soft drinks manufacturer, has said
supplies on the local market would improve shortly after it resumed full production
following technical and logistical bottlenecks.
Supplies of soft drinks have been erratic in recent months, especially in small towns and
remote areas of the country. Delta Corporation chief executive, Mr. Joe Mutizwa said this
was due to reduced production as a result of refurbishment of one of the manufacturing
plants, water shortages experienced in August and unusually high demand in the winter
season.
He said the group had resumed full production after completing the plant refurbishment this
month, which should see supplies improving on the local market.
“The overhaul has been completed and we are now back in full production. The supply is
getting back to normal, however consumers should note that this is a gradual process,” he
said.
Mr. Mutizwa said Delta Corporation was also unable to build up stocks in winter for the
summer period, as it traditionally, does because demand for soft drinks between June and
July was unusually strong this year. “ Demand for soft drinks was very high in June and July
hence, depriving us time to build up stocks,” he said.
He attributed the high demand for soft drinks to the economic recovery, saying that people
now had additional funds to spend on the soft drinks- New Ziana.
(a) Identity reasons for the erratic suppliers of soft drinks from the extract.
[3]
(b) (i) From the extract, identity two factors that influence demand for soft drinks.
[4]
(ii) Explain ways that Delta Corporation can use to meet the increasing demand
for soft drinks.
[4]
(c) In which market structure does Delta Corporation belong to? Justify your answer.
[3]
(d) Discuss the benefits of a big firm to consumers.

[6]
Page 104
CHAPTER 8
THEORY OF PRODUCTION
Chapter objectives
After reading and retaining comprehension of this chapter, you should be able to:-
1. Describe several objectives of the firms.
2. Explain managerial economies, financial economies, marketing economies, risk
bearing economies as well as the diseconomies of scale.
3. Understand the scope of the low of variable proportions and represent it on the
output model and diagram.
4. Distinguish between marginal product and average product and show these concepts
on diagram.
5. Illustrate the enmity/relationship between marginal costs, average costs, and average
total costs.
6. State the features of the long run average costs curve and explain why it is U-shaped.
7. Explain low the average short-run cost curves and used to draw up the long-run
average cost curve.
DEFINITION OF A FIRM
A firm is a unit that employs factors of production to produce commodities that it sells to
other firms, to households or to the central authorities. Commodities produced can be raw
materials, intermediate goods or final commodities.
Most firms have the following objectives:
(i) Seek to maximise profits;

(ii) Pre – empty competition;
(iii) Increase market share;
(iv) Maximising market share; and
(v) To be socially responsible
In economic analysis, however, the firm is assumed to be driven by the profit maximization
objective.
Definition of profits
Firms regard profit as the access of total operational revenue over resources used in
production as envisaged by accountants. Economists on the other hand refer to profit as the
excess of revenue over all opportunity costs involved in production including those of
capital.
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The decision of the firm
Management ponder on the following questions
(i) Where shall production be located?

(ii) What techniques shall be adopted, and what shall be the size and scope of
operation?
(iii) How shall the factors of production be combined?
(iv) What output shall be produced? and
(v) What pricing policies should be employed to maximize profits.
Comparison of the size of firm can be done by looking at the following facets
1. the equity size

2. the number of employees
3. the market share
4. technological level
ECONOMIES OF SCALE
(i) These are the advantages enjoyed by the firm in the form of lower average
costs as a result of its internal growth and mass production
(ii) They exist as a result of different benefits a firm can enjoy when it grows
bigger compared to smaller firms
(iii) These follow a series of some explanations, technological economies –
compared to smaller firms bigger firms employ expensive but highly
sophisticated and productive equipment and machinery. Such technology
results in lower averages costs of production.
(iv) The reason behind this is that bigger firms normally have adequate financial
resources and enough capacity to buy sophisticated, advanced and highly
productive machinery.
(v) Technical economies are also a result of the ability by the firm to buy
machinery and equipment in the most optimum combination
MANAGERIAL ECONOMIES
(i) They result from the employment of highly qualified and experienced
managers.
(ii) Bigger firms have got the financial resources to attract such personnel with
high levels of productivity, which significantly reduce average cost of
production once employed.
(iii) Bigger firms also have the scope and capacity to fully utilise such workers.
Page 106
Financial economies
(i) Bigger firms can easily access credit from the financial sector because they
are less risky and credit worth.
(ii) This is because they usually have adequate collateral and good history, and
higher returns.
(iii) Bigger firms obtain credit facilities at lower interest rates because of their
lower risk level.
(iv) Bigger firms also normally have huge profit resources, which they can use to
internally and cheaply finance their activities compared to borrowing
externally.
Marketing economies
(i) Bigger firms can employ highly qualified and experienced marketers who can buy
the right item, the right quality from the right source at minimum possible prices
(ii) Incidents of returns, breakage and rejects are minimized
(iii) Bigger firms normally enjoy big trade discounts because they buy in bulk.
(iv) The transpiration of commodities to and from the market in bulk by bigger firms
enable them to minimize unit transportation costs.
Risk bearing economies
(i) Advantage accruing to bigger firms as a result of their ability to diversify their
production lines and their markets.
(ii) These are the benefits of not putting all one’s eggs in one basket.
(iii) If one market product performs badly the losses incurred will partially be offset by
the favourable and improved conditions in the other markets
Diseconomies of Scale
These are faced due to rising costs as a result of firms growing excessively too big.
Diseconomies of scale are usually caused by:
1. Managerial problems
When the firm grows excessively too big, it becomes highly complex resulting in
managerial inefficiencies and high average productions costs.
2. Co – ordination problems
Large firms normally have many plants, divisions, departments and sections. In this case
it becomes difficult to co – ordinate the operations of those so that they are consistent
with each other.
Page 107
3. Bureaucratic inefficiencies
o Big firms tend usually to have high incidences of bureaucratic red tapes.
o It takes time to identify problems, to find solutions for those problems and to
implement them.
o The firm, which is excessively too big, therefore becomes highly unresponsive to
changes in customer requirements
4. Lower worker morale
Big organisations normally have a huge workforce to the extent that individual workers
end up failing to identify themselves with that company.
o This results in low labour productivity, high rate of absenteeism and unnecessary
leaves.
o The effect of this is to increase the firm’s average cost of production.
5. Higher price for factor inputs
Buying in large quantities by big companies may be a disadvantage because it increase

factor inputs against themselves.
THEORY OF PRODUCTION
Production refers to the process of transforming factor inputs such as land, labour, and
capital into goods and services
o Production function is the relationship between inputs and output.

o Inputs Production process Output
o The production functions of a firm only represent technically efficient methods of
transforming inputs into outputs
o Technical efficiency represents the production process, which minimise the quantity
of factor inputs for any given output.
Factors of production
These are:
1. Labour – the human physical and mental effort used in the process of production.
2. Capital – all man made equipment and machinery produced not for current consumption
but to facilitate production.
3. Land – all the natural resources provided to man by nature that can be used in the
process of production.
4. Entrepreneurship – this involves combining all the factors, coordinating them,
shouldering risks in the process of production
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PRODUCTION IN THE SHORT-RUN
o Short – run refers to the time period, which is short enough for the firm so that at
least one of its factors of production is fixed in the period.
o Factors which cannot be varied in the short run, are normally the fixed factors such
as land, capital and the state of the economy.
o To change output a firm can only vary the employment of the variable factors such
as labour.
o The production function is explained by the law of variable proportions of which
diminishing marginal returns are part of the function.
THE LAW OF VARIABLE PROPORTIONS
- This law observes that in the short run, as the firm continuously and successfully
increases the employment of a variable factor such as labour, while keeping other factors
constant, output initially increases at an increasing rate but later at a diminishing rate.
- This is because of the overuse of the fixed factors to levels that overstretch them;
- It is also due to overcrowding and congestion of the variable factor as its level of
employment increases; and
The law of variable proportion can be represented by the following output model.
Law of variable proportions
Quantity Total production Marginal product Average product

0 0 - -
1 5 5 5
2 12 7 6
3 21 9 7
4 32 11 8
5 42 10 8.4
6 50 8 8.3
7 56 6 8
8 60 4 7.5
9 60 0 6.5
10 55 -5 5.5
Page 109
The Production Function in the Short-Run
Negative marginal returns

Total production
Region of diminishing
Marginal returns
TP
Region of increasing
marginal returns
Qty of labour
Marginal product
This is the extra output resulting from increasing the employment of the factor by one unit
i.e. output attributable to the last unit of a factor with all other factors remaining constant.
Marginal product is the change in total output resulting from the use of one more (or one
less) unit of a factor
MP = Change in total output

Change in factor employment
The level of output where marginal product is maximum is called the point of diminishing
marginal returns. From this point any increase in factor employment results in diminishing
output at the margin.
Average product
It is merely the total product per unit of a factor, labour, for example
AP = TP
L
o As shown in the table, as more of the variable is used, average product first rises and
then falls.
o The point where average product reaches a maximum is called the point of
diminishing average productivity. Beyond this average productivity falls.
Page 110
The average and marginal product curves
Total product 60
TP 50
40 AP
30 MP
20
10
0
2 4 6 8 10 12 14 16
Qty of labour
o The law of diminishing returns states that if increasing quantities of a variable factor
are applied to a given quantity of a fixed factor, the marginal product, and the
average product, if the variable factor will eventually decrease.
The relationship between marginal and average product curves.

 The MP curve cuts the AP curve at the latter’s maximum point
 The key is that the average product curve slopes upward as long as the marginal product
curve is above it.
Costs of Production
Costs of production are the expenses incurred in the process of production. Economists view
costs to include both explicitly paid costs as well as implicit costs in the form of opportunity
cost. Costs of production are a mirror reflection of factor productivity and hence the
production functions.
Total costs
o Is divided into two parts – namely fixed costs and variable costs.
Fixed costs
o Are those costs that do not vary with output.

o They are also referred to as overhead costs or unavoidable costs.
Variable costs
o Costs which change due to changes in production

Page 111
o They are usually referred to as direct costs or available costs.
Average total costs
o Is the total cost of producing any given output divided by the number of units
produced, or the cost per unit.
o The average total cost is divided into Average fixed costs and Average variable
costs in just the same way as total costs were divided.
Marginal cost
Is the increase in the total cost resulting from raising production by one unit
Cost Curves
TC
Cost TVC
TFC
0 Output
The relationship between MC, AC and ATC
Cost MC
ATC
AVC
AFC
0 Qty
o The relationship between MC, AC and ATC

Page 112
o Marginal cost curve cuts the curve ATC and AVC curves at the lowest points.
o When ATC increases, MC increases and if AC decreases MC decreases due to constant
returns to scale.
o Exists when output changes by the same percentage in factor employment for example
doubling factor employment leading to doubling of output.
o Further expansion can not change anything except increasing costs and leading to a
company not meeting these costs.
The long run-Average cost curve
o This is the planning curve for the firm, which gives the minimum possible average cost
of producing any given level of output.
o It is made up of an infinity series of a firm’s short-run average cost curves associated
with different plant size
o It is U – shaped but wider than the average short-run cost curves (SRAC)
Long – run average cost curve

Costs
SAR1 SAR2 SAR3 SAR4
LAC
Economics of scale Constant Diseconomies of scale

economies of scale
0 Qty
The LRAC is tangential to a series of short – run average cost curves. In the long run, all
inputs are variable and at first, economies of scale are enjoyed. Beyond the optimum point
diseconomies of scale are incurred.
WIDE SHAPE
The wider shape of the Long Run Average Cost Curve reflects the following:
- More options in the long-run
- Envelopes short – run average total cost curves.
- Flexibility in the long run
- The falling part of the LAC is due to the economies of the scale enjoyed by the firm as it
moves from smaller plants to bigger plants.
- In this region the firm is also experiencing increasing returns to scale.
- Eventually as the firm continues to grow for example the size of the plants average cost
will start to increase
Page 113
Production in the long – run
The long run is that time period which is long enough for a firm so that it can vary all its
factors of production. There are, therefore, no fixed factors in the long – run. All factors are
variable
o In the long – run there the law of diminishing marginal returns does not exist.
o The behaviour of production is explained by returns to scale
Returns to scale
o A change in the scale of production refers to a situation whereby the firm increases
or reduces the employment of its factors of production by the same proportion or
percentage.
o When the firm does that, its production can either change by a greater percentage, or
by smaller percentage or by exactly the same percentage.
Increasing returns to scale
o This is obtained when output responses by more than proportionately to changes in

the scale of factor employment for example output increasing by 40% following a
28% increase in the level of factor employment.
o This is caused by economies of scale
Decreasing returns to scale
o Refers to a situation where outputs changes by a smaller percentage compared to the

percentage change in the factor employment.
o Increasing returns to scale normally results from diseconomies of scale
Constant returns to scale
o Refers to a situation where outputs changes by the same percentage as the

percentage change in the factor employment.
Nationalization
The government can be involved in the provision of goods and services through various
parastatals for many reasons. Some of the argument advanced in favour of state enterprise
include the following: -
Page 114
Strategic Reason
Some industries such as gas production, petroleum and even grain among others are so
strategic that they cannot be left to the whims of private enterprise. In order to control the
production and consumption of these products the state may find it prudent to produce them.
To Create Employment
Government can set shops in order to achieve one of its fundamental objectives – achieving
full employment. With no doubt, the government is the major employer in most economies
and will continue to hire people even when economic rational require that it lays off
workers.
Economies of Scale
Some industries require huge sums of start up capital and because of their size, only one
firm could exploit economies of scale in the industry. This is especially true with electricity
distribution. It would not be wise to set two or more electricity distribution companies.
Moreover, the costs of setting up may be beyond private investors and only the government
with it strong financial muscles may be able to set up.
Non-Marketable Goods
Some goods, especially public goods may not be produced by private firms because the
price mechanism fails to produce them and the government has to intervene in order to
produce them.
To Avoid Duplication
Some goods may need to be produced by a monopoly in order to avoid duplication and
hence wastefulness of scarce resources. Thus goods such as roads sewerage, street lighting,
electricity distribution among many are best (economically) produced by a single producer
than by many.
Social Welfare Maximization
To protect consumers, the government may set shop in order to counter exploitation of
consumers by private firms. Consumers may be exploited by private producers by way of
high prices and the government can produce and sell the product at a relatively cheaper
price.
Disadvantages
Whereas the above arguments have been put forward to justify state enterprise (intervention)
opponents of nationalisation argue that state enterprise is without its disadvantages. These
disadvantages include among many the following: -
Page 115
Inefficiency
State monopoly is not efficient in production and instead of protecting consumers from
exploitation by private firms it can itself result in consumer exploitation in two respects. It
produces a poor quality product and sells it at a higher price and at the same time consumers
in most cases do not have any alternatives.
It is a drain on national fiscus
The grants or subsidies that the government advances to public corporation are a drain on
the fiscus. This is because they form part of recurrent expenditure and as a result through the
PSBR may contribute to increased national debt.
Corruption
State enterprise may lead to high levels of corruption as service providers to state companies
may have to bribe officials in order to win lucrative contracts.
Privatisation
Privatisation involves the selling of state companies to the private sector. Reasons for
privatising state companies are premised on the following reasons.
Increase Efficiency
Privatisation is viewed as a way that can be used to increase efficient utilisation of scarce
resources. Privatisation, it is argued leads to increased competition which forces firms to
conduct research and development on a sustained basis in order to remain competitive. This
competition should thus lead to the best methods of production.
Empowerment
Privatisation can also be implemented in order to empower the previously marginalised
citizen. It allows for marginalised groups to partake in economic activity by way of buying
shares in public corporations hence the wealth of the state being enhanced.
Raising Revenue
The government can raise revenue to pay for its debt through proceeds from privatised
companies. In addition, privatization releases grants or subsidies that could have been given
to state companies to other alternative uses.
Economic Growth
It has been argued that private enterprise is the engine for economic growth. Thus in order
to realise this growth, there should be limited government role in order to enable private
players to contribute to national output. One of the major contributors of economic growth
is high levels of investment which can only materialise if the private sector takes a
predominate role in production.
Page 116
Disadvantages or private enterprise would include the following among many
Consumer Exploitation
Consumers can be exploited by private firms through the charging of higher prices
especially if they become monopolies.
Non-Marketable Goods
Some goods cannot be left to private sector production because the price mechanism is non-
functional. This is especially the case with public goods.
Empowerment
Whilst the objective of privatization might be to empower citizens economically by
participating in the economy as shareholders of companies, economic empowerment may
fail if only the rich have access to these state enterprises. The gap between the poor and the
rich may as a result widen.
Economies of Scale
The cost of running some business may be so high that companies may end up looking to
the government for working capital. This will likely result in the companies coming state
enterprises again.
NB: The disadvantages and advantages treated this far are not exhaustive and the reader is
encouraged to add to the list. Moreover, the reader must take note of the fact that
privatization and nationalisation are synonymous with free market entries and command
economies respectively.
Commercialization
This involves the charging by state enterprises of market based prices.
Survival of Small Firms

Small firms may survive in an environment where there are big firms for several reasons.
The reasons include the following: -
Niche Marketing
Small firms can survive if they look at a niche of the market where they can provide for the
special needs of the sector without being in direct competition with big firms.
Linkages
Some big firms may find it uneconomical to produce or provide a particular service and
instead allocate the production to small firms, which may have economies of scale in
production.
Subcontracting
Some big firms can subcontract non-core activities to small firms enabling them to focus
attention on the core business. This subcontracting will enable small firms to survive.
Page 117
Scale
Some scale of production may not necessitate the presence of large firms in the sector
because they may fail to realise economies of scale. This is especially true with services
such as shoe repair, barber and tyre mending to mention but a few.
Location
Some location may not accommodate a big firm because the market is so small that it can be
adequately serviced by a small firm. This is especially true in the case of tuckshops and
supermarkets for example. It might be economical to serve a particular market by setting a
tuckshop than a supermarket.
Takeovers and Mergers

Takeover involves a hostile bid by a large company to take control of a small company.
There is no agreement between the two companies to incorporate their business but instead a
financially strong company takes over a small weak company, though with potential for
growth.
Mergers on the other hand, occur between two or more companies who agree mutually to
combine their assets in order to consolidate their market position or market share. The
companies are of the view that they are stronger operating as one entity than as separate
entities.
VERTICAL AND HORIZONTAL INTEGRATION
Vertical Integration
This occurs when two firms at different levels of production merge their operations to
become one entity. Vertical integration may involve backward or forward integration
depending on the underlying motives. If a firm wants to be close to its market it may go for
forward integration. On the other hand, if it wishes to control the source of its raw materials
it may go for backward integration.
Backward integration may for example involve, National Foods taking over or buying a
commercial farm which is the source of its raw materials in order to ensure constant supply
of the crucial raw materials. Forward integration on the other hand, may involve, National
Food taking over, for example, Farm and City outlets to ensure that its products are pushed
through the market.
Horizontal Integration
Horizontal integration occurs when a firm takes over the operations of its rivals in order to
eliminate competition. For example, OK Supermarket may find it prudent to merge its
operations with TM Supermarket. This action will enable OK Supermarket to consolidate its
market position or share.
Page 118
1. Which period is the shortest in economic theory?

A Short run period
B Momentary period
C Long run period
D Very long run period
2. What name is given to a place where production actually take place in a production
unit?
A Firm
B Plant
C Industry
D Enterprise
3. The firm’s cost function is given by TC = $(20+10x) where TC is the total cost and x
is the level of output. Calculate the unit cost of producing the output if x =10units.
A $10
B $12
C $20
D $120
4. The firm’s short-run supply curve is:
A The marginal cost curve below the average variable cost curve.
B The marginal cost curve above the average variable cost curve.
C The marginal cost curve below the average total cost curve.
D The marginal cost curve above the average total cost curve.
5. Which one is an example of an external economy of scale?
A Managerial economies of scale
B Risk-bearing economies of scale
C Information economies of scale
D Technical economies of scale.
6. Two small firms x and y, producing the same type of product, A, merged. What
name is given to this type of integration?
A Vertical integration
B Horizontal integration
C Lateral integration
D Forward integration
7. The table below shows a firm’s total and marginal costs.
UNITS OF OUTPUT TOTAL($)

MARGINAL COST ($)
1 60 53
2 100 40
3 120 20
4 160 40
5 213 53
6 273 60
Calculate the average fixed cost of producing 7 units of output.
Page 119
The AFC is
A $1
B $19
C $20
D $60
8. What may have caused movement of the production possibility curve from PQ TO
RS?
Good P
X R
0 Good y S Q
A Economic decline
B Technical in efficiency
C Increased human capital in the economy
D Utilization of unemployed resources
9. The diagram below shows economic efficiency
AC 1
AC 2
0 Output
What type of economic efficiency is shown by the movement of cost curve, AC 1 to AC 2?
A Productive efficiency
B Technical efficiency
C X-efficiency
D Allocative efficiency
8. What is marginal cost pricing?

A Setting the price of a good so that it will be equal to the marginal cost of
producing hat good.
B Equating the price of a good to the average cost of producing it.
Page 120
C Setting the price of a good where it is greater than the marginal cost of
producing it.
D Setting the price of a good at a point where marginal cost is equal
Essays
1. (a) Explain what is meant by the short-run and long-run periods.

[10]
(b) Discuss why it is impossible for a firm to continuously enjoy economies of scale in
the
long-run.
[15]
2. (a) Explain the main ways of measuring the size of a firm.
[10]
(b) Discuss the benefits of large supermarkets over small supermarkets.
[15]
1. Alarm As Dunlop Halts Operations
FELIX NJINI
Chief Reporter
CAPACITY utilisation in industry has slumped to new lows with production processes
coughing to a halt in major manufacturing companies.
Industry experts, who ruled out prospects for an economic recovery in the short to medium-
term, this week said industry was now skating on thin ice with capacity utilisation having
sunk to around 20 percent.
Industry’s woes came to the fore last week when Dunlop Tyres stopped operations, citing
the shortage of foreign currency needed to procure spares and inputs.
Dunlop requires US$50 000 to manufacture tyres on a daily basis. At least 820 workers
were sent home at the country’s sole tyre manufacturer and exporter, leaving the country at
the mercy of imports, which might cost US$100 000 daily. Dunlop’s closure could also
result in more than 30 000 workers losing their jobs in down-streams industries. A number
of companies have also been thrown out of business as the harsh macro-economic
conditions take their toll on the vulnerable industry.
Apart from foreign currency shortages, most companies’ profit margins are being squeezed
by ever-rising production costs, driven by expensive foreign currency and exorbitant power
tariffs.
Page 121
SOURCE: THE FINANCIAL GAZETTE, OCTOBER 13-19, 2005
(a) (i) From the extract, identify the main reason for the closure of Dunlop.
[2]
(ii) Identify the market structure, described in the extract to which Dunlop
belongs. [2]
(b) (i) According to the extract what are the major problems faced by firms in
production. [3]
(ii) Suggest possible solutions to problems identified in b(i) .
[6]
(c) Suggest the likely elasticity of demand for spare-parts imports to Dunlop.
Support your answer. [2]
(d) Examine the effects of the closure of a big firm in an economy.

[3]
(e) Discuss why a firm cannot enjoy economies of scale indefinitely.

[2]
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CHAPTER 9
Chapter objectives
After reading and understanding the contents of this chapter, you should be able to:-
1. Define the principle of “marginal revenue product.”
2. Explain the factors which determine the supply and demand for labour.
3. Describe the role of Trade Unions, its merits and demerits to both members and
organizations.
4. Name the major assumptions of a perfectly competitive labour market.
5. Illustrate the Intervention of a Trade Union in a competitive labour market and
monopoly labour market.
6. Distinguish between Transfer Earnings and Economic Rent and illustrate these on a
diagram.
7. Describe the factors which account for the differences in wages.
The structure of labour markets

We outline the orthodox theory of wage determination. Wages are the price of labour and,
like prices in other markets, they are said to be determined by the interaction of the demand
for and supply of labour.
The demand for labour

Factor services are not demanded for their own sake, but because they are useful in the
production of output. The demand for inputs is derived from the demand for output, and for
this reason is called derived demand.
The marginal revenue product

The addition to the total product, from employment of an additional unit of labour is called
the marginal product of labour. In order to arrive at the marginal revenue product, we
multiply the marginal physical product (MPP) by the marginal revenue (MR), where the
marginal revenue is the value of output of each successive unit of labour services.
N.B. In order to decide how much labour to employ, how much output to produce, the firm
must compare the marginal revenue product (which is the firm’s demand curve) with the
marginal cost of employing an additional unit of labour.
Wage determination
The supply of labour

The supply of labour varies directly with the wage rate. At a higher wage rate more workers
are available for employment and vice versa.
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N.B. The supply of labour will be more elastic in the long run than in the short-run. In the
case of unskilled labour, supply will tend to be relatively elastic in both the short and long-
run, since little if any training is required.
Determination of Wages
Labour is the number of people willing and able to work
The Demand factors for labour include the following
- The demand for labour is derived demand in that it depends on the demand for the
commodity it produces.
- All factor inputs earn rewards that are explained in the theory of production.
Important Concepts
MARGINAL REVENUE PRODUCT
o This is revenue or amount added to the firm’s revenue by an extra worker.

o It is obtained as marginal physical product multiplied by the product marginal
revenue.
The demand curve for labour
Wage rate
W
W1
D (MRP)
0 M M1 Quantity of labour
Firms that seek to maximize profits hire or employ labour up to a point where the marginal
revenue product of labour equals the wage rate paid.
o The demand curve is the slope of the MRP

o When the demand curve is slopping downwards MP of labour will be equal to MPP
x MR
DETERMINANTS OF DEMAND FOR LABOUR
1. Elasticity of the product produced

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o Elasticity has significant impact on increase or decreases in employing variable

factors.
o If the product has an elastic demand more workers will be demanded and if inelastic
the opposite happens.
2. The power of the Trade Unions that represent the type of labour employed.
3. The nature of government involvement this goes hand in glove with the type of market
for example perfect, monopolistic and monopoly.
4. Derived demand – labour is demanded due to the type of product labour produces.
DETERMINANTS OF THE SUPPLY OF LABOUR
1. Population characteristics
The population size, age composition of the population, emigration, immigration, birth
and death rates.
2. Sacrificing argument
People tend to substitute leisure for money as income increases.
3. Legislation concerning working hours
If the number of working hours is reduced then the supply of labour is reduced.
4. Government Policy
Government policy on labour force with regard to age and sex, for example.
5. The role of Trade Unions
a) Wage bargaining
o If labour is producing products, which have an inelastic demand, then Trade

Unions have more power to negotiate for wage increases.
b) Protect its members
o They provide security to workers so that they cannot be dismissed by employers

with no apparent reasons.
c) Raising employment levels.

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A Perfectly Competitive Labour Market
A perfectly labour market refers to a market for labour where the wage rate is
determined by the market forces of demand and supply. In order to analysis a
competitive labour market, we need to make the following assumptions.
(i) There are many buyers and sellers of labour.

(ii) The labour being supplied is homogenous, that is, workers are perfect
substitute for each other,.
(iii) There are no barriers to entry and exit.
(iv) There is perfect information
(v) Firms are profit maximises and will employ labour up to a position where the
marginal revenue product equal the marginal input cost, that is the supply
(MRP = MIC).
A firm in a competitive labour market will seek to maximise its profits by employing
labour until the marginal revenue equal the supply for labour. This is the market or
equilibrium wage and quantity of labour both demanded and supplied. Any position
which does not satisfy this condition results in a disequilibrium in the labour market
can best be described diagrammatically as follows.
Wage determination in a competitive labour market.
Wage
Rate W1 S
W*
W2
MRP
0 L1 L2 L3 L4
Quantity of Labour
From the above illustration, the market wage ratio is WA and the number of workers
employed is L*. If the wage ratio is set at W1 more labour would be supplied L3 but only L1
will be demanded. At this wage rate there is a surplus labour on the market. Employees
will thus compete amongst themselves by offering to work at any wage rate below W 1 until
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W* is achieved. On the other hand, if the wage rate is W2 more labour would be demanded
and less will be supplied. As a result employers are forced to compete for the scarce labour
by offing any wage rate above W2 until W* is achieved. Thus only W* is the only market
wage rate. At this wage rate there is no incentive to both suppliers and demanders of labour
to move from this position.
Competitive labour markets with a trade Union.

Trade unions can intervene in the labour markets by setting minimum wages in order to
raise the welfare of their members. This is especially true when the market wage race is
viewed as unfairly reflecting labour effort. A minimum wage is any wage that a union may
set which is beyond the market wage as determined by the market forces of demand and
supply. The effect of a minimum wage is to raise the wage rate but this is done by
sacrificing some employment. Thus minimum wage s are likely to result in opportunity cost.
Some level of unemployment has to be accepted in return for a rise in the wage rate. We can
depict this diagrammatically as below.
Trade Union intervention in Competitive labour market.
Supply of labour
Wage WU
rate
WC
Demand of labour
0 LU LC L3 Quantity of labour
The wage rate as dictated by the market forces is Wc and its corresponding level of
employment is Lc. However, when a union decide to raise the wage rate to Wu (minimum
wage) the supply curve become Wu ES and quantity of labour employed becomes Lu where
demand (D) interacts with supply (Wu ES). This imposition of a minimum wage results in
reduced employment (Lc – Lu). The union in this case has managed to raise the wage rate at
a cost, unemployment represented by the difference between the employment at competitive
wage rate Lc and employment at the union wage rate Lu.
Monopsony labour market
In a Monopsony labour market there is only one demander for labour but that labour is
supplied competitively. Since there is only one demander for labour, a monopsonist is able
to set the wage rate at which it can hire different units of labour. This results in a downward
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sloping demand curve (marginal revenue product). On the other hand since labour is being
supplied competitively it follows that the supply and marginal input cost are different. The
supply curve of a monopsonist is below the marginal cost curve.
A profit maximising monopsonist will hire labour such that the marginal cost and not the
supply equal the marginal revenue product. We can illustrate this diagrammatically as
below.
Wage determination under Monopsony

Marginal cost
Average cost
Wmrp
Wm
D = MRP
Lm Quantity of labour
A profit maximising monopsonist will equate its marginal revenue to its marginal cost
resulting in the wage W and labour employed of Lm. However, given the fact that the same
labour is being supplied at a wage rate of Wm. There is no incentive or motivation for the
monopsonist to hire labour at W when it can obtain the same amount at a lower wage rate
(cost), Wm. By raising the way rate to W a monopsonist would be raising its cost
unnecessarily. Under a competitive labour market, however equilibrium wages rate would
result where demand interact supply i.e. he and we of labour would be employed. It is thus,
argued that less employment is achieved in a monopsonist labour market than under
competitive labour markets.
Intervention by trade unions

Trade unions may be motivated to raise the wage rate of its member’s in order to raise their
standard of living. If it is possible for labour to firm a union such that labour is now supplied
monopolistically, it is possible to raise both the level of employment and wage rate in a
Monopsony labour market simultaneously. However, this can only be achieved with a
certain range as depicted in the diagram below.
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Trade Union Intervention in the Monopsony labour market

MC
Wage
Rate
W S
Wu E
Wm
MRP
0 Lm Lu quantity of labour
The trade union intervention in the labour market can result in employment level of Lu and
wage rate of Wu. In this instance trade union has managed to raise both the wage rate as
well as the employment level for its members. The horizontal section WuE now represents
the marginal cost of the monopsonist and hence the wage rate is determined where WuE
interacts with the marginal revenue product. Trade Union intervention is only possible to
yield desirable results between wages of Wm and W beyond which any action will leave
members worse off. A wage below Wm reduces both labour being supplied and the
purchasing power. A wage rate above W will result in unemployment of members of the
union.
Factors affecting the unions ability to raise wages include:

Elasticity of demand for labour
Raising productivity
Persuading employers to cut profit margins
Controlling supply, restricting new entrants, e.t.c.
Controlling supply, refusing to supply labour below the desired wage.
THE ELASTICITY OF DEMAND FOR LABOUR.
The elasticity of demand for labour measures the sensibility of changes in the quantity of
labour demanded to changes in the wage rate. It is defined as: -
The EDL = % change in quantity of labour demanded

% change in the wage rate
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The elasticity of labour demand is greater: -
(i) The more price elastic is the demand for the good produced
(ii) The greater the elasticity of substitution between factors of production
(iii) The greater the elasticity the elasticity of the supply
(iv) The greater the share of labour in the total cost
TRANSFER EARNINGS AND ECONOMIC RENT.
Transfer earnings are the payments necessary to keep a factor of production in its present
use, equal to the earnings available in the best alternative use. Any payment above the
transfer earnings is called economic rent. For example, if to retain him in his present use a
firm has to pay an accountant $150 per month, and instead of paying him or her $150 it opts
for $175,transfer earnings would equal $150 and remainder of $25 would be classified as
economic rent. We can also use a diagram to illustrate these two concepts.
Transfer Earnings and Economic Rent

Wage rate
B
We
Economic
Rent
A Transfer
Earnings D
0 Le Quantity of labour
From the diagram above, the market price or wage rate is determined where the supply
curve and demand curve interact WE and the corresponding quantity of labour is LE. The
triangle AWED above represents economic rent whereas OABLE represents transfer
earnings.
NB: The proportion of economic rent against transfer earnings is dependent on the elasticity
of supply of labour. The different scenarios are presented below.
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(a) Unitary elasticity of supply (b) Perfectly inelastic supply
Wage rate
S
Wage rate
S
We We
50% Economic 100%
Rent Economic Rent
D D
50% Transfer
Earnings
0 Le 0 Le
Quantity of labour Quantity of labour
(c) Perfectly elastic supply
Wage rate
S
We
100% Transfer
earnings
0 Le
Quantity of labour
WAGE DIFFERENTIALS
Type of job
Different types of jobs command different wages. Some jobs can be done by anyone whilst
others call for a special skill. The former commands less than the later in terms of wages.
Thus when supply of labour of a particular job is in abundance, its accompanying wage is
less than when supply for labour is scarce. Thus, from the arguments presented above,
doctors are likely to earn higher wages because they are relatively scarce compared to for
example, street cleaners.
Nature of the Market

Labour markets where there are strong trade unions are likely to command higher wages
compared to markets where wages compared to markets where wages are determined
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competitively. Barriers to entry by certain professions, accountancy, and lawyers for

example can create scarcity for a particular type of labour culminating in higher wages
compared to markets where there are no regulations or restrictions.
Training and Education
Different levels of training and education command different wage levels. A university
graduate for example, is likely to earn more than an ordinary level certificate holder. This is
because a graduated invested more in human capital than an ’O’ Level Certificate holder.
Thus is encouraged people to invest more in human capital there should be incentives in
place. The knowledge that once one has invested more in education will be paid a higher
wage than the one who has not invested more in education will spur more investments in
education.
Skills and Experience
A highly skilled job is associated with higher wages compared to a lowly skilled job for
example, an engineer earns more than a shop assistant because the former demands high
levels of proficiency than the later. Experience and responsibilities one has can also result in
wage differentials within and between jobs. For instance a Senior Accountant is likely to
earn less than the director of finance by virtue of seniority or responsibilities within the
department.
Sex and Race
Traditionally female workers were treated as inferior to their male counterparts and used to
earn less than the later even when doing the same job. Moreover, the race card was also a
tool that could be used to discriminate against workers resulting in higher pay for a certain
group, in the majority of cases white employees compared to their black counterparts. Sex
and race discrimination could be traced back to the type of education one could access and
hence the job one could qualify for. However, sex and race discrimination is falling away
due to government labour laws that prohibit discrimination of any native.
MULTIPLE CHOICE
1. Human capital can be enhanced by the following except.

A training
B education
C higher wages
D experience
2. The diagram below shows the effect of a trade union in a monopoly labour market.
The initial wage before the introduction of a trade union is W1. The trade union
pushes the wage rate to W2.
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Wage rate E D =Marginal factor cost (MFC)

A
W3
S= Average factor cost (AFC)
W2 B
W1
W4 C
MRP
0
U
Number of workers employed
What will be the resultant supply curve after the introduction of a trade union in this labour
market?
A CBS
B W2BS
C WICBS
D W3AD
3. The diagram shows the interaction of demand and supply curves in a labour market.
Wage rate A S
B
W1
C
D
0 U number of workers employed

Which areas represents the economic rent and transfer earnings in this labour
market?
ECONOMIC RENT TRANSFER EARNINGS

A W1 BC O C B L1
B ABW1 W1BC
C ABC O C B L1
D OCBL1 ABW1
4. What is the magnitude of economic rent and transfer earnings in a labour market
where supply is perfectly elastic?
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ECONOMIC RENT TRANSFER

EARNINGS
A 50% 50%
B 0% 100%
C 100% 0%
D uncertain uncertain
5. Quasi-rent can be defined as:

A earnings which are necessary to retain a factor of production in its present use.
B earnings which are over and above that which is necessary to keep a factor of
production in its present use.
C Part of the factor’s earnings, which is economic rent in the short- run, but transfer
earring’s in the long-run.
D The worker’s supply price.
6. Net advantage of the worker is calculated as:
A Marginal utility of the wage plus marginal utility of work.
B Marginal private cost plus marginal external cost.
C Job satisfaction plus job dissatisfaction.
D Marginal private benefits plus margin external benefit.
7. The backward bending part of the supply curve of labour is caused by:
A An income effect which exceeds the substitution effect.
B The substitution effect which exceeds the income effect.
C Workers responding to the rise in the wage rate by substituting more labour
time in place of leisure time.
D A rise in income tax.
ESSAYS
1. (a) Explain the factors that influence the supply of labour. [10]
(b) Discuss the effects of a trade union in a perfectly competitive labour market and a
monopsonishic labour market [15]
2. Assess the extent to which the MRP theory explains wage determination in an
economy. [25]
4
DATA RESPONSE
AFRICA DELIBERATES ON IMPACT OF BRAIN DRAIN, VISA APPLICATIONS
HARARE – In Africa, many people have skipped national boundaries in attempts to find
better lives elsewhere.
Others have been forced to do so by civil wars, famines, disease outbreak, natural disasters
and most notably, economic hardships. This movement of people has had its toll on the
continent. According to UN estimates, about 20 000 African professionals leave the
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continent every year to developed nations where that are offered better salaries and
improved working conditions.
Last week, a seminar jointly convened by the International Organisation for Migration
(IOM) and the African Capacity Building Foundation (ACBF) and attended by 26 African
states deliberated on various issues like visa applications and brain drain, which refers to a
country’s loss of skilled and innovative people to nations.
Migration, he said, posed great challenges in both labour markets and social arrangements,
prompting the need to increase dialogue and practical co-operation among governments on
migration issues. Delegates made several recommendations to improve the management of
migration on the continent and outflows of people across the borders.
Participants recommended the establishment of banks that people in the Diaspora would
easily use in conveying remittance back to their countries of origin. The agreed on labour
exchanges between countries with surpluses and those that have little skilled human
resources.
(a) (i) Identify the main reason why African professionals migrate to developed
nations.
[2]
(ii) According to the extract, explain the impact of this move on developing
economies.
[2]
(b) Explain various ways, which the government of developing countries can use to
reduce the negative effects of migration to developed economies by their
professionals [4]
(c) According to the extract, how can the developing economies turn brain drain into
gain? [6]
(d) Discuss the effects of globalisation on labour markets in developing countries.

[6]
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CHAPTER 10
FISCAL POLICY AND PUBLIC FINANCE
Chapter objectives
After reading and retaining comprehension of this chapter, you should be able to:-
1. Give the objectives of fiscal policy and its tools.
2. Understand the difference between a discretionary fiscal policy and built in
stabilizers as well as expansionary fiscal policy and contractionary fiscal policy.
3. Outline the reasons for government spending.
4. State the main sources of governance financing.
5. List the characteristics of good tax.
6. Describe the form of tax system and illustrate them on a diagram.
7. Describe the features, examples advantages and disadvantages of direct taxes and
indirect taxes.
8. Set out the effect of domestic borrowing on the economy
9. Understand the incidence of taxation and illustrate it on the diagram.
FISCAL POLICY
It is a demand management policy involving manipulating levels and composition of

government expenditure, taxes and subsidies.
Objectives of fiscal policy
o To increase output and economic growth;

o To reduce and stabilize prices;
o To stabilise the exchange rate;
o To improve investment; and
o To improve employment
TYPES OF FISCAL POLICY
Fiscal Policy occurs in two forms – namely:
1. Discretionary fiscal policy

2. Built – in – stabiliser
Discretionary fiscal policy
Discretionary fiscal policy or fine - turning involves:
o It is a policy which is directed at influencing the level of economic activity rather

than at balancing the government budget;
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o It involves the acceptance by government that it must abandon the principle of

always seeking to balance its budget but to be prepared to budget for either a
deficit or a surplus to influence the level of aggregate demand.
BUILT – IN – STABILISERS
This is an automatic or induced fine-tuning of the economy
- Is anything that reduces the country’s cyclical fluctuations and is activated without a
conscious government decision.
- Direct taxes reduce demand and reduces the multiplier and the national income
- Transfer payments and subsidies counter cyclical fluctuations.
THE NATURE OF FISCIAL POLICY
Fiscal Policy can be expansionary or contractionary.

EXPANSIONARY FISCAL POLICY
Increasing government expenditure increases aggregate demand and reducing tax also
increases aggregate demand. In case of a recession an expansionary fiscal policy is
employed. This rescues the demand deficiency situation and increases the level of economic
activity.
AS
Expansionary fiscal policy
Price
Level
Po
AD
AD
Economic growth
GDP¹ GDP² Real GDP
An increase in aggregate demand is brought about by in increase in government spending, a

decrease in taxes which raises private spending. Aggregate demand moves from AD1 to
AD2. Real GDP consequently improves from GDP1, to GDP2
Contractionary fiscal policy AS
Price P1
level AD²
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A decrease in aggregate demand is brought about by a decrease in government expenditure

an increase in taxes or a combination of the two. Aggregate demand moves from AD2 to
AD1
CONTRACTIONARY FISCAL POLICY
This involves reducing aggregate demand through increasing taxes. In case there is inflation,
the correction would be to employ a contractionary fiscal policy. This lowers reduces
aggregate domestic demand, output and employment.
PUBLIC FINANCE
Components of government or public sector:
1. The central government

2. Local government
3. Nationalised industries
4. Quasi Government industries
The pattern of public expenditure
Current expenditure – this refers to day to day running expenses of the government. The
expenditure is on government worker’s salaries benefits paid to the employed, expenditure
on consumables like medicines, stationary and uniforms;
1. Capital expenditure – government investment in new roads, school building hospital,

buildings weapons.
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REASONS FOR GOVERNMENT PENDING
1. Public goods – these cannot be provided by private firms.

2. Merit goods – goods the government feels everybody should have whether or not they
can afford.
3. Social reasons – all of the goods and services provided by government for social
services.
4. Control of the economy – government uses its spending and taxation to influence the
economy.
Financing the public sector
There are six main sources of government financing
1. Public sector borrowing

2. Interest payments on loans of money made by the public sector
3. Rent from public – owned land and buildings
4. Profits from public – owned industries
5. Sale of shares in public – owned industries
6. Taxes on income wealth and expenditure
FISCAL POLICY TOOLS
1. Taxation
2. Borrowing
3. Government expenditure
The need for taxation

1. Main way of raising money for government
2. Can be used to raise prices and reduce consumption of harmful goods such as alcohol
and tobacco.
3. Can make foreign goods more expensive
4. Raising taxes can reduce the amount of money consumers have to spend.
Characteristics of good tax

Principles of taxation
Ability to pay
Individual should be asked to make equal sacrifice
Certainty
Tax-payers should clearly and easily understand how much they will have to pay, and when.
Convenience
It should be easy to pay and collect the tax.
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Economy
A tax should be cheap to collect otherwise it will to some extent be self- defeating.
How the tax system is designed

1. Progressive tax
2. Regressive tax
3. Proportional tax
Progressive tax
Tax rate
% Proportional tax
Regressive tax
Income $
Proportional tax – a fixed % is paid regardless of the level of income. It has an in built
mechanisation to solve economic problems such as demand-pull – inflation
Regressive tax – The relative amount of tax paid tends to decline as income increases eg
where sales tax is imposed on customer with different incomes
Programme tax – It can be defined as a tax which increases due to increases income levels
TYPES OF TAXES
There are basically two types of taxes - namely direct and indirect taxes.
a) Direct taxes
A direct tax is a tax that brings direct contact between the tax payer and the tax collector
It is a tax which is imposed on incomes, wealth and probably profits. Examples are
PAYE, Corporate tax and capital gains tax
Advantages of direct taxes
1. They can be used directly to solve economic problems such as inflation

2. It reduces the tendency to evade taxes.s
3 The government can calculate in advance the tax yield in advance.
Disadvantages
1 They may reduce the amount available to a business for its expansion programmes. This is
especially true with corporate tax.
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2 They normally demotivate or act as a disincentive to workers

3 They reduce consumer surplus if too high
b) Indirect taxes – This is a tax that does not bring together the tax period into direct
contact. An indirect tax is usually when one is associated with some transaction e.g. sales
tax, development taxes, rural electrification tax.
Advantages of indirect taxes

Indirect taxes can discourage the consumption of harmful goods such as cigarettes.
When charged on luxuries it gives the tax payer the choice to pay or not pay them.
They can also regulate consumed spending by their influence on prices.
They can be altered quickly and easily – ‘overnight’ changes of rate.
Disadvantages
They do not take into account personal circumstance or income.
As flat- rate taxes, they are regressive.
They influence the price level.
They can only be applied on goods with inelastic demand when used to raise revenue.
They can also lead to price fluctuation if applied to goods whose demand is elastic.
Examples of indirect taxes
VAT - Value Added Tax

This is a tax that is imposed on the value added at each and every stage of the production
process for a given commodity.
Sales tax - this is tax that is imposed on sales of final products but excluding basic
commodities like mealie - meal.
Customs duty - These are taxes imposed on imported goods in the form of tariffs.
Excise duty - Tax imposed on domestically produced goods which usually impinge
negatively on individuals health eg spirits, alcohol, tobacco etc.
Government expenditure
The economy faced with scarce resources is not at liberty to meat unlimited wants and will
have thus to allocate its resources among competing ends in a prudent manner. Thus, a
government is faced with a mammoth task given the size and objectives of public sector to
allocate scarce resources in order to achieve its economic objectives. These include:
To provide social and economic security
Defence and external relations
Commerce and industry
Local environment and allied services.
Provision of social and economic security. The government may have to allocate its
resources to the provision of public education and health, as well as social welfare
payments.
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Local environment and allied services.

The government has to allocate resources to the maintenance of law and order through the
police, and the courts, fire services, road maintenance just to mention but a few.
Defence and eternal relations

This categorical includes the costs of defending the country and other foreign policy
commitments.
Commerce and industry

From time to time government may grant industry resources to support their operations.
Other payments
These may include interest on the National debt.
The Central government borrowing requirements.

The main component here is the overall budget deficit.
The Public Sector Borrowing Requirements (PSBR).

This refers to the total amount the public sector needs to borrow from the private sector and
overseas to finance its expenditure for the forthcoming year. It involves borrowing by the
central government local authorities as well as public corporations.
The PSBR and the money supply.

An increase in the PSBR may result in an increase money supply. In practice, however, the
effect is uncertain. The effect on the money supply depends largely on the way the PSBR is
financed.
Methods of financing PSBR

There are several methods of financing the PSBR which include among may.
Borrowing from the non-bank private sector
Borrowing from overseas or in foreign currency
Borrowing from the banking system
By printing more money.
N.B. Only the last two of these methods lead to an increase in money supply.
Effect of domestic Borrowing - financial crowding out
1. If the government has to borrow money to finance its expenditure, financial savings will
not then be available for the wealth creating private sector. As a result additional
demand for their funds will push up interest rates and discourage borrowing for
investment expenditure.
2. Debt goes with interest. This imposes a burden on future generations which could be
recouped through an increase in taxes
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3. Inflation
If the government borrows the banking sector creating more liquidity this raises money
supply, which in turn will push prices up.
The National debt
The national debt refers to the total accumulated of all outstanding government spending.
When the national debt is held by citizens, it is caused internal debt. When it is held by
foreigners, it becomes external debt.
The burden of the national debt
The existence of national debt, ceteris paribus, imposes a burden on the community. This
argument is derived from the fact that a burden is imposed via the community being taxed to
meet interest payments on the debt. When any part of the debt is redeemed this too must be
met out of current tax receipts. The implication is, therefore, that the level of taxation would
be lower if the national debt did not exist.
The incidence of taxation

Economists refer to the question of who borners the tax burden as the tax incidence. It is
possible for those who make tax payments (suppliers) to tax authorities to shift some of the
burden onto others. This is especially true with indirect tax. We can use the
diagrammatically exposition below to explain this.
The Incidence of taxation S¹
D
S
P1
Price Proportion of tax borne by consumers
P0
Proportion of fax borne by producers
P2
S¹ D
S
The imposition of a sales tax for example,
Q
given supply and demand conditions of S and D
respectively will shift the supply curve to the lift (S1) rising the price from P to P1.. The
amount of tax is measured by the vertically difference between S and S1.. The price increase
is less than the full amount of tax, showing that producers pass only a proportion of the tax
burden to consumers. In this case consumers bear bc of the tax incidence, and producers ab.
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N.B. The amount of tax burden that the producers able to pass on to consumer depends on
the price elasticity of demand. The more demand is elastic there of demand higher the share
of tax burden that the consumer bears, vice versa.
We can also consider different scenarios if the price elasticity of demand is perfectly in
elastic, the whole tax burden is borne by the consumer. Moreover, if ped is perfectly elastic,
the whole of the tax burden is borne by producer. We can illustrate this diagrammatically.
Inelastic demand and incidence of taxation
D
Price
S¹
P1 Proportion of tax borne by

consumers S
S¹
P0
P2 Proportion of tax borne by producers
Quantity
Perfectly inelastic demand and incidence of taxation
D
S1
Proportion borne by consumers

P1 S
Price
P0
Quantity S1
Perfectly elastic demand and incidence of tax
Price
P0 D
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MULTIPLE CHOICE
1. Crowding out of private sector is caused by:

A too much government borrowing locally in the economy
B government investment in other countries.
C reduction of interest rates
D increased aggregate demand in the economy
2. Progressive taxation occurs when:

A the average rate of tax is higher than the marginal rate of tax.
B the marginal rate of tax is higher than the average rate of tax
C the average rate of tax is equal to the marginal rate of tax
D the average rate of tax is greater than unity
ESSAYS
1. Assess the effects to an economy of ways that can be used o finance the public sector-
borrowing requirement. [25]
2 (a) With illustrative examples, explain what is meant by direct taxes and indirect taxes.
[10]
(b) ‘All government revenue is generated from taxes.’ Discuss.
[15]
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1. MOZAMBIQUE’S EXTERNAL DEBT SERVICING OBLIGATIONS DECLINE.
MAPUTO.
THE HERALD, 21 OCTOBER 2005
As a result of the two instalments of the HIPC (Heavily Indebted Poor Mozambique’s
annual debt servicing obligations have fallen from over US$100 million in 1998 to about
US$57 million now, Finance Minister Manuel Chang told the Mozambican parliament, the
Assembly of the Republic on Wednesday.
Answering questions from the opposition about the country’s financial state, Chang said the
country’s debt stock stood at US$4,4 billion, in nominal terms, on December 31 2004,
compared with US$6billion before HIPC. Mozambique is also one of the 18 countries who
will benefit from this year’s initiative of the G8 group of most industrialised countries,
involves cancellation of 100 percent of multilateral debt owed to the World Ban, the
international Monetary Fund and the African Development Bank.
Chang confirmed that the cut-off date for this initiative is December 31 2004, and the
implementation date is scheduled for January 1 2006. So in principle everything
Mozambique owes to the three multilateral institutions except loans contracted this year has
been cancelled. But Chang was careful not to put an exact figure on this. He told AIM later
that the government is still waiting confirmation from the World Ban and the IMF of the
sums involved. Nonetheless the amount is expected to be in excess of US$2 billion.
That would mean the largest amount of Mozambique’s remaining debt is owed to those
bilateral creditors who are not members of the Club of Paris- mostly oil-producing countries
such as Algeria, Libya and Kuwait. Chang said Mozambique is trying to negotiate reduction
of this debt, too, with the help of international organisations such as the Commonwealth
HIPC Forum that Mozambique is currently chairing.
As for domestic debt, Chang said the government has resorted to long-term treasury bonds
to finance the budget deficit and short-term treasury bills to fund temporary treasury
deficits. The domestic debt stock stood at 2 585,5 billion meticais (about US$103 million)
as of the end of 2004. Some of this debt results from the near collapse of the two privatised
banks, the BCM and Austral, in 200 and 2001, which then had to be bailed out by the state.
Chang said that, with both the foreign and the domestic debt, “the government has been
honouring scrupulously its debt servicing obligations”.
E stressed that the government’s approach towards foreign aid is always to seek grants and,
where these are not available, soft loans. “We don’t accept commercial loans for state
investments,” declared Chang. The treasury position throughout the first half of the year
had been healthy, said Chang.
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At the end of the first quarter the treasury balance stood at 341,5 billion meticais, rising to
444 billion at the end of the second quarter, and to 476,6 billion at the end of September.
He believed that, by the end of the year, the targets for both state revenue and public
expenditure set down in this year’s budget would have been achieved.
The figures for the first six months might seem to belie this optimism. State expenditure
was 90 percent of what had been planned. Internal revenue (mainly taxes) was 97 percent of
the expected figure, and counterpart funds from foreign aid only 91,4 percent. But Chang
said there as a strong seasonal element in tax revenue, and he fully expected the shortfalls to
be made up in the second half of the year.
(a) (i) According to the information given, what has reduced Mozambique’s
annual debt serving obligations? [2]
(ii) How does the 98 group help the most indebted poor countries? [2]
(iii) Give the three multilateral institutions named in the information given.
[3]
(b) (i) Name one product, which has mainly contributed to Mozambique’s
national debt. [1]
(ii) Explain why the government prefers soft loans and grants as compared to
commercial loans to finance government activities. [2]
(c) (i) Explain the relationship between domestic debt and national debt. [2]
(ii) Analyse how funding the national debt contract money supply in an
economy. [3]
(d) Examine the effects of a national debt to an economy. [5]

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CHAPTER 11
MONEY AND BANKING
Chapter objectives
After reading this chapter and working through practice questions. You should
1. Be able to identify the functions of money and the characteristics of good money.
2. Explain the features of quasi money.
3. Define the aggregates of money supply in Zimbabwe.
4. Describe the money creation process by the Commercial banks.
5. Understand the Quantity theory of Money and explain it’s antique.
6. Outline the motives or reasons for holding money according to the Keynesian
Theory.
7. Distinguish between the Classical Theory and the Monetarist Theory.
8. State the factors which determine the supply of funds.
9. Describe the functions of the Reserve Bank of Zimbabwe as a supreme monetary
authority in the financial sector.
10. Understanding the functions of the Commercial banks, Merchant banks, discount
houses, Finance houses and building societies.
Money is any generally accepted medium of exchange. Any commodity that is widely
accepted as a medium of exchange in a society constitutes that society’s money. The
acceptability of money can be a result of its intrinsic value as is with commodity (silver and
gold) money or a result of Government’s legal backing as with fiat money.
THE HISTORY OF MONEY

In the early stages of the evolution of money commodities such as shells, silver and gold
were used as the medium of exchange. Every time a transaction was to be made, these
commodities had to be weighed to get quantities matching the value of the transaction. This
was tedious and time consuming given the bulky nature of these commodities. To reduce
this problem societies started to mint and use token/intrinsic coins with face values
reflecting their metal content. This coinage period collapsed when rulers and Monarchs who
had the sole right to mint coins started re-minting and debasing the coins of their metal
contents to enrich themselves. This resulted in high inflation and loss of confidence in coins
by the society.
Societies were forced to return to the usage of gold and silver as money. To ensure safe
keeping, these metals were deposited with goldsmiths who had strong vaults. Promissory
receipts were, in return, issued out by goldsmiths to depositors. Every time transactions
were to be carried out, depositors would first withdraw their gold and silver using those
receipts. The increase in the confidence of the people with the goldsmiths resulted in them
accepting the issued promissory receipts for trade instead of withdrawing gold and silver
first. Around the 1930s these receipts had become society’s money with gold and silver only
infrequently withdrawn for special occasions and transactions. This tempted goldsmiths to
over print receipts for interest lending. Such activities led to goldsmiths failing to honor
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most gold withdrawals from receipts holders and consequently to the collapse of the paper
money period. The role of note issuing was thereafter taken over from banks and goldsmiths
by Central banks which were given the sole right for note issuing by their governments.
Initially, fully backed and convertible notes were issued but as more money was required by
governments during war times, for example, central banks would be forced to overprint
money. This resulted in the emergence of fractionally backed notes. To avoid the collapse of
the monetary system laws were passed by governments prohibiting the conversion of notes
into gold and silver. Paper money was declared a legal tender and this is the fiat money
currently used by all societies. Today, modern money also includes deposit money, which is
created by commercial banks when they lend out money to their clients. Such created
deposits are part of money because the persons for whom they are created can write and use
cheques against the deposits for their transactions.
GRESHAM’S LAW
Gresham’s law states that ‘good money drives out good’ in the sense that when bad money
and good money co-exist in circulation; good money will be forced to disappear from
circulation as people prefer to keep for themselves good money and use bad money for
transaction purposes. This law was propounded by Gresham during the coinage period after
observing that the parallel circulation of debased and non-debased coins would always result
in the disappearance of the non-debased coins from circulation.
The implication of Gresham’s law today is that if two different currencies with different
values are allowed to co-circulate at a pegged exchange rate (eg the Zim$ and the US$;
Zim$ and the EURO$), the stronger currency will be forced to disappear from circulation by
the weaker currency.
FUNCTIONS OF MONEY.
Money performs four functions. These are as itemized below:
(i) A Medium of Exchange

As a medium of exchange, money facilitates trade when goods and services are exchanged
for money. Without money trade would be done using the barter system of exchange which
involves exchanging commodities for other commodities. Barter has many problems: it
requires a double coincidence of wants; it makes it difficult to assign prices to commodities
to determine their rates of exchange; it would be difficult to divide physical commodities to
facilitate small value transactions. Money as a medium of exchange reduces these problems.
People can sale their labour services and assets for money and use their money receipts to
buy all the other commodities they may want to consume.
(ii) A store of Value/Wealth.

Money commands purchasing power in that it can be used to buy other commodities and
assets. With money, people can choose to keep their wealth in the form of money as with
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during war times and reconvert back to real assets in future. For money to serve this
function efficiently, prices need to be stable to avoid the erosion of savers’ monetary wealth
over time.
(iii) A Unit of Account.

In a monetised economy, the prices of various commodities are expressed in monetary
terms. Money therefore serves as a measurement rod against which the values of other
commodities are reflected to facilitate trade. Without money a commodity’s value would
need to be measured in terms of other commodities and this would be subjective.
(iv) A Standard for deferred Payments

As a standard for deferred payments, money is used to objectively value an individual or
nation’s indebtedness in terms of the amount they would need to pay in future when a credit
purchase is made or when money is borrowed. The availability of money makes interest
calculation and accounting possible.
Characteristics of Good Money

For money to efficiently and effectively perform its functions it has to have specific
attributes or characteristics. These are:
i) Acceptability
A commodity which serves as a good medium of exchange has to be widely and generally
accepted by the society. The acceptability of money stems either from its intrinsic value as
with commodity money or from Government’s legal backing as with fiat money or legal
tender.
ii) Stability in Value

A good store of value/wealth is one whose value is stable over fairly long periods of time. If
the value of money is unstable as is the case during hyperinflationary periods, keeping one
wealth in the form of money becomes risky as it entails obtaining less physical wealth in
future. To maintain the society’s confidence in their money, inflation needs to be kept at
minimum levels.
i) Scarcity
For money to have economic value it should be scarce relative to its demand. Money
supplied in abundance and found every where and any time by everybody can not be
accepted as a medium of exchange or a store of value as its value would be unstable.
ii) Uniformity
Similar denominations of money in a country such as $10; $20; $50; $100 notes should be
identical/homogeneous. This is needed to make money easily recognizable and also to
minimize incidences of money counterfeiting.
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iii) Divisibility
Good money should be divisible into smaller and larger denominations without loss of
value. This will make it easy to price both small and big value commodities and also making
it possible and easy to facilitate both small value and big value transactions.
iv) Portability
Money should be easy to carry around. Its purchasing value should be high relative to its
physical quantity.
v) Durability
To facilitate many transactions before soaring out and replaced, good money should not
easily and quickly deteriorate. This will minimize the replacement cost of money.
Near Money/Quasi Money

These are financial assets held as close substitutes for money and largely performing the
same functions as those performed by money. Examples are demand and savings deposits.
People may prefer to these assets because of their following desired attributes:
i) Profitability
Generally all the categories of quasi money earn a return in the form of interest.
When inflation is generally high people may prefer to hold near money as a way of
hedging against the value-eroding effect of inflation on cash.
ii) Liquidity
Some financial assets such as demand deposits are almost as liquid as cash yet safer
to hold than cash. Wealth holders are not inconvenienced by holding such assets
when they want to carry out their transactions. For financial assets to be highly
liquid and equally acceptable as money, a stable and liquid financial sector needs to
be in place.
iii) Less Risk

Money assets should be risk free for people to hold them in the sense that the holder
should be certain of the return on and the liquidity of the asset without fears of
loosing of value. In a highly liquid financial sector with good banking practices, the
risk associated with holding financial assets is reduced and people can safely hold
them.
Money Supply
Money supply refers to the total stock of money in an economy in a given time period. This
is made up of hard currency and deposit accounts maintained with the financial sector.
Monetary Aggregates in Zimbabwe
The aggregates of money supply in Zimbabwe are as defined below:

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M1=Notes and Coins in Circulation + Demand Deposits (with the RBZ; Discount
Houses; Commercial Banks; & Merchant Banks).
M2=M1 + Savings Deposits with Commercial Banks + Under 30-Day Fixed Deposits with
Commercial and Merchant Banks
M3=M2 + Over 30-Day Fixed Deposits with Commercial Banks; the RBZ; Merchant Banks
+ Fixed Foreign Currency Accounts.
M4=M3 + Savings and Fixed Deposits with other Banking Institutions-the POSB; Finance
Houses; Building Societies + Private Sector Foreign Currency Holdings.
Of these aggregates, M1 is the narrow definition of money while M2 to M4 are broader

definition. The broadly defined categories are generally more active in terms of influencing
the interest rate, inflation and the level of economic activities. These are therefore
commonly the targets of monetary policy in Zimbabwe(especially M3).
MONEY CREATION BY COMMERCIAL BANKS

The demand deposits created by commercial banks in the process of lending money to their
clients constitute a significant proportion of Zimbabwe’s total money supply.
From experience commercial banks know that at any point in time some people may not
withdraw their money and that those who will, will only withdraw a proportion of their
deposits. This gives banks the opportunity, to extent as loans for an interest, that percentage
of their deposits which on average is not expected to be withdrawn in a particular time
period. Banks do this by creating checkable deposit against which the borrower can make
transactions by writing cheques.
If, for example, banks need to keep 10% of their deposits as cash to meet withdrawals (this
can also be imposed on banks by the RBZ as the statutory required reserve ratio); out of
$1000 of new cash deposits they will be able to create an extra $9000 of deposits in loans.
An Illustration of Deposit Creation by Banks

Assume all the banks are equal in size and in their volume of business.
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(1) Bank1’s
Balance
Sheet Assets
Liabilities Cash 1000
Deposit 1000 Loans 900
Created Deposits 900
(2) Bank2’s
Balance
Sheet Assets
Deposits 900 Loans 810
(3) Bank3’s
Balance
Sheet Assets
(4) Bank4’s
Balance
Sheet Assets
(5) Bank5
Balance
Sheet Assets
After the process of credit creation the total deposits will be:
D = $1000 + $900 + $810 + $729 + $656 + $590 + $531 + $478 + ..…+……=
$1000/0.10 = $10 000.
FORMULAE FOR MONEY SUPPLY DETERMINATION
(i) When the Private Sector does not have any Preference for holding cash
In situations where the non-bank private sector does not have any preference to hold cash
and the banking sector is required to keep a reserve ratio equal to r, the total money supply;
defined as M = D; is obtained from the following formula:
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D = R/ r
Where{; r=required reserve ratio}and {1/r = money multiplier}. R = Reserves of cash with
the banking sector.
(ii) When the Private Sector has got Preferences for Holding Money
When the private sector has got some preference for holding cash the total money supply
which is defined as : M = C + D becomes:
M= (c+1) (R+C)
r+c
Where (c+1)/(r+c) = the money multiplier; c= the desired cash ratio by the non banking
private sector; R= Cash Reserves with the Banking sector; C= Cash in the hands of the non-
banking private sector.
Example 2: If the cash ratio required by the non-banking private sector is 5% and the bank
required reserves are 10%; with an amount of $1000 as the total hard cash; the level of
money supply would be:
Ms = (0.05 + 1)/(0.1 + 0.05) {950 + 50}

= $7000.
The reduction in total money supply in this example follows from the reduction in cash
reserves available in the banking sector when the non-bank private sector has got some
preference to hold cash. Any increase in c due, for example, to a reduction in the non-bank
private’s confidence in the banking sector would result in reduced money supply. The
development of the financial sector which reduces money demand by the private sector
would, on the other hand, result in an increase the level of money supply.
THE QUANTITY THEORY OF MONEY
The Quantity Theory of Money is a theory of money neutrality whose roots are founded in
Irving Fisher’s (Classical economists’) equation of exchange. This theory posits that the
value of the total transactions in an economy is always identical to the level of money
supply multiplied by its velocity of circulation, ie:
MV = PT
Where: M = the level of money supply;

V = the transactions velocity of circulation;
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P = the general price level;

T = number of real transactions
This theory assumes that the velocity of money circulation is to be constant. It is also
assumed that the economy is in full employment such that the volume of real transactions
(T) is fixed. With these assumptions; the quantity theory of money predicts that the role of
money is limited to affecting the level of prices only without any impact on real variables
such as expenditure, income, employment and relative prices. Any change in the level of
money supply would completely be transformed into an equal change in prices. Inflation,
according the QTM, is therefore seen as a monetary phenomenon such that to cure it one
would simply need to reduce the level of money supply.
A Critique of the Quantity Theory of Money

(i) The theory sees money exclusively as a medium of exchange in the sense that people do
not have other uses for money other using it to facilitate their transactions. This assumption
fails this theory in practice where people have got diverse uses for money eg money can be
used to store one’s wealth; money can be used to speculative purposes.
(ii) The assumption of a fixed velocity of circulation of money is unrealistic. The

development of the financial sector and the wide use of cheques and other plastic
technologies (ATMs; credit cards; debt cards) all affect money demand and the velocity of
circulation of money.
(iii) The theory defines money supply in its narrow terms as the amount of currency in the
economy plus the value of demand deposits. In modern economies where broad money is
used for monetary policy and transactions purposes, the theory becomes inapplicable.
(iv) The postulation of money neutrality by the equation of exchange has failed in practice
as it has generally been observed that whenever the level of money supply is changed its
effect would fall on both real variables and the price level. This is because economies are
not always at full employment as assumed by the theory. Again, the existence of market and
information imperfections, unemployment, money illusion and price rigidities make money
non-neutral.
MONEY DEMAND
The demand for money refers to the desire by people to hold money. Unlike other
commodities which are demanded for consumption purposes; people demand money to hold
it. This can be for the need finance some transactions in future; or to guard against
unforeseen contingencies; or for future financial investments. There are three schools of
thought which explain why people may have the desire to hold money. These are:
a) The Classical Theory;

b) The Keynesian Theory;
c) The Monetarist Theory.
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The Classical Theory
This is also known as the Old Quantity Theory of Money in that it views money solely as a
medium of exchange. This theory simply recasts Irving Fisher’s equation of equation into a
money demand relationship as follows:
MV = PT
M = 1/V{PT}
Md = k(PT) : where k=1/V
In summary this states that money demand depends on the level of one’s transactions. This
conclusion logically follows from the Classical theory’s view of money as a medium of
exchange. People therefore demand money because of the non-synchronization of their
incomes and expenditures. All the factors which affect the level and nature of one’s
transactions therefore affect his money demand. These are:
The Level of Income: When income is high; the level of transactions would also generally
be high resulting in people demanding more money. Low levels of income are on the other
hand associated with less money being demanded.
The Length of the Payment Period: With the same income level, an increase in one’s
payment period would result in more money balances being held as more transactions would
now need to be conducted before the next pay day.
The General Price Level: When inflation is high money demand also increases as more
money would now be needed to command the same number of transactions. Without money
illusion, an increase in prices by 10% would result in people increasing their money
balances by 10%.
The Level of the Financial Sector Development: The more sophisticated is an economy’s
financial sector the smaller the amount of money people would have to hold to complete a
certain volume of business; e.g the use of ATMs; the use credit cards; the existence of
telegraphic money transfers; the existence of hire-purchase facilities;
Applicability in Less Developed Countries : The assertion that money demand depends of
one’s income; inflation; the payment period is largely correct in LDCs where money is
mainly used for transactions purposes. However, as people are getting more educated on
possible financial investments; interests rates are increasingly becoming important in money
demand.
The Keynesian Theory

Also known as the Liquidity Preference Theory; the Keynesian theory of money demand
identifies three motives or reasons for holding money. These are: the Transactions Motive;
the Precautionary Motive; and the Speculative Motive.
i) The Transactions Motive:

This is similar to the Classical theory of money demand. It states that part of the money held
by people is for their day to day transactions. This component of money demand is
completely affected by one’s income in the sense that the higher one’s income is the greater
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the transaction balances he needs to hold. Other factors such as the level of financial
development also affect transaction balances held by individuals.
ii) The Precautionary Motive

Precautionary money balances are those balances held to provide for unexpected
contingencies. The Keynesian theory posits that because events such as illness; death;
auctions; and bargain sales occur without prior expectations, individuals safeguard
themselves against them or provide for them by holding precautionary money balances. The
Keynesian precautionary balances are also affected by and are positively related to one’s
income.
iii) The Speculative Motive

This motive states that people may hold more or less money balances depending on their
expectations about the future interest rates and prices of financial assets. On the motive
money is seen as a close substitute of bonds such that the opportunity cost of holding money
would be the interest on bonds foregone. When current interest rates are high less money
would be demanded as the cost of holding it is high. Again the high interest rates would
generally lead wealth holders to expect them to fall in future leading to higher bond prices.
People would therefore use any excess balances of money held to buy financial assets in
anticipation of capital gains when the interest rate falls. If the current interest rate on bonds
is low; the cost of holding is also low and people would hold more money. In expectations
of higher interest rates and low bond prices, more money will also be held to avoid capital
losses on financial assets in future.
Applicability in Zimbabwe: The Kenesian transactions and speculative motives for money
demand are generally applicable and well explain the nature of money demand in Less
Developed countries with thin money and capital markets. The speculative motive tends to
be more appropriate in advanced economies were people are rich and more monetised. Such
people would be expected to worry more about financial investment opportunities for their
monies than would the average money holder do in Less Developed Countries. Most
research studies have also proved this by failing to find any systematic relationship between
money demand and the interest.
The Monetarist Theory

This is also known as the Modern Quantity Theory because it derives its money demand
from the Classical QTM. The monetarist theory sees money as any other assets and that its
demand depends on the holder’s budget constraint, on its price, the price of closely related
commodities ie: Md = f(Y,h,P,rb,re,Infl,U)
Where Md is money demand; Y is nominal income. Any increase in Y leads to an increase

in money demand; h represents the ratio of non-human wealth to human wealth acquired
through education and experience. As h falls so that the proportion of human wealth in the
total wealth stock rises, the demand for money increases. This increased demand for
liquidity balances the movement towards greater illiquidity in the wealth stock since labour
is more illiquid than other non-human forms of wealth; P represents the price level. This
implies that the monetarist money demand is a demand for real balances. Any increase in P
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which erodes real money balances held results in more money being held; rb and re
represent returns on bonds and equities respectively. When these increase less money will
be demanded and when they fall more money is demanded as it becomes less costly to hold;
Infl which stands for inflation represents the increase in value of physical assets. When the
prices of those assets increase people switch over to them and reduce their money balances.
Applicability in Zimbabwe: As argued in the Keynesian theory the level of income (Y); the
general price level (P); and the price of physical wealth (Infl) are more applicable in less
developed countries. Returns on bonds and equities are less applicable due to the thinness of
the financial sectors and limited access to information about events, available assets and
returns in the stock and money markets of Less Developed Countries.
The rate of interest - the price of money

There are many theories of interest. The two most important ones are:
a) The classical theory
b) The liquidity preference theory
According to the classical theory of interest, it is demand and supply of loanable funds that
determine the rate of interest. Interest is therefore a payment for the use of funds demanded
by individuals, firms and the Government.
THE SUPPLY OF FUNDS DEPENDS ON VARIOUS FACTORS. THESE

INCLUDE:
a) The level and size of the income of individuals
b) Expectations of change s in the value of money
c) Level of price
d) The wealth of a person.
Rate of interest
D
S
Interest
rate
%
0 Quantity of savings and investment
In classical theory, interest rate is determined by the interaction of the supply and demand
for funds as shown in the diagram.
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According to the liquidity preference theory interest rate is the reward for parting with
liquidity for a specific period.
S
RATE OF
INTERST
I
LP=Dd
0 Quantity
In Keynesian theory, interest rate is determined by the liquidity preference of the individuals
through expression on the supply and demand of money.
‘A’Level students would demand money for transactions motives because they only get
pocket money from their parents. The students would also keep money for precautionary
purposes but due to the limited amount that the students receive from the parents only an
insignificant proportion may be kept for this purpose.
None will be kept for speculative purposes as students with a limited income they may not
entertain any investment ideas.
A financial conservative professor with children, support will need money for transaction
purposes, precautionary purposes and speculative purposes. Transactions purpose demand
for money will be for purchasing day to day consumables such as groceries, bills e.t.c.
Since children are still young they may be need for money to be put aside in case children
get sick. Professors are also professionals who have had many years researching and
teaching experience and as such they may put aside some money as an investment.
Vending and dealings involves speculatory about likely changes in interest rates, exchange
rates e.t.c. The wheeler dealer will also hold money for transactions and precautionary
motives because as any other economic agent they need to make purchases as sells as keep
money to guard against unknown emergencies. The amount kept for the two would
constitutional proportion however, contribute a final proportion of their portfolio holding.
FINANCIAL INSTITUTIONS
Zimbabwe’s financial sector is made of the Central Bank-Reserve Bank of Zimbabwe; the
Zimbabwe Stock Exchange Market-the Capital Market; commercial Banks; discount
Houses; finance Houses; building Societies; merchant Banks; the POSB; other( the Credit
Guarantee Company-CGC; Small Enterprise Development Corporation-SEDCO; Venture
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Capital Company of Zimbabwe-VCCZ; Zimbabwe Development Bank-ZDB. The

traditional functions of these financial institutions are as outlined below:
The Reserve Bank of Zimbabwe/The Central Bank

This is the supreme monetary authority in the financial sector. The following functions are
those performed by the Reserve bank.
a) The Government’s Bank

The Reserve Bank accepts deposits from the central Government; its Ministries;
Departments and Parastatals as well as offering them with their various financial services
requirements. The Reserve bank also manages the National Treasury Account were all
government revenues from taxation, licenses, Revolving Funds are deposited and from
which payments on behalf of the Government are made.
b) Advisor to the Government

The Reserve Bank informs and advises the Government on issues relating to local and
international money and capital markets. The Reserve bank also manages the sale and
purchase of Government paper such as Treasury bills; bonds; Parastatal bills.
c) The Implementing Agent for Monetary Policy

The regulation of domestic money supply; credit and interest rates as monetary policy tools
is done on behalf of the Government by the Reserve bank.
d) The Bankers’ Bank

All the other financial institutions bank their monies with the Reserve Bank. This can be for
voluntary safe keeping or out of statutory requirements by the Bank for its monetary policy
or bank supervision purposes. Such deposits are also needed for inter-bank cheque
clearances.
e) The Lender of Last Resort

When financial institutions run short of liquidity to meet the withdrawal requirements of
their clients, the Reserve bank lends them the needed funds normally through its rediscount
window. Through this, the Reserve bank ensures liquidity and the society’s confidence in
the domestic financial sector.
f) The issuer of Notes and Coins

The Reserve bank has the sole right to issue new notes and coins in replacement of the
soared money.
g) The Financial Sector Supervisor

To ensure sound and ethical banking practices by the financial sector and to maintain public
confidence in the financial sector, the RBZ has got the powers to supervise the operations of
all the other financial institutions. This role is of paramount importance especially, in a
financially liberalized economy like Zimbabwe to minimize incidences of bank collapses.
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Commercial Banks
The major functions of a commercial bank are to accept deposits from the non-bank private
sector and to arrange short-term loans mainly in the form of overdrafts to the same clients.
Due to financial liberalization and de-segmentation, commercial banks like any other
financial institutions have acutely diverted from their traditional spheres of business.
Traditionally, commercial banks are entitled to operate and serve the following functions:
i) The Private Sector’s Banks.

Commercial banks accept deposits from private individuals, firms and other private
organisations. They offer a wide variety of financial assets with varying degrees of maturity,
profitability and liquidity which are convenient and affordable by both small and large
private sector savers.
ii) Providers of Short - Term Loans

Commercial banks are the major source of short – term loans in the form of bank overdrafts
to individuals and firms. Such short – term loans are usually needed for consumption
expenditure and for working capital financing.
iii) Providers of the Cheque System

Commercial banks provide and operate the cheque system of a country. This improves trade
and the convenience of conducting transactions. The cheque system also reduces the risks
associated with holding and transactions of large sums of cash.
iv) Providers of the Plastic Technology

Besides maintaining the country’s cheque system, commercial banks also issue and maintain
the usage of credit cards, debt cards, ATMs and other plastic technologies, which make
banking and trade easy and safe.
v) The Provision of the Stop Order System

Commercial banks can be instructed to make periodical transfers of money from their
clients’ current accounts to pay the clients’ periodical payments such as rent, hire purchase
installments, etc.
vi) Funds Transfer Systems

Commercial banks facilitate the transfer of money from one place to another through mail
transfers; electronic transfers. Mail transfers involve preparing a draft for the customer and
sending it to the beneficiary. Electronic transfers occur when the bank transfers money
through the telegraphic system SWIFT (Society of World Wide Interbank Financial
Telecommunication) or when a customer’s account is debited from a terminal at a point of
sale.
vii) Acceptance of Valuables for Safekeeping

Besides accepting deposits, commercial banks also accept valuables such as certificates,
deeds, wills, jewellery, etc for safe keeping for a fee.
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viii) Other Functions

The provision investment advice to clients; Provision of foreign exchange services and
Travellers’ cheques.
MERCHANT BANKS
Merchant banks are mainly involved in trade finance; credit acceptance and wholesale
banking.
i) Credit Acceptance
This is done by Merchant banks through providing guarantees for borrowing on behalf of
debtors or potential borrowers to their creditors. To facilitate such borrowing and trade at an
international level, Merchant banks draft letters of credit on behalf of their clients. Merchant
banks also lend out money for trade purposes.
ii) Share Underwriting

Merchant banks act as share issuing houses by purchasing shares at a guaranteed price from
the issuing company and later on resale them to the final investing shareholders. Reselling is
normally done at a premium when market conditions for the issued shares improve. This
makes funds for investment purposes readily available to the issuing firm and at the same
time reducing the risks of selling the shares at a discount.
iii) Facilitate Company Listing

Merchant banks facilitate, arrange for and advise private companies for their listing in the
Stock Exchange Market.
iv) Facilitate Off-shore Borrowing

Private firms can borrow money from foreign financial markets with the assistance and
advice of Merchant banks. Merchant banks can even at times borrow money from off-shore
markets on behalf of their clients.
vii) Portfolio Management and Advice

Merchant banks advice their clients on the best ways to raise money. They also provide
advice on how their clients can best invest their excess reserves of money.
vii) Wholesale Banking Institutions

Merchant banks accept deposits from corporate bankers who bank in large sums.
viii) Facilitate Mergers and Takeovers

Merchant banks act as go-between agents to facilitate and advise on the merging of different
firms or on the taking-over of one firm by another.
Discount Houses
These are an intermediary between the Reserve Bank and other financial institutions. They
are the window through which the Reserve bank lends money to the other financial
institutions in situations of liquidity shortages. Discount houses attract deposits from other
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financial institutions on call and also re-discount or liquidate their financial assets when
cash is needed.
Finance Houses
Finance Houses are mainly into financing the purchase of long term capital equipment. They
do this by providing hire-purchase and lease hire facilities.
Building Societies
Accept deposits from the private sector and provide long term loans in the form of
mortgages for housing and construction purposes.
MULTIPLE CHOICE
1. Which of the following is an example of substitute money?

A building society deposits
B credit card
C notes and coins
D cheques
2. What will be the money multiplier if the cash ratio is 10%?
A 0,1
B 1
C 10
D 100
3. Which of the following factors does not influence transactions demand for money?
A real income
B price level
C growing use of credit cards
D interest rate increase
4. Which of the following is not a function of prize?

A signaling function
B incentive function
C bartening function
D rationing function
Essays
1. Assess the extent to which commercial banks can create credit? [25]
2. ‘All the functions of the central bank revolves around issuing notes and coins in the
economy.' Analyse this statement. [25]
4.
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CHAPTER 12
THE MONETARY POLICY
Chapter objectives
1. Define the term, “Monetary Policy” and explain the reasons for using a monetary
policy.
2. Explain the tools of the Monetary Policy.
3. Distinguish between the Monetary Policy and the fiscal policy.
Monetary policy refers to action taken by the Central Bank (RBZ) on behalf of the
Government to try to influence either the supply of money or the price of money, as given
by the rate of interest.
Andrew Tibbitt defines monetary policy as a policy concerned with the cost and availability
of credit and the rate of growth of the money supply.
REASONS FOR USING A MONETARY POLICY.
1. Change in the money supply may cause inflation or reduce it – increase in money supply
causes increase in prices.
2. Change in interest rates affects aggregate demand – as interest rates fall more people
will want to spend more money.
3. Changes in money supply directly affect aggregate demand, output and employment
4. Interest rates can be used to affect the value of the local currency. Interest rates can be
raised to help influence the value of the local currency compared to foreign currency.
Therefore Monetary Policy involves influencing the supply of money and interest rates to
try and control the level of inflation unemployment, economic growth and the value of the
local currency.
HOW MONETARY POLICY WORKS
Tools of Monetary policy are:
1. Open market operations

2. Changing the reserve rates
3. Changing the discount rate
4. Persuasion
Open Market Operations (OMO)
This involves the sell or purchase on the open market by the central bank of government
securities. It can be used to increase or reduce the stock of money in circulation held by the
public. Suppose the central bank wishes to reduce excess liquid on the market, it offers for
sale commercial papers to the general public. Purchase of the commercial papers will lock
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the funds that were supposed to be used by members of the public in their various
transactions. This is usually the case when the bank is motivated by the desire to bring down
inflation. If on the other hand the central bank wishes to stimulate aggregate demand in
order to achieve desired levels of employment and economic growth, it can increase money
supply, which has the effect of reducing the rate of interest. This is done by buying back
government securities. This act has the effect of releasing additional funds into the
economy.
Interest Rate Policy

The central bank can also intervene to influence the interest rate, and in this way control the
growth of bank lending. A rise in interest rates might be expected to dampen down the
demand for bank credit, vice versa.
Special Deposits
Monetary authorities may require that financial institutions deposit a certain amount of their
bank deposits with them. Although these funds earn interest, they are effectively ‘frozen’
since those making the deposits do not have the right to withdraw them. This limits the
credit creation (lending) by financial institutions. Special deposits may however, be released
when the central bank wishes to see an expansion of the money supply.
The Reserve Ratio

The monetary authorities may also play with the reserve ratio in their desire to achieve
economic objectives. The reserve ratio, which is the proportion of bank deposits a bank may
be required to maintain or deposit with the central bank at a particular time may be raised or
lowered depending on the objectives the monetary authorities are pursuing. In order to
restrict credit creation and hence money supply in the economy, the central bank may raise
the reserve ratio to reduce the amount of deposits available for credit creation or on-lending.
It can on the other hand reduce the reserve ratio in order to expand credit creation and hence
money supply in the economy.
Actual reserve - required reserve

$50 000 - $ 2000 000 x 10 % = $ 30 000
If the legal reserve ratio is increased to say 20 %, then the excess reserve will be
$50 000 - $200 000 x 20 % = $ 100 000
Money supply at 10 % = 30 000 x 1

0,1
= $ 30 000
Money supply at 20 % = $ 10 000 x 1

0,2
= $ 50 000.
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From the calculations above it can be deduced that raising the reserve ratio increases the
required reserves from $ 20 000 to $ 40 000. Conversely lowering the reserve ratio changes
required reserves to excess reserves and increases the ability to banks to create new
moneylenders. At 10 % money supply is $ 300 000 which at $ 50 000.
The Discount Rate
The discount rate refers to the interest rate the financial institutions are charged by the
central bank for borrowing from it. In other words, they represent a cost to the financial
institutions for borrowing from the central bank. It has thus, the effect of raising or reducing
the costs of borrowing by banks and their ability to advance loans to their clients. If the
discount rate is raised, the cost to the banks is raised and banks in response will raise the
rate of interest they charge on their loans. This will have the effect of reducing the demand
for advances and hence aggregate demand is dampened. This is usually the case when the
reserve bank wants to bring inflation down. The central bank on the other hand, can reduce
the discount rate in order to encourage increased economic activity. A reduction in the
discount rate will force banks to reduce interest rates on their loans thereby encouraging
both corporate and individual citizens to borrow from the banks.
Funding
This involves the selling of more long-term debt (bonds) and the issue of short-term debt
(treasury bills). Since treasury bills are short-dated securities, they are highly liquid assets.
The monetary authorities can wipe out excess liquidity from the market by issuing fewer
treasury bills and thereby restrict the ability of banks to make loans.
 The monetary policy in conjunction with other policies seek to achieve the following
objectives, full employment, price stability, economic growth and equilibrium in the
balance of payment.
Other Monetary Policy Tools

Other tools of Monetary Policy are:
Moral Persuasion
Credit Ceilings.
ESSAYS
1. Assess the applicability of the loanable funds theory to interest rate determination in
an economy. [25]
1. Assess the extent to which the monetary policy and the fiscal policy can,
complement each other in solving inflation in the economy. [25]
5. Is it more difficult to define money, than to control its supply. Discuss [25]
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1. R B Z role in liquidity provision to banks By Vimbikayi M Kusema.
AS we approach the September 30 watershed dead-line for banks to satisfy the $10 billion
capitalisation requirement by the Reserve Bank of Zimbabwe (R B Z) , we want to look at
the role that the R B Z played in providing liquidity to banks when the financial services
sector in Zimbabwe experienced a liquidity crisis. To manage the crisis, the authorities had
to implement measures that averted a complete breakdown of the financial system while
attempting to limit the costs to taxpayers. It was also important for the authorities to
consider whether or not these actions would contribute to future moral hazard problems.
During the crisis, there was an effective division of labour development between the
Ministry of Finance and Development and the R B Z. The R B Z , with its financial
supervisory authority, acted its role as ‘ lender of last resort.’ This function implies giving
assistance to a bank facing liquidity problems. A number of local banks received financial
assistance from the R B Z during the liquidity crunch. Such assistance is only given after a
full analysis of the problems afflicting such a bank and the reasons why they arose.
The assistance will only be given on specific conditions and the purpose is to prevent the
bankruptcy of the bank receiving assistance or avoid the danger of problems spreading to
other banks through a ‘ run on such a bank.’ Some banks had to undertake forced changes
that are in line with R B Z requirements so as to be assisted through the Troubled Banks
Fund, which was used to provide emergency liquidity assistance (ELA). The main purpose
of this special assistance was to protect depositors. However such assistance is never
guaranteed or given automatically. As a result banks may accordingly go bankrupt leading
to severe hardships for depositors who lose their deposits at such banks.
Emergency liquidity assistance should be implemented with speed for it to be effective in a

crisis situation. Threats to the financial system can emerge suddenly and authorities must
react very quickly.
The growth and increasing globalisation of financial markets, the high volatility in these
markets and the increasing complexity of financial institutions increase the risk for a sudden
crisis and increase the probability that such a crisis will spread from one market to another.
It is because of these factors that requests for liquidity support may arise very rapidly. This
is the reason why the R B Z should closely monitor general financial market developments
to detect potential crisis situations that may call for emergency liquidity assistance.
However, the authorities must have a common strategy on how the crisis should be managed
in order to avoid excessive support to the financial sector. Excessive support can lead to
undue costs to taxpayers and to unsound incentives for the financial sector, hence the need
to have a limit to the support that is provided. The pre-requisite for any support from the R
B Z should be that there is considerable risk for a systematic crisis that may lead to a decline
of real economic activity. A breakdown of payments systems or restrictive granting of
credit, a credit crunch, affects real economic activity.
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The R B Z , as a central bank, has a better capability than other authorities to provide
financial support, if the need arises, very quickly. The main reason for this is that the central
bank has the instruments for lending available and it has resources in its balance sheet or the
credibility to get resources if they are needed (for example in foreign currency).
It also has an established capacity to judge whether a crisis may occur as a result of an
institution’s financial problems. The R B Z is able to make this judgement by virtue of its
role as provider of the central payment system, its presence in financial markets and its
general knowledge of the state of the economic and financial system.
This is why the R B Z provided liquidity support to a number of banks for normal
operations and settlement requirements. However, this should not be taken as an argument
for government to use the R B Z as a provider of support of support because it does not want
to use budgetary resources. The central bank should be independent and control its own
resources.
SOURCE: INFINITY ASSET MANAGEMENT CITED IN THE FINANCIAL

GAZETTE, SEPTEMBER 23-29, 2004.
1. (a) (i) From the passage, identify the problem faced by banks. [2]
(ii) Explain the role of R B Z in solving the problem identified in a (i) [2]
(b) (i) How are depositors going to be affected by the problem in a (i) [2]
(ii) Explain why the R B Z is the best institution to solve the problems faced by the
banks. [4]
(c) (i) Identity any two factors which worsen the problem faced by banks.
[2]
(ii) Give any two functions of the R B Z implied in the extract. [4]
(d) Examine the effects of the closure of a bank on the economy [4]
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CHAPTER 13
UNEMPLOYMENT
Chapter objectives.
After reading and retaining comprehension of this chapter, you should be:
1. Aware of the principle of unemployment that s its scope and nature.
2. Familiar with the types of unemployment.
3. Able to explain the benefits of unemployment as well as its negative costs.
4. Able to describe the relationship between inflation and unemployment using the
Philips Curve.
5. Aware of the role of government as far as unemployment is concerned.
 It is the total number of employable people who are looking for work but cannot find it.
 The constitutionally agreed employable age is from 16 up to 60 years (Zimbabwe)
 Unemployment rate is calculated as follows: = Total No. of unemployment X100
Total working population
The nature of unemployment
 Unemployment adversely affects any economy and is among the worst evils of any
society.
 Its type can easily explain unemployment.
TYPES OF UNEMPLOYMENT
STRUCTURAL UNEMPLOYMENT.
This can be caused by changes in the structure of the economy. It is usually a result of the
economy adopting structural policies and may be a sign of economic growth. The adoption
of ESAP by Zimbabwe in 1991 caused structural changes in the economy’s productive
sectors that resulted in many people being laid off from their jobs.
FRICTIONAL UNEMPLOYMENT
Caused by labour turnover. It is made up of people who are caught between jobs in the
process of changing from one to the other.
- In other words it exists when people will be moving between jobs.

- It is mostly made up of young people who often try several jobs before settling into the
one that satisfies them the most.
- It can also be caused by information asymmetry regarding new prospective employers.
DEMAND DEFICIENT UNEMPLOYMENT / CYCLICAL UNEMPLOYMENT

Cyclical unemployment occurs because aggregate expenditure in the economy is not
sufficient to stimulate the supply response needed for employment of all the available
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labour. It is the amount of unemployment caused by a recessionary gap when national

income falls short of potential income.
VOLUNTARY UNEMPLOYMENT
This comprises of people who do not want to work at the prevailing wage rates. This
category of unemployment naturally exists in any economy. Voluntary unemployment is
usually rampant in countries that pay unemployment/ social benefits.
SEASONAL UNEMPLOYMENT
This is caused by seasonal variations

Tourism and agro – based economies are usually affected by this type of unemployment
TECHNOLOGICAL UNEMPLOYMENT
This is caused by changes in technology which render some people redundant.

Mechanization also replaces workers with machinery. The coming of computers, for
example, resulted in most typists trained in the use of manual typewriters joining the
unemployed. Excavators have replaced many general workers in the civil engineering and
construction industries.
BENEFITS OF UNEMPLOYMENT
The benefits of unemployment include the following
1. Natural unemployment gives an economy the ‘reserve army of the unemployed’ that can
be called to boost production and economic growth in the event of expansionary
policies.
2. It gives a lot of time to employers to choose suitable staff for the job
3. It gives someone more time to persue leisure and cultural activities
Negative costs
The costs of unemployment includes the following: -
1. Represents a wastage of productive resources and potential output

2. Reduces status or affects social stigma
3. High levels of divorce
4. High levels of prostitution
5. High levels of poverty
6. High levels of inflation
THE RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT
Inflation and unemployment are two enemies that usually do not co-exist. When they do, the
situation is known as stagflationary.
 Reducing inflation would cause more unemployment and vice – versa
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 Neoclassical and Monetarists say that the relationship is for a short period. The inverse
relationship collapses as employment would returns to its previous level, but at a higher
level of inflation.
The Philips Curve

P1
+7 P -7
+6 -6
+5 -5
Inflation +4 -4
+3 -3
+2 -2
+1 -1
0 0
-1 1 2 3 4 5 6 7 +1
-2 unemployment (%) +2
The inverse relationship between unemployment and inflation was propounded by Professor
AWA Philips 1914 – 1975.
Other views on the relationship

Other economists have noted the following with regard to the Philips relationship
1. No convincing relationship exists between prices and unemployment.

2. A relationship exists but events have caused it to shift rightwards
3. M. Sherman, a radical American economist suggested that the relationship is the other
way round i.e increasing inflation is associated with increasing unemployment.
The Role of Government
There is no cure all solution to unemployment. Instead it is important to cook at each type
of unemployment and the solutions that might be doctored to cure it.
Structural Unemployment
This type of unemployment is caused by changes in the structure of the economy. Intense
competition may also reduce demand for products of an industry. In addition, demand for a
particular type of product may fall as a result of substitutes emerging on the market, like
was the case with tin and copper. Falling demand for tin and copper, for example, lead to
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the closure of Kamativi and Mhangura mines in Zimbabwe respectively. It is crucial,

therefore, in prescribing solutions in structural unemployment that we look at its underlying
causes. With respective to competition, the government can impose tariffs in order to
reduce the cost advantage of the competitors and hence committing their room to lead to
company closures. It can also look at alternative uses of the produce in question, just to
mention but a few.
Frictional Unemployment
This type of unemployment can be solved by making information available about the
existence of vacancies in the market at a cheaper price. The government may also tax
unemployment benefit funds in order to reduce unemployment benefit funds in order to
reduce the disposable income available to job seekers. This should motivate them to search
for employment as a matter of urgency.
Technological Unemployment
The government can put in place legislation that compels companies to give training to their
employees which is compatible with the new technology. Companies and government alike
may need to help victims of technological advancement to set their own business by way of
training and grants.
Seasonal Unemployment
This type of unemployment is the most difficult to address. However, the government may
encourage employees to train in other disciplines which are not affected by seasonal
variations by setting up vocational training centres.
Demand Deficient Unemployment

The government can address demand deficient unemployment by expansionary fiscal and
monetary policy. These policies are aimed at stimulating aggregate demand. An
expansionary fiscal policy could for instance, involve reducing corporate and income tax.
This has the effect of increasing demand for goods and services of both producers and
consumers respectively. This is because a reduction in taxes increases disposable income
available to producers and consumers. This increase in demand for goods and services can
only be matched, ceteris paribus, by employing additional labour.
The government can also influence aggregate demand and hence employment through its
direct public spending. Welfare benefits to poor citizens, for example, may lead to
increased demand for goods and services which lead to an increase in economic activity and
hence employment as additional labour is required to meet the demand. Through its public
works programme the government can also influence employment levels in the economy.
Employed labour through the public works programmes create new demand for goods and
services which can only be met by employing additional labour ceteris paribus.
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On the other hand, the government can influence aggregate demand and hence employment
through the use of expansionary monetary policy and enables banks to create more credit
(discount rate, reserve ratio and OMOs). A reduction in interest rate, ceteris paribus,
increases demand for loans by both consumers and producers. This increases demand for
goods and services which can only be matched by employing additional labour. The
discount rate has a direct bearing on the rate of interest and hence its effect is the same as a
reduction in interest rate. OMOs on the other hand, have the effect of increasing liquidity in
the market which leads to increase in demand for goods and services. More labour may be
required to produce the additional output to match demand.
EXAMINATIONS TYPED QUESTIONS

ESSAYS
1. (i) Identify the different types of unemployment prevailing in your economy.

[12]
(ii) Discuss how these types of unemployment can be solved in your economy.
[13]
2. With all the costs at unemployment to society, should the government give first
priority to solving this problem in the economy. [25]
2. UNEMPLOYMENT: ONE OF SADC’S BIGGEST CHALLENGES

By Sifelani Tsiko
RISING unemployment among young people is one of the biggest challenges facing
countries in the Southern Africa Development Community (Sadc) region.
Labour analysts estimate that youth make up more than half of the unemployed in the Sadc
region of more than 106 million people. Youth unemployment rates in this region range
from 60 and 40 percent for the youth under 20 years of age as well as those between 20 and
30 years.
Swaziland had a youth unemployment rate of between 20 and 30 percent in 2002; Lesotho
34 percent in 1999 while young people in the age group 15- 25 accounted for 61 percent of
Zimbabwe’s unemployed population according to 1998 figures.
Overall unemployment rates indicate that the region’s joblessness rates range between 25
percent for better performing economies to highs of 80 percent in countries facing economic
hardships.
Youths in the region often face many disadvantages that include lack of skills, experience
and dim prospects for employment owing to the economic difficulties facing many countries
in the region.
The International Labour Organisation (ILO) senior labour market policy specialist, Mr.
Rajendra Paratian told participants to a three-day regional conference on youth employment
that despite the differing levels of economic prosperity in the region, youth unemployment
is reaching worrying levels for all the countries in the Sadc region.
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‘ The countries in the sub- region are diverse in size, level of development, economic
structures and labour markets, but have in common these pressing and deep-seated socio-
economic problems,’ he said.
‘There is very little or no job creation, high and persistent unemployment,
underemployment, poverty and decent work deficits.’ The three-day youth conference drew
participants from nine countries that included Botswana, Lesotho, Malawi, Mozambique,
Namibia, South Africa, Swaziland, Zambia and Zimbabwe.
The meeting sought to create a forum for exchange of views on the scope, characteristics
and causes of unemployment and challenges in these countries.
Labour experts, workers representatives, youth organisation, employers representatives,

government officials, donors and international labour agency specialists all acknowledged
that youth unemployment is a powder keg that will explode any time unless practical steps
are taken to address it. ‘Youth unemployment is one of the biggest challenges of our times,
not only in Africa but the World over,’ says Public Service, Labour and Social Welfare
Minister Cde Nicholas Goche. Labour analysts project that there will be 1,2 billion
unemployed youths worldwide if nothing is done to strengthen job and income generating
capacity of small and micro enterprises.
The world youth unemployment rate has risen marginally from 11,7 percent in 1994 to 13,8
percent in 2004. In 2004, sub-Saharan Africa had a youth unemployment rate of 19,7
percent, which is high when compared with East Asia’s rate of 7,5 percent
‘What we need is a comprehensive, multi-sectoral and multidimensional approach that
addresses youth employment within broader policy interventions,’ says Mrs. Regina Amadi-
Njoku, ILO regional director for Africa.
‘We need employment policies that are embedded in broader pro-growth and poverty
alleviation policies and that are also linked to both youth specific and anti-discrimination
policies.’
Labour analysts say job market trends in the Sadc region include early entry into the labour
market (children between 10-14 constitute 30 percent of labour force), cyclical problems of
employment, rising unemployment rates, falling levels of decent work opportunities, long-
term unemployment, declining social security mechanisms and the HIV/Aids menace that is
threatening the labour market. Signs of distress among the youth in the region are evident.
‘More and more young people do not see their future in the formal economy, but in the
informal sector as evidenced in Zambia,’ says Mr. Paratian.
Juvenile delinquency, drug abuse and violence are rising largely due to hunger, poverty and
unemployment that emanate from economic and social exclusion.
Labour experts warned that long periods on unemployment in early life could have serious
implications on employability, earnings and access to quality jobs.
They also say that some southern Africa countries will lose between one third and one
quarter of their skilled and educated population by 2015 due to the ravaging HIV/Aids
pandemic.
Some of the challenges facing the youth in the region include constraints to policy-making
and implementation, mismatch between education and training and labour market needs and
poor support for institutional mechanisms to monitor and implement policies. Participants
say youth employment initiatives are often affected by inadequate resources, poor
monitoring and implementation of action plans, uncoordinated responses, poor economic
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growth, limited investment and the failure to articulate and recognise youth development
among national priorities.
Solutions to youth unemployment, they say, include a solid formal education, effective and
relevant vocational training, equal opportunities, entrepreneurship development, investment
growth, employment intensive growth and the development of labour market information
systems within an integrated approach. But the general picture of youth unemployment in
the region is much more complex and bleak than what experts may think.
Economies in southern Africa remain weak and fragile due to distortions and fluctuations in
community prices on the international markets.
The economies are agro- based and are prone to the ravages of nature such as droughts and
floods that may impact negatively on economic performance and ultimately job creation.
Economic liberalisation policies have since the 1990s added to the woes facing the job-
hungry youths. Companies are closing down, some are retrenching, downsizing while some
are becoming more mechanised leading to reduced job opportunities for millions of school
leavers in the region.
In the end, it is not conferences or summits that will create jobs but practical investments in
entrepreneurial skills, developing education and training and the expansion of productive
employment opportunities that will bring smiles to the growing armies of unemployed youth
in the region.
(a) (i) According to the information given, which country is suffering most from youth
unemployment in the SADC region.? [1]
(ii) Name some types of unemployment that are explained in the information given.
[3]
(b) (i) Describe the social effects of unemployment as explained in the

information given. [4]
(c) (i) According to information given, what are the main cause of
unemployment among
the youth in the SADC region?
[3]
(ii) Explain the possible solutions to this youth unemployment problem.
[3]
(d) Discuss the consequences of unemployment in an economy. [4]
3. DROP IN UNEMPLOYMENT RATE FORECAST
Business Reporter
ZIMBABWE’ S unemployment rate is poised to drop from a peak of 70 percent to 30
percent in the next two years if the nation consolidates economic gains, a research by the
Employers Confederation of Zimbabwe has revealed.
It shows that the stable macro-economic climate has created favourable conditions to
increase local and foreign investments.
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“The anticipated increase in investment will positively create jobs for those who are
entering the labour market and the unemployed,” it says. The unemployment rate has been
hovering around 70 percent during the past four years owing to the harsh and unstable
economic climate. Company closures and shrinking investment inflows were the major
factors behind the soaring unemployment rate. “ But there is still hope that the restoration of
macro-economic fundamentals such as the decline in interest rates, inflation and budget
deficit will harmonise employment opportunities,” said EMCOZ.
Statistics show that the country’s labour market is facing an excess demand for jobs with
more than 600 000 people seeking employment annually. However only a quarter of the job
seekers are being absorbed into the mainstream labour markets.
The situation is posing a threat to the skilled workforce as some of them are leaving the
country in search of jobs in the Southern Africa Development Community, Europe and
Asia.
EMCOZ said the stimulation of employment would depend on the sustainability of
economic gains.
“Gains attained during the past 15 months will have a major bearing in as far as the increase
in employment is concerned,” said the organisation. But economic analysts said the country
would face challenges in stimulating employment. “ It is an uphill task that will require
commitment from key players in the economy, the Government and employers,” said Mr.
Albert Mutyiri, a labour economist. Mr. Mutyiri said the country’s unemployment rate was
the highest in the SADC region as neighboring nations enjoyed an average unemployment
rate of 10 percent.
(a) Explain why the ECZ has forecasted a drop in the level of unemployment. [2]
(b) (i) Identify the causes of unemployment from the information given. [4]
(ii) What is the main type of unemployment explained in the passage? [2]
(c) Analyse the relationship between investment and unemployment. [6]

(d) Examine the effects of unemployment in an economy. [6]
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CHAPTER 14
INFLATION
Chapter objectives
1. Define the term “Inflation.”
2. Explain the different types of inflation and illustrate them on the diagrams.
3. State the causes of Cost Push Inflation and structural Inflation.
4. Describe the effects of inflation and the ways of reducing the rate of inflation.
Inflation refers to persistent increase in the general price level in a country. Inflation has the
effect of eroding the purchasing power of money. There are four major types of inflation
with each being defined by its causes. These are:
DEMAND PULL INFLATION
Demand pull inflation emerges due to the existence of excess demand over supply. When
supply is too little to satisfy existing demand prices are pulled up by the prevailing shortages
in the markets of the various commodities. This is illustrated below:
An Increase in Demand:
Demand – pull inflation

AD2 LS
AS2
AD1
Price level P3
P2 AD2
P1
AD1
Q1 Q2
A shift in aggregate demand from AD1, to AD2 drives the price level up. Conversely a
temporary increase in real out put results from Q1 to Q2 at a price of P2. Predominantly
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nominal ways will rise the contraction of aggregate supply. This has the effect of returning
output to its previous level of Q1 at an even higher price P3.
Demand pull inflation as represented by an outward shift of the aggregate demand from
AD1 to AD2 are normally caused by demand shocks some of which are listed below:
(i) An Increase in the Level of Money Supply

An increase in the level of money supply creates a situation where people find themselves
holding more money balances than before. As a result expenditure will be increased as
people try to get rid of the extra money balances. This situation of too much money chasing
too few goods, through increased demand pressures, will result in prices being pulled up.
(ii) An Increase in Government Expenditure

In most countries the Government constitute a significantly large proportion of total
expenditure. To this extend, large increases in government will significantly raise total
domestic expenditure leading to an increase in the general level. Higher government
expenditures also result in higher inflation by raising interest rates.
(iii) An Increase in Disposable Incomes

When disposable incomes increase either as a result of an increase in money wages or a
reduction in income taxes people will find themselves with more purchasing power. This
will result in them increasing their consumption expenditure thus exerting more pressures on
aggregate demand. If such an increase in aggregate demand results in shortages, prices will
be forced upwardly.
(iv) Hire Purchase and Credit Availability

The availability of consumer loans or credit and hire purchase facilities or the easing of
terms on such facilities also increases aggregate expenditure and inflation. This is because
these facilities make it possible and easier for low income individuals who could not have
afford to buy some commodities to participate in the markets of those commodities.
COST PUSH INFLATION

This is inflation caused by an increase in the prices of factor inputs such as wages, interest
rates, exchange rate devaluation and the price of fuel and raw materials. When these prices
increase firms pass them on to final consumers by increasing their prices to avoid an erosion
of their profits. It should be noted that in practice demand pull and cost push inflation are
not always completely independent. An increase in wages, example, causes both demand
pull and cost push inflation. This practical inseparability between these two forms of
inflation is also clearly shown by the following Wage-Price spiral, which is typical of the
Zimbabwean economy in the 1990s.
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The Wage-Price Spiral
Trade Union
(Consumers)
Real wages Eroded Higher Wages

(Demand Pull Inflation)
Higher Prices Higher Production Cost

(Cost Push Inflation)
Firms
(Producers)
Causes of Cost Push Inflation
(i) Increase in wages ; eg as trade unions bargain for higher wages and salaries.
(ii) Increase in interest rates; eg due to tight monetary policy or too much government
borrowing and expenditure.
(iii) Exchange rate devaluation- mainly when firms rely heavily on imported inputs.
(iv) Increase in the price of fuel
STRUCTURAL INFLATION
Structural inflation is the general increase in prices, which is initiated by the existence of
structural bottlenecks and constraints that exist in the economy. These can be natural or a
result of domestic macroeconomic and political policies. When they exist they result in
general shortages, which in turn push up prices.
Causes of Structural Inflation

(i) Natural disasters such as droughts; floods; earthquakes.
(ii) Adverse macroeconomic policies such as investment controls; price controls; interest
rate controls; foreign exchange controls.
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(iii) Institutional restrictions eg adverse legislation on investment and bureaucracy in

investment approval.
(iv) Political factors such as political instability and wars; bad political policies and
ideologies.
IMPORTED INFLATION
This type of inflation mainly affects an economy if it heavily depends on imports for
domestic consumption and production. A foreign price shock in the trading partners of the
economy would result in imports landing in the domestic markets at higher prices. Imported
inflation does not occur only if the exchange rate is completely market determined and is
able to neutralize such foreign price shocks.
The Rate of Inflation
The following descriptions can be used to indicate the rate of inflation:
(i) Creeping Inflation: exists when the increase in prices is still very low such as in the case
of a single digit inflation.
(ii) Runaway/Galloping Inflation: When prices increase and an accelerated rate. Inflation
starts to be a noticed problem and controlling it will be difficult. Money starts failing to
perform effectively its four functions, ie as a medium of exchange; store of value; unit of
account; and as a standard for deferred payments. People
(iii) Hyperinflation: Highest levels of inflation. At this stage money ceases to be a generally
acceptable medium of exchange. The use of other inflation hedges and ‘dollarization’
will be rampant eg commodities; assets; and foreign currencies will be preferred as
opposed to the domestic currency.
EFFECTS OF INFLATION
Inflation is one of the worse macroeconomic evils of any society. Its effects are as
summarized below:
(i) Inflation erodes the purchasing power of money
With inflation; the real value of money and consequently nominal incomes such as
wages, interest, profit, and rent is eroded. Money is made to buy less quantities of goods
and services over time.
(ii) Inflation benefits debtors and the expense of creditors
Because inflation erodes the real value of money; money lent out today and repaid after a
period will have lost its purchasing power. Unless interest rates are more than the rate of
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inflation; wealth will be redistributed from creditors to debtors whenever a credit

transaction is undertaken.
(iii) Inflation increases the cost of living/reduces the standards of living
With inflation people will need to spend more to buy the same goods and services for
their day to day living. Alternatively stated, if nominal incomes fail to adjust adequately
for inflation, as is normally the case in many countries, people will be forced to leave on
smaller quantities of goods and services over time.
(iv) Inflation negatively affects the balance of payments
Inflation reduces the price competitiveness of domestic goods and services in the world
market and increases that of foreign goods and services in the domestic market. Domestic
inflation therefore encourages imports and discourages exports and leads to a balance of
payments deficit. Overtime inflation also leads to the domestic exchange rate
depreciation.
(v) Inflation negatively affects investment
With high and unstable inflation it becomes difficult for investors to formulate profit
expectations and to project future business cash flows. Inflation therefore increases
investment risks and discourages investment.
(vi) Inflation causes political and social unrest
When inflation is low government are credited and when it’s high they are discredited.
Political and social upheavals in the form of strikes, demonstrations, wars and destruction
of property are a recurrent feature in countries with high inflation levels.
DEFLATIONARY POLICIES
To reduce inflation, the following policies can be implemented:
(i) Tight fiscal policy
This involves reducing government expenditure and or increasing taxes. This would
reduce demand pressures in the economy and reduce demand pull inflation. A reduction in
government expenditure would also reduce domestic interest rates and consequently cost
push inflation.
(ii) Tight monetary policy
Tight monetary policy in the form of reducing money supply and credit availability solves
the problem of too much money chasing too few goods. It should however be noted that
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the same tight monetary policy may fuel up cost push inflation through increasing interest
rates especially in a country like Zimbabwe in the 1990s where many firms rely on
borrowed funds.
(iii) Tight incomes policy
This involves indexing wages and salaries to labour productivity. To avoid unsustainable
demand pressures, wages and salaries should be increased only up to rates that match the
increase in labour productivity.
(iv) Price controls
The placement of price controls and ceilings by the government is a short run measure
which suppresses inflation. In the long run when inflation pressures can no longer be
contained, the increase in prices will be acute and worse. This is what happened in the
case of Zimbabwe when it moved from a controlled economy to a more liberalized
economy in the 1990s.
(v) Supply sided policies
These are policies that are meant mainly to reduce structural inflation through the removal
of structural bottlenecks that exist in the economy. Generally, structural policies are
implemented through the World Bank-International Monetary Fund Structural Adjustment
Programmes. These policies include trade liberalization; domestic markets deregulation
and decontrolling; the capital account (foreign investment) liberalization; institutional
reforms. It should be noted, however, that structural policies such as the deregulation and
decontrolling of the domestic markets might cause high inflation in the short run due to
the removal of the price suppressions, which normally exist before liberalization. In the
long run through improved investment and supply prices would be expected to fall.
EXAMINATIONS TYPED QUESTIONS
MULTIPLE CHOICE
1. A deflationary gap occurs when:
A there is deficient demand in the economy.
B there is too much demand in the economy
C excess demand pulls up prices
D the equilibrium national income
2. The disadvantage of using the tight monetary policy to reduce inflation is that:
A it reduces the interest rate
B It worsens the balance of payments deficit
C it leads to unemployment
D it increases output.
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ESSAYS
1. How effective is the fiscal policy in controlling inflation in a country?

2. (a)Explain what is meant by deflationary and inflationary gaps. [10]
(b) Discuss how the inflationary and deflationary gaps can be corrected. [15]
3. Is inflation always bad to an economy? [25]
KENYA INFLATION FALLS TO 4.3%
NAIROBI-Kenya’s year-on-year inflation rate dropped to 4.3 percent in September from 6.9
percent in August as falling food prices offset higher fuel costs, the Central Bureau of
Statistics (CBS) said on Monday. Underlying annual inflation, which excludes food, dipped
to 6.6 percent in September in east Africa’s biggest economy from 6.7 percent in August.
The food and non-alcoholic beverages index decreased by 1.4 percent in September
compared with August because of falling sugar, tomato, maize grain and flour prices, the
CBS said.
But the fuel and power index rose by 2.1 percent in September compared with August
because of a jump in kerosene and electricity prices. The cost of 200 kilowatt-hours of
electricity was 1 684 shillings in September, compared with 1 534 shilling in August, a 7.4
percent rise.
The average retail price of a litre of kerosene was 52.31 shillings, compared with 42.99
shillings a litre in September 2004, a 21.7 percent jump.
(a) (i) Which product led to significant decrease in inflation in Kenya? [1]
(ii) Name two products whose index rose significant. [2]
(b) (i) Name the type of inflation caused by higher fuel costs. [2]
(ii) Explain why an increase in fuel costs is said to have a ‘ripple effect’ on the prices of
other products in an economy. [4]
(c) (i) Account for a fall in food prices. [4]
(ii) Give two factors considered when looking at the problem of inflation. [2]
(d) Discuss whether the government should be worried by the problem of inflation in an
economy. [5]s
Millers lament shortage of inputs
Business Reporter
The country’s milling industry is facing a shortage of raw materials leading to limited
suppliers of basic food in the wholesale and retail markets.
A survey done by Business Chronicle yesterday showed that most milling companies were
scaling down operations due to the shortages of essential raw materials and inadequate
foreign currency to import machinery.
National Foods Holdings limited, company secretary, Mr. Andrew Lorimer, said the raw
materials would be the greatest challenge. “Raw materials will be our greatest challenge,
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however the Government has stated its commitment to ensuring food security for the nation,
and the group looks forward to playing its part in achieving this goal,” said Mr. Lorimer.
He said the company is facing dramatic inflationary pressures on raw materials costs and
overhead.
“Management has worked hard to co-operate with and support the Government in their
initiative to deliver food at affordable prices. Through negotiations, the group hopes it will
realise, in turn, timeous fair price increase for its products,” he said. A manager for a local
bakery, R&K Bakery, said inadequate fuel supplies had led to the shortage of bread in the
retail markets within the city.
“For us to produce bread we need diesel because our ovens operate on diesel. And for us to
deliver bread, we need diesel for the delivery vans,” said the manager.
He said the company was failing to import fuel due to inadequate foreign currency.
“As we speak, ten delivery cars are parked, they do not have fuel. We do not have foreign
currency to import fuel and that has caused these shortages. We do have the flour, yeast and
everything that is needed to produce bread but we do not have fuel to process and deliver
our products,” he said.
But an official of a Bulawayo-based milling company, said food shortages have been
experienced due to the drought.
“ The food shortages have been severe in the drought-prone areas in Matebeleland South
which has been experiencing perennial droughts in the past years,” said the official.
He said the region as a whole has been affected by a long dry spell.
“ The grain situation in the province has been made more critical because most farmers
planted maize, which does not do well in the region,” said the official.
(a) (i) What is meant by ‘scaling down of operations?’ [2]

(ii) From the extract, explain reasons why most milling companies scaled down
their operations. [2]
(b) How can timeous fair price increases for the products enable companies to deliver
food at affordable prices? [2]
(c) (i) Explain two measurers which companies can undertake to reduce inflation.
[4]
(ii) Explain two measurers the government can undertake to reduce inflation.
[4]
(d) Discuss the effects of inflation. [6]

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CHAPTER 15
ECONOMIC GROWTH
Chapter objectives
1. Define the term, “Economic Growth.”
2. Explain the relationship between Economic growth and Production possibilities
curve
3. Describe the major methods of measuring Economic Growth.
4. Understand the Indication of Economic growth and the factors which determine
Economic growth.
5. Discuss the ways in which the government can use the Monetary policy and fiscal
policy instruments to stimulate economic growth.
Economic growth is the increase in the amount of goods and services the whole economy
produces in the current year over and above what it produced the previous year.
It is an outward shift of the production possibilities curve mainly attributed to technological

and investment increases in an economy. It is an increase in output or GBP. Economic
growth can be measured using three major methods.
(i) Real per capital income i.e. income per head.

(ii) Oscillatory movements
These are wave like movements in the economy, the ups and downs or upswings
and downswings in the economy shown as follows.
Peak/ boom Peak/ boom
Economic
growth
Recovery/
expansion
depression
0 Time - Period
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Business cycles are simply recurrent but irregular fluctuations in economic activity.
The angle will begin anywhere and then will continue through the four phases.
Peak – the highest point
Recession – GDP begins to decline, factories start laying off workers, people have less
money to spend.
- It is a period of at least six months of continued decline in real GNP.
- It ends when GNP stops failing and levels off into the phase known as the length.
Recovery – there is economic expansion, laid off workers are called such to their jobs and
overall unemployment declines.
(iii) Physical indicators

These are tangible and can be felt in the economy such as
 Inflation
 Unemployment
 Depressed investment
 Distressed demand
 Shortages of products
 Closure of companies or trimming down of operations.
MEASURING ECONOMIC GROWTH

The rate of economic growth is measured by real national income or GDP on a yearly basis
or any other period. When prices rise there may be no real growth in output or incomes.
This only represents a rise in nominal GDP. As a result, to find out how much real output
has changed, the effect of inflation must be taken into consideration.
For the economists, people are only better off if real GDP per capital increase.
Real per Capita Income = Real GDP

Size of population
If there is real output growth, then there has been economic growth. The nature of the goods
being produced will determine the living standards. The better gauge of economic growth is
by observing if real GDP has increased over the time period per head of the population.
If the value of real output GDP for country A in 1990 was $ 500 000 and the population
being 50 000, then real GDP per capital = $ 500 000
50 000
= $ 10 per capita per year
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If in the other year 1991 real output GDP for country was $ 600 000 then:
real GDP per capita = $ 600 000

50 000
= $ 12 per capita
Long run aggregate supply curves shifting rightward over time indicating economic growth.
Price Level AS1 AS’1 AS2 AS2
P2
AD2
P1 AD1
Q1 Q2
Real domestic output
In the long run, a nation must expand its production capacity in order to grow on the supply
side. But aggregate demand must also expand or else the extra capacity will stand idle.
Economic growth depends on an enhanced ability to produce. The supply side of economic
growth is illustrated by the outward expansion of the production possibilities curve as from
Y0 X0 to Y1 X1. The demand side of economic growth is shown by the movement from a
point on Y0 X0 to an optimal point on Y1 X1
The Production Possibilities Curve
Y1
Capital
goods Y0 Economic growth
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0 X0 X0
Economic growth is shown by the shift of the production possibilities curve outward as
shown above.
Economic growth is shown by the shift from Y0 X0 to Y1 X1. The shift is due to many
factors including the following: -
 Increase in the quantity and quality of resource

 Technological advance
 Population
 Investment
 Political stability
Other factors which determine economic growth
1. Fertile land, minerals, forest, scenic locations, strategic waterways can facilitate
rapid economic growth.
2. Size and productivity of labour force logically the larger the skilled workers, the
much greater the opportunity to produce more goods.
3. Capital accumulation
4. This refers to infrastructure, buildings, machinery and the amount of tools available
in the manufacturing industries. If an economy posses a sizeable number of these
more goods can be produced in the absence of these then more skilled labour will lie
idle.
5. Political stability
6. A politically stable economy will motivate investors both locally and externally to
increase production. Wars, demonstrations strikes and civil strife will disrupts
production and dampen investor’s spirit to the production sector.
Government Role
The government can stimulate economic growth through expansionary fiscal and monetary
policy respectively.
Expansionary Fiscal Policy
The government can prescribe any or all of the following in order to influence a positive
growth in national output.
Taxes
The government can manipulate taxation in order to influence economic growth. Firstly, it
can reduce corporate and income tax respectively. A reduction in corporate tax leaves firms
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with more funds to use for their expansion activities. If firm find a reduction in a corporate
tax as an incentive to expand given that ploughed back profits are cheaper source of finance,
output resulting from this increased capacity will contribute to economic growth, ceteris
paribus. The government may also stimulate consumption by consumers through a
reduction in income tax increases consumers’ disposable income and as a result consumers
are expected to demand more goods and services. Firms are, ceteris paribus, supposed to
respond to this surge in demand by increasing output in order to take advantage of this
increase in demand brought about by a reduction in corporate tax.
Secondly, the government can give tax incentives to firms producing output for the export
markets. This is usually in form of tax breaks and tax holidays. Any exemption from paying
tax provides firms with a cheap source of finance enabling them to expand their production,
hence contributing to increased out put – economic growth.
Subsidies
Subsidies can also be given to firms in order to enable them to produce their output at a
lesser cost. Once the cost of production has been reduced by subsidies there is incentive for
terms to produce more output contributing to economic growth.
Government Expenditure
The government can itself be involved instate enterprise. This is a form of production where
parastatals or public corporations are encouraged to produce output by the government by
setting shop. The government can also influence aggregate demand through the public
works programme which have potential increase output through the multiplier process. The
government can in addition, assist especially small-to-medium enterprises to set up shop by
building factory sheds for them. SMEs would be set up in the process given the fact that
part of their start up capital would have been contributed by the government through the
factory sheds provided.
Expansionary Monetary Policy

The government can also influence aggregate demand and hence economic growth through
an expansionary monetary policy. An expansionary monetary policy would consist of the
following, rediscount rate, reserve ratio, interest rate and open market operations among
many.
Discount Rate
This refers to the interest rate that the central bank charges on borrowings by financial
institutions. If the discount rate is reduced, it means the cost by financial institution from
the central bank is also reduced. This will give cue to the financial institutions to reduce
their interest rate on loans to members of the public. A reduction in interest rate should
influence both corporate and individual citizens to borrow more from the banks. Output,
ceteris paribus, is expected to increase in response to expand borrowings.
Reserve Ratio
The central bank can also stimulate economic activity by reducing the reserve ratio. A
reserve ratio dictate how much of the bank deposits should be banked with the central bank.
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A reduction in the reserve ratio leaves banks with more funds for credit creation (loans). An
expansion of credit available to consumers and producers should also influence positively
aggregation demand, ceteris paribus.
Interest Rate
The reserve bank can also reduce the rate of interest to stimulate aggregate demand and
hence economic growth. The rate of interest is the cost of capital and plays a crucial role in
determining the ability of both consumers and producers to borrow from financial
institutions to meet their respective goals. If the rate of interest is reduced, ceteris paribus,
we anticipate demand for loans to increase since the cost of borrowing will have been
reduced. This increase in demand should be followed by increases in output, that is,
economic growth.
Open Market Operations (OMOS)
The monetary authorities can also influence aggregate demand positively through OMOS.
This they do by buying back commercial papers such as treasury bills from the banking
sector and members of the public. This has the effect of increasing money supply in the
economy. Demand for goods and services is expected as a result to increase leading to
economic growth.
ESSAYS
1. (a) Using the production possibility curve, explain the economic problem of scarcity.
[10]
(b) Economic growth solves the basic economic problem of scarcity. Discuss.
[15]
2. How useful are the GDP statistics in comparing living standards between countries.
[25]
[15]
3. Discuss the benefits of economic growth in the economy such as Zimbabwe.
[2]
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CHAPTER 16
NATIONAL INCOME ACCOUNTING
Chapter objectives
1. Appreciate the scope of National Income Accounting.
2. Be aware of the principles of National Income Accounting.
3. Understand Gross Domestic Product, Gross National Product, Net National Product,
Personal income and Disposable Income as measures of National Income.
4. Explain the methods of National Income Accounting, that is, Expenditure Approach,
Income Approach and Output Approach.
5. Illustrate the output approach and Income Approach.
6. Respect the pitfalls of National Income Accounting
7. Apply the concept of National Income multiplier to National Income Accounting.
8. Describe the Aggregate Supply- Aggregate Demand Approach using illustrations.
National Income accounting involves the recording and analysis of the value of total
production in a country for a particular time period. Such data is normally recorded on a yearly;
half yearly; or quarterly basis. National income accounting data is important for the following
reasons:
. The data allows policy makers to measure the level of economic performance for the
country. Economic growth which involves the expansion of the value of real production,
for example, would mean an improvement in the economy’s activities such as investment,
consumption and employment. This accounts therefore makes it easier to compare
performance and welfare over time within the same country and across different countries
in a given time period.
. The accounts give policy makers an insight into the nature and composition of production
and income. This is because national income accounts aggregate similar expenditures such
as business investment and similar incomes such as employee compensations together in a
way that is useful for economic analysis. This helps to explain why one country, for
example could be growing faster or slower than the other.
. The information provided by the accounts makes it easier for a country to formulate and
implement appropriate macroeconomic policies to improve the performance of the
economy.
. Finally, national income accounts are used by international organisations such as the IMF,
the World Bank, foreign governments and donors to assess the performances of their loans,
grants and donations to other countries. Such data is also used by the same organizations to
assess the level of poverty or development of a country to determine whether assistance is
worth extending to such a country.
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PRINCIPLES OF NATIONAL INCOME ACCOUNTING
National Income accounting involves the compilation of the monetary value of current
production. The following features are worth noting when compiling the accounts:
. The aggregation of total production is done at market prices or in monetary terms. This
homogenizes the physically different commodities such as automobiles; grain; furniture;
etc into a common denominator so that they can be added together.
. The accounts measure the expenditure and income stream that comes from current
production of goods and services. Transactions in second hand commodities; financial
assets and stocks; and transfer payments are not reflected in the accounts because they do
not involve current production. Only charges and costs on the facilitation of such
transactions such as brokerage fees and commissions are included because they constitute
current production.
. The value of a commodity is recorded once. This is the principle of avoiding double or
multiple counting of the same commodities which would overstate the value of total
production. The problem of double counting can be illustrated by the following example in
the production of a shirt: Suppose the production of the shirt starts in the cotton field by a
farmer who produces and sells cotton to a Milling and Weaving company for $200 which
in turn sells cloth to a Clothing manufacturer for $300 who in turn sells the completed shirt
to a Wholesaler for $400 who in turn sells the shirt to the Retailer for $550 who finally sells
the shirt to the consumer at $700. From this chain of production, adding the values of
production at intermediate stages would overstate the value to $1150 yet the actual value of
production is only $700. To avoid the problem of double counting one can either take the
value of the final product which is $700 in this case; or adding value added at each stage of
production which is $200 + $100 + $100 + $150 + $150 = $700.
MEASURES OF NATIONAL INCOME
GROSS DOMESTIC PRODUCT:
GDP measures the amount of income earned or produced in a country. This is production
done within a country regardless of whether the means of production are owned by the
nationals of a country or by foreigners.
GROSS NATIONAL PRODUCT
This is the value of output produced by the nationals or citizens of a country. This includes
production undertaken and income earned by Zimbabweans both within and outside the
boundaries of the country. The difference between GDP and GNP is therefore the value of
net factor income to or from abroad ie:
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GNP = GDP + Foreign Income (Inflow less Outflow)
Net foreign income is the difference between property income received by foreigners owning
factors of production in Zimbabwe and property income earned by Zimbabweans on their
investments and ownership of factors of production in other countries.
NET NATIONAL PRODUCT
NNP defines Gross National Product net of capital consumption allowance. This is the value
of production after subtracting the estimated cost of depreciation on fixed capital goods.
NNP therefore represents the value of production a country can consume without eating into
fixed investments. A country whose gross capital formation is greater than its capital
consumption allowance will be building up on its productive capacity and has got the
capacity to grow in future.
Personal Income
This is income which is actually received by the factors of production after adding any
transfer receipts from the government; or from the foreign sector. Personal income is also
net of corporate income taxes and retained profits.
DISPOSABLE INCOME
This defines income which is at the disposal of people after subtracting personal income
taxes. Such income can be used for consumption or investment expenditure.
METHODS OF NATIONAL INCOME ACCOUNTING
These are the approaches used to measure the value of production. They identically yield the
same results. They are:
The Expenditure Approach;
The Income Approach;

The Output Approach;
The fact that these three approaches are identical can be illustrated by the following circular
flow diagram of production and income which assumes an economy made up of households
and firms only.
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The Circular Flow Diagram of Income

FIRMS
Income (The Income Approach) Expenditure/

{Wages; Profits; Interest;Rent} Receipts (The Expenditure App)
Factor Services
Labour; Entrepreneurship Goods and Services(The Output App)
Capital; Land}
HOUSEHOLDS
THE EXPENDITURE APPROACH
This measures income by adding up all final expenditures on currently produced commodities.
Broadly aggregated, such expenditures are: consumption expenditure; investment expenditure;
government expenditure; and net foreign expenditure. In summary, a country’s Gross Domestic
Product using the expenditure approach is defined as:
GDP = C + I + G + X – M
Consumption (C): This is expenditure by households on currently produced durable; semi-

durable; and non-durable commodities for final consumption. Such commodities include:
furniture; cars; radios; clothes; and food.
Investment (I): This is investment expenditure by the business sector and government in real
physical capital goods and inventories to be used to facilitate future production. It is made up
of: i) the purchase of equipment and machinery by firms and the government. ii) Expenditure
on construction and infrastructural development by the government and the private sector. iii)
Physical changes in the business sector inventories. When investment is gross; the measure
obtained is Gross Domestic Product. After allowing for or deducting capital consumption
allowance or depreciation GDP is converted to Net Domestic Product. A country whose gross
capital formation is greater than its capital consumption will be adding to its productive
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capacity while a country whose capital consumption exceeds its capital formation will be
eating into its productive capacity.
Government Expenditure (G): This sums up all government re-current expenditure on

purchasing finished goods and services and on wages and salaries. Government transfer
payments such as war veterans gratuities and pensions; student payouts; and social welfare
grants are excluded. All public sector investment expenditures are included under investment
and faces the risk of experiencing reduced growth in future.
Exports (X): Exports constitute domestically produced commodities sold to foreign countries.
These are added to get the value of production because they constitute incomes earned by
factors in the exporting country. The effect of such exports is to enhance domestic
employment, production and incomes.
Imports (M): Imports are part of domestic expenditure which falls on foreign produced
commodities. They constitute domestic incomes earned in foreign countries and as such
contract the economy. This is why expenditure on imports is subtracted to get the value of
domestic production.
THE OUTPUT APPROACH
The Output approach is similar to the expenditure approach except that the value of output will
be classified by the sectors or industries from which they are produced eg Mining;
Manufacturing; Tourism; Education; Health; Agriculture; Banking; etc.
The Income Approach
The Income approach records the value of current production by summing up all incomes
earned by the factors of production engaged in current production processes. This is necessarily
identical to the expenditure approach in the sense that whenever one spends to buy a
commodity somebody will be receiving the same money. In other words the value of a
commodity as measured from the expenditure incurred to acquire it is the same as getting its
value by taking the total income earned from it. When the final consumer buys a shirt at $700;
this amount of money will be distributed among wages as remuneration for labor; interest as
remuneration for capital; rent for land; and profits for entrepreneurship. Gross Domestic
Product from the income approach is therefore obtained as:
GDP = Profit before tax + Wages + Interest + Rent
GDP as measured in this way is recorded at factor cost because it excludes indirect taxes and
subsidies. Indirect taxes represent expenditure paid but which is not received by any of the
factors of production while subsidies represent earned income for which no expenditure in any
of the expenditure aggregates is made.
Profit: This is the net income before tax and depreciation for all corporate business entities. An
adjustment for non-produced profit resulting from the monetary appreciation or depreciation of
inventories should be made. To get GDP at market prices all unearned income such as indirect
taxes net of subsidies are supposed to be added back.
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Wages: These constitute all the income earned as wages and salaries in the formal sector; and
the proprietors’ incomes in unincorporated business entities and farms. They also include the
imputed or estimated value of production by subsistence farmers.
Interest: This is all income earned on financial investments.
Rent: This constitute all the payments made for the services of land. Rent includes the imputed
rentals on owner occupied houses and land.
An Illustration: The Expenditure and Incomes Approaches

The Output/Expenditure Approach The Income Approach
Consumption Wages XX
Durables XXX Formal Sector XXX
Semi-durables XX Informal Sector XXX
Non-Durables XXXX Proprietor’s Income XXX
Investment Net farm Income XXX
Private Sector XXX Rent XX
Government XXX Imputed XXX
Construction XXX Paid XXX
Phy change in inventories XXX Profits XX
Government Formal sector XXX
Finished Goods XX Less monetary appreciation in stocks X
Exports XXX Interest on Financial Investments XX
Less Imports (XXX) Net Domestic Product (factor Cost) XXX
Add Depreciation XX
GDP (Factor Cost) XXX
Add net income frome abroad
(XX)
GNP (Factor Cost)
XXX
Add Indirect Taxes
XXX
Less Subsidies
(XX)
GDP at Market Prices XXXX GDP at market Prices
XXXX
Relationships between Various National Income Measures
GDP at market prices XXXXX

Net Income from Abroad (XXX)
GNP at market prices XXXX
Less Capital Consumption Allowance (XX)
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NNP at market prices

XXXX
Less Indirect Taxes (XX)
Add Subsidies XXX
Net National Product at factor cost XXXX
Add Government Transfer Payments XXX
Less Corporate Income Taxes (XX)
Less Retained Earnings (XX)
Add Transfer Payments from abroad XXX
Personal Income XXXX
Less Personal Taxes (XX)
Disposable Income XXXX
Nominal Income and Real Income
Nominal Income refers to the value of current production as measured at current market
prices. Any changes in nominal income are a result of both the effects of inflation and real
output changes. This implies that nominal income is a mis-representation of the actual
performance of a country.
Real income on the other hand measures the value of production at constant prices. Changes
in real income are therefore a result of physical changes in output and measure an
economy's economic growth.
After national income accounts have been recorded at current market prices, they are
deflated into their real income equivalents using the following conversion formula:
Real Income = Nominal Income x 100

General Price Index
Example: Converting nominal Income to Real Income

Year 1990 1995 1998
Nominal Income $b 5000 10800 20400
Price Index(90=100) 100 245 460
Real Income 5000 x100 10800 x 100 20400 x 100
100 245 460
Pitfalls in Using National Income Accounts
When using national income accounts to measure and compare the levels of economic
performance over time in the same country or across different countries, the following
problems are encountered:
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(i) The role of the informal sector
In most Developing Countries a significant proportion of total production takes place in the
informal sector. Such informal sector activities include production by housewives, and other
fix-it-yourself activities. To the extent that the role played by the informal sector changes
from time to time, estimating the value of production in this sector may result in the
underestimation or overestimation of the value of total production in a country. The levels
of such activities may also be different across countries making cross-country comparisons
of economic performances difficult by housewives, although significantly large in Less
Developed Countries, is completely excluded from the compilation of national income
accounts. This leads to the underestimation of the value of production in these countries
compared to the more monetized developed countries.
(ii) The problem of income distribution

National income accounts only show aggregate incomes and expenditures. They do not
show how the earned income is distributed across the various sectors and individuals of a
country. Because welfare heavily depends on the distribution rather than total income; the
are possibilities that one country can show very high rates of economic growth than other
countries yet still the majority of its population could be starving because of the existence of
high degrees of income disparities.
(iii) The nature of production
The welfare of a country's population depends of the nature of the goods produced. A
country can show significantly high levels of economic growth while at the same devoting
much of its resources to the production of military equipment or capital goods. The material
wellbeing in such a country could lower than in another country with lower rates of
economic growth but producing more consumer goods to feed its population.
(iv) Welfare is dependent on many other things
Measuring and comparing welfare by simply looking at national income accounts is

misleading. This is because the welfare of a country also depends on many other variables
like peace, freedom, democracy and love which are not included in any of the measures of
national income accounts. A country can therefore show a good performance on its national
income accounts when at the same time due to political instability its people could be
suffering.
(v) The conversion of nominal income to real income
The usage of the general price index to convert nominal measures to real measures is
subjective. This is because the price index used depends on economic and political
conditions in its base year. Changing the base year, for example, from one year to another
would result in the same index giving completely different real measures. Again weights of
different commodities included in the base year basket could be completely different from
the current and future consumption patterns resulting in the index number misrepresenting
inflation in a particular year of interest.
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(vi) The conversion of national income to common currencies
The conversion of the national income accounts of different countries to a similar currency
to enable cross country comparisons is difficult and subjective. This is because using the
exchange rate as is commonly done is misleading as the exchange rate itself is exposed to
the effects of political stability, speculation, and other foreign exchange market conditions
which change from time to time. Such factors may also not have a significant bearing on the
level of economic performance of a country. Using the purchasing power parities of the
different currencies for such conversion is also misleading due to differences in the nature of
production and consumption across countries.
(vii) National income and the environment
Economic growth as indicated by the growth of national income accounts may be

unsustainable if such growth leads to the depletion of natural resources and the destruction
of the environmental. Such growth, which undermines future growth and development, does
not lead to improved welfare.
NATIONAL INCOME DETERMINATION

This topic is on how changes in Government expenditure, consumption expenditure,
investment expenditure, imports and exports affect income and employment.
The Income-Expenditure Approach
According to this approach:

The equilibrium levels of employment, production and income are determined where an
economy's aggregate expenditure is equal to its income ie:
Equilibrium Income: Y = E = C + I + G + X – M
Where Y = income
C = Consumption defined as C= C0 + C’Yd; with Co as autonomous consumption;
C’ as
the marginal propensity to consume; and Yd as disposable income.
I = Investment
G = Government expenditure
X = Exports
M = Imports
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Diagrammatically presented, equilibrium income is where the Y=E (450 line) intersects the
expenditure function (E= C + G + I + X – M).
Expenditure 450 (Y=E)
(E)
E1
E0
E Y
0 Y0 Y1 Income (Y)
The income = expenditure diagram can be used to analyse and explain the impact of
changes in any one of the expenditure components (C, I, G, X, M). With an expenditure
level of E0, for example, equilibrium income is Y0. An increase in G, I, C, or X which
increases total domestic expenditure to E1 would increase income to Y1. A decrease in
these or an increase in imports does the opposite by reducing income from Y1 to Y0.
The Leakages-Injections Approach

In this approach equilibrium income is established where leakages out of the economy’s
income are equal to injections into the economy ie:
Equilibrium Income: Leakages = Injections
S+M+T = I+X+G
An increase in any one of the injections would increase income and employment while an
increase in any one of the leakages would reduce employment and income.
The Aggregate Supply-Aggregate Demand Approach

Using this approach, equilibrium income is exists when aggregate demand is equal to
aggregate supply. Boosting the level of economic activities (increasing economic growth
and reducing unemployment) would require increasing the level of aggregate demand. This
can be done by reducing the level of taxation; increasing the level of government
expenditure; increasing the level of exports; or reducing the level of imports. When there is
excessive unemployment, as assumed by Keynesians the general price level will remain
unchanged after increasing aggregate demand. When the economy is already in full
employment as assumed by Classical economists; the increase in demand will result in
inflation. Under normal circumstances, the increase in aggregate demand will result both in
inflation and an increase in output.
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The AD-AS Approach AS
P4
P3
P2
P1 AD5
P0 AD4
AD3
AD0 AD1 AD2
0 Y0 Y1 Y2 Y3 Y4 Real Output
* To influence the level of economic activities; the Keynesian model puts more
emphasis on aggregate demand management. The model is more biased towards the
usage of fiscal policy tools.
* The model also observes that any change in any of the components of aggregate
expenditure will result in a more than proportionate change in the level of output and
income through the multiplier process.
THE NATIONAL INCOME MULTIPLIER
This concept observes that an increase in expenditure always results in a bigger increase in
income. This is shown by the Y=E diagram above where a smaller change in expenditure
from E0 to E1, for example, leads to a bigger increase in income from Y0 to Y1. This is
because the initial increase in expenditure is received as income by some people in the
economy. These in turn spend part of it (C’E) which is also received by other people as
income. The recipients of (C’E) will also spend part of it (C’C’E) which will be received as
income by other people. The process goes on until the last dollar is received and spent.
In a closed economy with no Government, the national income multiplier is calculated as:
M = Y = 1 . = 1 .
E 1-mpc mps
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In an open economy with government taxation the national income multiplier is calculated
as:
M = Y = 1 .
E 1- (1-tax)mpc + mpm
Where mpc = marginal propensity to consume, and mps = marginal propensity to save and
mpm = marginal propensity to import.

MULTIPLE CHOICE
1. In order to convert national income at market prices to factor cost,

A subtract subsidies and add taxes
B add subsidies and subtract taxes
C add net property income from abroad
D subtract net property income from abroad
2. Given that the government spends $100m on the construction of a bridge and the
marginal propensity to consume in the economy is 0,6, what will be the change in
national income in the economy?
A $100m
B $125m
C $333,3m
D $600m
ESSAYS
[15]
1. (a) Using illustrate examples, distinguish GNP at market prices from GDP at factor cost.
[10]
(b) A country, which experiences a higher GDP, enjoys higher standards of living.
Discuss. [15]
2. (a)What is the difference between ‘equilibrium level of national income’ and ‘full
employment level of national income.’?
[12]
(b) Analyse the effects of
(i) A decrease in direct taxation
(ii) An increase in consumption of consumer goods and
(iii) An increase in savings on equilibrium national income.
[13]
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CHAPTER 17
ECONOMICS FOR DEVELOPING COUNTRIES
Chapter objectives
1. Understand the important aspects of development.
2. Recognise the characteristics of developing countries.
3. Differentiate between short -run development and long- run developments
4. Know and provide guidance to management on how to measure an underdeveloped
country.
5. Explain the policies which can be adopted by governments to promote economic
development.
Introduction
Michael P. Tadaro defines development as the process of improving the quality of all human
lives. Three equally important aspects of development are:
1. Raising people’s living levels, i.e. their incomes and consumption levels of food,
medical services, and education e.t.c, through relevant economic growth process.
2. Creating conditions conducive to the growth of people self – esteem through the
establishment of services, political and economic systems and institutions, which
promote human definite and respect.
3. Increasing people’s freedom to choose by enlarging the range of their choice variables,
of increasing variables of consumer goods and
4. Services (Economic for a developing world, 487)
CHARACTERISTICS OF DEVELOPING COUNTRIES
1. High population growth in developing countries each family has as many children as
possible.
2. High motality rate - this is due to lack of medical facilities and the high costs of
medication.
3. Medical facilities – these facilities are very poor as a result diseases are common such as
cholera and malaria.
4. Agricultural area – under development countries produce primary products such as
tealeaves, coffee seeds and rice for local consumption. Very little is exported.
5. Low education level – it is taken to be the government’s duty to provide this merit
good. Private schools are very expensive as a result very few people will have access to
quality education.
6. Underdevelopment – due to the high growth rate, underdevelopment countries are
densely populated.
7. Poor sanitation facilities – the poor facilities lead to hygienic environment. The
standard of living is so poor that the people’s’ health is affected detrimentally
8. Poor housing- families are poor sheltered and this lowers the standard of living.
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Development in under - developed countries
Short – run development
The Government should build up departments to provide basic necessities for the people.
This includes the development of distribution channels for:
a) Goods
b) Food
c) Medical supplies.
Educational institutions need to be developed together with health institutions. Housing is

also a cause of concern. Once there have been developed they will help raise the standards
of living of the majority of the people.
Long – run developments
This calls for the development of infrastructure in the position of:

1. Basic power stations
2. Water works
3. Road and bridge networks
4. Railways
5. Airports
6. Sea ports
7. Telecommunications services
8. Educational institutions - (i) Primary schools
(ii) Secondary schools
(iii) Technical
(iv) Polytechnic colleges.
The development of infrastructure create employment and reduce the burden on

Government in respect to social welfare cases. Development of the education sector
improves the pool of skilled labour. The development of the services improve commerce
It is apparent that the move into secondary industries will create jobs for the young people.
With developing countries this has been possible through multinationals that create more
employment for the locals. This brings about increased production which in-turn brings
about choices of products and prices within the market set –up. Such development lead into
high value manufacturing and into tertiary industries like:
1. Tourism
2. Technological advancement in industries.
Tourism brings in currency, which will in turn offset balance of Payment deficits. Tourism
is a foreign income earner for most under developed countries.
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HOW TO MEASURE AN UNDER DEVELOPED COUNTRY
1. The standard of living is measured by the Gross Domestic Product, (GDP) per head.
For the under developed countries the GDP per capital is very low as the population is
Ballooning i.e. a low GDP being spread over vast sums of people.
2. Size and composition is much smaller relative to the population as the economics of
these countries tend to be foreign dominated.
3. Specialize in agriculture – these countries have a dependence on agriculture with ill
equipment and also affected by the drought. These countries are mainly producers and
have extremely small tertiary sectors.
4. Technology and capital accumulation – most capital equipment is imported from
developed countries and theirs is quite backward. Added to this there is a lower capital
labour rate where one worker has very few or no machines to work with.
Policies to promote economic development:
1. Family planning programme
This is a population control measure. The government encourages families to adopt family
planning programmes to control the population. Injectibles, family planning tablets and
sheaths can be used.
2. Medical facilities
These could be improved and they lengthen each individuals’ life span and reduce infant
mortality rate. More clinics and hospitals could be built to alleviate this problem.
3. Literacy Rate
More schools should be constructed and quality education offered as the high percentage of
the population will have formal education and improve the literacy rate. In turn an educated
elite will increase worker’s productivity leading to a more efficient production of goods and
services.
4. Housing and Sanitation Facilities
There is need to be improved through construction of more houses and maintain the
premises clean through imposing laws about cleanliness. This would improve the standards
of living.
5. Industrial Peace and Harmony
The Government, employees and employers representatives need to come to a consensus

pertaining wages, working conditions of services. Once this is done there may be higher
productivity and create efficiency as this leads to faster economic growth.
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6. Government provide merit and public goods
The Government should act as a provider of merit and public goods. This in turn will
control citizens as the Government subsidies theses commodities. The private sector may
provide these services at exorbitant rates.
7. Entrepot Trade
This involves the economy bearing its industrialisation policy on import substitution.

MULTIPLE CHOICE
1. The main advantage of privalisation is:

A Creation of private monopolies.
B An increase in government spending.
C Promotion of competition and efficiency.
D Sale of government assets.
ESSAYS
1. Discuss the relationship and conflicts between economic growth and other macro
economic objectives. [25]
4. In what ways may businesses integrate? Give reasons why they may wish to do so.
[25]
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CHAPTER 18
MARKET FAILURE AND EXTERNALITIES
Chapter Objectives
1. Define the term “market failure”
2. Explain the causes of market failure.
3. Appreciate the divergence between private costs ad social costs (externalities)
MARKET FAILURE
Market failure occurs when the price mechanism or the free market system fails to allocate
resources in the best way a society would want.
As a result of market failure, many people believe it is desirable to restructure and

supplement the unrestricted workings of the market.
 Allocation of resources is the duty of the government to ensure that all sectors get
access to the resources.
 Misallocation of resources will occur if market prices and profit do not accurately
reflect the benefit to the society, for example allocation of credit to farmers.
 The government can use the cost benefit analysis concept as a way of evaluating
social and environmental impact of a project so as to charge or pay subsidies to
manufacturing and operating companies.
 Market failure is in two parts, that is failure of the market system to achieve
efficiency in the allocation of societal resources and the other is the failure to serve
social goals other than efficiency.
Causes of Market Failure
i. Market Imperfections
The existence of monopolies and oligopolies may result in suppliers pursuing their self
interests at the expense of external benefits and costs to the society.
Information asymmetry may result in rigidities with regard to factor mobility. This results in
factor under or unemployment.
ii. Collective consumption of public goods
PUBLIC GOODS
These are goods whose consumption by one party does not reduce the amount available to
others. Public goods are also referred to as collective consumption goods. These goods have
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two main characteristics, that is, they are non- rivalry in consumption and secondly are non-
excludable in consumption.
Non- rivalry. Non – rivalry in consumptions means that consumption by one part does not
reduce the amount available to others.
Non - exclusive. Non- exclusive implies that one cannot be excluded from consuming the
good by any other party. Even if one pays for them, once they are produced it would be very
difficulty to prevent non-payers from enjoying the good. This is often referred to as the free
rider problem.
Largely because of the feature of non- exclusivity, it means the price mechanism fails to
play its signalling and rationing role. Since the price mechanism is non- functional, there is
no incentive to produce public goods. Thus, if left to the price mechanism to decide on the
amount to produce there will be under or none production of public good. The marginal cost
of producing public goods is zero and thus, they cannot be priced. In order to correct the
market failure to produce public goods, the government in the majority of cases intervenes
and produce them on behalf of the general public because they are desirable for their social
benefits. Consumers pay indirectly for the production of public goods through taxations,
which is the major source of finance of public goods. Example of public goods include
defence, police, roads, street-lighting, public parks just to mention but a few.
iii. Divergence between Private costs and social costs (externalities)

This can lead to misallocation of resources in free market systems.
Too little goods may be produced by firms in which external benefits prevail while there
may be more than an optimum output of commodities whose production involves
detrimental externalities (W.J Banmol “Economic Theory and Operations”)
Externalities may be harmful or beneficial for example construction of a road passing

through a growth point may be beneficial, while production of cement dust is bad for the
communities closer to the cement producing factory.
Bad externalities affect social costs due to too much production for example pollution and
congestion.
iv. Common property resources/Lack of private property rights
This is about natural resources e.g. communal lands, communal boreholes and oceans. In a
free market with free forces of demand and supply, there is high tendency to over exploit
and abuse such common properties.
MULTIPLE CHOICE
1. Which one of these is not a source of market failure?

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A Positive externalities
B Public goods
C Merit goods
D Equitable distribution of income and wealth.
2. Using the cost benefit analysis, a project is appraised when:
A Its social costs exceed its social benefits.
B Its social benefits exceed its social costs.
C Its external costs exceed its external benefits.
D Its external benefits exceed its external costs.
ESSAYS
1.(a) What do you understand by the terms ‘Commercialisation’ and ‘Privatisation’. [10]
(b) Assess the benefits of Privatisation.
[15]
2.(a) What do you understand by the term negative production externality?
[10]
(b) Assess the effectiveness of government policies in correcting this type of
externality.
[15]
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CHAPTER 19
ECONOMIC POLICIES
Chapter objectives
After studying this chapter and working through the questions and examples, you should be
able to:
1. Define what is meant by economic policy.
2. Outline the examples of government economic objectives.
3. Explain how the policy instruments can be used to promote full employment, price
stability, economic growth, interdependence of aims and equilibrium in the balance of
payment.
4. Identify the macro-economic problems and policies which can be adopted to address
them.
5. Be familiar with the key issues relating to supply side policies.
6. Understand the key concepts and principles in exchange rate regimes.
7. Describe how the exchange rate is determined in Zimbabwe.
8. Recognise the benefits and pitfalls of floating exchange rates.
9. Give reasons why the value of a currency fluctuates.
Introduction
Michael Todaro defines an economic policy as a statement of objectives and the methods of
achieving those objectives (policy instruments) by Government, a business concern, and etc.
Some examples of Government economic objectives are maintaining full employment,
achieving higher rate of economic growth, reducing income and regional development
inequalities, maintaining price stability, policy instruments include fiscal policy, monetary
and financial policy and legislative controls (e.g. price and wage control, rent control).
Full Employment
Governments all over the world are concerned with the associated costs of unemployment
and work around the clock to address the problem of unemployment. The concept of full
employment however is difficult to define since some degree of unemployment will have to
occur at any point in time. However, the government’s aim is to achieve some level of
employment, which it considers acceptable. This acceptable level is dictated somewhat by
the priority given to other economic aims.
Price Stability
Price stability does not imply a commitment to zero inflation. Changes in supply and
demand conditions can lead to price fluctuations in various product markets. This is an
inevitable feature of the price mechanism. Again, we can only say the role the government
is to decide an acceptable rate of inflation given the constraints imposed by its other aims.
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Equilibrium in the Balance of Payment (BOP)
This is not a concept that can easily be defined. However, since all imports must be paid for
by exports one definition is that the flow of autonomous debits be equaled by the flow of
autonomous credits. At any moment in time, it is possible for a country to experience either
a surplus or deficit in its BOP so that there is disequilibrium. The concept of equilibrium
should thus be related to some period of time over which equilibrium should be achieved.
Balance of payment equilibrium would be achieved when over a given period of time
autonomous transactions cancel each other in such a way that does not impede the
government’s efforts to achieve its other policy objectives.
Economic Growth
The government should aim to foster economic growth because of its accompanying
benefits. Economic growth has been given high priority as a policy objectives by most
governments because of its contribution to improved standard of living. Standard of living
will rise if the growth of output exceeds the growth of population. If per capital income
grows (rises) this will translate into a rise in standard of living.
Interdependence of Aims
There is conflict of interest in achieving the above policy objectives simultaneously. The
government is thus faced with a conflict of policy objectives. The policy objective of full
employment for instance is conflicted with price stability. It is also additionally conflicted
with equilibrium in BOP. As demand in the economy is increased to achieve full
employment rises in income will lead to increased demand for imports. Additionally, the
achievement of economic growth is often in conflict with the achievement of price stability
and equilibrium in the BOP. Failure to maintain a high level of demand in the economy
because of the desire to achieve these other objectives hinder investment and growth.
INSTRUMENTS OF POLICY
Fiscal Policy
These consists of variations in government income and expenditure. The main fiscal stance
is outlined in the national budget annually where the government outlines its income and
expenditure plans for the forthcoming year. The government sets its expenditure and
taxation levels to achieve a particular level of the GDP consistent with its considered
various policy objectives.
Monetary Policy
This consists of policies designed to influence the supply of money and / or its ‘price’ that
is, the rate of interest.
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Exchange Rate Policy
The government can manipulate the exchange rate to achieve its policy objectives. It can for
instance, devalue its currency to promote exports, increase economic growth and
employment levels. This is particularly possible if the economy has the capacity to supply
the outside markets.
Income Policy
This is synonymous with controls on wages than anything else. It is mainly used as an anti-
inflationary measure even though it can also be used as an income redistribution tool. In its
anti-inflationary drive, the government can direct that organisations both private and public
should freeze wage increments to dampen demand for goods and services.
Todaro has produced the inter – relationship between problems and policies:
Problem Policy
Poverty and inequality asset redistribution (mainly from growth) land

Reform.
Provision of rural social services poverty - focused
investments (target groups) tax and subsidy policies
Job creation urban and rural improved education
Access.
Excessive population growth eradicate poverty.
Provide family planning services. Monetary incentives
and education and job opportunities for women.
Improved materialised nutrition and health.
Urban unemployment reducing inflation by eliminating artificial urban –
Rural incentive and economic opportunity imbalance.
Getting faster prices right choosing and / or developing
appropriate labour – intensive technologies. Poverty
focused rural incentives modifying urban incentive
effects of inappropriate educational facilities showing
population growth.
Agricultural slagnation and Rural institutional reforms (land tenure, small –
Rural underdevelopment farmer areas to credit, informal biological and
Chemical inputs, crop insurance, new seeds) improved
rural education, health, sanitation, water supplies and
other social services. Specialized rural training
programmes. Rural public works export promotion.
Inappropriate and unequal modification of education demands by reorientation
Education. Of economic signals and incentives towards rural
Sector. Improved access through system of loans,
subsidies and tuition according to ability to pay.
Minimisation of excessive credentialisation. Property
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non- – formal, out of school education. Re- orientary

curricular.
(Economics for a developing world, 371)
SUPPLY SIDE POLICIES
These are policies, which are specifically concerned with the performance of producers in
the economy, e.g. legislation about restrictions on trade practices by trade unions, control
over the development of monopoly power and anti- competitive practices. Supply side
policies also include most economic reform policies.
EXCHANGE RATE REGIMES
Exchange rates are the rate at which one country’s currency can be exchanged for other
currencies in the foreign exchange market. There are various exchange rate regimes, but we
shall limit our analysis to only two broad: categories floating exchange rates and fixed
exchange rates.
We need to highlight here before we go into detail on the determination of exchange rates
under various regimes that appreciation and depreciation of the exchange rate shall only be
confined to the floating exchange rate regime. Devaluation and revaluation of the exchange
rate should only be used when dealing with fixed exchange rate.
Floating Exchange Rates
The exchange rate under this system is determined by the interaction of demand and supply
of the currency.
Demand
Demand for foreign currency arises out of the desire to purchase another country’s exports
or to invest abroad. For example, the demand for the Zimbabwe dollar in the foreign
exchange market arises partly from the desire of foreigners to purchase Zimbabwean
products (our exports), or to invest in Zimbabwe. The demand for Zimbabwean dollars
varies inversely with its price and as a result the demand curve is downward sloping.
Supply
The supply for Zimbabwe dollar similarly in the foreign exchange markets arises from the
demand of Zimbabwean importers for goods and services produced abroad or from the
desire to invest in foreign countries. For example, in order to buy South African exports
Zimbabwean importers require South African rands. These can be obtained when the
importer sells his or her Zimbabwean dollar in foreign exchange market. The supply curve
for the Zimbabwe dollar is also normal- upward sloping reflecting that that more Zimbabwe
dollars are supplied at higher exchange rate.
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EXCHANGE RATE DETERMINATION
The equilibrium exchange rate is determined by the interaction of the market forces of
demand and supply of the currency. The rate determined will be the equilibrium rate and
there can be no variation from this unless conditions of demand and supply change. The
diagram below illustrates how the exchange for Zimbabwean dollars against the rand is
determined.
The Demand and Supply for the Zimbabwean Dollar
3
D$
Price of R in Zim dollars
S$
$2
S$ D$
0
Q1 Quantity of Z$ per period
The figure above shows that with demand and supply conditions given by D$ D$ and S$ S$,
the equilibrium exchange rate is $1 = R2. At any given rate below this rate there will be a
shortage of Zimbabwe dollars and its exchange value will rise. At any rate above this, there
will be a surplus of Zimbabwe dollars and its value will fall.
The factors which cause changes in floating rates are numerous. Changes in a country’s
current balance are clearly important since sales for exports and purchases of imports are
major factors affecting demand for, and supply of different currencies on the foreign
exchange markets. Changes in interest rates also contribute significantly to changes in the
equilibrium exchange rate because of their impact on short-term capital flows (hot money)
and therefore in the demand and supply schedule. Rumours of expected changes in
exchange rates are also likely to influence short-term capital flows. Investors can move their
money into a country before its exchange rate appreciate in order to earn windfall profits
and withdraw when it depreciates. Capital losses on the other hand can be avoided by
moving funds out of the country before the exchange rate depreciates, and then back when it
appreciates.
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Fixed Exchange Rates
It is possible for the government to fix the rate at which its currency can be exchanged for
other trading partners’ currencies. This results in a system called fixed exchange rate
regime. The government through its Central Bank can intervene in the foreign exchange
market to maintain a particular exchange rate. Such intervention is motivated by the desire
to offset changes in demand and supply conditions, which would result in fluctuations in the
exchange rate. The way in which exchange rate stability is achieved by intervention is
explain through the illustration below.
Maintaining a Fixed Exchange Rates
S
Price of Zim $ in terms of SA Rand
S1
1.80
D1
0 qa qc qb
Quantity of Zim $
Assume that our exchange rate is fixed at $1 = R2, between the dollar and the rand and that
supply and demand conditions for the dollar are initially represented respectively by S and
D. If the demand for imports from South Africa increases, there will be an increase in the
supply of dollars to the market (importers selling the dollar in exchange for the rand)
represented by S1. This will cause a down ward pressure on the exchange rate and in a free
floating exchange regime, the price would fall to $1 = R1.80. However, because the
authorities are committed to maintaining the exchange rate at $1 = R2, they will be forced to
buy the excess supply of Zimbabwe dollars (qa qb) that exists at this exchange rate, using the
rands in the foreign exchange reserves. The increased demand for dollars is shown by D 1,
which offsets the increase in supply (S1) and prevents any movements in the exchange rates.
Whatever the cause of pressure on fixed exchange rates, the authorities must take action
which exactly offsets changes in the conditions of supply and demand in the foreign
exchange market if fixed parity values between different currencies are to be maintained.
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Your homework as the reader is to consider the action the authorities should take if there are
changes in demand conditions.
Fixed and Floating Exchange Rates Compared
Advantages of Floating Exchange Rates

Automatic adjustments to BOP disequilibrium. The main advantage of floating exchange
rates is that it provides an automatic mechanism for the maintenance of BOP equilibrium.
The exchange will depreciate if there is a BOP deficit leading to increases in exports and
reduced expenditure on imports. The exchange rate will appreciate if there is BOP surplus.
This appreciation in the exchange rate should promote increased demand for imports and
reduce demand for exports thus resulting in an equilibrium BOP position.
GREATER FREEDOM TO PURSUE DOMESTIC GOALS

Government can concentrate on objectives such as attaining full employment and increasing
economic growth without having to worry on the implications of these objectives on the
BOP.
Economies in the use of foreign exchange reserves

There is no need to maintain foreign exchange reserves, as is the case with a fixed exchange
rate regime.
Less Speculative Activity
Speculation occurs due to uncertainty on the likely movement of the exchange rate. Under a
fixed exchange rate system, authorities are supposed to disclose the amount of import cover
available to thwart any speculative behaviour. In the absence of such information
speculators may with draw their funds in order to cushion themselves from changes in the
exchange rate. With a floating exchange rate, the direction of the exchange rate is either way
and thus there is no room to speculate on whether the exchange rate will appreciate or
depreciate against or in favour of you.
DISADVANTAGES OF FREE FLOATING EXCHANGE RATES

Increased Uncertainty
The possibility of changes in the external value of different currencies might deter long-term
investments or make firms reluctant to negotiate long-term trade contracts with different
countries. There is much greater certainty when exchange rates are fixed.
Increased Speculative Activity
There are greater opportunities for gains, which may encourage speculators to take positions
in the market in anticipation to changes taking place in exchange rates.
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Increased Volatility
The exchange rate is subject to short-term changes, which occur in response to changes in
supply and demand conditions. Under a fixed exchange rate system these short-term
fluctuations in the exchange rate are smoothed by timely government intervention.
Reasons Why the Value of a Currency Fluctuates

1. Changes in the BOP account.
2. Inflation
3. Changes in interest rates
4. Speculation
ESSAYS
1. Discuss the effectiveness of the policies of trade, borrowing and industrialisation for
development.
[25]
2. Assess the effectiveness of policies meant to achieve equitable distribution of
income and wealth in an economy. [25]
Gono announces new export incentives

The Governor of the Reserve Bank of Zimbabwe, Dr Gideon Gono, yesterday unveiled a
fresh basket of export incentives as monetary authorities intensify efforts to augment the
country’s foreign currency reserves.
Dr Gono said the incentives were focused on augmenting the country’s foreign currency
reserves with exporters expected to spearhead the drive. In line with this, the Governor
announced a new exchange rate of Z$17 500, a rate which he said was more than the
purchasing power parity of between $14 000 and $15 000. He said because of the
adjustment, the central bank was scrapping the five percent export facility availed to
exporters in the previous monetary policy statement.
The import tracking control system has also been suspended allowing holders of free funds
to import capital products to increase productivity with no questions being asked as to the
source of funds. Dr Gono also said the auction system would be reviewed in time to allow
pricing mechanisms to assume a greater role in foreign currency allocation.
A total of 51 auctions have been conducted to date while the amount allotted was increased
to US $12,5 million since 1 June this year.
The carrot and stick retention scheme has also been enhanced with immediate effect
allowing exporters who remit their funds within 30 days to retain 50 percent of their foreign
currency. Exporters who remit their foreign currency within 31-60 days have been allowed
to retain 25 percent of their earnings while the horticulture sector has been given a 10
percent retention scheme.
Individuals and exporting companies holding hard currency in their Foreign Currency
Accounts have also been allowed to liquidate their money at the enhanced support price of
$17 500.
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Dr Gono said the moves would allow for an increase in export proceeds, with CDI acquittals
amounting to US $569 million by 15 July up from US $490,8 million in the corresponding
period last year.
Dr Gono said mining accounted for the increased export proceeds with the sector
contributing 42 percent of the commodity.
“The mining sector has contributed about 42 percent. Sustained growth in the mining sector
has been driven by the availability of the concessional productive and export sector funding
facilities that are available to mining houses,” he said.
Earnings from mineral exports increased by 14,1 percent in the first half of 2005 driven by
platinum, which contributed 16,2 percent to the total earnings. Receipts from the
manufacturing sector however declined to US $630,3 million in the first half of 2005 from
US $771,5 million in the corresponding period last year.
(a) From the extract, identify any two-export incentives.

[2]
(b) (i) According to the extract, identify the exchange rate regime to be used in the
economy.
[2]
(ii) Suggest reasons for adopting the exchange rate regime in b(i).
[4]
(c) (i) Explain what is meant by the purchasing power parity.
[2]
(ii) With the new exchange rate of US $1 to Z $17 500 higher than the
purchasing power parity, is the Zimbabwean exchange rate overvalued or
undervalued? Support your answer.
[4]
(d) Discuss the advantages of export oriented growth in an economy.
[6]
Government to cut tariffs on finished goods

Zimbabwe will reduce tariffs on finished goods from the Southern Africa Development
Community by up to 20 percent next year to comply with SADC free – trade protocol
requirements. The new tariff regime, which will come into effect from 01 January next year,
seeks to reinforce regional trade, improving the quality of locally produced commodities
and increased domestic competition. Officials in the Ministry of Finance yesterday
confirmed that tariff reduction for products such as furniture, footwear, clothing, electrical
gadgets and many finished items would be introduced early next year. “A tariff phase down
for finished products will be implemented in January but it is imperative to note that the
reduction is done in phases and it is being formulated in a method that guarantees survival
of local firms from influx of imported goods,” said an official. The official said captains of
industry agreed to the lowering of the tariffs but declined to give figures. However, industry
sources said that tariffs would be reduced by between 10 and 20 percent. Zimbabwe has
almost phased out tariffs on raw materials to increase industrial productivity. The tariff
phase down is being done under two systems, category A and category B. “Category A is
for raw materials and working capital while Category B includes all the finished items or
commodities,” said the Ministry of Finance official. Last month the SADC secretary –
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general, Dr Tomaz Salomao, held a meeting with the Government and the private sector on
the need to reduce tariffs.
Dr Salomao noted that Zimbabwe was lagging behind other member nations in complying
with the protocol requirements and recommended that the country accelerate its tariff
reforms. South Africa has already removed all duties on imports from the region, with the
exception of sugar and clothing. SADC has targeted to achieve a zero tariff regime by 2008.
Dr Salomao said that the country’s unstable economic climate would adversely affect the
SADC trade protocol objectives.
Business Chronicle understands that some key members of industry were resisting
proposed tariff structures under the protocol citing the need to protect local goods and
companies. There are fears that a free trade zone could result in dumping of cheap and
substandard goods by some countries. Trade expert and Confederation of Zimbabwe
Industries chief economist, Mr Farai Zizhou, said that SADC member nations would
convene in February next year to review the progress on phasing out tariffs.
“Zimbabwe is implementing policies to comply with the protocol and next year there will
be a meeting to review success of the protocol,” he said. Mr. Zizhou said that the meeting
would focus on the removal of trade barriers, compliance with the protocol, multiple
membership of trade bodies and many trade issues.
(a) (i) What is meant by the term ‘tariff’ and ‘dumping’?

[2]
(ii) What does SADC aim to achieve by adopting the new tariff regime.
[1]
(iii) From the text, what will be the main problems in a country of adopting the
new tariff regime.
[2]
(b) (i) Apart from a tariff, give other methods of protecting trade.
[2]
(ii) Give two advantages of using a tariff in protecting trade as compared to other
methods.
[2]
(c) Discuss the benefits of free trade to a country such as Zimbabwe.
[6]
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CHAPTER 20
INTERNATIONAL TRADE
Chapter Objectives
After working through this chapter, you should be able to:
1. Explain what is meant by international trade.
2. Differentiate between the absolute advantage and comparative advantage.
3. Review the critique of the absolute and comparative advantage analysis.
4. Understand the gains derived from international trade.
5. Understand the reasons why countries restrict trade.
6. Appreciate the various types of restrictions which may be imposed to restrict
international trade.
7. Outline and analyse the different elements of the balance of payments.
8. Explain the difference between short-term capitals flows and long- term capital flows
9. Describe the ways of connecting balance of payment deficit.
Introduction
International trade involves the movement of goods and services across international
boundaries in exchange for foreign currency. Exports constitute domestic commodities sold
to foreign countries in exchange for foreign currency. Imports on the other hand constitute
foreign commodities bought in our domestic markets. Imports entail an outflow of foreign
currency in payment of such commodities. Countries trade at an international level in order
to exploit possible gains from specialisation in the form of increased world production;
consumption and material wellbeing such trade is associated with.
MUTUAL GAINS FROM SPECIALIZATION AND TRADE
a) The Absolute Advantage Case
A country is said to have an absolute advantage in the production of a commodity if it can

produce more units of that commodity than the other country using the same amount of
resources. If countries have different absolute advantages in production; their specialization
in the production of those commodities for which they have an absolute advantage would
lead to increased production of at least each of the commodities.
An Illustration:
Assume with 100 man hours of labour Japan and Zimbabwe can produce the following
quantities of maize and cars:
Before Specialisation
Maize (tonnes) Cars
Japan 6 100
Zimbabwe 200 2
Total 206 102
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This implies that Japan has an absolute advantage in producing cars while Zimbabwe’s
absolute advantage lies in the production of maize. Assuming that before specialisation each
of the countries was devoting 50% of its resources to each of the two commodities;
complete specialisation would increase the production of maize and cars to 400 tonnes and
200 cars respectively as shown below:
After Specialisation
Maize (tonnes) Cars
Japan - 200
Zimbabwe 400 -
Total 400 200
This implies that after trade each country would be able to consume more of everything.
b) Comparative Advantage
A country has a comparative advantage in the production of a commodity if the opportunity

or relative cost of producing that commodity is lower than in the other country. Even if one
country has got an absolute advantage in the production of the commodities; as long as there
are differences in relative costs of production, there would still be exploitable gains from
specialization. This is shown below:
Assume after 10 years Zimbabwe and Japan can now produce the following quantities when
using 50 man hours on Maize and 50 man hours on cars:
Before Specialisation:
Maize (tonnes) Cars
Japan 50 150
Zimbabwe 50 10
Total 130 160
Opportunity cost of Production:

Maize (cars) Cars (Maize t)
Japan 3 cars 1/3 t of Maize
Zimbabwe 0.2 cars 5 t of Maize
The opportunity cost of maize production is lower in Zimbabwe than in Japan while that of
car production is lower in Japan despite the fact that Japan is more efficient in absolute
terms than Zimbabwe in at least both commodities. If Zimbabwe completely specialize in
maize production while Japan uses 75% of its resources in car production total production
could still be increased as illustrated below:
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After Trade and Specialization:

Maize (tonnes) Cars
Japan 25 225
Zimbabwe 100 -
Total 125 225
Sources of Differences in Absolute and Comparative Advantages
As illustrated above the reasons for specialization and trade are enshrined in differences in
absolute and comparative advantages in production across countries. The reasons why
absolute and comparative advantages can be different across countries are:
i) Differences in factor endowments
The abundance of different factors in different countries in most cases is different. One
country can have abundant labour supply for example Zimbabwe while another could have
abundant capital for example USA. In such cases countries would have an absolute
advantage in producing and exporting those commodities produced by their abundant
factors. This is reason why Zimbabwe produces more of and export labour intensive
commodities such as tobacco while the USA would export capital intensive commodities
such as computers.
ii) Climatic and Soil Fertility Differences
Countries with good climatic conditions and fertile soils suitable for agricultural production
enjoy absolute and comparative advantages in the production of agricultural commodities
than other countries.
iii) The Existence of Competitive/ Acquired Advantage.
Where a country can quickly acquire and adopt advanced foreign technologies or when a
country is more aggressive on research for new techniques of producing a given commodity
it can build for itself an advantage in the production of that commodity over other countries.
This is the case where with the Green Revolution some Asian countries ended up being net
exporters of wheat from being net importers before the Revolution.
A Critique of the Absolute and Comparative Advantage Analysis
The two-country-two-commodity framework in which the comparative and Absolute

advantage is analysed, is too simple and unrealistic. In reality hundreds of countries trade
and thousands of commodities are traded in. It is difficult if not impossible to recommend
on the direction of specialization and trade in such situations.
Conclusions and recommendations from the absolute and comparative advantage analysis
are based on physical units. This ignores and undermines the importance of variety and
differences in the quality of the commodities produced in different countries.
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The analysis assumes that there are no transport and other trade expenses such as insurance
and tariffs. When these are incorporated there are possibilities that what is regarded as an
absolute and or comparative advantage may end up being outweighed by such costs thus
forcing countries to continue producing commodities they may have an absolute or a
comparative disadvantage in.
Some countries may have absolute or comparative advantages in the production of some
commodities but at the same time having inadequate resources to supply the whole world. In
such cases specialisation would lead to world shortages. The analysis also erroneously
assume that all countries are in good books. Where there are no good relationships (for
example political) among or between countries some countries would still have to produce
everything.
Other Gains from International Trade
As has been illustrated above the first gain from trade is increased production through
international specialization. The other possible gains from trade which explain why
countries would need to trade are as itemized below:
(a) Increased Variety-following the increase in the number of producers when there is
trade than without trade.
(b) Increased Market Opportunities- The world market is bigger than the domestic
markets. This gives domestic firms an opportunity for expanding production and enjoy
economies of scale than when they were restricted to the domestic market.
(c) Increased Efficiency and Quality: The opening up of the economy to international
trade increases the level of competition faced by firms. This forces firms to be more
efficient in production and also to produce high quality commodities.
(d) Possibilities for Technology Transfers and Diffusion: International trade leads to
possibilities of the interaction of firms and governments in different countries. This
makes it possible and easier to cross pollinate advanced technologies especially from
developed to less developed countries.
(e) Promotes Other Relationships: With trade other relationships such as political and
cultural relationships can be initiated and strengthened across countries bilaterally and
multilaterally for example: SADC; OAU; WTO; COMESA etc
Reasons Why Countries Restrict Trade (Disadvantages of Free Trade)
The reasons why countries may put restrictions on international trade despite the possible
gains from such trade are many and varied. These include the need to:
(a) Protect the Balance of Payments and the Exchange Rate: to avoid or reduce a
balance of payments deficit and the subsequent exchange depreciation it is associated
with a country can restrict its imports of foreign commodities.
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(b) Protect Infant Industries: Emerging industries are in most cases less efficient and
competitive to withstand foreign competition. Exposing such firms to foreign
competition by the already existing firms would lead to them collapsing before maturity.
(c) Avoid Dumping by Foreign Producers: Dumping involves the selling of foreign
commodities in local markets by foreign firms at prices below costs of production as a
way of getting rid of such commodities. Some of such commodities could be reject or of
hazard for consumption. Governments intervene in trade to guard against such
undesirable trade.
(d) Raise Revenue: Governments may place excise taxes and import duties on
internationally traded commodities to supplement its tax revenue.
(e) Avoid Overdependence: The Government may need to ensure the production of some
strategic commodities such as ammunition; guns; food etc to avoid the country’s over
dependence on other countries for such important commodities. This may be done
through restricting the importation of such commodities even if the domestic cost of
producing them is high.
INTERNATIONAL TRADE
BARRIERS TO INTERNATIONAL TRADE
Despite the perceived gains from trade, countries some times adopt measures to restrict
international trade. There are various types of restrictions, which may be imposed including
the following.
Tariffs
These are taxes that are placed on imported products. Imposition of tariff on a product has
the effect of rising the price of this product in the domestic market. Ceteris paribus, this will
lead to reduced consumption of imported goods or services. Tariffs will not, however, be
effective if the demand for the good is inelastic. Consumers can only respond by reducing
the quantity demanded for the good or service if its demand is elastic, that is, the good has
substitutes in the domestic market. The problem of imposing tariffs, however, is that other
countries whose goods a tariff is imposed on are likely to retaliate since our imports
represent their exports.
Quotas
These are volume restrictions on imports. Specific limits are placed on the quantity of a
particular product that can be imported. Quotas have the effect of creating shortages of the
good in question in the domestic market thereby increasing its price. Consumers will thus be
forced to switch to locally produced goods. The problem with quotas as with tariffs is that
other countries can retaliate by imposing quotas on the country’s exports.
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SUBSIDIES
A country’s export basket can become competitive on foreign markets when the government
absorbs part of the production costs in form of subsidies granted to exporting firms. Given
that part of the production costs have been covered through the subsidies, firms are able to
charge a lower price in the domestic market than would be possible and hence consumers
are encouraged to switch expenditure from imported products to locally produced goods.
Exchange rate control
The government can manipulate the exchange rate in order to protect its firms from foreign
competition. A devaluation of the exchange rate has the effect of rising the price of imports,
ceteris paribus. This should be followed by a reduction in imports. The government may
also exercise control on which product foreign exchange should be released for, and in what
quantities. Failure to access foreign exchange by importers may also limit the amount of
imports. As highlighted before these restrictions may also result in retaliations by other
trading partners.
Technical barriers
Governments can put in place regulations on product specifications. These product

specifications may entail improving on the product or producing a completely new product,
which may result in unnecessary costs.
EMBARGOES
These constitute a complete ban on the importation or exportation of specific commodities.

Imports put on embargo are in most cases those of moral or health hazard such as some
drugs, tapes, books, etc.
TERMS OF TRADE
A country’s terms of trade refers to the rate at which that country’s exports trade against its
imports i.e. the volume of exports a country needs to finance the purchase of one unit of its
imports. This is defined as:
TOT = Index of Export Prices X 100

Index of Import Prices
Changes in the terms of trade are measured by changes in the value of this index. Terms of
trade are said to be favourable when the index is greater than 100 ceteris paribus and
unfavourable when it is less than 100. Great care should be taken on the interpretation of
unfavourable or movements in the terms of trade. It is the price changes which are
favourable or unfavourable. An unfavourable movement in a country’s terms of trade (a
decrease) can be a result of lower export prices or higher import prices. Such a movement
has got the effect of increasing the country’s balance of payments deficit. A decrease in
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terms of trade also results in the depreciation of the exchange rate. Terms of trade can, on
the other hand, improve due to either an increase in the prices of the country’s exports or a
reduction in the prices of its imports. The effect of such a movement is to improve the
country’s balance of payments position and also to appreciate the exchange rate.
CAUSES OF CHANGES IN THE TERMS OF TRADE
Inflation
Excess aggregate demand over aggregate supply or costs rising faster than productivity will
raise the value of the terms of trade index because it causes a rise in domestic (export) prices
for example. Thus, a relatively high or low inflation rate compared to trading partners can
cause changes in the TOT.
Exchange rate
Where for example a country’s currency depreciates, the domestic price for its exports will
be unchanged but the domestic price of its imports will increase. Depreciation therefore,
reduces the value of the TOT index, appreciation reduces the domestic price of imports, and
therefore raise the TOT.
Changes in Commodity Prices
Where the price of their products is bid upon world markets, the TOT of the exporting
countries will rise, for importing countries the TOT index will fall. A slump in the
commodity prices will however have an opposite effect.
NB. The reader is encouraged to add to the list some causes that lead to changes in the
TOT.
THE BALANCE OF PAYMENT (BOP)
The Balance of Payments (BOP) account is a record of all the international transactions of a
country. It records exports, imports, transfers, foreign loans and grants etc. All transactions
which bring in foreign currency are recorded as positive e.g. exports. All transactions which
result in foreign currency outflow, such as imports are recorded as negative. The BOP is
subdivided into three sections – namely the Current Account, The Capital Account and the
Financing section.
Current account
A current account is an account of the dealings in imports of goods and services. It is

divided into three:
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(i) Transaction of goods

Is an account of dealings in the visible or tangible goods like computers, mineral
e.t.c.
(ii) Transactions of invisibles

Mainly concern services e.g. teaching, banking, insurance etc. Intangibles can also
come in form of direct investment earnings e.g. interest, profits and dividends from
Zimbabwe or other countries.
(iii) Transfers
It comes into being when the government and private sector give some grants,
paying subscriptions and contributions to international organisations. It usually
comes in form of gifts to Zimbabwe from other countries and vice versa.
Capital Account
Capital accounts record dealings in assets and liabilities. It only records new transactions of
assets and liabilities and is divided into:
1. Short term capital flows
Represents records of foreign deposits in Zimbabwean banks and loans from abroad to
Zimbabwe (Inflow of money). Deposits by Zimbabweans abroad are treated as outflows of
money.
2. Long term capital flows / accounts
Records capital investments for example opening up factories or manufacturing firms in

Zimbabwe.
OFFICIAL FINANCING/ CHANGES IN RESERVES

This account records a country’s holding of foreign reserves and gold. It also serves as the
means of correcting imbalances between inflows and out flows of foreign currencies.
Definition of Terms
Visible trade refers to the purchase of physical goods export and import.
Invisible trade refers to the purchase or sale of services. Current account shows at the end of
the accounting period the sum of the invisible balance and visible balance. This gives us the
current balance referred to as the balance of trade, because it shows the net deficit or surplus
on goods and services traded.
Short- Term Capital Flows

These are speculative in nature referred to sometimes as ‘ hot money’. They can be moved
from one country to another very rapidly in search of quick capital gains.
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Long Term Capital Flows

It involves the purchase of long-term commercial papers such as government bonds or
shares in publicly listed companies. They might involve in addition, the creation of real
physical assets such as the setting up of factories or offices.
The Balancing Item

This accommodates the errors that might have been encountered in the calculation of export
and import transactions. A positive value indicates that there have been unrecorded exports
and a negative figure that there has been unrecorded net imports.
The Balance of Official Financing

This is the net value of the current balance, plus the capital balance, plus the balancing item.
Its value gives the overall balance of payment surplus or deficit. A positive figure implies a
balance of payment surplus and a negative figure, a BOP deficit. It is a good indicator of the
country’s competitiveness with the rest of the world.
Official Financing
This section shows how BOP deficit or surplus is financed.
NB. The current balance indicates the country’s comparative advantage in exports of
invisible and visible trade. A positive value indicates comparative advantage whereas a
negative reflects a comparative disadvantage. We can also break current balance into visible
and invisible trade in our guest to examine the source of comparative advantage. The
analysis can also be extended to the capital account.
(Economics, Principles and Practice, Philip Black)

BOP must be always at Zero, however, in practice there may be a BOP deficit where exports
exceeds imports or BOP surplus which imports exceed exports.
Correction of BOP deficit

A BOP deficit is a cause of concern amongst policy makers. Policy prescriptions have to be
administered to correct it. They include among many the following.
Exchange Rate Manipulation

The country can devalue its exchange rate to encourage exports and discourage imports.
This only works, however, when demand for exports and imports is price sensitive, that is,
elastic. A devaluation of the exchange rate would reduce the price of exports on foreign
markets stimulating demand for our exports, ceteris paribus. On the other hand, it will work
to discourage imports by raising their prices relative to obtaining domestic prices.
Official Borrowing
The government may borrow from multilateral financial institutions such the IMF, the
World Bank or even the African Development Bank to finance its deficit. It may also appeal
to some donor countries that will offer the foreign exchange at friendly conditions than the
former institutions.
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Trade Restrictions
The government may impose trade restrictions to limit the amount of imports. However, as
highlighted previously this can only work if it is not followed by retaliation by trading
partners.
Disinvestment
The government may close foreign offices (embassies) which consume foreign exchange. It
may also direct its nationals to disengage from investments that use foreign exchange.
Deflation
The government may also be forced to implement deflationary measures that may result in
reduced appetite for foreign goods – i.e., reduce the marginal propensity to import. This may
be done by increasing both corporate and income tax to reduce disposable income available
to corporate and individual citizens. A wage freeze may also be necessary to dampen
aggregate demand and hence the sucking in of imports.
NB. The policy prescriptions above are not exhaustive and you are as a reader encouraged to
look for more. A balance of payment surplus is not also desirable because of its attendant
costs. It is corrected through policy reversals of the above. However, in an examination,
students are encouraged to discuss each point on how a BOP surplus may be addressed.
MULTIPLE CHOICE
1. Which factor is most likely going to reduce the external value of a country’s
currency if a country pursues a flexible exchange rate?
A An increase in interest rate
B An increase in exports
C Political instability in the economy
D Lower inflation rate in the economy.
2. Which of the following is a disadvantage of floating exchange rate?
A Overvalued or undervalued currency
B Balance of payments disequilibrium takes time to correct.
C Instability in exchange rates
D Reduces speculation in the economy.
3. In an open economy with government intervention, which element is not a leakage?
A Government expenditure on house construction
B Value added tax.
C Importation of good and services
D Savings by households in the economy
Page 229
ESSAYS
1. (a) Explain what is meant, by the terms ‘deficit financing’ and ‘budget deficit’.
[10]
(b) Discuss the effectiveness of ways of reducing the budget deficit.
[15]
2.
3. Discuss when and why a government should be concerned with a deficit a balance
of payments.
[25]
4. Discuss the applicability of the comparative advantage theory to world trade.
[25]
5. (a) Explain the accelerator theory.
[10]
(b) Discuss the limitations of the accelerator theory.
[15]
1. Global firm Harris forges link with local it company
Staff Reporter
GLOBAL technology powerhouse. Harris Corporation has forged a commercial link

with a local information technology (IT) firm, Afrotronics (Private) Limited, to
market communications equipment in the public and private sector.
Harris Corporation is a United States based international communications equipment
company whose main focus is providing product, systems and service solutions for
commercial and government customers.
The company’s four operating divisions serve markets for microwave, broadcast and
government communications systems. The commercial partnership deal with
Afrotronics, a small IT company still on the fringes of the fledgling IT sector, was
likely to culminate into a partnership agreement in the coming years. Apart from
Zimbabwe, Harris Corporation is also trying to penetrate the Malawian, Zambian
and Mozambique markets.
Gino Mils, Harris Corporation regional sales manager for Southern Africa told The
Financial Gazette that the firm had sealed a deal with Afrotronics to market
broadband wireless technology products in Zimbabwe’s telecommunications
industry. Mils said Harris, which has over 50 years’ presence in Africa, enjoys a 37
percent market share in microwave telecommunications products. ‘We are trying to
penetrate the Zimbabwean market by forging commercial links with the existing
players in the sector.
‘But it takes a lot of time to build up a strong base which might culminate in technical
partnership,’ Mils said. He said their major target was Zimbabwe’s fast expanding
telecommunications industry as government moves to bridge the information technology
Page 230
gap. The government has said it would be rolling out massive infrastructural projects in the
telecommunications industry. Apart from parastatals, Harris is also eyeing contracts with
communications firms in the private sector.
Harris also markets military equipment such as tactical radio communications, tactical
networking data, integrated communications systems, antenna and accessories.
SOURCE: THE FINANCIAL GAZETTE, SEPTEMBER 23-29, 2004
(a) (i) With reference to the extract, what is the main objective pursued by
Harris corporation?
[2]
(ii) How does Harris Corporation penetrate markets in different
countries. [2]
(b) (i) Identify how Harris Corporation is able to cover risks in business.
[4]
(ii) Explain how Harris Corporation is going to benefit from a partnership
with Afrotronics.
[4]
(d) (i) Identify the main reason why Harris corporation preferred to forge
links
a firm in Zimbabwe.
[2]
(ii) If Harris Corporation and Afrotronics were going to merge, what type
of
merging will it be?
[2]
(e) Examine the effects of a foreign firm merging with a local firm.
[4]
Page 231
CHAPTER 21
DEVELOPMENT PROGRAMMES IN ZIMBABWE
ECONOMIC STRUCTURAL ADJUSTMENT PROGRAMME
Chapter objectives
After reading this chapter and working through the practice questions, you should be able
to:
1. Understand the scope of Economic Structural Adjustment Programme and its main goals.
2. Appreciate the Structural Adjustment Programme Policy reforms.
3. Describe the Trade liberalisation policies.
4. Outline the ways of reducing government expenditure.
5. Describe the objectives of ESAP in Zimbabwe, its reforms and evaluation.
Structural adjustment programmes (SAPs) are meant to introduce market reforms, so that
competition can help improve the allocation of resources, by getting the signals right and
creating a climate that allows businesses to respond to those signals, in ways that enhance
economic growth.
Structural adjustment is a process of undertaking sustained policy reforms aimed at

redirecting an economy in decline towards sustainable and poverty reducing growth.
Structural adjustment programmes are usually undertaken in conjunction with stabilisation
programmes. Stabilisation aims at restoring macro economic balance so that reforms can be
implemented in a conducive economic environment. Macro economic imbalances are
manifested in high inflation, unemployment, chronic national budget deficits and external
sector imbalances. Economic instability is caused by too much aggregate expenditure
relative to a country’s production capacity.
MAIN GOALS OF SAPS
- SAPs are there to reduce state intervention in the economy and increase production of
goods for export.
- To even out the balance of payments deficits and improve market competitiveness.
- Encourage efficient resource allocation so as to increase economic growth.
Zimbabwe adopted ESAP in 1991 due to unstable fiscal and external imbalance. The
government of Zimbabwe was faced with deteriorating investment levels and serious
shortage of foreign exchange from 1980 – 1990s (the government of Zimbabwe in 1991,
Kadenge 1992).
THE SAP POLICY PACKAGE
These are the reforms, which were drawn by the International Monetary Fund and the World
Bank.
Page 232
The reforms include:
 decontrol of prices
 de – regulation of trade
 devaluation of currency
 removal of subsidies
 reduction in public expenditure
 wage restrictions
 removal of tariffs and other import controls
 privatization and commercialization
 good governance and human rights
 removal of administrative controls
Chakaodza 1993 divided the reforms into three categories, namely those that deal with trade
liberalization policies, fiscal and monitory policies and governance and human rights.
Trade liberalisation policies

This involves the gradual removal of controls in a country’s trading system with the rest of
the world. It includes:
(i) Price decontrol on commodities to increase the amount of goods produced. More
employment is thus provided for the people and more foreign currency is earned
from imports arising from increased productivity
(ii) Removal of wage controls allows workers in each industry to negotiate with the
employers and agree on the rate of pay. This is often called collective bargaining
(iii) Removal of import controls such as tariffs and quotas removes the Balance of
Payment constraint. This was done to allow market forces to determine the
exchange rates and all economic activities.
(iv) Removal of subsidies to allow firms to be more competitive and produce more for
exportation
REDUCING GOVERNMENT EXPENDITURE
Third world governments must reduce their expenditures so as to reduce high inflation
levels. Less developed economies usually spend a lot of money on politics to please their
followers rather than developing the economy.
DEVALUATION
Devaluation makes exports cheaper and buyers abroad are likely to purchase more quantities
thereby stabilising the Balance Of Payments. Devaluation of a country is a net exporter than
a net importer.
Page 233
INTEREST RATE POLICY
Low levels of interest rates result in capital outflows, as the incentive to invest or save
domestically will be low. High interest rates act as a incentive for saving and investment in
the domestic economy.
PRIVATISATION
This involves the sale of government owned equity in nationalised industries, parastatals or
other commercial enterprises to private investors. Privatisation improves economic
efficiency and productive efficiency, as companies will be competing to gain market share
and improve product adoption. High quality product can be produced due to competition
and privatisation enables an economy and government to get a lot of revenue through taxes.
GOOD GOVERNANCE AND HUMAN RIGHTS
The World Bank instituted issue of good governance and human rights and improves
political and economic stability. Corruption was regarded as a thing of the past and evil.
Governments use these to respect the presence of a human being and child labour was
considered immoral.
Evaluation of reform programmes
1. SAPs were anti – human (UNICEF 1991). They launched a human face as it was about
de – regulating the government in all economic activities. The government was no
longer given the mandate to provide subsidies to companies, no free education and
health. This affected the lives of the less privileged residents or locals. These effects
were shown when Zimbabwe adopted ESAP in 1991 where there was an inclusion of a
social dimension adjustment.
2. SAPs were drawn to suit the needs of the Americans as they had limited aid to
recipients. Less developed economies have chronic deficits so they needed a lot of
money to finance their activities and their deficits led to countries failing to pay their
debts. The World Bank was the one to approve donor funds after seeing that the
economy has services its debts and there is good governance and human rights.
3. SAPs imposed too much austerity – countries have reduced output unnecessarily during
adjustments due to cuts in investment, reductions in profitability of investments, as well
as reductions in incentives for government workers to work productively (Kadenge et
all, 2000)
4. Stewart (1991) noted that adjustment policies did not succeed, except in monopoly of
cases in restoring economic growth. Many less developed countries have less declining
investment and per capita income and high population numbers which consume more of
Page 234
an economy’s produce resulting in a country importing more, thereby worsening the

Balance Of Payment position
Zimbabwe’s Economic Structural Adjustment Programme (ESAP 1991 – 95)

ESAP was officially launched in February 1991 to help the economy from direct controls to
more indirect ones. Zimbabwe had a declining economy and was put to even out the
problems.
OBJECTIVES OF ESAP
1. Reduce Government deficit from 10 % of GDP to %5 by the fiscal year 1994 / 5.

2. Reform of public enterprises to eliminate the large budgetary burden covered by
subsidies through making enterprises operationally efficient and more commercially
orientated.
3. Civil service reform – to reduce the number of civil servants in non- – critical areas, so
as to cut the size of the wage bill while increasing wages for civil servants remaining in
key positions.
4. Monetary and fiscal policy reform - to strengthen monetary management, show credit
creations to reduce inflationary pressures and to liberalize operations of the financial
sector to encourage savings and improve efficiency of intermediation activities.
5. Trade and exchange market liberalisation to create a market based foreign exchange
system and shift to a tariff based system of protection.
6. Domestic deregulation and investment promotion, to liberalize investment and de –
regulate prices and agricultural marketing and equally important to abolish or modify
bye – laws and regulations that humper investment.
7. Implementation of a social dimension, of adjustment programme to protect poor and
vulnerable groups from the negative transitional effects of economic reforms.
(Adopted from ZIMPREST document Box 1 page 3)
REFORMS UNDER ESAP
 Deregulation of the economy

 Trade liberalisation
 Privatisation of parastatals
 Fiscal and monetary policy reform
 Civil service reforms
Evaluation of ESAP (ZIMPREST DOCUMENT)
1. Budget deficits exceeded targets throughout the ESAP period. The deficits were largely
financed thorough domestic borrowing, thus crowding out the private sector. Inflation
increased and interests rates soared up.
2. The overall performance of the public enterprises worsened significantly during the
reform period. Huge losses were incurred by many public enterprises thus worsening
the position of the fiscus. Agricultural marketing boards made significant problems with
Page 235
respect to commercialisation. The Government in an effort to facilitate the process took

over debts of the public enterprises including the GMB amounting to $ 423 billion thus
contributing to the unusually high budget in 1994 / 5.
3. Significant progress was made on civil service reform as 94 % of the target posts were
abolished and the wage bill was reduced from 16 – 5 % of GDP in 1990 / 91 to 10,4 %
in 1994 / 5.
4. Administrative allocation of foreign currency was stopped in 1993, and individual
foreign currency accounts were introduced in June 1991. The financial sector reform –
foreign exchange and bureaux was introduced in January 1994. They were allowed to
buy and sell foreign currency and travelers cheques for holiday and business travels
within certain limits imposed by exchange control.
5. The amendment of the Labour Relations’ Act of 1985 – employers were given the
powers to retrench labour when they were making losses. The failure of ESAP led to
the adoption of ZIMPREST (1996 – 2000).
6. Recurring brought also affected the pace of reform with the budget deficit still not
reduced to the largest levels.
7. The tight monetary policy brought down inflation to around 20 % which was still above
10 % target by 1995. Unfortunately basic food prices were the main contributor to the
high inflation rates under ESAP.
8. High normal interest rates created liquidity problems, which affected business and
hindered domestic investors in the short – run, particularly small to medium enterprises
but also some large ones in the textile industry.
9. The quality of education and health services for the poor majority generally declined
under cost recovery, insufficient S.D.F and the fast spreading AIDS epidemic. No doubt
it was the short term negative impact of ESAP which became most apparent as
compared to the long term benefits.
Question 1
Rising world oil prices spell tougher times for ZIM
SOARING international oil prices, on the back of the weakening local unit point to a bleak
future for motorists who continue to bear the brunt of a protracted fuel shortage spanning six
years and steep price increases on the parallel market.
International oil prices have risen sharply over the past few months, reaching a record high
US$66 per barrel this week amid indications that the price could break the US$70 mark
soon owing to growing demand, mainly in Asia.
Players in the petroleum industry are already pushing for yet another price hike to remain
viable and to catch up with the 62 percent plunge suffered by the Zimbabwe dollar against
major currencies last month.
Page 236
The government approved a 178 percent increase in the pump price of fuel recently, having
kept the prices at uneconomic levels for several months.
This has, in turn, triggered an inflation spiral, with annualized, inflation jumping a massive
90.5 percentage points to 264.8 percent in July. Suppliers have not improved, despite the
massive price hike, with industry players pointing to a volatile economic environment,
which has already rendered the revised prices unviable. As a result a vibrant informal fuel
market is charging rates between $45 000 and $60 000 per litre of petrol and diesel, a figure
way ahead of the stipulated $10 000 on the same commodity.
Analysis also points to the recent introduction of fuel sales in foreign currency, where a litre
costs US$1 ($18500 at the auction rate), as another contributing factor in the recent increase
in fuel prices on the informal market. The development has created arbitrage opportunities
from those with access to free funds who can purchase the fuel from designated filling
stations, while intrepid arbitrageurs plunder the parallel foreign currency market, where
US$1 is trading at $40 000, to buy the fuel for on selling at a profit.
The government has not committed itself to regular reviews of the price to take into
consideration inflation and exchange rate movements, a situation which has resulted in
massive price shocks when the authorities finally move to correct the situation.
(a) (i) According to the article, what has led to an increase in the price of oil in Zimbabwe?
[2]
(ii) What has caused international oil prices to rise sharply over the past few months?
[1]
(b) (i) Outline the evidence from the article, that oil is under priced in Zimbabwe.
[2]
(ii) Explain the major effects of an increase in the price of oil.
[2]
(c) (i) Describe the trend of annualised inflation in Zimbabwe.
[2]
(ii) Name three types of inflation implied in the passage.
[3]
(iii) What is the main advantage to Zimbabwe of selling fuel in foreign currency?
[2]
(d) Discuss the benefits, to the economy, of using price controls to reduce inflation.
[6]
Page 237
REFERENCES
1. FOR PREFACE
1. Jack Jenkins), A textbook of Questions and Answers in ‘A’ Level Economics,
Unwin Hyman, USA. (1980.
2. ‘A’ Level Economics Syllabus 9158/1/2/3. (Zimsec)
FOR CHAPTER 1
1. G.L Thirkettle, Basic Economics 2nd Edition, M & E Handbooks, London (1974).
2. Royer D Blair et al, Microeconomics with Business Applications, John Wiley &
Sons New York (1987).
3. Jack Jenkins. A Textbook of Questions and Answers in ‘A’ Level Economics
Unwin Hyman USA (1980).
4. Kutsoyannis A Modern Microeconomics, 2nd Edition, London UK. (1979)
FOR CHAPTER 2
1. Rowell R, Economics for Professional Studies 2nd Edition, DP Publications Ltd UK.
(1993).
2. J. Harvey, Intermediate Economics, 3rd Edition, Macmillan Education Limited
London (1980)
3. Lipsey R An introduction to Positive Economics, 5th Edition, Butter and Tanner Ltd,
Frome and London (1980).
4. Hansan J, Economics for Students, 4th Edition, Macdonald & Evans Ltd (1958).
5. Geoff Riley, A Revision Guide to ‘A’ Level Economics. The Design & Print
Corporation Ltd, Newcastle (1994).
FOR CHAPTER 3
1. Fitzpatrich D. Microeconomics, Oxford, New York (1990).
2. Kotler H. Macroeconomics, Amherst College, Toronto (1992).
3. Geof Riley, A Revision Guide to ‘A’ Level Economics. The Design & Print Corporation
Ltd, New Castle. (1994).
4. Royer LeRoy Miller Economics explained, Butler and Tanner Frone and London UK.
(1988).
5. Varian Hal Intermediate Microeconomics, A Modern Approach 4th Edition, W.W, Norton
& Company, New York. (1996).
6. Caincross Introduction to Economics, Butterworth & Company Publications Ltd. London.
(1960).
CHAPTER 4
1. Thirkettle G. Basic Economics 2nd Edition, M & E Handbooks London. (1974).
2. Powell R, Economics for Professional Studies 2nd Edition DP Publications Ltd U.K.
(1993).
3. Kutsoyanis A Modern Microeconomics, 2nd Edition, Macmillan, London U.K. (1979).
4. Roger LeRoy Miller Economics explained, Butter and Tanner Frome and London UK.
(1988).
5. Roger D Blair et al Microeconomics with Business Applications John Wiley & Sons.
New York. (1987).
Page 238
CHAPTER 5
1. J. Harsey Intermediate Economics, 3rd Edition, Macmillan Education Ltd, London. (1980)
2. Varian H. Intermediate Economics, W.W Norton & Company New York. (1993)
3. Hanson J Economics for Students, Macdonald & Evans Ltd. (1958)
4. Dornbusch R) Microeconomics, 2nd Edition, McGraw- Hill USA. (1981).
5. Powell R Economics for Professional Studies 2nd Edition DP Publications Ltd UK.
(1993).
CHAPTER 6
1. Powell R. Economics for Professional Studies 2nd Edition DP Publications Ltd UK.
(1993).
2. Caincoss, Introduction to Economics, 3rd Edition, Butterworth & Company Publishers Ltd
London. (1960).
3. Thirkettle, Basic Economics 2nd Edition, M& E Handbooks, London. (1974).
4. J. Harvey, Intermediate Economics, 3rd Edition, Macmillan Education Ltd, London.
(1980).
5. Hanson J. Economics for Students, 4th Edition, Macdonald & Evans Ltd. (1958).
CHAPTER 7
1. Lipsey R. An introduction to Positive Economics 5th Edition Butler and Tanner Ltd
Frome and London. (1980).
2. Powell R Economics for Professional Studies 2nd Edition DP Publications Ltd UK.
(1993).
3. Kutsoyannis A, Modern Microeconomics 2nd Edition, London UK. (1994).
4. Nancy W & Roger L.M, Economics explained. Butler and Tanner Frome and London
UK. (1988).
5. Geoff R. A revision Guide to ‘A’ Level Economics. The Design & Print Corporation Ltd
Newcastle. (1994).
CHAPTER 8
1. The Financial Gazette, September 30- October 6, 2004.
2. Fitzpatrich, Microeconomics, Amherst College, Toronto (1990).
3. Varian H, Intermediate Economics, W.W Norton & Company New York (1993).
4. McConnell B, Economics 8th Edition McGraw-Hill (2005).
5. Geoff R. A revision Guide to ‘A’ Level Economics The Design & Print Corporation Ltd.
Newcastle (1994).
CHAPTER 9
1. Thirkettle G. Basic Economics 2nd Edition, M & E Handbooks, London. (1974)
2. Varian H, Intermediate Economics, A modern Approach 4th Edition W.W Norton & Co,
New York. (1996).
3. J. Harvey, Intermediate Economics 3rd Edition Macmillan Education Ltd London. (1980)
4. McConnel B, Economics, McGraw-Hill. (2005)
5. Vane H Economics Dalgrave, foundations Great Britain. (1999)
6. Poole H, Principles of Macroeconomics DC Health Co USA. (1991)
Page 239
CHAPTER 10
1. J. Harvey, Intermediate Economics, Macmillan Education Ltd London. (1980)
2. Lipsey R, An introduction to Positive Economics 5th Edition Batler and Tanner Ltd
Fonme (1980) and London
3. Hanson J. Economics for students Macdonald & Evans Ltd. (1958)
4. Caincross, Introduction to Economics 3rd Edition Butterworth & Co Publishers Ltd
London. (1960).
CHAPTER 11
1. Kenkins J A Textbook of Questions and Answers in ‘A’ Level Economics. Unwin Hyman
USA. (1980).
2. Samuelson A & Nordhaus W, Economics 14th Edition McGraw-Hill Inc Singapore.
(1992).
3. J. Harvey, Intermediate Economics Macmillan Education Ltd London. (1981)
4. Lipsey R. An introduction to Positive Economics 5th Edition Butler and Tanner. Ltd
Frome and London. (1980).
5. Hanson, Economics for students MacDonald & Evans Ltd (1958).
CHAPTER 12
1. McConnel, Economics MacGraw-Hill Inc. (2005).
2. Chris M & Vane H, Economics, Palgrave Foundations, Great Britain. (1999).
3. Samuelson A & Nordhaus W, Economics, McGraw-Hill In. Singapore. (1992).
4. Donbusch R. Macro-Economics, 2nd Edition, Lexion Publishers Johannesburg. (1993).
5.Poole H, Principles of Macroeconomics, DC Health & Co. USA. (1991).
6. Donbusch R, Macroeconomics 2nd Edition McGraw-Hill USA. (1981).
CHAPTER 13
1. Kearh J Principles of Macroeconomics DC Health & Co USA (1993).
2. McConnel B Economics McGraw-Hill Inc. (2005).
3. Vane H Economics Palgrave Foundations Great Britain. (1999).
4. Samuelson A & Modhaus N, Economics McGraw-Hill Inc Singapore. (1992).
CHAPTER 14
1. Samuelson A & Nordhaus W, Economics McGraw-Hill Inc. Singapore. (1992).
2. McConnel B, Economics McGraw-Hill. (2005).
3. Vane H, Economics Palgrave Foundations Great Britain. (1999).
4. Kearh J, Principles of Macroeconomics DC Health and Co. USA. (1993).
5. Pooke H, Principles of Macroeconomics DC Health Co USA. (1991).
6. Geoff R, A Revision Guide to ‘A’ Level Economics. The Design & Print Corporation
Ltd. (1994).
CHAPTER 15
1. Samuelson A & Nordhaus W, Economics 14th Edition McGraw-Hill Inc. Singapore.
(1992).
2. Vane H Economics Palgrave Foundations Great Britain. (1999).
3. Poole H Principles of Macroeconomics DC Health & Co USA. (1991).
Page 240
4. Varian H Intermediate Economics WW Norton & Co New York. (1993).
CHAPTER 16
1. Miller R & Nancy W Economics explained Butler and Tanner Frome and London UK.
(1998).
2. J. Harvey Intermediate Economics 3rd Edition MacMillan Education Ltd London. (1980).
3. Manchester Economics Project: Understanding Economics 9th Impression Ginn & Co.
Ltd, Edinburgh. (1976).
4. McConnell B Economics McGraw-Hill Inc. Singapore. (2005)
CHAPTER 17
1. McConnell B Economics McGraw-Hill Inc. Singapore. (2005)

2. Vanne H Economics Palgrave foundations Great Britain. (1999)
3. Samuelson A & Nordhaus W Economics McGraw-Hill Singapore. (1992)
4. Thirkettle G Economics 2nd Edition M & E Handbooks London. (1974)
CHAPTER 18
1. Thikettle G Basic Economics 2nd Edition M & E Handbooks, London. (1974).
2. Dorn bush R. Macroeconomics 2nd Edition McGraw-Hill Inc. USA. (1981).
3. Carncross Introduction to Economics Butler worth & Co. Publishers Ltd London. (1960).
CHAPTER 19
1. McConnell B Economics McGraw-Hill Inc. Singapore. (2005).
2. Poole H Principles of Macroeconomics DC Health & Co USA. (1991) .
3. J Harvey Intermediate Economics McMillan Education Ltd London. (1980).
4. Manchester Economics Project 9th impression Understanding Economics Ginn & Co Ltd
Edinburgh. (1976)
CHAPTER 20
1. Samuel A & Nordhaus W Economics McGraw-Hill Inc. Singapore. (1992).
2. McConnel B Economics, McGraw-Hill Inc. Singapore. (2005).
3. Vane H Economics, Palgrave Foundations Great Britain. (1999).
CHAPTER 21
1. Todaro M Economics for a developing world Longman London & New York. (1998).
2. McConnel B Economics McGraw-Hill Inc. (2005).

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‘A’ LEVEL

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THE SCOPE OF ECONOMICS ............................................................................................................. 16

CHAPTER OBJECTIVES ...................................................................................................................... 16

DIVISIONS OF ECONOMICS ................................................................................................................ 20

DIFFERENCES BETWEEN MICRO AND MACRO - ECONOMICS................................................... 20

MULTIPLE CHOICE ............................................................................................................................................... 22

GRAPHS AND THEIR MEANING ......................................................................................................... 23

CHAPTER OBJECTIVES ...................................................................................................................... 23

THE ECONOMIZING PROBLEM .......................................................................................................... 32

CHAPTER OBJECTIVES ...................................................................................................................... 32

NEEDS AND WANTS RESOURCES ............................................................................................. 32

THE ECONOMIC SYSTEMS ................................................................................................................. 37

CHAPTER OBJECTIVES ...................................................................................................................... 37

THE THEORY OF SUPPLY AND DEMAND ......................................................................................... 42

CHAPTER OBJECTIVES ...................................................................................................................... 42

PERFECTLY ELASTIC DEMAND CURVE ................................................................................................................ 55

DETERMINANTS OF DEMAND ............................................................................................................ 62

CONSUMER BEHAVIOUR .................................................................................................................... 69

CHAPTER OBJECTIVES ...................................................................................................................... 69

TOTAL VARIABLE COSTS .................................................................................................................................... 81

CHAPTER 2 CONSUMER SURPLUS ............................................................................................... 93

CHAPTER 1 CONSUMER SURPLUS ............................................................................................... 93

STANDARDIZED OR DIFFERENTIATED PRODUCTS ..................................................................... 100

NON – PRICE COMPETITION ............................................................................................................ 100

CHAPTER 8 ......................................................................................................................................... 104

CHAPTER 9 ......................................................................................................................................... 122

CHAPTER 10 ....................................................................................................................................... 135

FISCAL POLICY AND PUBLIC FINANCE ......................................................................................... 135

CHAPTER 11 ....................................................................................................................................... 147

MONEY AND BANKING ..................................................................................................................... 147

CHAPTER 12 ....................................................................................................................................... 163

THE MONETARY POLICY .................................................................................................................. 163

CHAPTER 13 ....................................................................................................................................... 168

UNEMPLOYMENT ............................................................................................................................... 168

CHAPTER 14 ....................................................................................................................................... 176

INFLATION .......................................................................................................................................... 176

CHAPTER 15 ....................................................................................................................................... 184

ECONOMIC GROWTH ........................................................................................................................ 184

CHAPTER 16 ....................................................................................................................................... 190

NATIONAL INCOME ACCOUNTING .................................................................................................. 190

CHAPTER 17 ....................................................................................................................................... 202

ECONOMICS FOR DEVELOPING COUNTRIES ............................................................................... 202

CHAPTER 18 ....................................................................................................................................... 206

MARKET FAILURE AND EXTERNALITIES ....................................................................................... 206

CHAPTER 19 ....................................................................................................................................... 209

ECONOMIC POLICIES ........................................................................................................................ 209

CHAPTER 20 ....................................................................................................................................... 219

INTERNATIONAL TRADE .................................................................................................................. 219

CHAPTER 21 ....................................................................................................................................... 231

DEVELOPMENT PROGRAMMES IN ZIMBABWE ............................................................................. 231

The questions set can either be on:

Data response questions

STIMULUS RESPONSE QUESTIONS