Economics Notes - Faith

TABLE OF CONTENTS
COURSE SYLLABUS ii
1.0 INTRODUCTION TO ECONOMICS 1
1.1 The Meaning of Economics 1
1.2 The Scope of Economics 1
1.3 Human wants 2
1.4 Economic resources 4
1.5 scarcity and choice 5
1.6 Opportunity Cost 6
1.7 Resource Allocation 6
1.8 Review Questions 11
2.0 DEMAND ANALYSIS
11
2.1 Concept of Demand 12
2.2 Factors Determining Demand of a Product 17
2.3 The Concept of Elasticity of Demand 19
3.0 SUPPLY ANALYSIS
24
3.1Concept of Supply 24
3.2 Factors Affecting Supply of a Product 27
3.3 The Concept of Elasticity of Supply 29
4.0 PRICE DETERMINATION
36
4.1 Concept of Price Determination 36
4.2 Determination of Prices in a Free Market Economy 36
4.3 Role of Government in Price Determination 44
5.0 PRODUCTION
46
5.1 Meaning of Production 46
5.2 Factors of Production 47
5.3 Concept of Return to Scale in Production 53
5.4 Economies of Scale 57
6.0 THEORY OF THE FIRM
61
6.1 Concept of the Firm 61
6.2 Various costs in a firm 65
6.3 Concept of Revenue 68
6.4 Review Questions
74
7.0 MARKET STRUCTURES
74
7.1 Meaning of Market Structures 74
7.2 Types of Market Structures 74
8.0 LABOUR MARKET
87
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8.1 Demand and Supply of Labour 89
8.2 Factors Influencing Demand and Supply of Labour 91
8.3 Types of Reward for Labour 95
100
9.0 NATIONAL INCOME
100
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9.1 Meaning of National Income 100
9.2 Determination of National Income 101
9.3 Indicators of Standards Of Living 106
10.0 INFLATION 110
10.1 Meaning of Inflation 110
10.2 Causes of Inflation 111
10.3 Effects of Inflation on the Economy 112
10.4 Measures to Control Inflation 113
11.0 MONEY AND BANKING 113
11.1 Concept of Money 113
11.2 Types of Banks 118
11.3 Role of Central Bank in the Economy 121
11.4 Review questions 121
12.0 PUBLIC FINANCE 122
12.1 Sources of Government Revenue 122
12.2 Government Expenditure 124
12.3 Purpose of Taxation 127
12.4 Review questions 134
13.0 UNEMPLOYMENT 134
13.1 Meaning of Unemployment 134
13.2 Types of Unemployment 135
13.3 Causes of Unemployment 135
13.4Ways of Managing Unemployment 137
KNEC Revision Papers 138

COURSE SYLLABUS
ii

WEEK TOPIC SUB-TOPIC
1 INTRODUCTION TO -Meaning of the term economics
ECONOMICS  Scope of economics
 Human wants
 Economic resources
 scarcity and choice
 Opportunity cost
 Resource allocation
2 DEMAND ANALYSIS -Meaning of demand
- Factors determining demand
- the concept of elasticity of demand
3 SUPPLY ANALYSIS -Meaning of supply
- Factors determining supply
- The concept of elasticity of supply
4 PRICE -Concept of price determination
DETERMINATION -Determination of price in a free market economy
-Role of government in price determination
5 PRODUCTION -Meaning of production
-Factors of production
-The concept of return to scale in production
-Economies of scale
6 THE THEORY OF THE -The concept of the firm
FIRM -Various costs in a firm
-The concept of revenue in a firm
-Meaning of economics of scale
7 MARKET - CAT
STRUCTURES -Meaning of market structures
-Various market structures
8 LABOUR MARKET -Meaning of demand and supply of labour
-Factors influencing demand and supply of labour
-Types of reward for labour
9 NATIONAL INCOME -Meaning of national income
-Determination of national income
- Indicators of standards of living
10 INFLATION -Meaning of inflation
- Causes of inflation
- Effects of inflation on the economy
- Measures to control inflation
11 MONEY AND -Concept of money
BANKING -Types of banks
-functions of money
-Role of the central bank in the economy
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12 PUBLIC FINANCE -Sources of government revenue
- Government expenditure
- Purpose of taxation
13 UNEMPLOYMENT -Meaning of unemployment
-Types of unemployment
-Causes of unemployment
-Ways of managing unemployment
12-13 REVISION AND END TERM EXAMS
ASSESSMENT
CAT …………………………….30%
End Term Exams……………….70%
References
nd
1. Mudida,R.(2010). Modern Economics (2 Ed).Focus Publishers.Nairobi
st
2. Sanjay, R., ( 2013). Modern Economics (1 Ed), Manmohan. Canada
3. Waynt, J., (2013), Basic Economics for Students and Non-students,Bookboon.com
4. Krugman & Wells,(2013), Microeconomics 2d ed. ( Worth)
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TOPIC 1
1.0 INTRODUCTION TO ECONOMICS
1.1 The Meaning of Economics

The modern word "Economics" has its origin in the Greek word "Oikonomos" meaning a
steward. The two parts of this word "Oikos", a house and "nomos", a manager sum up what
economics is all about. How do we manage our house?
There is an economic aspect to almost any topic education, employment, housing,

transport, defence etc. Economics is a comprehensive theory of how the society works.
Alfred Marshal defined economics as the "Study of man in the ordinary business of life".
Paul Samuelson, an American Economist defined it as: "The study of how people and
society choose to employ scarce resources that could have alternative uses in order to
produce various commodities and to distribute them for consumption, now or in future
amongst various persons and groups in society.
The word scarcity as used in economics means that; All resources are scarce in the sense
that there are not enough to fill everyone's wants to the point of satiety. i.e We have limited
resources, both in rich countries and in poor countries. The economist‘s job is to evaluate
the choices that exist for the use of these resources. Thus we have another characteristic
of economics; it is concerned with choice.
In summary, Economics is defined as "The social science which is concerned with the
allocation of scarce resources to provide goods and services which meet the needs and
wants of the consumers"
Reasons for Studying Economics

a) Economics provides underlying principles for optical resources allocation which enable
individuals and firms to make economically rational decision.
b) Economics enables individuals and organization to appreciate constricts imposed by
the economic development within which the entity operate.
c) Economics enables citizens to the appreciate parameters that determines development
process so that they can contribute in facilitating in development and solve economic
problems that characterize their society.
d) Economic is analytical and its study helps to develop logical reasoning
1.2 The Scope of Economics

The study of economics begins with understanding of human ―wants‖. Scarcity forces us
to economise. We weigh up the various alternatives and select that particular assortment
of goods which yields the highest return from our limited resources. Modern economists
use this idea to define the scope of their studies.
Although economics is closely connected with such social sciences as ethics, politics,
sociology, psychology and anthropology, it is distinguished from them by its concentration
on one particular aspect of human behaviour – choosing between alternatives in order to
obtain the maximum satisfaction from limited resources.
In effect, the economist limits the study by selecting four fundamental characteristics of
human existence and investigating what happens when they are all found together, as they
usually are.

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First, the ends of human beings are without limit. Second, those ends are of varying
importance. Third, the means available for achieving those ends – human time and energy
and material resources – are limited. Fourth, the means can be used in many different
ways: that is, they can produce many different goods.But no single characteristic by itself
is necessarily of interest to the economist. Only when all four characteristics are found
together does an economic problem arise.
Resources are the ingredients that are combined together by economists and termed
economic goods i.e. goods that are scarce in relation to the demand for them.
(i)Economic Goods: All things which people want are lumped together by
economists and termed economic goods i.e. goods that are scarce in relation to
the demand for them.
(ii)Free Goods: These are goods which people can have as much as they want, e.g.
air. Economic resources are scarce or limited in supply and command a price i.e. they have
money value. Examples include Land, Labour, and Capital/Entrepreneurship. They are also
called factors of production. The rewards from these factors are;
Land-rent/loyalty Labour- salary/wages
Capital –interest Entrepreneurship – profit/loss
Non-economic resources are unlimited in supply and are free. They do not require the use
of scarce resources to produce and have no monetary value e.g. air, sunshine, rain etc.
Economics is concerned with economic resources since scarcity poses an economic
problem and therefore allocation decisions have to be made.
1.3 Human wants

Human want may be defined as an insatiable desire or need by human beings to own
goods or services that give satisfaction or the capacity of satisfying ones needs. The basic
needs of man include; food, housing and clothing. They include tangible goods like houses,
cars, chairs, television set, radio, e.t.c. while the others are in form of services, e.g. tailoring,
carpentry, medical; e.t.c. Human wants and needs are many and are usually described as
insatiable because the means of satisfying them are limited or scarce. Human needs are
the effective desires for certain things which express themselves in sacrifices or efforts
necessary to obtain them.
Types of Human wants

Human wants can be classified into three categories necessaries, comforts and luxuries.
a. Necessaries:
Necessaries refer to the basic or primary wants for food, clothing, shelter, medical care,
education, etc. These are the urgent needs of human beings. A person has to face several
difficulties without the satisfaction of these wants. Necessaries may be further classified
into three categories.
(i) Necessaries of existence: There are the goods and services without which human
life is impossible. Food, water, air, clothing and accommodation are examples of
such necessaries.
(ii) Necessaries for efficiency: These refer to the goods and services which are not
required for survival. Rather they are necessary to make people efficient. For
example, a person can survive without books and stationery. But their use will
make him more efficient.
(iii) Conventional necessaries: These mean the things which have become necessary
due to habits, customs and traditions. For example, wearing of new clothes on
marriage, decorating houses, cutting cakes on birthdays are not required for

maintaining life or increasing efficiency. These have become necessary by force
of habits and social customs.
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b. Comforts:
Comforts refer to the goods and services which make life easier and comfortable. They
provide freedom from suffering, anxiety, pain, etc. Comforts improve our health and
efficiency.For example, a chair may be necessary for efficiency but a cushion on it will
make us comfortable. Comforts like fans, coolers, well furnished houses cheer our minds.
c. Luxuries:
Luxuries refer to the goods and services which give us pleasure and prestige. Motor cars,
air conditioners, diamond jewellery, designer clothes, etc. are examples of luxuries. These
things may not increase efficiency or comfort but they provide us happiness and status in
society.
The above classification of wants is not rigid. A thing which is a comfort or luxury for one
person or at one point of time may become a necessity for another person or at another
point of time.For example; a car may be a luxury for a laborer, a comfort for a teacher but a
necessity for a doctor. Whether a certain want is a necessity, a comfort or a luxury
depends upon the person, the place, the time and the circumstances. Sometimes, human
wants are also broadly classified into Primary wants which refer to wants for necessaries
of life without which man cannot exists and Secondary wants referring to wants for things
over and above the necessaries.
Characteristics of Human Wants:

The following are the important characteristics of wants.
(i) Wants are unlimited: Famous economist Marshall has rightly said that human wants
are countless in number and are varied in kind As soon as one want is satisfied another
want takes its place. This endless circle of wants continues throughout life. For
example, a person who has never used a fan would wish to have a fan. When this want
is satisfied, he would wish to get an air cooler .Once these wants are satisfied, and then
he would wish to have an air conditioner, a car and so on. Thus, we see wants never
come to an end.
(ii) A single want is satiable: Each want taken separately can be satisfied. It has rightly
been said that there is a limit to each particular want. For example, if a man is thirsty he
can satisfy his thirst by taking one, two or three glasses of water and after that he does
not want water at that point of time.
(iii) Some wants arise again and again: Most wants recur. If they are satisfied once, they arise
again after a certain period. We eat food and hunger is satisfied but after a few hours, we
again feel
hungry and we have to satisfy our hunger again with food. Therefore, hunger, thirst etc.
are such wants which occur again and again.
(iv) Varying nature of wants: Wants vary with time, place and person. They are also
influenced by many factors like income, customs, fashion, advertisement etc. For
example, we want medicines only when we are sick. Ice is needed in summer season
only. We need coats when it is cold. Similarly, people have started using things like T.V.
Sets, mobile phones, car and many other luxury goods due to increase in their income
and change in fashion. Thus, wants have been found to vary and to multiply with the
economic development of a country.
(v) Present wants are more important than future wants:Present wants are more
important. A person uses most of his limited resources for the satisfaction of present
wants. He does not worry much about his future wants because future is uncertain and
less urgent. For example, providing for the education of children in the present is more
important than providing for old age security in future.

(vi) Wants change and expand with development: A simple example to show how wants
are changing is the telephone. Earlier, in the rural areas there were not many
telephones, but today
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telephone has become a necessity for everybody for keeping in touch with their near
and dear ones. People using telephone earlier, are now using mobile phones. They
want more and more facilities in their mobile phones such as, Camera, Internet and so
on.
(vii)Wants are complementary: It is a common experience that we want things in groups. A
single article out of group can not satisfy human wants by itself. It needs other things
to complete its use e.g. a motor-car needs petrol and mobile oil it starts working. Thus
the relationship between motor-car and petrol is complementary.
(viii)Wants are competitive: Some wants competes to other. We all have a limited amount
of money at our disposal; therefore we must choose some things and reject the other.
E.g. tea and coffee
(ix)Some Wants are both complimentary and competitive: When use of machinery is done
the use of labour needs to be reduced. This indicates competitive nature. But to run the
machinery the labour is also required and as such it indicates complimentary
relationship.
(x)Wants are alternative: There are several ways of satisfying a particular want. For
example, a person who wants to travel from one place to another may hire a taxi or
may board a bus or train. The final choice depends upon their relative prices, the money
available and the time available.
(ix)Wants create economic activity: Human wants give rise to economic activities.
Unlimited and ever increasing human wants accelerate the pace of industry, commerce
and trade.
1.4 Economic resources

Economic resources are the goods or services available to individuals and businesses
used to produce valuable consumer products. The classic economic resources include
land, labor and capital. Entrepreneurship is also considered an economic resource
because individuals are responsible for creating businesses and moving economic
resources in the business environment. These economic resources are also called the
factors of production. The factors of production describe the function that each resource
performs in the business environment.
a) Land
The term land in economics is used in a special sense. It does not mean soil or earth
surface alone. Land in economics means natural resources. It includes all those things
which are found under and over the surface of earth. In the words of Marshall, the land
means the material and the forces which Nature gives freely to man‘s aid in land and water,
in air and light and heat. Land thus include soil, crops, mineral deposits, forests, oceans
etc. Land as a factor of production cannot be increased because it‘s impossible to get
additional land apart from one given by nature. It can only be improved in quality so as to
produce more goods. Its reward is /remuneration is rent/loyalty.
Characteristics of Land
 It‘s a basic factor of production i.e. production cannot take place without it
 It‘s supply is fixed i.e. earth‘s surface cannot be added
 it lacks geographical mobility i.e. cannot be moved from one geographical area to
another
 it‘s quality is not uniform i.e. productivity of one piece of land is different from
another
 Productivity can be increased by increasing unit of capital and land
 it‘s a natural resource
 It‘s subject to the law of diminishing returns.

b) Labour

Labour refers to any human effort whether physical or mental applied in production
However, not all human effort is labour. For it to be labour, it must be aimed at production
i.e. paid for. The reward for labour is wages and salaries.
In economics, the term human resources include both labour and entrepreneurial ability. It
may be noted that it is the services‘ of labour which are bought and sold for money and not
the labor itself. As regards the supply of labour, it depends upon the (i) size of total
population (ii) age composition of the population (iii) the availability working population, (iv)
the working hours devoted to production (v) the remuneration paid to the workers, etc.,
The entrepreneur or enterprise is the person who takes initiative and combines resources
for the production of goods and services
c) Capital
The term capital refers to all manmade resources which aid to production. Thus
machinery, equipment, tools, factories, storage, transportation, etc., which are used in
the production of new goods and supplying them, to the ultimate consumers are
capital resources. Capital also includes those goods used to produce other goods
(producer goods). Its reward is interest
Characteristics of Capital
 It‘s man-made hence its supply is under man‘s control
 it‘s a basic factor of production
 it‘s subject to depreciation i.e. through wear and tear
 Can be improved by technology
d) Entrepreneurship
It‘s the ability to organize other factors of production for effective production. This is done
by an entrepreneur an (organizer, a manager or a risk taker) and its reward is Profit or Loss
Functions of Entrepreneur
 Control of business
 Start the business
 Make decisions (policy maker)
 Acquire and pay for all factors of production
 Bear all the risks and enjoys the profit
 owns the whole project
1.5 scarcity and choice

To the economists all things are said to be scarce, since by ―scarce‖ they mean simply
―that there are not enough to fill everyone‘s wants to the point of satiety‖. Most people
would probably like to have more of many things or goods of better quality than they
possess at present: larger houses perhaps in which to live, better furnished with the latest
labour-saving devices, such as electric washers, cookers, refrigeration; more visits to
theatre or the concert hall; more travel; the latest models in motor cars; radios and
television sets; and most women exhibit an apparently insatiable desire for clothes.
People‘s wants are many, but the resources for making the things they want – labour, land,
raw materials, factory buildings, machinery – are themselves limited in supply. There are
insufficient productive resources in the world, therefore, to produce the amount of goods
and services that would be required to satisfy everyone‘s wants fully. Consequently, to the
economist all things are at all times said to be ―scarce‖.

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1.6 Opportunity Cost
Because there are not enough resources to produce everything we want, a choice must be
made about which of the wants to satisfy. In economics, it is assumed that people always
choose the alternative that will yield them the greatest satisfaction. We therefore talk of
Economic Man.
Choice involves sacrifice. If there is a choice between having guns and having butter, and a
country chooses to have guns, it will be giving up butter to the guns. The cost of having
guns can therefore be regarded as the sacrifice of not being able to have butter. The cost
of an item measured in terms of the alternative forgone is called its opportunity cost.
1.7 Resource Allocation

Resources are the means to achieve certain ends. One of the most important functions of
the economic system is the allocation of scarce resources and commodities. Resource
allocation ―refers to the way in which the available factors of production are allocated
among the various uses to which they might be put‖. Allocation in economics is therefore
studying of how resources that are scarce are delivered by producers. It also examines It
also examines how scarce goods and services are among consumers. It is a very
important theme in economics.
The allocation of resources enables us to determine how much of the various kinds of
goods and services will actually be produced. Uses of resources in one industry should be
interpreted as if they have been drawn from some other industry having relationship
through common input. If output of one product is increased with given resources, the
output of another product is decreased. Therefore, the optimum allocation of resources
between two products shall depend upon the degree of urgency of demand for them and
the resultant cost savings there from to the society.
Allocation of resources is a problem in welfare economics. It has close relationship with
the theory of general equilibrium. It is advisable to introduce the topic of resource
allocation at macro level first and then extend the arguments to cover the problems of a
firm.
The allocation of resources thus involves sharing of resources among competing sectors.
Whatever, the type of economy be it capitalist, socialist or mixed, decision has to be made
regarding allocation of resources. In a capitalist economy decision about the allocation of
resources are made through the free market price mechanism. A capitalist or free market
economy uses impersonal forces of demand and supply to decide what quantities and
thereby determining the allocation of resources. The producers in a free market economy
motivated as they are by profit consideration take decisions regarding what goods are to
be produced and in what quantity by taking into account the relative prices of various
goods.
Significance of resource allocation

Resource allocation is important in that it helps solve the following problems:
a) What to produce? Because resources are scarce production of all goods and services
needed by a society are beyond its capacity. It is simply not possible for any economy.
So, it has to select a set among various alternatives production which must meet the
maximum social need. An economy should follow social efficiency while allocating
resources. The social norms and values should guide to maximize social satisfaction
so allocation is best which satisfies the most. The problem of what to produce and

how much to produce depends on the needs of the citizens of the country

b) How to produce? This is concerned with the method of production. In some cases,
labor may play a major role. It is called labor intensive technology. In others, capital
may play a major role. It is called capital intensive. A labor intensive method creates
more jobs favouring more employment. It helps in mitigating unemployment problem.
Capital intensive production goes for large volume of production. It commends rapid
growth rate.
c)For whom to produce? Production for masses or productions for profit are two major
choices that every economy has to decide. Basic needs of common people cannot be
ignored. Of course, the priority goes to wage goods production. In the quality is
determined by the level of living standard, which is the outcome of the development
level of the economy. Therefore, as the development level of goods, higher production
of superior goods proceeds towards fetching super profits. This issue is also related
with maintaining social justice. Meeting the basic requirements of all segments of
population is the main criteria of resources allocation.
d) Promotion of Efficiency in Economy: How to run an economy efficiently is the first
concern of resource allocation. Economics efficiency is measured in additional welfare
achieved without worsening any result. It means that new reallocation of resource
must not only be able to maintain the existing level but also achieving new heights.
Alternatively, reallocation may be profitable somewhere but incurring losses elsewhere.
The main objective is to increase aggregate profitability of the economy.
e) Achieving Balance in Economy: Another purpose of resource allocation is the
maintenance of balance among different sectors of an economy. The balance between
rural and urban sectors, between home consumption and export promotion, between
consumer goods and capital goods and regional balance are the healthy signs of an
economy. Investments in these different sectors are very important. How much to
invest in what sector? This is the major question, which is studied in this topic.
Economic Systems and Resource Allocation

When we look around the world we find that there are only a limited number of ways in
which societies have set about answering the four fundamental economic questions.
These ways or methods are called Economic systems. They are free enterprise, centrally
planned and mixed economies. We will now examine these briefly.
a) The free enterprise (the price system)
The free market system is where the decision about what is produced is the outcome of
millions of separate individual decisions made by consumers, producers and owners of
productive services. The decisions reflect private preferences and interests. For the free
enterprise to operate there must be a price system/mechanism which is a situation where
the vital economic decisions in the economy are reached through the workings of the
market price.
Thus, everything – houses, labour, food, land etc come to have its market price, and it is
through the workings of the market prices that the "What?", "How?", and "For whom?"
decisions are taken. The free market thus gives rise to what is called Consumer
Sovereignty – a situation in which consumers are the ultimate dictators, subject to the
level of technology, of the kind and quantity of commodities to be produced. Consumers
are said to exercise this power by bidding up the prices of the goods they want most; and
suppliers, following the lure of higher prices and profits, produce more of the goods.
The features of a free market system are:

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(i)Ownership of Means of Production: Individuals are free to own the means of production
i.e. land, capital and enjoy incomes from them in the form of rent, interest and profits.
(ii)Freedom of Choice and Enterprise: Entrepreneurs are free to invest in businesses of
their choice, produce any product of their choice, workers are free to sell their labour
in occupations and industries of their choice; Consumers are free to consume
products of their choice.
(iii)Self Interest as the Dominating Motive: Firms aim at maximising their profits, workers
aim at maximising their wages, landowners aim at maximising their return from their
land, and consumers at maximising their satisfaction
(iv)Competition: Economic rivalry or competition envisages a situation where, in the
market for each commodity, there are a large number of buyers and sellers. It is the
forces of total demand and total supply which determine the market price, and each
participant, whether buyer or seller, must take this price as given since it's beyond his
or her influence or control.
(v)Reliance on the Price Mechanism: Price mechanism is where the prices are determined on
the market by supply and demand, and consumers base their expenditure plans and
producers their production plans on market prices. Price mechanism rations the scarce
goods and services in that, those who can afford the price will buy and those who cannot
afford the price will not pay.
(vi)Limited Role of Government: In these systems, apart from playing its traditional role of
providing defence, police service and such infrastructural facilities as roads for public
transport, the Government plays a very limited role in directly economic profit making
activities.
Resource allocation in a free enterprise

Although there are no central committees organising the allocation of resources, there is
supposed to be no chaos but order. The major price and allocation decisions are made in
the markets. The market being the process by which the buyers and sellers of a good
interact to determine its price and quantity.
If more is wanted of any commodity say wheat – a flood of new orders will be placed for it.
As the buyers scramble around to buy more wheat, the sellers will raise the price of wheat
to ration out a limited supply. And the higher price will cause more wheat to be produced.
The reverse will also be true. What is true of the market for commodities is also true for
the markets for factors of production such as labour, land and capital inputs.
People, by being willing to spend money, signal to producers what it is they wish to be
produced. Thus what things will be produced will is determined by the shilling votes of
consumers, not every five years at the polls, but every day in their decisions to purchase
this item and not that.
The ―How?‖ questions is answered because one producer has to compete with others in
the market; if that producer cannot produce as cheaply as possible then customers will be
lost to competitors. Prices are the signals for the appropriate technology.
The ―for whom?‖ question is answered by the fact that anyone who has the money and is
willing to spend it can receive the goods produced. Who has the money is determined by
supply and demand in the markets for factors of production (i.e. land, labour, and capital).
These markets determine the wage rates, land rents, interest rates and profits that go to
make up people‘s incomes. The distribution of income among the population is thus

determined by amounts of factors (person-hours, Acres etc) owned and the prices of the
factors (wages-rates, land-rents etc).
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Advantages of a Free Market System
i) Incentive: People are encouraged to work hard because opportunities exist for
individuals to accumulate high levels of wealth.
ii) Choice: People can spend their money how they want; they can choose to set up their
own firm or they can choose for whom they want to work.
iii) Competition: Through competition, less efficient producers are priced out of the market;
more efficient producers supply their own products at lower prices for the consumers
and use factors of production more efficiently. The factors of production which are
no longer needed can be used in production elsewhere. Competition also stimulates
new ideas and processes,
which again leads to efficient use of resources.
iv Flexibility: A free market also responds well to changes in consumer wishes, that is, it is
flexible. v)Reduced size of civil service: Because the decision happen in response to
change in the market there is no need to use additional resources to make decisions,
record them and check on
whether or not they are being carried out. The size of the civil service is reduced.
Disadvantages of a Free Economy

The free market gives rise to certain inefficiencies called market failures i.e. where the
market system fails to provide an optimal allocation of resources. These include:
i) Unequal distribution of wealth: The wealthier members of the society tend to hold most
of the economic and political power, while the poorer members have much less
influence. There is an unequal distribution of resources and sometimes production
concentrates on luxuries i.e. the wants of the rich. This can lead to excessive numbers
of luxury goods being produced in the economy. It may also result to social problems
like crimes, corruption, etc.
ii) Public goods: These are goods which provide benefits which are not confined to one
individual household i.e. possess the characteristic of non-rival consumption and non-
exclusion. The price mechanism may therefore not work efficiently to provide these
services e.g. defence, education and health services.
iii) Externalities: Since the profit motive is all important to producers, they may ignore
social costs production, such as pollution. Alternatively, the market system may not
reward producers
whose activities have positive or beneficial effects on society.
iv)Hardship: Although in theory factors of production such as labour are ―mobile‖ and can
be switched from one market to another, in practice this is a major problem and can
lead to hardship through unemployment. It also leads to these scarce factors of
production being wasted by not using them to fullest advantage.
v) Wasted or reduced competition: some firms may use expensive advertising campaigns
to sell
―new‖ products which are basically the same as many other products currently on
sale. Other firms, who control most of the supply of some goods, may choose to
restrict supply and therefore keep prices artificially high; or, with other suppliers, they
may agree on the prices to charge and so price will not be determined by the
interaction of supply and demand.
vi) The operation of a free market depends upon producers having the confidence that
they will be able to sell what they produce. If they see the risk as being unacceptable,
they will not employ resources, including labour and the general standard of living of
the country will fall.

b) Planned economies
Is a system where all major economic decisions are made by a government ministry or
planning organisation. Here all questions about the allocation of resources are determined
by the government.
9

Features of this system
The command economies rely exclusively on the state. The government will decide what is
made, how it is made, how much is made and how distribution takes place. The resources
and factors of production are owned by the government on behalf of the producers and
consumers. Price levels are not determined by the forces of supply and demand but are
fixed by the government. Although division of labour and specialisation are found, the
planned economies tend to be more self-sufficient and tend to take part in less
international trade than market economies.
Advantages of Planned System
i)Uses of resources: Central planning can lead to the full use of all the factors of
production, so reducing or ending unemployment.
ii) Large scale production: Economies of scale become possible due to mass production
taking place.
iii) Public services: ―Natural monopolies‖ such as the supply of domestic power or
defence can be provided efficiently through central planning.
iv) Basic services: There is less concentration on making luxuries for those who can afford
them and greater emphasis on providing a range of goods and services for all the
population.
v) Wealth and income distribution: There are less dramatic differences in wealth and
income distribution than in market economy
Disadvantages of the Planned System
The centrally planned economies suffer from the following limitations:
i) Lack of choice: Consumers have little influence over what is produced and people may
have little to say in what they do as a career.
ii) Little incentive: Since competition between different producers is not as important as in
the market economy, there is no great incentive to improve existing systems of
production or work. Workers are given no real incentives to work harder and so
production levels are not as high as they could be.
iii) Centralised control: Because the state makes all the decisions, there must be large
influential government departments. The existence of such a powerful and large
bureaucracy can lead to inefficient planning and to problems of communication.
Furthermore, government officials can
become over privileged and use their position for personal gain, rather than for the good
of the rest of the society.
iv)Centralised decision making: The task of assessing the available resources and
deciding on what to produce, how much to produce and how to produce and distribute
can be too much for the central planning committee. Also the maintenance of such a
committee can be quite costly.
c)The Mixed Economy

There are no economies in the world which are entirely ‗free market‘ or planned, all will
contain elements of both systems. The degree of mix in any one economy is the result of a
complex interaction of cultural, historic and political factors. For example the USA which is
a typical example of a largely work-based society, but the government still plans certain
areas of the economy such as defence and provides very basic care for those who cannot
afford medical insurance.
Features of this system

The mixed economy includes elements of both market and planned economies. The

government operates and controls the public sector, which typically consists of a range of
public services such as
10

health and education, as well as some local government services. The private sector is
largely governed by the force of mechanism and ―market forces‖, although in practice it is
also controlled by various regulations and laws.
Some services may be subsidised, provided at a loss but kept for the benefit of society in
general(many national railways, for example, are loss making), other services such as
education or the police may be provided free of charge (though they are paid for through
the taxation system).
The private sector is regulated, i.e. influenced by the price mechanism but also subject to
some further government control, such as through pollution, safety and employment
regulation.
Advantages of the Mixed Economy
i) Necessary services are provided in a true market economy, services which were not able
to make profit would not be provided.
ii) Incentive: Since there is a private sector where individuals can make a lot of money,
incentives still exist in the mixed economy.
iii) Competition: Prices of goods and services in the private sector are kept down through
competition taking place.
Disadvantages of Mixed Economy
i) Large monopolies can still exist in the private sector, and so competition does not really
take place
ii) There is likely to be a lot of bureaucracy and ―red tape‖ due to existence of a public
sector.

1. Define the following terms as used in
economics i) Choice ii) Opportunity
cost
2. Explain four reasons for studying economics
3. Discuss five characteristics of human wants
4. Explain the importance of resource allocation in an economy
5. Outline five disadvantages of a free market system
6. a) What are the main factors of production?
b) What determines the supply of demand for the factors of production that you have
identified in
a) above?
References
nd
st
2. Sanjay, R., (2013). Modern Economics (1 Ed), Manmohan. Canada
3 Waynt, J., (2013), Basic Economics for Students and Non-students,
Bookboon.com 4. Krugman & Wells, (2013), Microeconomics 2d ed. ( Worth)
TOPIC 2
2.0 DEMAND ANALYSIS
In any economy there are millions of individuals and institutions and to reduce things to a
manageable proportion they are consolidated into three important groups; namely; Households,
Firms and Central Authorities. Household refers to all the people who live under one roof and
who make or are subject to others making for them, joint financial decisions. The household
decisions are assumed to be consistent, aimed at maximizing utility and they are the principal

owners of the factors of production. The firm is the unit that uses factors of production to
produce commodities then it sells either to other firms, to household, or to central authorities.
The firm is thus the unit that makes the decisions
11

regarding the employment of the factors of production and the output of commodities.
They are assumed to be aiming at maximizing profits. Central authorities which is a
comprehensive term includes all public agencies, government bodies and other
organizations belonging to or under the direct control of the government. They exist at the
centre of legal and political power and exert some control over individual decisions taken
and over markets.
2.1 Concept of Demand

Demand is the quantity or amount of a commodity that buyers are willing and able to buy
at a given price over a given period of time. The quantity demanded is the amount of a
product people are willing to buy at a certain price; the relationship between price and
quantity demanded is known as the demand. The term demand signifies the ability or the
willingness to buy a particular commodity at a given point of time. Effective demand is the
ability to buy a commodity supported by the willingness to buy. Desire to buy but no money
or having money but no will to buy isn‘t demand hence it is called desire.
Law of demand
The law of demand states that, if all other factors remain equal (ceteris peribus), the
higher the price of a good, the less people will demand that good. In other words, the
higher the price, the lower the quantity demanded. The amount of a good that buyers
purchase at a higher price is less because as the price of a good goes up, so does the
opportunity cost of buying that good. As a result, people will naturally avoid buying a
product that will force them to forgo the consumption of something else they value more.
The chart below shows that the curve is a downward slope.
A, B and C are points on the demand curve. Each point on the curve reflects a direct
correlation between quantity demanded (Q) and price (P). So, at point A, the quantity
demanded will be Q1 and the price will be P1, and so on. The demand relationship curve
illustrates the negative relationship between price and quantity demanded. The higher the
price of a good the lower the quantity demanded (A), and the lower the price, the more the
good will be in demand (C).
Abnormal Demand Curves

1
2

The law of demand does not hold for all commodities in all situations. There are
exceptions when more is demanded when the price increases. These happen in the case
of:
(i) Inferior goods: Cheap necessary foodstuffs provide one of the best examples of
exceptional demand. When the price of such a commodity increases, the consumers
may give up the less essential compliments in an effort to continue consuming the
same amount of the foodstuff, which will mean that he will spend more on it. He may
find that there is some money left, and this he spends on more of the foodstuff and
thus ends up consuming more of it than before the price rise. A highly inferior good is
called Giffen good after Sir Robert Giffen. In addition, Increase in prices of some low
quality goods may mean improvement in quality therefore the demand will increase
with increases in price.
(ii) Articles of ostentation (snob appeal or conspicuous consumption): There are some
commodities that appear desirable only if they are expensive. In such cases the
consumer buys the good or service to show off or impress others. When the price
rises, it becomes more impressive to consume the product and he may increase his
consumption. Some articles of jewellery, perfumes- and fashion goods fall in this
category.
(iii) Speculative demand: If prices are rising rapidly, a rise in price may cause more of a
commodity to be demanded for fear that prices may rise further. Alternatively,
people may buy hoping to resell it at higher prices. In all the above three cases, the
demand curve will be positively sloped i.e. the higher the price, the greater the
quantity bought. These demand curves are called reverse demand curves (also
called perverse or abnormal demand curve).
(iv) Necessities: These are things that one cannot do without; hence demand will not
change even if the prices go up e.g. Maize flour.
(v) Habitual goods and services: Some goods and services will be consumed at the same
quantities at any price because goods and services become habitual e.g. alcohol,
cigarettes.
Different types of demand

a)Negative demand: If the market response to a product is negative, it shows that people
are not aware of the features of the service and the benefits offered. Under such
circumstances, the marketing unit of a service firm has to understand the psyche of the
potential buyers and find out the prime reason for the rejection of the service. For
example: if passengers refuse a bus conductor's call to board the bus. The service firm
has to come up with an appropriate strategy to remove the misunderstandings of the
potential buyers. A strategy needs to be designed to transform the negative demand
into a positive demand.
b)No demand: If people are unaware, have insufficient information about a service or due
to the consumer's indifference this type of a demand situation could occur. The
marketing unit of the firm should focus on promotional campaigns and communicating
reasons for potential customers to use the firm's services. Service differentiation is one
of the popular strategies used to compete in a no demand situation in the market.
c)Latent demand: At any given time it is impossible to have a set of services that offer
total satisfaction to all the needs and wants of society. In the market there exists a gap
between desirables and the available. There is always a search on for better and newer
offers to fill the gap between desirability and availability. Latent demand is a
phenomenon of any economy at any given time, it should be looked upon as a business
opportunity by service firms and they should orient themselves to identify and exploit

such opportunities at the right time. For example a passenger traveling in an ordinary
bus dreams of traveling in a luxury bus. Therefore, latent demand is nothing but the gap
between desirability and availability.
13

d)Seasonal demand: Some services do not have an all year round demand; they might be
required only at a certain period of time. Seasons all over the world are very diverse.
Seasonal demands create many problems to service organizations, such as: - idling the
capacity, fixed cost and excess expenditure on marketing and promotions. Strategies
used by firms to overcome this hurdle are like - to nurture the service consumption habit
of customers so as to make the demand unseasonal, or other than that firms recognize
markets elsewhere in the world during the off-season period. Hence, this presents and
opportunity to target different markets with the appropriate season in different parts of
the world. For example the need for Christmas cards comes around once a year or the,
seasonal fruits in a country.
Other types of demand
 Effective demand: This occurs when a consumers desire to buy a good can be
backed up by his ability to afford it.
 Derived demand: This occurs when a good or factor of production such as labour is
demanded for another reason
Composite Demand – A good which is demanded for multiple different uses
Joint demand – goods bought together e.g. printer and printer ink.
Demand Curve Derivation

a) Demand schedule
The plan of the possible quantities that will be demanded at different prices is called demand
schedule. The plan of the possible quantities that will be demanded at different prices by an
individual is called individual demand schedule. Such a demand schedule is purely hypothetical,
but it serves to illustrate the First Law of Demand and Supply that more of a commodity will be
bought at a lower than a higher price. Theoretically, the demand schedule of all consumers of
a given commodity can be combined to form a composite demand schedule, representing the
total demand for that commodity at various prices. This is called the Market demand schedule
as shown in the table below;.
Price
(Ksh) 20 18 16 14 13 12 10 11 9 8
demande
Quantity d 100 120 135 150 165 180 200 240 300 350
(per week) (000)
These prices are called Demand Prices. Thus, the demand price for 200,000 units per
week is KShs 11 per unit.
b) Demand Curves
The quantities and prices in the demand schedule can be plotted on a graph. Such a graph
after the individual demand schedule is called The Individual Demand Curve and is
downward sloping. An individual demand curve is the graph relating prices to quantities
demanded at those prices by an individual consumer of a given commodity. The curve can
also be drawn for the entire market demand and is called a Market Demand Curve as
below:

14

Consider a market consisting of two consumers:
.At price P1 above, consumer 1 demands q1, consumer II demands quantity q2, and total
market demand at that price is (q1+q2). At price p2, consumer 1 demands q'1, and
consumer II demands quantity q'2 and total market demand at that price is (q'1+q'2). DD is
the total market demand curve.
Changes in the price of a product bring about changes in quantity demanded, such that
when the price falls more is demanded. This can be illustrated mathematically as follows:
Q d = a - bp
Where Qd is quantity demanded
a is the factor by which price
changes p is the price
Thus, ceteris paribus (all other things constant), there is an inverse relationship between
price and quantity demanded. Thus the normal demand curve slopes downwards from left
to right as follows:
Shift and Movement along Demand

Curve a)Movement along demand
curve
A movement refers to a change along a curve. On the demand curve, a movement denotes
a change in both price and quantity demanded from one point to another on the curve. The

movement implies
15

that the demand relationship remains consistent. Therefore, a movement along the
demand curve will occur when the price of the good changes and the quantity demanded
changes in accordance to the original demand relationship. In other words, a movement
occurs when a change in the quantity demanded is caused only by a change in price, and
vice versa.
Price
When price falls from p1 to p2, quantity demanded increases from q1 to q2 and movement
along the demand curve is from A to B. Conversely when price rises from p2 to p1 quantity
demanded falls from q2 to q1 and movement along the demand curve is from B to A.
b) Shifts in Demand Curve

A shift in a demand curve occurs when a good's quantity demanded changes even though
price remains the same. This occurs when, even at the same price, consumers are willing
to buy a higher quantity of goods. The position of the demand curve will shift to the left or
right following a change in an underlying determinant of demand.
Increases in demand are shown by a shift to the right in the demand curve. This could be
caused by a number of factors, including a rise in income, a rise in the price of a substitute
or a fall in the price of a complement. Conversely, demand can decrease and cause a shift
to the left of the demand curve for a number of reasons, including a fall in income,
assuming a good is a normal good, a fall in the price of a substitute and a rise in the price
of a complement. Decreases in demand are shown by a shift of the demand curve to the
left as explained in the figure below.
16

[Type text] [Type text]
Price
In the figure below, DD represents the initial demand before the changes. When the
demand increases, the demand curve shifts to the right from position DD to positions
D2D2. The quantity demanded at price P1 increases from q1 to q'1. Conversely, a fall in
demand is indicated by a shift to the left of the demand curve from D2D2 to DD. The
quantity demanded at price P1 decreases from q1 to q1
Factors That Cause Shifts in Demand Curve

Some of the factors that can cause a demand curve to shift include:
i) Change in income - If consumer incomes increase, we might reasonably expect that
demand for some luxury goods will increase.
ii Change in preferences/tastes - If a product becomes more (less) liked, the quantity
demanded will increase (decrease).
iii)Change in prices of goods that are complimentary - If the price of gasoline goes up
substantially, the demand curve for large SUV's should shift down.
iv) Changes in prices of goods that are substitutes - If the price of pork increases
(decreases), demand for beef would likely increase (decrease).
v) Advertising - An effective advertising campaign could increase the quantity demanded
of a particular good. It could also decrease the demand for a competing good.
vi) Expectations - If consumers expect a good to become more expensive or hard to get in
the future, it could alter current demand
vii) Shifts in market demographics - As segments of the population age or their
composition changes, their demands also change. Because segments are not equally
distributed – that is, there are not a consistent number of people in every age category
– larger segments have a more noticeable impact on demand. The baby boomers are
an excellent example of this.
viii) Distribution of income - For example, if the rich get richer, and the poor get poorer,
demand for luxury goods could increase.
2.2 Factors Determining Demand of a Product

Even though the focus in economics is on the relationship between the price of a product
and how much consumers are willing and able to buy, it is important to examine all of the
factors that affect the demand for a good or service. These factors are also called
Determinants of demand and they include;
1
7

a) Price of the Product
There is an inverse (negative) relationship between the price of a product and the
amount of that product consumers are willing and able to buy. Consumers want to buy
more of a product at a low price and less of a product at a high price. This inverse
relationship between price and the amount consumers are willing and able to buy is
often referred to as The Law of Demand. E.g. if there is an increase in price from p2 to
p1 then there will be a fall in demand from Q2 to Q1
b)The Price of Related Goods

demand of some commodities is affected by demand of other commodities depending
on their relationship e.g. for complimentary goods – goods used together like pen and
ink, when prices of ink increases, the demand for a pen will fall as a result of decrease
in demand for ink. For Substitutes which are commodities that can be used instead of
each other e.g. coffee and tea. A rise in price of coffee reduces its demand and instead
consumers will tend to consume more tea thereby raising its demand i.e some goods
are considered to be substitutes for one another: you don't consume both of them
together, but instead choose to consume one or the other.
c) The Aggregate National Income and its distribution among the population
In normal circumstances as income goes up the quantity demanded goes up. In such a
case
the good is called a normal good. However, there are certain goods whose demand
shall increase with income up to a certain point, then remain constant. In such a case
the good is called a necessity e.g. salt. Also there are some goods whose demand
shall increase with income up to a certain point then fall as the income continues to
increase. In such a case the good is called an inferior good.
d) Changes in taste, fashion and preferences of consumers

Individual tastes and preferences greatly influence the demand for a commodity. If
taste change in favor of a commodity, more of the commodity is likely to be bought
even if it is expensive e.g. imported goods change in fashion which affects demand
since more of the commodity is demanded when in fashion and less when out of
fashion.
e) Government policy
Governments may come up with policies to encourage or discourage consumption of a
commodity through;
i) Tax-increase in taxes leads to increase in price leading to low demand and vice
versa
ii) Subsidies-Leads to decrease in price leading to high demand.
iii) Legislation – passing laws made to encourage or discourage consumption e.g.
opening bars for a few hours to discourage alcohol consumption.
iv) Price control- Controlling prices to ensure that they do not go beyond certain

limits
1
8

f) The Consumer's Expectations
One‘s expectations for the future can also affect how much of a product one is willing
and able to buy. For example, if you hear that Apple will soon introduce a new iPod that
has more memory and longer battery life, you (and other consumers) may decide to
wait to buy an iPod until the new product comes out. When people decide to wait, they
are decreasing the current demand for iPods because of what they expect to happen in
the future. Similarly, if you expect the price of petrol to go up tomorrow, you may fill up
your car with petrol now. So your demand for petrol today increased because of what
you expect to happen tomorrow.
g) The Size and Structure of the Population
A larger population, other things being equal, will mean a higher demand for all goods
and services. Changes in the way the population is structured also influences demand.
Many European countries have an ageing population and this leads to a change in the
demand. Goods and services required by the elderly increase in demand as a result.
The demand for retirement homes, insurance policies suitable for elderly drivers and
smaller cars may increase as a result.
Also as population increases, the population structure changes in such away that an
increasing proportion of the population consists of young age group. This will lead to a
relatively higher demand for those goods and services consumed mostly by young age
group e.g. fashions, films, nightclubs, schools, toys, etc.
h) Advertising
An effective advertising campaign could increase the quantity demanded of a particular
good. It could also decrease the demand for a competing good.
2.3 The Concept of Elasticity of Demand

Elasticity is a term widely used in economics to denote the ―responsiveness of one
variable to changes in another.‖ In proper words, it is the relative response of one variable
to changes in another variable. The phrase ―relative response‖ is best interpreted as the
percentage change.
The quantity of a commodity demanded per unit of time depends upon various factors
such as the price of a commodity, the money income of consumers, the prices of related
goods, the tastes of the people, etc., etc. Whenever there is a change in any of the
variables stated above, it brings about a change in the quantity of the commodity
purchased over a specified period of time. The elasticity of demand measures the
responsiveness of quantity demanded to a change in any one of the above factors by
keeping other factors constant.
When the relative responsiveness or sensitiveness of the quantity demanded is measured

to changes in its price, the elasticity is said be price elasticity of demand. When the change
in demand is the result of the given change in income, it is named income elasticity of
demand. Sometimes, a change in the price of one good causes a change in the demand
for the other. The elasticity here is called cross electricity of demand. The three Main types
of elasticity are now discussed in brief.
Types of Elasticity of
Demand a) Price elasticity of
demand
Price elasticity of demand is the degree of responsiveness of quantity demanded of a
good to a change in its price. Precisely, it is defined as the ratio of proportionate change in

the quantity demanded of a good caused by a given proportionate change in price (ceteris
paribus, i.e. holding constant all the other determinants of demand, such as income).. The
formula for measuring price elasticity of demand is:
19

Price elasticity of demand= Proportionate (percentage) change in quantity
demanded Proportionate (percentage) change in
price
It can be described in symbolic terms.
Ed= (ΔQ/Q)×100/(ΔP/P)×1OO = (ΔQ×P)/(ΔP×Q)
Where ΔQ is change in quantity demanded, Q is initial quantity demanded, ΔP is
change in price, P is the initial price, Ed is price elasticity of demand.
Example: Let us suppose that price of a good falls from sh. 10 per unit to sh. 9 per unit in a
day. The decline in price causes the quantity of the good demanded to increase from 125
units to 150 units per day. The price elasticity using the simplified formula will be:
Ed= (ΔQ/Q)×100/(ΔP/P)×1OO = (ΔQ×P)/(ΔP×Q)

= ({150-125}/125)×100/ ({10-9}/10)×1OO = (25×10)/(1×125) = 2
The elasticity coefficient is greater than one. Therefore the demand for the good is elastic.
The concept of price elasticity of demand can be used to divide the goods into three
groups.
(i). Elastic: When the percent change in quantity of a good is greater than the percent
change in its price, the demand is said to be elastic. When elasticity of demand is
greater than one, a fall in price increases the total revenue (expenditure) and a rise
in price lowers the total revenue (expenditure)
(ii) Unitary elasticity: When the percentage change in the quantity of a good demanded
equals percentage in its price, the price elasticity of demand is said to have
unitary elasticity. When elasticity of demand is equal to one or unitary, a rise or fall
in price leaves total revenue unchanged.
(iii)Inelastic: When the percent change in quantity of a good demanded is less than the
percentage change in its price, the demand is called inelastic. When elasticity of
demand is

20

inelastic or less than one, a fall in price decreases total revenue and .a rise in its
price increases total revenue
Factors influencing Price Elasticity of Demand:

Price elasticity of demand is influenced by:
a) Nature of Commodity
b) Availability of Substitutes
c) Number of Uses
d) Durability of commodity
e) Consumer‘s income
(b) Income Elasticity of Demand

Income is an important variable affecting the demand for a good. When there is a change
in the level of income of a consumer, there is a change in the quantity demanded of a good,
other factors remaining the same. The degree of change or responsiveness of quantity
demanded of a good to a change in the income of a consumer is called income elasticity
of demand. Income elasticity of demand can be defined as the ratio of percentage change
in the quantity of a good purchased, per unit of time to a percentage change in the income
of a consumer. The formula for measuring the income elasticity of demand is:
Income elasticity of demand= Proportionate (percentage) change in

demand Proportionate (percentage)
change in income
Putting this in symbol gives;
Ei= (ΔQ/Q)×100/ ( Y/Y)×1OO = (ΔQ×Y)/( Y×Q)

Where ΔQ is change in quantity demanded, Q is initial quantity demanded, Y is
change in income, Y is the initial income, Ei is income elasticity of demand.
A simple example will show how income elasticity. of demand can be calculated. Let us
assume that the income of a person is sh. 4000 per month and he purchases six CD‘s per
month. Let us assume that the monthly income of the consumer increase to sh. 6000 and
the quantity demanded of
CD‘s per month rises to eight. The elasticity of demand for‘ CD‘s will be calculated as under:
ΔQ =8-6=2, Y= 6000-4000 = sh 2000, original quantity demanded = 6, original income sh.

4000
Ei=2×4000/ 2000×6 = 0.66

21

The income elasticity is .66 which is less than one.
Categories of income elasticity

When the income of a person increases, his demand for goods also changes depending
upon whether the good is a normal good or an inferior good. For normal goods, the value
of elasticity is greater than zero but less than one. Goods with an income elasticity of less
than 1 are called inferior goods. For example, people buy more food as their income rises
but the % increase in its demand is less than the % increase in income.
c) Cross Elasticity of Demand:

The concept of cross elasticity of demand is used for measuring the responsiveness of
quantity demanded of a good to changes in the price of related goods. Cross elasticity of
demand is defined as the percentage change in the demand of one good as a result of the
percentage change in the price of
Cross elasticity of demand= Proportionate (percentage) change in demand of

commodity A Proportionate (percentage) change in
price of commodity B
another good. The formula for measuring cross elasticity of ‗demand is:
Putting this in symbol gives;
EAB= (ΔQA/QA) / (PB/PB) = (ΔQA×PB)/( PB×QA)

Where ΔQA is change in quantity of A demanded, QA is initial quantity of a
demanded, PB is change in price of B, P is the initial price of B, EAB is cross
elasticity of demand of
commodities A&B.
The numerical value of cross elasticity depends on whether the two goods in question are
substitutes, complements or unrelated.
(i)Substitute good: When two goods are substitute of each other, such as coke and Pepsi,
an increase in the price of one good will lead to an increase in demand for the other
good. The numerical value of goods is positive Coke and Pepsi which are close
substitutes. If there is increase in the price of Pepsi called good A by 10% and it
increases the demand for Coke called good B by 5%, the cross elasticity would be 0.2,
therefore, Coke and Pepsi are close substitutes.
(ii) Complementary goods: However, in case of complementary goods such as car and
petrol, cricket bat and ball, a rise in the price of one good say cricket bat by 7% will bring
a fall in the demand for the balls (say by 6%). The cross elasticity of demand (-6/7)= -
0.85 (negative).
(iii)Unrelated goods: The two goods which are unrelated to each other, say apples and
pens, if the price of apple rises in the market, it is unlikely to result in a change in
quantity demanded of pens. The elasticity is zero of unrelated goods.

2
2

Two goods that complement Two goods that are Two goods that are
each other show a negative substitutes have a positive independent have a zero
cross elasticity of demand: cross elasticity of demand: cross elasticity of demand: as
as the price of good Y rises, as the price of good Y rises, the price of good Y rises, the
the demand for good X falls the demand for good X rises demand for good X stays
constant

1. Outline the factors that influence price elasticity of demand of a product
2. Explain the concept of shift in demand curve and highlight the factors that causes the
shift
3. State the factors that may lead to increase or decrease of demand of a commodity
4. Highlight five exemptions to the law of demand
5. State the difference between a demand schedule and a demand curve
References
nd
st
Bookboon.com 4. Krugman & Wells,(2013), Microeconomics 2d ed. ( Worth)
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TOPIC 3
3.0 SUPPLY ANALYSIS
3.1Concept of Supply
Supply and demand is perhaps one of the most fundamental concepts of economics and it
is the backbone of a market economy. Supply represents how much the market can offer.
Supply is the quantity of goods/services per unit of time which suppliers/producers are
willing and able to put on the market for sale at alternative prices other things held
constant. The quantity supplied refers to the amount of a certain good producers are
willing to supply when receiving a certain price.
The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a
certain price. But unlike the law of demand, the supply relationship shows an upward slope.
This means that the higher the price, the higher the quantity supplied. Producers supply
more at a higher price because selling a higher quantity at a higher price increases revenue.
Thus the normal supply curve slopes upwards from left to right as follows:
A, B and C are points on the supply curve in the figure below. Each point on the curve
reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the
quantity supplied will be Q2 and the price will be P2, and so on.
Unlike the demand relationship, however, the supply relationship is a factor of time. Time
is important to supply because suppliers must, but cannot always, react quickly to a
change in demand or price. So it is important to try and determine whether a price change
that is caused by demand will be temporary or permanent. For example; if there's a sudden
increase in the demand and price for umbrellas in an unexpected rainy season; suppliers
may simply accommodate demand by using their production equipment more intensively.
If, however, there is a climate change, and the population will need umbrellas year-round,
the change in demand and price will be expected to be long term; suppliers will have to
change their equipment and production facilities in order to meet the long-term levels of
demand.
Exceptional supply curves

In have some situations the slope of the supply curve may be reversed.
i) Regressive Supply: In this case, the higher the price within a certain range, the smaller
the amount offered to the market. This may occur for example in some labour markets
where above

24

certain level, higher wages has a disincentive effect as the leisure preference becomes
high. This may also occur in undeveloped peasant economies where producers have a
static view of the income they receive. Lastly regressive supply curves may occur with
target workers.
ii) Fixed Supply: Where the commodity is rare e.g. the ―Mona Lisa‖, the supply remains the
same regardless of price. This will be true in the short term of the supply of all things,
particularly raw materials and agricultural products, since time must elapse before it is
physically possible to increase output.
Supply curve
derivations a) Supply
schedules
The plan or table of possible quantities that will be offered for sale at different prices by
individual firms for a commodity is called supply schedule as in the following table.
Theoretically the supply schedules of all firms within the industry can be combined to form
the market or industry supply schedule, representing the total supply for that commodity at
various prices.
Price per unit (KShs) 20 25 30 35 40 45 50

Quantity offered for Sales per month (in ‘000) 80 120 160 200 240 285 320
These prices are called the supply prices.
b) Supply curves
The quantities and prices in the supply schedule can be plotted on a graph. Such a graph is
called the firm supply curve. A supply curve is a graph relating the price and the quantities
of a commodity a firm is prepared to supply at those prices. The typical supply curve
slopes upwards from left to right. This illustrates the second law of supply and demand
―which states that the higher the price the greater the quantity that will be supplied‖. The
supply curve representing the above schedule would appear as below;
60
5
0 Price per
Unit
40
30
20
10
0 10 20 30 40 50 60 70
Number of Units Supplied (in 000's)
The market supply curve is obtained by horizontal summation of the individual firm supply
curves i.e. taking the sum of the quantities supplied by the different firms at each price. If
we consider an industry consisting of two firms, At price P1, firm I (diagram below)
supplies quantity q1, firm II supplies quantity q2, and the total market supply is q1+q2. At
price P2, firm I supplies q‘1, firm II supplies quantity q‘2, and the total market supply is
q‘1+q‘2,. SS is the total market supply curve.

2
5

Shift in supply curve and movement along the same supply curve
For economics, the "movements" and "shifts" in relation to the supply and demand curves
represent very different market phenomena:
a) Movements along the supply curve
A movement along the supply curve means that the supply relationship remains consistent.
Therefore, a movement along the supply curve will occur when the price of the good
changes and the quantity supplied changes in accordance to the original supply
relationship. In other words, a movement occurs when a change in quantity supplied is
caused only by a change in price, and vice versa.
When price increases from P1 to P2, quantity supplied increases from Q1 to Q2 and
movement along the supply curve is from A to B. Conversely when price falls from P2 to
P1, quantity supplied falls from q2 to q1 and movement along the supply curve is from B
to A.
b) Shifts in the supply curve

Shifts in the supply curve are brought about by changes in factors other than the price of
the commodity. A shift in supply is indicated by an entire movement (shift) of the supply
curve to the right (downwards) or to the left (upwards) of the original curve.
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When supply increases, the supply curve shifts to the right from S1S1 to S2S2. At price P1,
supply increases from q1 to q‘1 and at price P2 supply increases from q2 to q‘2.
Conversely, a fall in supply is indicated by a shift to the left or upwards of the supply curve
and less is supplied at all prices. Thus, when supply falls, the supply curve shifts to the left
from position S2S2 to position
S1S1. At price p1, supply falls from q‘1 to q1 and at price p2, supply falls from q‘2 to q2.
Factors that would cause a shift in the supply curve include:

i) Cost e.g. An increase in crude oil costs for a plastic manufacturer would shift the supply
curve up and to the left. Changes in technology can dramatically decrease costs.
ii) Government tax policy - Increases in business taxes will cause the supply curve to shift
up and to the left. A government subsidy to producers will cause more supply to be
available i.e. the supply curve will shift down and to the right.
iii) Weather/climate - Changes in weather and/or climate will especially influence
agricultural product supply.
iv) Prices of substitute products - If farmers can grow wheat instead of corn, and the price
of wheat goes up, then the supply curve for corn will shift up and to the left as more
farmers switch from corn to wheat.
v) Number of producers - As the number of firms/individuals producing a product
increases, we would expect more supply to be available
3.2 Factors Affecting Supply of a Product

They are also referred to as determinants of supply and include:
a) Price of the product
There is a direct relationship between quantity supplied and the price so that the higher the
price, the more people shall bring forth to the market. As a general rule, price of a
commodity and its supply are directly related. It means, as price increases, the quantity
supplied of the given commodity also rises and vice-versa. Mathematically this can be
illustrated as follows:
Qs = -c + dp
Where: Qs is the quantity
supplied -c is a constant
d is the factor by which price
changes P is the price

7

The reason why a greater quantity is supplied at a higher price is because, as the price
increases, organizations which could not produce profitably at the lower price would find it
possible to do so at a higher price. One way of looking at his is that as price goes up, less
and less efficient firms are brought into the industry. The direct relationship between price
and supply, known as ‗Law of Supply‘ and the other determinants are termed as ‗other
factors‘ or factors other than price‘.
b) Price of other product
The influence depends on the relationship between the goods or if the products share
same inputs
i) Substitutes: If X and Y are substitutes, then if the price X increases, the quantity
demanded of X falls. This will lead to increased demand for Y, and this way
eventually lead to increased supply of Y.
ii) Complements: If two commodities, say A and B are used jointly, then an increase in
the price of A shall lead to a fall in the demand for A, which will cause the demand
for B to fall too.
iii) Shared inputs: Increase in the prices of other goods makes them more profitable
in comparison to the given commodity. As a result, the firm shifts its limited
resources from production of the given commodity to production of other goods.
For example, increase in the price of other good (say, wheat) will induce the
farmer to use land for cultivation of wheat in place of the given commodity (say,
rice).
c) Production costs
As the prices of those factors of production used intensively by X producers rise, so do the
firms‘ costs. This decreases the profitability and cause supply to fall, as some firms
reduce output and other, less efficient firms make losses and eventually leave the industry.
Similarly, if the price of one factor of production would rise (say, land), some firms may be
tempted to move out of the production of land intensive products, like wheat, into the
production of a good which is intensive in some other factor of production. On the other
hand, decrease in prices of factors of production or inputs, increases the supply due to fall
in cost of production and subsequent rise in profit margin.
d) Means of transport
Goods transport and communication facilitates free and quick mobility of factors of
production to the producing centers and the final products to the market. Presence of
good means of transport and communication thus increases the supply of a good.
Changes in supply of inputs due to inefficient transport will affect the quantity supplied; if
this falls, less shall be supplied and vice versa.
e) Stability of the government
Existence of internal peace and stability will increase the production and supply of a good.
With political disturbances, labor unrest and wars production and supply of a good will be
hampered.
f) Government policy
The imposition of a tax on a commodity by the government is equivalent to increasing the
costs of production to the producer because the tax ―eats‖ into the firm‘s profits. Hence
taxes tend to discourage production and hence reduce supply. Conversely, the granting of
a subsidy is equivalent to covering the costs of production. Hence subsidies tend to
encourage production and increase supply
g) Natural hazards/ climate
Natural events like weather, pests, floods, etc also affect supply. These affect particularly
the supply of agricultural products. If weather conditions are favourable, the supply of
agricultural products will increase. Conversely, if weather conditions are unfavourable the

supply of such products will fall.
h) State of technology
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Technological changes influence the supply of a commodity. Advanced and improved
technology reduces the cost of production, which raises the profit margin. It induces the
seller to increase the supply. However, technological degradation or complex and out-
dated technology will increase the cost of production and it will lead to decrease in supply.
i)Time
Given that it takes time for firms to adjust the quantities they produce, the supply is likely
to be more elastic the longer the period of time under consideration. In the momentary
period, supply cannot be increased even if there is a substantial rise in price. In the short-
run, supply can be increased by employing more variable factors of production. This is
because in the long-run, the quantities of all factors of production can be increased.
j) Goals / Objectives of the firm:
Generally, the aim of the firm is to maximize profits. Besides, maximum sales, maximum
output and maximum employment are also the goals of the firm. These goals and change
in them affect the supply of the commodity. Normally, supply of a commodity increases
only at higher prices as it fulfills the objective of profit maximization. However, with
change in trend, some firms are willing to supply more even at those prices, which do not
maximise their profits. The objective of such firms is to capture extensive markets and to
enhance their status and prestige.
k) Expected change in price:
In case producers expect an increase in the price, they will withdraw goods from the
market. Consequently, supply will decrease. If price is expected to fall in future, supply will
naturally increase.
3.3 The Concept of Elasticity of Supply

Elasticity of supply of a commodity is the degree of responsiveness of the quantity
supplies to changes in price. Like the elasticity of demand, the elasticity of supply is the
relative measure of the responsiveness of quantity supplied of a commodity to a change in
its price. The, greater the responsiveness of quantity supplied of a commodity to the
change in its price, the greater is its elasticity of supply. Precisely, the elasticity of supply is
defined as a percentage change in the quantity supplied of a product divided by the
percentage change in price. It is calculated using the following formula:
The calculation of elasticity of supply is comparable to the calculation of elasticity of

demand, except that the quantities used refer to quantities supplied instead of quantities
demanded. Over a short time period, firms may be able to increase output only slightly in
response to an increase in prices. Over a longer period of time, the level of production can
be adjusted greatly as production processes can be altered, additional workers can be
hired, more plants can be built, etc. Therefore, elasticity of supply is expected to be greater
over longer periods of time.e.g. the supply elasticity of wheat to be very high as farmers
can easily switch land that is used for wheat over to other crops such as corn and
soybeans. On the other hand, an oil refinery cannot easily switch its production capacity
over to another product, so low oil-refining margins do not reduce the quantity supplied by
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very much. Due to high capital costs, higher refining margins do not necessarily induce
much greater supply. So the supply elasticity for oil refining is fairly low.
Factors that determines the elasticity of supply of a commodity

Elasticity of supply plays a very important role in determining prices of products. The
extent of rise in price of a commodity depends on the elasticity of supply. Various factors,
which determine the elasticity of supply of a product, are given below.
(i) Marginal Cost: Elasticity of supply of a commodity depends on the marginal cost of
production. The elasticity of supply of a commodity would be less if the marginal cost
of production goes up. In the short run, diminishing marginal returns operates as some
factors are fixed. This gives rise to expansion of marginal cost of production. The
expansion of marginal cost causes the elasticity of supply in the short run to be less
elastic. On the other hand, in the long run the supply curve of a commodity is more
elastic. In an increasing cost industry the supply of a commodity is more elastic. In the
constant cost industry the supply of a commodity is perfectly elastic. In the decreasing
cost industry the supply curve slopes negatively.
(ii) Producers response: The elasticity of supply for a product depends on the
producers‘ responsiveness to the change in its price. The quantity supplied of a
commodity will not change if the producers do not react positively to the increase in
prices. Producers do not always increase the quantity supplied of a commodity to a
rise in price. e.g. In some developed countries agricultural producers meet their fixed
money income by selling smaller quantities of food grain. Thus with further rise in price
they produce and sell smaller quantities rather that more.
(iii) Infrastructural facilities: The expansion of supply of a commodity also depends on
the availability of productive facilities and inputs. The agricultural producer cannot
increase in response to the rise in price unless there is sufficient flow of fertilizers,
irrigation etc. In case of industrial goods the expansion of supply is inhibited by the
shortage of power, storage facilities, fuel and the essential raw materials.
(iv) Possibility of Substitution: The change in supply in response to the change in price
depends on the possibility of substitution of a product for others. If the market price of
potato rises, resources will be shifted from other cultivations like tomato and employed
in the cultivation of potato. The greater the possibility of shifting of resources to the
potato cultivation, the greater is the elasticity of supply of potato.
(v) Duration of time: The elasticity of a product also depends on the length of time. If the
time is longer producers get sufficient time to make adjustment for changing output in
response to the change in price, the greater the reaction of output, the greater the
elasticity of supply. On the basis of time market is divided into three types, (i) Market
period (ii) Short-run (iii) long-run. In the market period the supply is perfectly inelastic as
there is no more production. In the short run, output can be changed by changing the
variable factors only. Thus during short period the supply is elastic. In the long run
supply of a commodity is more elastic as the firms can adjust all factors of production
and also new firms can enter or leave the industry.
Price Elasticity of Supply

Price elasticity of supply measures how responsive producers are to a change in the price
of good. It is defined as a measure of the responsiveness of quantity supplied to change in
price. It is measured by dividing the percentage change in quantity supplied by the
percentage change in price.
Thus the Percentage Method formula is:

30

Price elasticity of supply= Percentage change in quantity
supplied Percentage change in
price
This can be epresses as;

Es= (ΔQs/Qs)×100/ (ΔP/P) ×1OO = (ΔQs×Qs)/(ΔP×P)
Where ΔQs is change in quantity supplied, Qs is original quantity supplied, ΔP
is change in price, Y is the original price.
Price Elasticity of supply measures the degree of responsiveness of quantity supplied to

changes in price. Because of the positive relationship between price and quantity supplied
the price elasticity of supply ranges from zero to infinity.
Price Elasticity of Supply and the Slope of the Slope Curve
For a straight line supply curve, the gradient is constant along the whole length of the
curve, but elasticity is not necessarily constant. However, at any given point the steeper
the supply curve, the more inelastic will be the supply. For this reason, steeply sloped
supply curves are usually associated with inelastic supply and non-steeply sloped supply
curves are usually associated with elastic supply.
Types of Price Elasticity of Supply

There are five types of elasticity of supply;
i) Perfectly Inelastic (Zero Elastic) Supply:
Supply is said to be perfectly inelastic if the quantity supplied is constant at all prices. The
supply curve is a vertical straight line and the elasticity of supply is equal to zero. When
price rises from P1 to P2, quantity supplied stays fixed at q, and when price falls from P2
to P1, quantity supplied stays fixed.
In the case of a price rise, this is the situation of the very short-run or the momentary
period which is so short that the quantity supplied cannot be increased, e.g. food brought
to the market in the morning. It is also the case where the commodity is fixed in supply e.g.
land. In the case of a price fall, this is the case of a highly perishable commodity which
cannot be stored, e.g. fresh fish.
A perfectly inelastic supply curve is a straight line parallel to the Y- axis as shown in Fig.
3.9. It is clear from the figure that in this case, supply will not increase at all how so ever
much price may rise. The producers dump the produced quantity of a commodity for
whatever it would bring. Here, the price of the commodity depends upon the demand of
the commodity. The higher the demand, the higher will be the price.
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ii)Inelastic Supply (Es < 1):
Supply is said to be price inelastic if changes in price bring about changes in quantity
supplied in less proportion. Thus, when price increases quantity supplied increases in less
proportion, and when price fall quantity supplied falls in less proportion. The supply curve
is steeply sloped and the elasticity of supply is less than one. When price increases from
P1 to P2, quantity supplied increases in less proportion from q1 to q2. This is the case
when there are limited stocks of the product or the product takes a long time to produce
such that when price rises, quantity supplied cannot be increased substantially.
Conversely, if price falls from P2 to P1, quantity supplied falls in less proportion from q2 to
q1. This is the case of a commodity which is perishable and cannot be easily stored, e.g.
fresh foods like bananas and tomatoes. These are perishable but not so highly perishable
as fresh fish. When price falls, quantity supplied cannot be drastically reduced.
When the percentage change in quantity supplied is less than the percentage change in
price, supply of the commodity is said to be inelastic or less than unit elastic (Fig. 3.12).
This type of supply curve passes through the quantity (X) axis
iii) Unit Elasticity of Supply Elastic (Es =1):

Supply is said to be of unit elasticity if changes in price bring about changes in quantity
supplied in the same proportion. Thus, when price rises, quantity supplied increases in the
same proportion,
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and when price falls, quantity supplied falls in the same proportion. The supply curve is a
straight line through the origin, and the elasticity of supply is equal to one or unity.
When price rises from P1 to P2, quantity supplied increases in the same proportion from
q1 to q2. This is the case of a commodity of which there is a fair amount of stocks or
which can be produced within a fairly short period of time. Conversely, when price falls
from P2 to P1, quantity supplied falls in the same proportion from q2 to q1. This is the
case of a commodity which is fairly easily stockable e.g. dry foods, like dry beans and dry
maize.
Supply of a commodity is said to be unit elastic, if the percentage change in quantity

supplied is equal to the percentage change in price. Any straight line supply curve passing
through the origin has an elasticity of supply equal to unity irrespective of the slope of this
straight line and the scales of the two axis. But, it is important to realise that unitary
elasticity of supply unlike unitary elasticity of demand, has no special economic
significance.
iv) Elastic Supply (E s> 1):

Supply is said to be price elastic if changes in price bring about changes in quantity
supplied in greater proportion. Thus, when price increases, quantity supplied increases in
greater proportion. The supply curve is not steeply sloped and the elasticity of supply is
greater than one. When price rises from P1 to P2, quantity supplied rises in greater
proportion from q1 to q2. This is the case when there are a lot of stocks of the commodity
or the commodity can be produced within fairly short period of time so that when price
rises, quantity supplied can be increased substantially. Conversely, if price falls from P2 to
P1, quantity supplied falls in greater proportion from q2 to q1. This is the case of a
commodity which is easily stockable e.g. manufactured articles. When price falls, quantity
supplied can be substantially reduced. The commodity is then stored instead of being sold
at a loss or for very reduced profit. When the percentage change in quantity supplied
exceeds the percentage change in price, supply of the commodity is said to be elastic or
more than unit elastic (Fig. 3.11). This type of supply curve passes through the price (Y)
axis.

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v)Perfectly Elastic Supply (Es =∞)
It means that at a price, any quantity of the good can be supplied. But, at a slightly lower
price, the firm will not sell at all. It is purely an imaginary concept and can only be
explained with the help of an imaginary supply schedule.
In this case, the elasticity of supply is infinity and the supply curve is a straight line parallel
to the X-axis as shown in Fig. 3.8. Price remains OP irrespective of changes in supply and
a small rise in price evokes an indefinitely large increase in the amount supplied. Further, a
small drop in price would reduce the quantity, producers are willing to supply to zero. This
is the case of Government price control.
Importance of the Price Elasticity of Supply

i) If the supply of a commodity is elastic with respect to a price rise, producers will
benefit by prices not rising excessively. But if the supply is inelastic with respect to a
price rise, they will tend to be overpricing of the commodity to the disadvantage of the
consumers. Even the producers will not benefit as much as they would if the supply
was elastic because although they are charging high prices, the supply is limited.
ii) If the supply is inelastic with respect to a price fall: This increases the risk of the
business because it means that producers may be forced to sell the commodity at
very low prices as the
3
4

commodity cannot be easily stored. But if the supply is elastic with respect to a price
fall, the business is less risky as the commodity can easily be stored, and producers
will not be forced to sell at low prices.
iii) The price elasticity of supply is responsible for the fact that the prices of agricultural
products tend to fluctuate more than those of manufactured products.

1. Explain what is meant by elasticity of supply and state the factors that determine the
supply of a good in the market.
2. Explain the concept of movement along a supply curve
3. State the law of supply and explain two conditions under which it cannot apply.
References
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TOPIC 4
4.0 PRICE DETERMINATION
4.1Concept of Price
Determination Definition of price
The price of an item is the point where the supply at a given price intersects the demand at
a specific price. If it costs sh1 to manufacture a sweet, then a sweet manufacturer may be
willing to supply 100,000 sweets if customers pay sh10 for each, 50,000 for sh 5, and 1,000
for sh1. Customers, however, would buy 100,000 at sh1, and only 1,000 at sh10. By
determining how many units the supplier will provide at a given price, and overlaying that
with how many units the consumers will buy at a given price, economists can determine
the "equilibrium point," the point where suppliers and customers are both willing to buy a
certain amount of product at a certain price. For these sweets, a manufacturer may be
willing to produce 45,000 sweets at sh4.75 because customers will demand 45,000 sweets
at that price. Pricing at the equilibrium point is efficient because suppliers will produce
only what the market will purchase, without over- or under-producing and thereby incurring
extra costs or foregoing potential revenue.
Factors Affecting Price

The final sale price of a good or service can be affected by factors other than supply or
demand. For example, the government may impose special taxes that are added to the list
price at the time of sale. Some governments set mandatory minimum prices for controlled
products like alcohol. Governments also monitor retailers for signs of collusion and price-
fixing. For example, if there are two sellers of milk in a small town, they could agree to both
charge the same high price for the milk in order to increase their profits. However, this
practice is illegal under many countries and, if found guilty, the retailers could face
substantial penalties.
4.2 Determination of Prices in a Free Market Economy

a) Interaction of supply and demand, equilibrium price and quantity
In perfectly competitive markets the market price is determined by the interaction of the
forces of demand and supply. In such markets the price adjusts upwards or downwards to
achieve a balance, or equilibrium, between the goods coming in for sale and those
requested for purchase. Demand and supply react on one another until a position of stable
equilibrium is reached where the quantities of goods demanded equal the quantities of
goods supplied. The price at which goods are changing hands varies with supply and
demand. If the supply exceeds demand at the start of the week, prices will fall. This may
discourage some of the suppliers, who will withdraw from the market, and at the same
time it will encourage consumers, who will increase their demands. This is known as
buyers market.
Conversely, when the price is low, suppliers are only willing to supply fewer products but
consumers are trying to buy a larger quantity than supplied. There are therefore many
disappointed customers, and producers realise that they can raise prices. This is known as
sellers market. There is thus an upward pressure on price and it will rise. This may
encourage some suppliers, who will enter the market, and at the same time it will
discourage consumers, who will decrease their demand.
This can be shown by comparing the demand and supply schedule below.

36

Price of Quantity
Quantity Supplied Pressure
Commodit
y of X Demanded of X
of X (kg/week) on Price
(£/kg) (kg/week)
A 10 100 20 Upward
B 20 85 36 Upward
C 30 70 53 Upward
D 40 55 70 Downward
E 50 40 87 Downward
F 60 25 103 Downward
G 70 10 120 Downward
A Twin force is therefore always at work to achieve only one price where there is neither
upward nor downward pressure on price. This is termed the equilibrium or market price
which is the market condition which once achieved tends to persist or at which the wishes
of buyers and sellers coincide. This can be identified by drawing a demand curve and
supply curve then identifying their point of intersection as shown
From the chart, equilibrium occurs at the intersection of the demand and supply curve,
which indicates no allocative inefficiency. At this point, the price of the goods will be P*
and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of
goods and services are constantly changing in relation to fluctuations in demand and
supply.
Any other price anywhere is called disequilibrium price. As the price falls the quantity
demanded increases, but the quantity offered by suppliers is reduced, since the least
efficient suppliers cannot offer the goods at the lower prices. This illustrates the third
―law‖ of demand and supply that ―Price adjusts to that level which equates demand and
supply‖.
A Mathematical Approach to Equilibrium Analysis

The demand and supply relationships explained earlier on can be expressed in
mathematical form. The standard problem is one of finding a set of values which will
satisfy the equilibrium condition of the market model.

37

Equilibrium in a single market model
A single market model has three variables: the quantity demanded of the commodity (Qd),
the quantity supplied of the commodity (Qs) and the price of the commodity (P).
Equilibrium is assumed to hold in the market when the quantity demanded (Qd) = Quantity
Supplied (Qs) . It is assumed that both Qd and Qs are functions. A function such as y = f (x)
expresses a relationship between two variables x and y such that for each value of x there
exists one and only one value of y. Qd is assumed to be a decreasing linear function of P
which implies that as P increases, Q d decreases and Vice Versa. Qs on the other hand is
assumed to be an increasing linear function of P which implies that as P increases, so
does Qs.
Mathematically, this can be expressed as follows:

Qd = Qs
Qd = a – bP where a,b > 0. ……………………….(i)
Qs = -c + dp where c,d >0. ………………………(ii)
Both the Qd and Qs functions in this case are linear and can be expressed graphically as
follows:
Qd = a - bP QS = -c + dP
Once the model has been constructed it can be

solved. At equilibrium,
Qd = Qs
a – bP = -c + dP
P = a +
c b
+d
To find the equilibrium quantity Q , we can substitute into either function (i)
or (ii). Substituting P into equation (i) we obtain:
Q = a – b (a+c) = a (b+d) – (a+c) = ad -
b bc
b+d b+d b+d
Taking a numerical example, assume the following demand and supply functions:
P = 100 – 2P
Qs = 40 + 4P
At equilibrium, Qd = Qs

38

 100 – 2 P = 40 + 4 P
6P=
60  P =
10
Substituting P = 10, in either equation.

Qd = 100 – 2 (10) = 100 – 20 = 80 = Qs
A single market model may contain a quadratic function instead of a linear function. A
quadratic function is one which involves the square of a variable as the highest power. The
key difference between a quadratic function and a linear one is that the quadratic function
will yield two solution values.
In general, a quadratic equation takes the following

2
form: ax + bx + c = 0 where a  0.
Its two roots can be obtained from the following quadratic formula:
2
X = -b + ( b – 4ac)
2a
Given the following market model:

Qd = 3 –
22
P = 6P
–4
At equilibrium:
2
3 – P = 6P –
2
4 P + 6P – 7
=0
Substituting in the quadratic

formula: a =1, b = 6, c = -7
2
= - 6 + 6 – 4 (1 x –
7) 2 x 1
2
6 4(1x7)
=6
2x1
P = 1 or –7 (ignoring –7 since price cannot be
negative)  P = 1
Substituting P = 1 into either
2
equation: Qd = 3 – (1) = 2 = Qs
Q=2
Equilibrium in a two commodity market

Let us consider a two-commodity market model in which the two commodities are related
to each other. Let us assume the functions for both commodities are linear. The two
commodities are complementary commodities say (cars (c ) and petrol (P). The functions
representing the commodities are as follows:

39

Qdc = 820 – 10 Pc – 4Pp Qdp = 590 – 2Pc – 6Pp
Qsc = -120 + 6Pc Qsp = - 240 + 4Pp
At equilibrium,
1) Qdc = Qsc
820 – 10Pc – 4Pp = - 120 +
6Pc 940 – 16Pc – 4Pp = 0
2) Qdp = Qsp
590 – 2Pc – 6Pp = -240 +
4Pp 830 – 2Pc – 10Pp = 0
There are now therefore two equations:

940 – 16Pc – 4Pp = 0. …………………(i)
830 – 2Pc – 10Pp = 0 ………………….(ii)
Multiply (ii) by 8 which gives (iii). Subtract (i) from (iii) to eliminate Pc and solve
for Pp. 6,640 – 16 Pc – 80Pp = 0..(iii)
- (940 – 16Pc – 4Pp = 0 ……………….(i)
5,700 - 76Pp = 0
Pp = 75
Substituting Pp = 75 in (i) we
obtain: 940 – 16Pc – 4(75) = 0
16pc =
640 Pc
= 40
Substituting Pc = 40 and Pp = 75 into Qd or Qs for each market.

1) Qdc = 820 – 10 (40) – 4
(75) = 820 – 400 – 300
Qdc = 120 = Qsc
2) Qdp = 590 – 2 (40) – 6

( 75) = 590 – 80 – 450
Qdp = 60 = Qsp
b. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*. This occurs
when the market has;
i. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will
be allocative inefficiency.
40

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At
P1, however, the quantity that the consumers want to consume is at Q1, a quantity much
less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is
being consumed. The suppliers are trying to produce more goods, which they hope to sell
to increase profits, but those consuming the goods will find the product less attractive and
purchase less because the price is too high.
ii. Excess Demand

Excess demand is created when price is set below the equilibrium price. Because the price
is so low, too many consumers want the good while producers are not making enough of it.
In this situation, at price P1, the quantity of goods demanded by consumers at this price is
Q2. Conversely, the quantity of goods that producers are willing to produce at this price is
Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the
consumers. However, as consumers have to compete with one other to buy the good at
this price, the demand will push the price up, making suppliers want to supply more and
bringing the price closer to its equilibrium.
c) Stable and Unstable Equilibrium
41

Equilibrium is said to be stable equilibrium when economic forces tend to push the market
towards it. In other words, any divergence from the equilibrium position sets up forces,
which tend to restore the equilibrium i.e. At prices below equilibrium price there is an
excess demand which pushes the price up.
Unstable equilibrium on the other hand is one such that any divergence from the
equilibrium sets up forces which push the price further away from the equilibrium price. it
mostly occurs in cases of inferior good or a veblen good which exhibit an ―abnormal‖
demand curve which means that at prices above equilibrium, there is excess demand
which pushes the price upwards and away from the equilibrium. Similarly, at prices below
equilibrium, there is excess supply which pushes the prices even further down.
Equilibrium Position
The equilibrium position shifts as a result of;
a) Changes in
demand i) Increase in
demand
P
D2 S
D1
p2
p1
S D2
q1 q2qd Q
SS is the supply curve and D1D1 the initial demand curve shifts to the right, to position
D2D2. P1 is the initial equilibrium price and q1 the initial equilibrium quantity. When
demand increases to D2D2, then at price P1, the quantity demanded increases from q1 to
qd. But the quantity supplied at that price is still q1. This leads to excess demand over
supply (qd – q1). This causes prices to rise to a new equilibrium level P2 and the quantity
supplied to rise to a new equilibrium level, q2. A decrease in demand would have an
opposite effect
ii) Decrease in demand
42

P
D1 S
D2
p1
p2
S
D1
D2
qd q2 q1 Q
At the initial equilibrium price P1, quantity demanded falls from q1 to qd. But the quantity
supplied is still q1 at this price. Hence, this creates excess of supply over demand, and this
causes price to fall to a new equilibrium level P2 and quantity to fall to a new equilibrium
level q2.
b) Changes in
supply i) Increase
in Supply
P
S1 S2
p1
p2
S1
S2 D
q1 q q2
DD is the demand curve and S1S1 the initial supply curve. If supply increases, the supply
curve shifts to the right to position S2S2. At the initial equilibrium price P1, quantity
supplied increase from q1 to q2. This creates a glut in the market and this causes the price
to the new P2 and the quantity increases to a new equilibrium level q2.
ii) Fall in Supply
43

P
S
S1 2
D
p2
p1
S2 D
q2 q1 q2
When the supply falls, the supply curve shifts to the left to position S1S1. At the initial
equilibrium price P1, quantity supplied falls from q1 to q 21 but the quantity demanded is
still q1. This creates excess of demand over supply which causes price to rise to a new
equilibrium level P21 and quantity to fall to a new equilibrium level q21 and quantity to fall
to a new equilibrium level q2.
4.3 Role of Government in Price Determination

The government may intervene in the market and mandate a maximum price (price ceiling)
or minimum price (price floor) for a good or service. For example, some governments
legislate the maximum price that a landlord can charge a tenant for rent. Such rent-control
policies, though well-intentioned, result in disequilibrium in the housing market since, at
the government-mandated price ling, the quantity of housing supplied falls short of the
quantity of housing demanded. An example of minimum prices (price floors) in the United
States is the minimum wage, which specifies the lowest hourly wage an employer can pay
an employee. Price floors result in market disequilibrium in that quantity supplied at the
mandated price exceeds quantity demanded. For example, suppose the market equilibrium
price is Pe in figure below. If the government mandates a price floor at which is above
equilibrium price Pe, quantity supplied will be Q3, which is greater than the Q1 demanded at
the price. A mandated price ceiling of Pc, on the other hand, causes quantity demanded Q4
to exceed the Q2 quantity supplied.
The government can alter an equilibrium price by changing market demand and/or market
supply. The government can restrict demand by rationing a good, i.e., by shifting the
demand schedule down and to left. When a good is rationed, an individual not only must
be willing and financially

4
4

able to buy a commodity but also must possess a government-issued coupon which
permits purchase.
Equilibrium price can be altered by shifting the market supply curve. A tax on a good raises
its supply price-shifts the market supply curve up and to the left- and causes the
equilibrium price to increase and the equilibrium quantity to fall. A subsidy to the producer
lowers the commodity's supply price, shifts market supply down and to the right, and
results in a lower equilibrium price and larger equilibrium quantity.
For example In the figure below, a market supply S and demand D for gasoline is presented.
Equilibrium price is initially P0 while equilibrium quantity is Q0. Suppose the government
seeks to reduce gasoline consumption, i.e., decrease the quantity demanded. A tax of 50
cents on each gallon sold would decrease market supply, shift market supply curve to the
left to S', and raise the equilibrium price to P1; equilibrium quantity falls from Q0 to Q1
gallons.

1. Distinguish between supply, demand and equilibrium price.
2. The table below shows the demand and supply schedules for a product:
PRICE (KShs. per kg) DEMAND (kg) SUPPLY (kg)

10 100 20
20 85 36
30 70 53
40 55 70
50 40 87
60 25 103
70 10 120
Draw the demand and supply curves and draw the equilibrium price and quantity.
3. Given the market model
and
P Q
= Qs, Qd = 48 – 4Qs= -6 + 14P, Find P
TOPIC 5
45

5.0 PRODUCTION
5.1 Meaning of Production
Production theory is the study of production, or the economic process of converting inputs
into outputs. Production uses resources to create a good or service that are suitable for
use. This can include manufacturing, storing, shipping, and packaging. Some economists
define production broadly as all economic activity other than consumption. They see every
commercial activity other than the final purchase as some form of production.
Production is a process, and as such it occurs through time and space. Because it is a flow
concept, production is measured as a ―rate of output per period of time‖. There are three
aspects to production processes: the quantity of the good or service; produced the form of
the good or service created; and the temporal and spatial distribution of the good or
service produced.
A production process can be defined as any activity that increases the similarity between
the pattern of demand for goods and services, and the quantity, form, shape, size, length
and distribution of these goods and services available to the market place.
Purpose of Production
There are not enough resources (land, labor, and capital) to produce enough goods and
services (consumer goods and services, capital goods, and government goods and
services,) to achieve everyone's goals. Scarcity implies that "overproduction" is not a
plausible explanation for recession, and that overproduction of some goods should always
be understood as implying the under production of other, more valuable goods. While there
may be a "general glut" of goods, the problem is some kind of coordination failure rather
than too much production of everything. Increasing the productive capacity of the
economy--the supplies of resources like land, labor, and capital and the enhancement of
resource productivity--is a "good" thing, and the key issue is the allocation of resources to
produce the most valuable goods and services.
However, a more fundamental principle of macroeconomics is that the purpose of

production is consumption. This principle is worth emphasizing because some criticisms
of Keynesian economics by free market economists go too far in dismissing the
importance of consumer expenditure for the economy. Production by firms in consumer
goods industries is driven by expectations of consumer expenditures in the near future.
And the production of many intermediate goods--materials and partially finished goods--
while directly driven by expectations of purchases by other firms in the near future, are
indirectly driven by expected future consumer expenditures. Since firms will not produce
what they do not expect sell, expected consumer expenditures are important in
determining both output and employment.
It is not only productive capacity, or "supply" that drives production, employment, and
income, it is also expenditure on that productive capacity, or "demand." Both supply and
demand are important. In a social order, including a market order, people produce goods
and services for other people to consume, and they consume goods and services that
other people produce. However, in a market system, people directly provide resources for
sale to others, who use those resources to produce goods and services, in order to sell
products to others. They sell these resources and products for money, and then use that
money to purchase goods and services.
Adam Smith's metaphor of the invisible hand suggests even if the people in a market

economic order fail to see that the purpose of their production is consumption, prices
should create signals and
46

incentives that coordinate their activities so that their production is directed towards
consumption. For example, someone may think that they work to accumulate wealth, but
some prices will adjust to a level where their efforts to accumulate wealth become
consistent with the purpose of production--the consumption of goods and services.
The reason households want to earn income is consumption, buying consumer goods and
services. So while people directly provide resources to firms is to earn income, and the
reason firms use the resources to produce goods and services is to pay for the resources
and earn profit, people do this mostly to spend the income they earn on consumer goods
and services. The provision of resources and the production of goods and services is
mostly being directed towards consumption. For the most part, the market economic
system creates a flow of employment of resources, production of goods and services, and
expenditures on those goods and services consistent with the basic principle that the
purpose of production is consumption. Saving and investment are consistent with the
principle that the purpose of production is consumption to the degree that households
save in order to fund future consumption and firms invest in order to produce consumer
goods in the future.
Governments fund their purchases of resources (like labor) and government goods and
services by taxation. Those earning incomes pay taxes to the government. This reduces
their disposable income (after tax income) and so their ability to purchase consumer
goods and services. The government hires workers and purchases various goods and
services. Sadly, this reduces the capacity of the private sector to produce goods and
services, which matches the reduction in the ability of households to buy consumer goods
and services.
5.2 Factors of Production

The sum totals of the economic resources which we have in order to provide for our
economic wants are termed as factors of production. Traditionally economists have
classified these under four headings. They are:
a)Land
b)Labour
c)Capital
d)Enterprise
The first two are termed primary factors since they are not the result of the economic
process; they are, so to speak, what we have to start with. The secondary factors, however
are a consequences of an economic system. The various incomes which the factors
receive can be termed factor rewards or factor returns. Labour receives wages and
salaries, land earns rent, capital earns interest and enterprise earns profit.
a)Land
The term land is used in the widest sense to include all the free gifts of nature; farmlands,
minerals wealth such as coal mines, fishing grounds, forests, rivers and lakes. In practise it
may be very difficult to separate land from other factors of production such as capital but,
theoretically, it has two unique features which distinguish it. Firstly, it is fixed in supply. As
land includes the sea in definition, then we are thus talking about the whole planet, and it is
obvious that we cannot acquire more land in this sense. Secondly, land has no cost of
production. The individual who is trying to rent a piece of land may have to pay a great deal
of money but it never cost society as a whole anything to produce land.

4
7

b)Capital
Capital as a factor of production can be defined either as the stock of wealth existing at
any one time and as such, capital consists of all the real physical assets of society. An
alternative formulation of capital is that it refers to all those goods, which are used in the
production of further wealth.
Capital can be divided into fixed capital, which is such things as building, roads, machinery
etc and working capital or circulating capital which consists of stocks of raw materials and
semi-manufactured goods. The distinction is that fixed capital continues through many
rounds of production while working capital is used up in one round; For example, a
classroom would be fixed capital, while stocks of chalk to be used for writing would be
circulating/working capital.
As stated previously, capital is a secondary factor of production, which means that results
from the economics system. Capital has been created by individuals forgoing current
consumption, i.e. people have refrained from consuming all their wealth immediately and
have saved resources which can then be used in the production of further wealth.
c) Labour
Labour is the exercise of human, physical and mental effort directed to the production of
goods and services. Included in this definition is all the labour which people undertake for
reward, either in form of wages and salaries or incomes from self employment. We would
not, therefore include housework or the efforts of do-it-yourself enthusiasts, even though
these may be hard work.
Labour is no doubt the most important of all factor or production, for the efficiency of any
production will to a large extent depend on the efficiency and supply of the labour working
in the process. Besides labour is also the end for which all production is undertaken.
Supply of labour refers to the number of workers (or, more generally, the number of labour
hours) available to an econo my. The supply of labour is determined by:
i. Population Size: In any given economy, the population size determines the upper limit
of labour supply. Clearly there cannot be more labour than there is population.
ii. Age Structure : The population is divided into three age groups. These are:
 The young age group usually below the age of 18, which is considered to be the
minimum age of adulthood. People below this age are not in the labour supply,
i.e. they are not supposed to be working or looking for work.
 The working age group, usually between 18 and 60, although the upper age limit
for this group varies from country to country. In Kenya for example, for public
servants, it is 55 years. It is the size of this group which determines the labour
supply.
 The old age group, i.e. above 60 years is not in the labour force.
iii. The Working Population: Not everybody in the working age group will be in the labour
force. What is called the working population refers to the people who are in the
working group, and are either working or are actively looking for work, I.e. would take
up work if work was offered to them. These are sometimes called the actively active
people. Hence this group excludes the sick, the aged, the disabled and (full time)
housewives, as well as students. These are people who are working and are not
willing or are not in a position to take up work was given to them.
iv. Education System: If the children are kept in school longer, then this will affect the
size of the labour force of the country.

4
8

v. Length of the Working Week: This determines labour supply in terms of Man-hours.
Hence the fewer the holidays there are, the higher will be the labour supply. This does
not, however mean that if the number of working hours in the week are reduced,
productivity if there is a high degree of automation.
vi. Remuneration: The preceding five factors affect the supply of labour in totality.
Remuneration affects the supply of labour to a particular industry. Thus, an industry
which offers higher wages than other industries will attract labour from those other
industries.
vii) The Extent to Barriers to Entry into a Particular Occupation: If there are strong
barriers to the occupation mobility of labour into a particular occupation, e.g. special
talents required or long periods of training, the supply of labour to that occupation will
be limited.
viii) Efficiency of Labour: Efficiency of labour refers to the ability to achieve a greater
output in a shorter time without any falling off in the quality of the work that is,
increase productivity per man employed. The efficiency of a country‘s labour force
depends on a number of influences
 Climate: This can be an important influence on willingness to work, for
extremes of temperatures or high, humidity are not conducive to concentration
even on congenial tasks.
 Education and training: Education and training produce skills and therefore
efficient labour. Education has three aspects: general education, technical
education and training within industry. A high standard of general education is
essential for developing intelligence and providing a foundation upon which
more specialized vocational training can be based. Technical training provided
in the universities, colleges and by industry itself. Training within industry is
given by each firm to its employees.
 Working Conditions: Research has shown that if working conditions are safe
and hygienic, the efficiency of labour will be higher than if the conditions were
unsafe or unhygienic.
 Health of the worker: The efficiency of the worker is closely related to his state
of health which depends on his being adequately fed, clothed, and housed.
 Peace of Mind: Anxiety is detrimental to efficiency. People (workers) may be
tempted to overwork themselves to save at the expense of health to provide for
contingencies like times of sickness, unemployment and old age. Others may
be worried about their work or their private problems.
 Efficiency of the Factors: The productivity of labour will be increased if the
quality of the factors is high. The more fertile the land, the greater will be the
output per mass, other things being equal. Similarly, the greater the amount and
the better the quality of the capital employed, the greater will be the productivity
of the labour. Efficiency of the organization is even more important since this
determines whether the best use is being made of factors of production.
 Motivating factors: These are factors which boost the morale of the workers
and hence increase the efficiency. They include such things as free or
subsidized housing, free medical benefits, paid sick leave, allowing workers to
buy shares in the company and incorporating workers‘ representatives in the
decision-making of the firm, In this way the workers feel that they are part and
parcel of the organization and are not being use
 The Extent of Specialization and Division of Labour: The greater the amount of
specialization, the greater will be the output per man; Division of labour
increases the efficiency of labour.

4
9

d)The Entrepreneur:
Land, capital and labour are of no economic importance unless they are organised for
production. The entrepreneur is responsible not only for deciding what method of
production shall be adopted but for organising the work of others. He has to make many
other important decisions such as what to produce and how much to produce. The major
functions of an entrepreneur are; first Uncertainty bearing since ost production is
undertaken in anticipation of demand. Firms will produce those things which they believe
will yield profit. They do not know that they will do so because the future is unknown and
second, Management Control which involves responsibility for broad decisions of policy
and the ability to ensure that these decisions are carried out.
Factor Mobility
Factor mobility means the ease with which a factor can be moved from one form or area
of employment to another. There are two aspects to mobility. Movement from one
employment to another is called occupational mobility and movement from one place of
employment to another is called geographical mobility.
i)Mobility of Land
Land is geographically immobile in that a given piece of land cannot be moved from one
place to another. However, land can be occupationally mobile in that it can be put to
different uses, e.g. farming, grazing and building. Some forms of land have limited
occupational mobility in that they can be put to a limited number of uses e.g. arid or desert
areas and mountainous land. The former may be used as grazing land by nomadic people,
unless it is found to have mineral deposits, while the latter may be used as a tourist
attraction or for pleasure in mountain climbing. Immobility geographically implies that it
cannot be used to increase production of a particular product unless this is done at the
expense of other products.
ii)Mobility Capital
Some forms of capital are immobile in both geographical and occupational sense e.g.
heavy machinery and railway networks. Usually once such equipment has been installed on
land in a particular place, it becomes uneconomical to uproot it and move it to another
place. Hence, because of the heavy costs that such an operation would involve, it is for all
practical purposes geographically immobile. Also such equipment can usually be put to
only the use for which it was intended and it is occupationally immobile.
Other forms of capital are geographically immobile but are occupationally mobile e.g.
buildings. Once a building has been set up in a place, it cannot be moved intact to another
place, but it can be converted to a hotel or bar. Other forms of capital are mobile both
geographically and occupationally e.g. vehicles and hand tools which can be moved from
place to place and can also be put to different uses. Mobility geographically facilitates
production. Immobility occupationally makes it difficult to increase output in the short run.
iii) Mobility of Entrepreneur
The most mobile of the factors of production is probably the entrepreneur. This is because
the basic functions of the entrepreneur are common to all industries. Whatever the type of
economic activity, there will be a need to raise capital, to organise the factors of
production and to take the fundamental decisions on where, what and how to produce.
iv) Mobility of Labour

Mobility of labour means the capacity and ability of labour to move from one place to
another or from one occupation to another or from one job to another or from one industry
to another.

5
0

Labour is relatively mobile geographically, but less so occupationally in that people can be
moved from one place to another but find it hard to change occupations if it is highly
specialized
Types of Mobility of Labour
Mobility of labour is of the following
types: a. Geographical Mobility:
When a worker moves from one place to another within a country or from one country to
another, it is called geographical mobility of labour. For example, the movement of
labour from Kisumu to Nairobi or from Kenya to England is geographical mobility.
b. Occupational Mobility:
Occupational mobility refers to the movement of workers from one occupation to
another. This mobility is further divided into the following two types:
(i) Horizontal Mobility: The movement of labour from one occupation to another in the
same grade or level is called horizontal mobility. For example, a bank clerk joins as an
accounts clerk in a company.
(ii) Vertical Mobility: When a worker of a lower grade and status in an occupation moves
to another occupation in a higher grade and status, it is vertical mobility. Just as a
school lecturer
becomes a college lecturer, a clerk becomes a
manager, etc. c. Mobility between Industries:
The movement of labour from one industry to another in the same occupation is
industrial mobility. For example, a fitter leaving a steel mill and joining an automobile
factory.
Factors Determining Mobility of Labour:

The mobility of labour depends upon the following factors:
 Education and Training: The mobility of labour depends on the extent to which
labour is educated and trained. The more a person is educated and skilled, the
greater are his chances of moving from one occupation or place to another.
Geographical and vertical mobility depend on education and training.
 Outlook or Urge:The outlook or urge of workers to rise in life determines their
mobility. If they are optimist and broad minded, they will move to other jobs and
places. Differences in language, habits, religion, caste, etc. will not be hindrances in
their mobility.
 Social Set-up: The mobility of labour also depends upon the social set-up. A society
dominated by caste system and joint family system lacks in mobility of labour. But
where the joint family and caste system do not exist or have disintegrated the
mobility of labour increases.
 Means of Transport: Well developed means of transport and communications
encourage mobility labour. The worker knows that in case of emergency at home,
he can easily communicate with his father phone or travel back by train within the
country or by aeroplane if he is abroad.
 Agricultural Developments: With agricultural development, labour moves from high
population to low population areas during busy seasons.
 Industrialisation: The mobility of labour is determined by industrial development.
Workers move from different occupations and places to work in factories.
Industrialisation also leads to urbanisation and workers move from rural and semi-
urban areas to industrial centres and big cities.
 Advertisement: Advertisements relating to jobs in newspapers also determine the
mobility of labour. Accordingly, workers move between places and occupations.

5
1

 State Help: When the state starts industrial centres, and estates, employment
exchanges, dams, public works, etc., they encourage mobility of labour.
 Peace and Security: The mobility of labour depends to a large extent on law and
order in the country. If the life and property of the people are not safe, they will not
move from their present places and occupations to others.
Obstacles in Mobility of Labour:

There are many factors which hinder mobility of labour. They are differences in climate,
religion, caste, habits, language, customs, tastes, etc. The other factors are illiteracy,
ignorance, indebtedness, attachment to property and place, poverty, economic
backwardness, lack of means of transport and communications and employment
opportunities, etc.
Levels of Production
A nation‘s economy can be divided into three sectors (levels) to define the proportion of
the population engaged in the production sector. This categorization is seen as a
continuum of distance from the natural environment. The continuum starts with the
primary sector, which concerns itself with the utilization of raw materials from the earth
such as agriculture and mining. From there, the distance from the raw materials of the
earth increases. The three levels are;
a)Primary level
This is the basic level where production starts. It‘s sometimes known as extraction level
and involves production of raw materials. At this level, products are extracted or harvested
products from the earth. The primary sector includes the production of raw material and
basic foods. Activities associated with the primary sector include agriculture (both
subsistence and commercial), mining, forestry, farming, grazing, hunting and gathering,
fishing, and quarrying. The packaging and processing of the raw material associated with
this sector is also considered to be part of this sector.
b) Secondary level
The secondary sector of the economy manufactures finished goods. It involves the
transformation of raw or intermediate materials into goods e.g. manufacturing steel into
cars, or textiles into clothing. All of manufacturing, processing, and construction lies within
the secondary sector. Activities associated with the secondary sector include metal
working and smelting, automobile production, textile production, chemical and engineering
industries, aerospace manufacturing, energy utilities, engineering, breweries and bottlers,
construction, and shipbuilding.
c) Tertiary level
The tertiary sector of the economy is the service industry. This sector provides services to
the general population and to businesses. Activities associated with this sector include
retail and wholesale sales, transportation and distribution, entertainment (movies,
television, radio, music, theater, etc.), restaurants, clerical services, media, tourism,
insurance, banking, healthcare, and law. The services at this level can be divided into;
Commercial services which concerned with the movement, storage and distribution of
goods and wholesaling, retailing, banking, insurance etc and Direct personal service which
includes services offered directly to consumers e.g. medicine, teaching, legal practice,
pastoral duties etc
Types of production
Broadly, there are two types of production; Direct and
indirect a) Direct production

52

This is the lowest level of production and is also referred to as subsistence production .
Subsistence productions refers to output from the production process that is just enough
for the survival. This amount of production is therefore not adequate to meet all needs and
wants of a family, community or a country, hence the products are not marketed i.e. there
is no exchange of goods and services.. For example, subsistence farming involves the
production of crops to feed the family and for survival.
The disadvantages of direct production include; Lack of volume production, Hindering

innovation and development, Encouraging individualism since it is self-centered, lack of
specialization because ability is spread over many years and production of low quality of
goods and services because of lack of control and specialization
b) Indirect production
Indirect production refers to production that is more than survival level. It involves
production of Goods and services with the aim of exchanging them for other goods or
services or for money. It provides output that is enough to satisfy domestic needs and
wants. This production is adequate to supply local demand and the excess if available can
be exported. Large industries can produce large quantities of output to satisfy local
consumption and earn foreign exchange from export, for example, the sugar and banana
industries. This production is geared towards satisfying the wants of an individual and
those of others and it is characterized by; production with a view of exchange, results to
supply of goods and services and the producer specializes in one or a few areas of
production. The advantages of this type of production include allowing one to get goods
and services he cannot produce and enabling specialization which leads to greater
production and saves a lot of time.
5.3 Concept of Return to Scale in Production

In the short run, a firm's growth potential is usually characterized by the firm's marginal
product of labor, i.e. the additional output that a firm can generate when one more unit of
labor is added. This is done in part because economists generally assume that, in the short
run, the amount of capital in a firm (i.e. the size of a factory and so on) is fixed, in which
case labor is the only input to production that can be increased. In the long run, however,
firms have the flexibility to choose both the amount of capital and the amount of labor that
they want to employ- in other words; the firm can choose a particular scale of production.
Therefore, it's important to understand whether a firm gains or losses efficiency in its
production processes as it grows in scale.
Returns to scale are determined by analyzing the firm's long-run production function, which
gives output quantity as a function of the amount of capital (K) and the amount of labor (L)
that the firm uses. In the long run, companies and production processes can exhibit
various forms of returns to scale- increasing returns to scale, decreasing returns to scale,
or constant returns to scale as discussed below.
Decreasing Returns to Scale

Decreasing returns to scale occur when a firm's output less than scales in comparison to
its inputs. i.e. Decreasing returns to scale is closely associated with diseconomies of scale
(the upward part of the long-run average total curve).For example, a firm exhibits
decreasing returns to scale if its output is less than double when all of its inputs are
doubled. Decreasing returns to scale happen

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3

when the firm's output rises proportionately less than its inputs rise. For example, in year
one, a firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year
two it employs 400 workers, uses 100 machines (inputs doubled), and produces 1,500
products (output less than doubled). Common examples of decreasing returns to scale are
found in many agricultural and natural resource extraction industries. In these industries,
it's often the case that increasing output gets more and more difficult as the operation
grows in scale since an organization may become too big, thus creating too many layers of
management, too many departments, and too much red tape leading to a lack of
communications, inefficiency, delays in decision-making, and inefficient production.
Constant Returns to Scale

Constant returns to scale occur when a firm's output exactly scales in comparison to its
inputs. For example, a firm exhibits constant returns to scale if its output exactly doubles
when all of its inputs are doubled. Equivalently, one could say that increasing returns to
scale occur when it requires exactly double the quantity of inputs in order to produce twice
as much output. Firms that exhibit constant returns to scale often do so because, in order
to expand, the firm essentially just replicates existing processes rather than reorganizing
the use of capital and labor. In this way, you can envision constant returns to scale as a
company expanding by building a second factory that looks and functions exactly like the
existing one.
Increasing Returns to Scale

Increasing returns to scale is closely associated with economies of scale (the downward
sloping part of the long-run average total cost curve in the previous section). Increasing
returns to scale occur when a firm increases its inputs, and a more-than-proportionate
increase in production results. For example, in year one a firm employs 200 workers, uses
50 machines, and produces 1,000 products. In year two it employs 400 workers, uses 100
machines (inputs doubled), and produces 2,500 products (output more than doubled) and
input prices remain constant, increasing returns to scale results in decreasing long-run
average costs (economies of scale). A firm that gets bigger experiences lower costs
because of increased specialization, more efficient use of large pieces of machinery (for
example, use of assembly lines), volume discounts, and other advantages of producing in
large quantities.
Law of Diminishing Returns (Law of Variable Proportions)

The law of diminishing returns states that adding more of one factor of production will at
some point yield lower per-unit returns. The law of diminishing returns occurs because
factors of production such as labour and capital inputs are not perfect substitutes for each
other. This means that resources used in producing one type of product are not
necessarily as efficient (or productive) when switched to the production of another good or
service. For example, workers employed in producing glass for use in the construction
industry may not be as efficient if they have to be re-employed in producing cement or
kitchen units. Likewise many items of capital equipment are specific to one type of
production. They would be much less efficient in generating output if they were to be
switched to other uses. This can be explained using the example below;
In the example of productivity given below, the labour input is assumed to be the only
variable factor by a firm. Other factor inputs such as capital are assumed to be fixed in
supply. The ―returns‖ to adding more labour to the production process are measured in
two ways:

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4

Marginal product (MP) = Change in total output from adding one extra unit of
labour Average product (AP) = Total Output divided by the total units of labour
employed
In the example below, a business hires extra units of labour to produce a higher quantity
of wheat. The table below tracks the output that results from each level of employment.
Total Physical
Units of Labour Product Marginal Physical Average Physical
Product(APP) (tonnes
(TPP) (tonnes of Product (MPP) of
Employed
wheat) (tonnes of wheat) wheat)
0 0
1 3 3 3
2 10 7 5
3 24 14 8
4 36 12 9
5 40 4 8
6 42 2 7
7 42 0 6
8 40 -2 5
This illustrates one of the most important and fundamental principles involved in
economics called the law of diminishing returns or variable proportions. The law of
diminishing returns comes about because of several reasons:
i) The ability of labour to substitute for the fixed quantity of land i.e ability of factors of
production to substitute each other.
ii)The marginal physical output of labour increases for a time, as the benefits of
specialization and division of labour make for greater efficiency.
iii) Later all the advantages of specialization are exhausted.
iv)The law of diminishing returns comes about because each successive unit of the
variable factor has less of the fixed factor to work with. In fact, they therefore start
getting in the way of others with the fixed factor with consequent decline in output.
From the figure (next page) we can see the law leads to three stages of production as
indicated in the following graphs, namely, stage of:
Stage I: Increasing returns
Stage II: Diminishing
returns Stage III: Negative
returns
Characteristics of the Three Stages

Stage I
Here the Total Physical Product, Average Physical Product and Marginal Physical Product
are all increasing. However MPP later starts decreasing. The stage is called stage of
increasing returns because either the APP or MPP is increasing. Short-run production
Stage I arises due to increasing average product. As more of the variable input is added to
the fixed input, the marginal product of the variable input increases. Most importantly,

marginal product is greater than average product,
55

which causes average product to increase. This is directly illustrated by the slope of the
average product curve.
The observations about the shapes and slopes of the three product curves in Stage I show
that:
 The total product curve has a positive slope.
 Marginal product is greater than average product. Marginal product initially
increases, the decreases until it is equal to average product at the end of Stage I.
 Average product is positive and the average product curve has a positive slope.
Stage II
Is a stage of diminishing returns and we have: Diminishing Average Physical Product,
Diminishing MPP and Increasing Total Physical Product. APP and MPP are declining but
since the MPP is still positive, the TPP keeps on rising. The stage where MPP reaches zero,
TPP reaches maximum.
The three product curves reveal the following patterns in Stage II.
 The total product curve has a decreasing positive slope. In other words, the slope
becomes flatter with each additional unit of variable input.
 Marginal product is positive and the marginal product curve has a negative slope.
The marginal product curve intersects the horizontal quantity axis at the end of
Stage II.
 Average product is positive and the average product curve has a negative slope.
The average product curve is at its a peak at the onset of Stage II. At this peak,
average product is equal to marginal product.

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Stage III
Marks a change in the direction of TPP curve. The APP continues to diminish the MPP
continues to diminish too, but it is negative and is what distinguishes stage III from II and I.
This is the stage of negative returns. The onset of Stage III results due to negative
marginal returns. In this stage of short-run production, the law of diminishing marginal
returns causes marginal product to decrease so much that it becomes negative.
Stage III production is most obvious for the marginal product curve, but is also indicated
by the total product curve.
 The total product curve has a negative slope. It has passed its peak and is heading
down.
 Marginal product is negative and the marginal product curve has a negative slope.
The marginal product curve has intersected the horizontal axis and is moving down.
 Average product remains positive but the average product curve has a negative
slope.
Relevance of the Law of Diminishing Returns

The law of diminishing returns is important in that it is seen to operate in practical
situations where its conditions are fulfilled. Thus, in a number of developing countries with
peasant agricultural economies populations are increasing rapidly on relatively fixed land,
and with unchanging traditional methods of production. Consequently, productivity in
terms of output per head is declining, and in some cases total productivity is falling.
Also the law of diminishing returns is important in the short run. The aim of the firm is to
maximize profits. This happens when the firm is in a state of least-cost-factor-combination.
This is achieved when the firm maximises the productivity of its most expensive factor of
production. Productivity is measured in terms of output per unit of the factor. Thus, if the
variable factor is the most expensive factor, the firm should employ the variable factor
until APP is at the maximum. If the fixed factor is most expensive the firm should employ
the variable factor up to the level when TPP is at maximum.
Where Does the Firm Operate?

The firm will avoid stages I and III and will instead choose stage II. It will avoid stage I
because this shall involve using the fixed factor inefficiently because its MPP is increasing
since the variable input is spread to scarcely (thinly) over the fixed input. Expansion of the
variable input will permit specialization, hence increased output because of effective use
of the variable input.
The firm shall avoid stage III because MPP for the variable input is negative.
Stage II is chosen because the marginal returns for both resources are diminishing. Here
the MPP and APP are declining but the MPP of both resources is positive. With one factor
fixed, and additional unit of the variable input increases total product. Therefore the firm
which attempts to be economically efficient operates in stage II.
5.4 Economies of Scale

Economies of scale in production mean that production at a larger scale (more output) can
be achieved at a lower cost (i.e. with economies or savings). The cost advantage that

arises with
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increased output of a product. Economies of scale arise because of the inverse
relationship between the quantity produced and per-unit fixed costs; i.e. the greater the
quantity of a good produced, the lower the per-unit fixed cost because these costs are
shared over a larger number of goods. Economies of scale may also reduce variable costs
per unit because of operational efficiencies and synergies. Economies of scale are the
cost advantages that a business can exploit by expanding their scale of production. The
effect of economies of scale is to reduce the average (unit) costs of production.
Economies of scale are most likely to be found in industries with large fixed costs in
production and hence economies of scale are prevalent in highly capital intensive
industries such as chemicals, petroleum, steel, automobiles etc.
The table below illustrates the concept of economics of scale i.e. that as output increases,
average cost per unit decreases.
Long Run Output (units

per Total Costs (sh) Long Run
month) Average Cost (sh
per
unit)
1,000 8,500 8.5
2,000 15,000 7.5
5,000 36,000 7.2
10,000 65,000 6.5
20,000 120,000 6.0
50,000 280,000 5.6
100,000 490,000 4.9
500,000 2,300,000 4.6
Economies of scale can be classified into two main types: Internal – arising from within
the company; and External – arising from extraneous factors such as industry size.
i) Internal Economies of Scale

Internal economies of scale are those obtained within the organisation as a result of the
growth irrespective of what is happening outside. They are a key advantage for a business
that is able to grow. Most firms find that, as their production output increases, they can
achieve lower costs per unit. They take the following forms:
a)Technical Economies Of Scale:
Technical economies of scale may occur due to the following;
i. Indivisibilities: These may occur when a large firm is able to take advantage of an
industrial process which cannot be reproduced on a small scale, for example, a blast
furnace which cannot be reproduced on a small scale while retaining its efficiency.
ii. Increased Dimensions: These occur when it is possible to increase the size of the
firm‘s equipment and hence realize a higher volume of output without necessarily
increasing the costs at the same rate. For example, a matatu and a bus each require
one driver and conductor. The output from the bus is much higher than that from the
matatu in any given period of time, and although the bus driver and conductor will
earn more than their matatu counterparts, they will not earn by as many times as the
bus output exceeds the matatu output, i.e. if the bus output is 3 times that of the
matatu counterparts.

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iii. Economies of Linked Processes: Technical economies are also sometimes gained by
linking processes together, e.g. in the iron and steel industry, where iron and steel
production is carried out in the same plant, thus saving both transport and fuel costs.
iv. Specialisation: Specialisation of labour and machinery can lead to the production of
better quality output and higher volume of output.
v. Research: A large firm will be in a better financial position to devote funds to research
and improvement of its product than a small firm.
b) Marketing Economies of Scale
This can be achieved through;
i. The buying advantage: A large-scale organisation may buy its materials in bulk and
therefore get preferential treatment and buy at a discount more easily than a small
firm.
ii. The packaging advantage: It is easier to pack in bulk than in small quantities and
although for a large firm the packaging costs will be higher than for small firms, they
will be spread over a large volume of output and the cost per unit will be lower.
iii. The selling advantage: A large-scale organisation may be able to make fuller use of
sales and distribution facilities than a small-scale one. For example, a company with
a large transport fleet will probably be able to ensure that they transport mainly full
loads, whereas small business may have to hire transport or dispatch part loads.
c) Organisational Economies of Scale
As a firm becomes larger, the day-to-day organisation can be delegated to office staff,
leaving managers free to concentrate on the important tasks. When a firm is large
enough to have a management staff they will be able to specialise in different functions
such as accounting, law and market research.
d) Financial Economies
A large firm will have more assets than a small firm. Hence, it will find it cheaper and
easier to borrow money from financial institutions like commercial banks than a small
firm. i.e. Larger firms are usually rated by the financial markets to be more ‗credit
worthy‘ and have access to credit facilities, with favourable rates of borrowing. In
contrast, smaller firms often face higher rates of interest on overdrafts and loans.
Businesses quoted on the stock market can normally raise fresh money (i.e. extra
financial capital) more cheaply through the issue of shares. They are also likely to pay a
lower rate of interest on new company bonds issued through the capital markets.
e) Risk-bearing Economies
All firms run risks, but risks taken in large numbers become more predictable. In
addition to this, if an organisation is so large as to be a monopoly, this considerably
reduces its commercial risks.
f) Overhead Processes For some products, very large overhead costs or processes must
be undertaken to develop a product, for example an airliner. Cleary these costs can only be
justified if large numbers of units are subsequently produced.
g) Diversification
As the firm becomes very large it may be able to safeguard its position by diversifying its
products, process, markets and the location of the production.
ii) External Economies

These are advantages enjoyed by a large size firm when a number of organisations group
together in an area irrespective of what is happening within the firm. They include
a) Economies of concentration
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When a number of firms in the same industry band area they can derive a
together in great
deal of mutual advantages from one another. Advantages
might include a pool of skilled
workers, a better infrastructure (such as transport, specialised warehousing,
banking, etc.) and the stimulation of improvements. The lack of such external
economies is serious handicap to less developed countries.
b) Economies of information
Under this heading we could consider the setting up of specialist research facilities
and the publication of specialist journals.
c) Economies of disintegration
This refers to the splitting off or subcontracting of specialist processes. A simple
example is to be seen in the high street of most towns where there are specialist
research photocopying firms.
Diseconomies of scale
Diseconomies of scale occur when the size of a business becomes so large that, rather
than decreasing; the unit cost of production actually becomes greater. Diseconomies of
scale flow from administrative rather than technical problems.
a) Bureaucracy: As an organisation becomes larger there is a tendency for it to become
more bureaucratic. Decisions can no longer be made quickly at the local levels of
management. This may lead to loss of flexibility.
b) Loss of control: Large organizations often find it more difficult to monitor effectively
the performance of their workers. Industrial relations can also deteriorate with a large
workforce and a management, which seem remote and anonymous.
Optimal Size of a Firm

This is the most efficient size of the firm, at which its costs of production per unit of
output will be at a minimum, so that it has no motive either to expand or reduce its scale of
production. Thus, as a firm expands towards the optimum size it will enjoy economies of
scale, but if it goes beyond the optimum diseconomies will set in.
In the short-run, a firm would build the scale of plant and operate it at a point where the
average cost is at its minimum. This is regarded as the optimum level of production for the
firm concerned, if the demand for the product increases from this least cost output; it
cannot change the amount of land, buildings, machinery and other input in short period of
time. It has to move along the same scale or type of plant. The average total cost,
therefore, begins to rise due to the diseconomies of the scale.
In the long run, all inputs are variable. The firm can build larger plant sizes or revert to
smaller plants to deal with the changed demand for the product. If the size of plant
increases to cope with the increased demand, the average cost per unit begins to fall due
to the economies of scale such as increased specialization of labor, better and greater
specialization of management, efficient utilization of productive equipment, etc., etc. So
long as the resources are successfully utilized, the average cost of production continues
declining.
Eventually a stage comes when the firm is not able to use the least cost combination of
inputs. The building of a still larger plant cause the average cost of production to go up.
The point at which the

60

per unit cost is the lowest is the optimum level of production for the firm is the firms the
most efficient size.

1. (a) What are factors of production?
(b) Explain the meaning of mobility of factors of production. To what extent are
factors of Production mobile
(c) State the aspects of significance of factor mobility
2. (a) What are the main factors of production?
(b) What determines the supply and demand of the factors of production that you
have
identified in (a) above?
3.(a) (i) State the law of variable proportions
(ai)What key assumptions underlie this law?
(b) Discuss fully the three main stages associated with the law
TOPIC 6
6.0 THEORY OF THE FIRM
6.1 Concept of the Firm
The theory of the firm is a microeconomic concept founded in neoclassical economics
that states that firms (corporations) exist and make decisions in order to maximize profits.
Businesses interact with the market to determine pricing and demand and then allocate
resources according to models that look to maximize net profits. The theory of the firm
goes along with the theory of the consumer, which states that consumers seek to
maximize their overall utility
The theory of the firm is always being re-analyzed and adapted to suit changing economies
and markets. Early economic analysis focused on broad industries, but as the nineteenth
century progressed, more economists began to look at the firm level to answer basic
questions about why companies produce what they do, and what motivates their choices
when allocating capital and labor. Modern takes on the theory of the firm take such facts
as low equity ownership by many decision-makers into account; some feel that CEOs of
publicly held companies are interested not only in profit maximization, but also in goals
based on sales maximization, public relations and market share.
Distinction between Firm and Industry

A firm is an organization that combines scarce resources for the production and supply of
goods and services. The firm is used by entrepreneurs to bring together otherwise idle
resources. The term firm is often used synonymously with the business, enterprise, or
company. If there is a difference, a firm is functionally defined and need not be a typical for
-profit business. A firm can be profit oriented, nonprofit, privately owned, or government
controlled. The key role played by a firm is the production of output using scarce
resources. Firms are the means through which society transforms less satisfying
resources into more satisfying goods and services.
A firm is more or less similar to the concept of a business establishment. The term is
mostly used in relation to companies providing judicial services to clients who are known
as law firms, but applies to all businesses. A firm can be a sole proprietorship or a

partnership, but the basic premise is that it
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1

is run for making profits. A firm operates inside an industry such as a firm that makes and
supplies steel to other companies requiring steel while all these companies exist under the
steel industry.
In economics, the economy of a country is divided into an umbrella of industries where an

industry consists of all organized activities for production and processing of products.
However, industry is also described as retail and wholesale depending upon the nature of
transactions with the customers. There are also industries in services sector such as the
banking industry or the insurance industry. An industry covers all economic activities that
are organized and carried on by all individuals, units, firms, businesses, and organizations
existing and working inside it.
The differences between Firm and Industry are therefore;

• Industry refers to a kind of business inside an economy while a firm is a business
establishment inside an industry.
• There can be many firms inside an industry.
• Industry is not an entity while a firm is a type of company.
• A firm is a type of business whereas an industry is a sub sector of an economy.
• Rules and regulations are made for an industry, and that typically apply to all firms
inside the industry.
Localization of Industries
Localization of industries means the tendency on the part of industries to be concentrated
in regions which are most suited for their development. Some industries are carried on and
developed in certain areas because of their natural or acquired advantages. For example,
sugar industry is localized in sugar growing areas simply on the basis of nearness to
source of raw material.
Factors Affecting Location of Industries

The important factors which influence the localization of industries are:
(i) Nearness to raw material
One of the very important factor which affects the birth of an industry in certain areas is
the nearness to sources of raw material. The availability of raw material near the
location of the industry helps considerably in reducing the transport cost and so the
total cost of production of the commodity. It is due to this reason that most of the
industries are established in regions where the raw material is available in abundance.
(ii) Availability of source of power
Availability of cheap power resources is another important factor which influences the
concentration of industries in particular areas. If for instance, electricity is to be carried
over to a long distance where the industry is located or the coal which serves as raw
material is to be transported at a far-off distance from whereat is extracted, it will not
then he economical to set up the industry at such places which are far away from the
sources of power.
(iii) Physical and climate conditions
Physical and climatic conditions have important considerations on the growth of
industry. If suitable climate and desirable physical conditions exist for a particular
industry, that will he established and developed in that region then.
(iv) Nearness to market
Industries have a tendency to be localized in those areas where the market is near at
hand. The goods produced can be easily brought in the market and there can be much

saving in the cost of transportation.
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(v) Supply of trained labor
Supply of trained labor is another great attraction for the concentration of an industry in
a particular area
(vi) Availability of capital
Industries may spring up in those areas where capital is available at a lower rate.
(vii) Momentum of an early start
Sometimes, it so happens, that an industry gets itself established and developed in a
particularly locality not due to the reasons discussed above but Just by some chance
or other. Later on, that locality acquires reputation in the production of the commodity
and more industries are set up there.
Advantages of Localization:
When an industry is localised in a particular locality, it enjoys a number of advantages which are
enumerated below.
(i) Reputation: The place where an industry is localised gains reputation, and so do the
products manufactured there. As a result, products bearing the name of that place find
wide markets, such as Sheffield cutlery, Swiss watches, Ludhiana hosiery, etc.
(ii) Skilled Labour: Localisation leads to specialisation in particular trades. As a result,
workers skilled in those trades are attracted to that place. The localised industry is
continuously fed by a regular supply of skilled labour that also attracts new firms into the
industry. Besides, there is the local supply of skilled labour which children of the workers
inherit from them. The developments of the watch industry in Switzerland, of the shawl
industry in Kashmir are primarily due to this factor.
(iii) Growth of Facilities: Concentration of an industry in particular locality leads to the
growth of certain facilities there. To cater to the needs of the industry, banks and financial
institutions open their branches, whereby the firms are able to get timely credit facilities.
Railways and transport companies provide special transport facilities which the firms
utilise for bringing inputs and transporting outputs. Similarly, insurance companies provide
insurance facilities and thus cover risks of fire, accidents, etc.
(iv) Subsidiary Industries: Where industries are localised, subsidiary industries grow up to
supply machines, tools, implements and other materials, and to utilise their by-products.
For example, where the sugar industry is localised, plants to manufacture sugar machinery,
tools and implements are set up, and subsidiary industries crop up for the manufacture of
spirit from molasses and for rearing poultry which utilise molasses in feed.
(v) Employment Opportunities: With the localisation of an industry in a particular locality
and the establishment of subsidiary industries, employment opportunities considerably
increase in that locality.
(vi) Common Problems: All firms form an association to solve their common problems.
This association secures various types of facilities from the government and other
agencies for expanding business, establishes research laboratory, publishes technical and
trade journals, and opens training centres for technical personnel. As a result, all firms
benefit.
(vii) Economy Gains: Localisation leads to the lowering of production costs and
improvement in the quality of the products when the firms benefit from the availability of
skilled labour, timely credit, quality materials, research facilities, market intelligence,
transport facilities, etc. Besides, the trade gains through the reputation of the place, the
people gain through larger employment opportunities, the government gains through larger
tax revenue, and thus the economy gains on the whole.

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3

Disadvantages of Localization:
Localization has certain disadvantages too. They are as follows:
(i) Dependence :When an industry is localised in a particular locality, it makes the
economy dependent for its requirements of the products manufactured there. Such
dependence is dangerous in the event of a war, a depression, or a natural calamity
because the supplies of the products will be disrupted and the entire economy will suffer.
(ii) Social Problems: Localisation of industries in a particular locality creates many social
problems, such as congestion, emergence of slums, accidents, strikes, etc. These
adversely affect the efficiency of labour and the productive capacity of the industry.
(iii) Limited Employment: Where an industry is localised, employment opportunities are
limited to a particular type of labour. In the event of a recession in that industry,
specialized labour fails to get alternative employment elsewhere. Again, if such specialized
labour organizes itself into a powerful trade union, it can force the employers to pay higher
wages which may raise the cost of production and adversely affect the industry.
(iv) Diseconomies: With the passage of time, the concentration of industries in a particular
locality, economies of scale may give way to diseconomies. Transport bottlenecks emerge.
There are frequent power break-downs. Financial institutions are unable to meet the credit
requirements of the entire industry due to financial stringency. As already noted above,
labour asks for higher wages and better living conditions. All these tend to raise costs of
production and reduce production.
(v) Regional Imbalances: Concentration of industries in one region or area leads to the lop-
sided development of the economy. When one industry is localised in a region, it attracts
more entrepreneurs who establish other industries there because of the availability of
infrastructure facilities like power, transport, finance, labour, etc. Thus such regions
develop more while the other regions remain backward.
Employment opportunities, the level of income, and the standard of living increase at a
much higher rate in these regions as compared with the other regions of the country. The
people of the backward regions feel envious and jealous of the people of the developed
regions and the government has to start its own industries or encourage private enterprise
to start industries by giving a number of concessions.
Delocalization
To overcome the disadvantages of localization of industries, delocalization which is also
known as decentralization is recommended. Decentralization refers to the policy of
dispersal of industries, whereby an industry is scattered in different regions of the country.
Besides removing the defects of localization of industries, the policy of decentralization is
essential from the strategic and defence points of view. The policy of decentralization of
industries requires the development of sources of power and means of transport in all
areas of the country.
To encourage private enterprise to set up industries in backward areas, the state

government should provide land, power and other infrastructure facilities at concessional
rates. The central government should give tax concessions and various financial
institutions should provide cheap credit facilities. It is in this way that the disadvantages of
localization can be removed and the different regions develop in a balanced way.
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6.2 Various costs in a firm
Like in the theory of production or output, the theory of costs is concerned with the Short
Run and the Long Run. In the short run a firm will have fixed and variable costs of
production. Total cost is made up of fixed costs and variable costs. The long run is a
period of time in which all factor inputs can be changed. The firm can therefore alter the
scale of production.
i) Short-run Costs
The table below gives an example of the short run costs of a firm
Total Fixed Total Variable Total
Output Cost Cost Cost Average Total Cost Marginal Cost
Units TFC (sh) TVC (sh) TC (sh) ATC (sh per unit) MC (sh)
0 100 0 100
20 100 40 140 7.0 2.0
40 100 60 160 4.0 1.0
60 100 74 174 2.9 0.7
80 100 84 184 2.3 0.5
100 100 90 190 1.9 0.3
120 100 104 204 1.7 0.7
140 100 138 238 1.7 1.7
160 100 188 288 1.8 2.5
180 100 260 360 2.0 3.6
200 100 360 460 2.3 5.0
Plotting this gives us Total Cost, Total Variable Cost, and Total Fixed Cost.
a. Fixed Costs (FC):

These are costs which do not vary with the level of production i.e. they are fixed at all
levels of production. They are associated with fixed factors of production in the Short Run.
Fixed costs relate to the fixed factors of production and do not vary directly with the level
of output. (I.e. they are exogenous of the level of production in the short run). Examples of
fixed costs include; buildings, leasing of capital equipment, the annual business rates
charged by local authorities, the costs of full-time contracted salaried staff, interest rates
on loans, the depreciation of fixed capital and insurance. Total fixed costs (TFC) remain
constant as output increases upto a certain level.
b) Variable Costs (VC)

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These are costs, which vary with the level of production. The higher the level of production,
the higher will be the variable costs. They are associated with variable factors of
production in the Short Run. Examples are costs of materials, cost of fuels, labour costs
and selling costs
c. Total Cost (TC)
This is the sum of fixed costs and variable costs i.e. Total Costs (Tc) = Total Fixed Cost
(Tfc) +
Total Variable Costs (Tvc)
Total Fixed costs and Total Variable costs are the respective areas under the Average
Fixed and Average Variable cost curves.
d) Average Fixed Cost (AFC)

This is fixed cost per unit of output, obtained by dividing fixed costs by total output i.e.
AFC = Total Fixed

Costs Total
output
Average fixed costs are found by dividing total fixed costs by output. Average fixed costs
will fall continuously with output because the total fixed costs are being spread over a
higher level of production causing the average cost to fall.
The average fixed cost (AFC) curve will slope down continuously, from left to right.
e. Average Variable Cost (AVC)
This is the average cost per unit of output, obtained by dividing variable costs by total
output i.e.
AVC = Variable Cost

Total Output

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6

The average variable cost (AVC) curve will at first slope down from left to right, then reach
a minimum point, and rise again. AVC is ‗U‘ shaped because of the principle of variable
Proportions, which explains the three phases of the curve:
a) Increasing returns to the variable factors, which cause average costs to fall, followed
by:
b) Constant returns, followed by:
c) Diminishing returns, which cause costs to rise.
f. Average Total Costs (ATC)

This is total cost per unit of output, obtained by dividing total cost by total
output i.e. ATC = Total Cost
Total Output
Average total cost (ATC) can be found by adding average fixed costs (AFC) and average
variable costs (AVC). The ATC curve is also ‗U‘ shaped because it takes its shape from the
AVC curve, with the upturn reflecting the onset of diminishing returns to the variable factor.
Average total cost (ATC) is also called average cost or unit cost. Average total costs are a
key cost in the theory of the firm because they indicate how efficiently scarce resources
are being used
g. Marginal costs
Marginal cost is the cost of producing one extra unit of output. It can be found by
calculating the change in total cost when output is increased by one unit. Thus, if TCn is
the total cost of producing n units of output and TCn -1 is the total cost of producing n-1
units of output, then the marginal cost
of producing the ‗nth‘ of unit of output is calculated as:
Marginal Cost = TCn - TCn-1
It is therefore derived solely from variable costs, and not fixed costs. The marginal cost
curve falls briefly at first, then rises. Marginal costs are derived from variable costs and are
subject to the principle of variable proportions.
The marginal cost curve is significant in the theory of the firm for two reasons: It is the
leading cost curve, because changes in total and average costs are derived from changes
in marginal cost and The lowest price a firm is prepared to supply at is the price that just
covers marginal cost.
Average total cost and marginal cost are connected because they are derived from the
same basic numerical cost data. The general rules governing the relationship are:
a)Marginal cost will always cut average total cost from below.

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b)When marginal cost is below average total cost, average total cost will be falling, and
when marginal cost is above average total cost, average total cost will be rising.
c)A firm is most productively efficient at the lowest average total cost, which is also
where average total cost (ATC) = marginal cost (MC).
Since Marginal costs are derived exclusively from variable costs, and are unaffected by
changes in fixed costs. The MC curve is the gradient of the TC curve, and the positive
gradient of the total cost curve only exists because of a positive variable cost. This is
shown below:
h) Sunk costs
Sunk costs are those that cannot be recovered if a firm goes out of business. Examples of
sunk costs include spending on advertising and marketing, specialist machines that have
no scrap value, and stocks which cannot be sold off.
ii) Long run Cost

In the Long Run, all factors of production are variable. The firm is thus constrained by
economies or diseconomies to scale. The long run is a period of time in which all factor
inputs can be changed. The firm can therefore alter the scale of production. If as a result
of such an expansion, the firm experiences a fall in long run average total cost, it is
experiencing economies of scale. Conversely, if average total cost rises as the firm
expands, diseconomies of scale are happening.
6.3 Concept of Revenue

The revenue of a firm together with its costs determines profits. The term ‗revenue‘ refers
to the receipts/ amounts received obtained by a firm from the sale of certain quantities of
a commodity at various prices.. For example, if a firm gets sh. 16,000 from sale of 100
chairs, then the amount of sh. 16,000 is known as revenue. Revenue is an important
concept in economic analysis and directly influenced by sales level, i.e., as sales increases,
revenue also increases. The concept of revenue consists of three important terms; Total
Revenue, Average Revenue and Marginal Revenue.

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8

Revenue concepts
i) Total Revenue (TR):
Total Revenue refers to total receipts from the sale of a given quantity of a commodity or
the total sale proceeds of a firm by selling a commodity at a given price. It is the total
income of a firm.
Total revenue is obtained by multiplying the quantity of the commodity sold with the
price of the commodity.
Total Revenue = Quantity × Price i.e. R=P x Q
For example, if a firm sells 10 chairs at a price of sh. 160 per chair, then the total revenue
will be: 10 Chairs × sh. 160 = sh 1,600
ii)Average Revenue (AR):

This is the revenue per unit of the commodity sold. It is obtained by dividing Total
Revenue by total quantity sold.
Average Revenue = Total Revenue/Quantity
For example, if total revenue from the sale of 10 chairs @ sh. 160 per chair is sh.
1,600, then: Average Revenue = Total Revenue/Quantity = 1,600/10 = sh 160
For a firm in a perfectly competitive market, the AR is the same as price. Therefore, if
price is denoted by P, then we can say:
P = AR
This can be explained as under:

TR = Quantity × Price … (1)
AR = TR/Quantity …… (2)
Putting the value of TR from equation (1) in equation (2), we get

AR = Quantity × Price / Quantity
AR = Price
A buyer‘s demand curve graphically represents the quantities demanded by a buyer at

various prices. In other words, it shows the various levels of average revenue at which
different quantities of the good are sold by the seller. Therefore, in economics, it is
customary to refer AR curve as the Demand Curve of a firm.
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iii) Marginal Revenue (MR)
This is the increase in Total Revenue resulting from the sale of an extra unit of output.
i.e. the additional revenue generated from the sale of an additional unit of output. Thus,
if TRn-1 is Total Revenue from the sale of (n-1) units and TRn is total revenue from the
sale of n units, then the marginal revenue of the nth unit is given as:
MRn = TRn-TRn-1
For example, if the total revenue realised from sale of 10 chairs is sh. 1,600 and that
from sale of 11 chairs is sh. 1,780, then MR of the 11th chair will be:
MR11 = TR11 – TR10

MR11 = sh. 1,780 – sh. 1,600 = sh. 180
However, when change in units sold is more than one, then MR can also be calculated as:
MR = Change in Total Revenue/ Change in number of units = ΔTR/ΔQ
For example: If the total revenue realised from sale of 10 chairs is sh. 1,600 and that
from sale of 14 chairs is sh. 2,200, then the marginal revenue will be:
MR = TR of 14 chairs – TR of 10 chairs / 14 chairs -10 chairs = 600/4 = sh.

150
Total Revenue (TR)can also be calculated as the sum of marginal revenues of all the
units sold.
It means, TRn = MR1 + M2 + MR3 + ……….MRn or, TR = ∑MR
Relationship between revenue concepts

The relationship between different revenue concepts can be discussed under two
situations:
 When Price remains Constant (It happens under Perfect Competition). In this
situation, firm has to accept the same price as determined by the industry. It means,
any quantity of a commodity can be sold at that particular price.
 When Price falls with rise in output (It happens under Imperfect Competition). In
this situation, firm follows its own pricing policy. However, it can increase sales only
by reducing the price.
The relationship between different revenue concepts can be discussed, When Price
remains constant and when Price falls with rise in output.
i) Relationship between AR and MR (When Price remains Constant):

When price remains same at all output levels (like in case of perfect competition), no firm
is in a position to influence the market price of the product. A firm can sell more quantity
of output at the same price. This means, the revenue from every additional unit (MR) is
equal to AR. As a result, both AR and MR curves coincide in a horizontal straight line
parallel to the X-axis as shown in Figure below

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As shown in the figure, price (AR) remains same at all level of output and is equal to MR.
As a result, demand curve (or AR curve) is perfectly elastic.
ii) Relationship between TR and MR (When Price remains Constant):

When price remains constant, firms can sell any quantity of output at the price fixed by the
market. As a result, MR curve (and AR curve) is a horizontal straight line parallel to the X-
axis. Since MR remains constant, TR also increases at a constant rate Due to this reason,
the TR curve is a positively sloped straight line (see Figure below). As TR is zero at zero
level of output, the TR curve starts from the origin.
iii) Relationship between TR and Price line:
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When price remains constant at all the levels of output, then Price = AR = MR. Therefore,
price line is the same as MR curve. Also, TR = I MR. So, the area under MR curve or price
line will be equal to TR. In Figure below, TR at MR level of output = OP x OQ = Area under
price line.
iv) Relationship between AR and MR (When Price Falls with rise in output):
When firms can increase their volume of sales only by decreasing the price, then AR falls
with increase in sale. It means, revenue from every additional unit (i.e. MR) will be less
than AR. As a result, both AR and MR curves slope downwards from left to right. This
relationship can be better understood through Figure. 7.4 below: In the figure, MR and AR
fall with increase in output. However, fall in MR is double than that in AR, i.e., MR falls at a
rate which is twice the rate of fall in AR. As a result, MR curve is steeper than the AR curve
because MR is limited to one unit, whereas, AR is derived by all the units. It leads to
comparatively lesser fall in AR than fall in MR.
It must be noted that MR can fall to zero and can even become negative. However, AR can
be neither zero nor negative as TR it is always positive.
v) General relationship between AR and MR:
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The relationship between AR and MR depends on whether the price remains same or falls
with rise in output. However, if nothing is mentioned about the nature of price with rise in
output, then the following general relation exists between AR and MR:
 AR increases as long as MR is higher than AR (or when MR > AR, AR increases).
 AR is maximum and constant when MR is equal to AR (or when MR = AR, AR is
maximum).
 AR falls when MR is less than AR (or when MR < AR, AR falls)
It must be noted that specific relationship between AR and MR depends upon the relation
of price with output, i.e., whether price remains same or varies inversely with output.
Importance of Revenue Concept

Four important areas where the concept of revenue has great significance are profit:
determination, determination of full capacity, equilibrium determination of the firm and
factor pricing.
i) Profit Determination:
The AR and MR curves form important tools for economic analysis. The AR curve is the
price line for the producer in all market situations. By relating the AR curve to the AC curve
of a firm, it can be found out whether it is earning supernormal or normal profits or
incurring losses.
 If the AR curve is tangent to the AC curve at the point of equilibrium, the firm earns
normal profits.
 If the AR curve is above the AC curve, it makes supernormal profits.
 In case the AR curve is below the AC curve at the equilibrium point, the firm incurs
losses.
ii) Determination of Full Capacity
It can also be known from their relationship whether the firm is producing at its full
capacity or under capacity. If the AR curve is tangent to the AC curve at its minimum point,
(as under perfect competition) the firm produces at its full capacity. Where it is not so (as
under monopoly or monopolistic competition), the firm possesses idle capacity.
ii). Equilibrium Determination of the Firm
The MR curve when intersected by the MC curve determines the equilibrium position of the
firm under all market situations. Their point of intersection determines price, output, profit
or loss of a firm.
iv) Factor Pricing:

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The use of the average marginal revenue concepts helps in determining the prices of
factor services. In factor pricing they are inverted U-shaped and the average and marginal
revenue curves become the average revenue productivity and marginal revenue
productivity curves (ARP and MRP) and are useful tools in explaining the equilibrium of the
firm under different market conditions.

1. Distinguish between technical economics of scale and market economics of scale
2. Define the term revenues and explain three types of revenue
3. What is meant by an optimum size of a firm?
4. Outline five disadvantages of localization of industries
5. Using a well labeled diagram, explain the terms total cost, fixed costs, variable costs
and marginal costs
References
nd
st
TOPIC 7
7.0 MARKET STRUCTURES
7.1 Meaning of Market Structures
A Market may be defined as an area over which buyers and sellers meet to negotiate the
exchange of a well-defined commodity. Markets may also mean the extent of the sale for a
commodity as in the phrase, ―There is a wide market for this or that commodity‖. In a
monetary economy, market means the business of buying and selling of goods and
services of some kind.
Market Structures refers to the nature and degree of competition within a particular
market. Capitalist economies are characterized by a large range of different market
structures. These include the following: perfect competition, monopoly, monopolistic
competition, oligopoly and duopoly
7.2 Types of Market Structures

a) Perfect Competition
The model of perfect competition serves as a benchmark of economic efficiency against
which real world markets can be measured. Although there are few real world examples of
pure competition, it is still beneficial to study it as a model. Market power refers to the
ability to influence price of a product. In a perfectly competitive market, there is little
market power for producers.
The closest example of a perfectly competitive market would be a farmers market. Many
farmers bring their produce to the same location. This meets the first condition of a
perfectly competitive market. The goods and services need to be identical to one another.
Let's suppose you are looking for tomatoes at the farmers market. One tomato should be
able to be substituted in for another. The third condition is that all the farmers should be
aware of all the different market conditions, so that no farmer is able to offer a huge
reduction in price. This means farmers are equally aware of growing conditions,

transportation costs, cost for rental of space to sell the product at the market,
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4

and so on. Finally, if it is known that the price of tomatoes is high, other people need to be
able to enter the market and sell tomatoes. There cannot be barriers to entry.
The characteristics (conditions) of this market are summarized as follows;

i.There are many buyers and sellers to the extent that the supply of one firm makes a very
insignificant contribution on the total supply. Both the sellers and buyers take the price
as
given. This implies that a firm in a perfectly competitive market can sell any quantity
at the market price of its product and so faces a perfectly price elastic demand curve.
ii. The product sold is homogenous so that a consumer is indifferent as to whom to buy
from.
iii. There is free entry into the industry and exit out of the industry.
iv.Each firm aims at maximising profit.
v.There is free mobility of resources i.e. Perfect market for the resources.
vi.There is perfect knowledge about the market.
vii.There is no government regulation and only the invisible hand of the price allocates
the resources.
viii. There are no transport costs, or if there are, they are the same for all the producers.
Advantages of Perfect Market

 It achieves, subject to certain conditions, an allocation of resources which is:
socially optimal‖ or ―economically efficient‖ or ―pareto efficient‖.
 Perfectly competitive firms are technically efficient in the long run, in that they
produce that level of output, which minimizes their average costs, given their small
capacity.
 Perfect competition achieves an automatic allocation of resources in response to
changes in demand.
 The consumer is not exploited. The price of goods, in the long run will be as low as
possible. Producers can only earn a normal profit, which are the minimum levels of
profits necessary to retain firms in the industry, due to the existence of free entry
into the markets.
Disadvantages of Perfect Competition

 There is a great deal of duplication of production and distribution facilities amongst
firms and consequent waste.
 Economies of scale cannot be taken advantage of because firms are operating on
such a small scale. Therefore although the firms may be highly competitive and
their prices may be as low as is possible, given their scale of production,
nevertheless it is a higher price that could take advantage of economies of scale.
 There may be lack of innovation in a situation of perfect competition. Two reasons
account for this:
i) The small size and low profits of the firm limit the availability of funds for
research and
development
ii)The assumption of free flow of information, and no barriers to entry, implies that
innovations, will immediately be copied by all competitors, so that ultimately
individual firms will not find it worthwhile to innovate.

Realism of Perfect Competition
75

The assumptions of perfect competition are obviously at variance with the conditions
which actually exist in real world markets. Some markets approximately conform to
individual assumptions, for example, the stock exchange is characterized by a fairly free-
flow of information but the information requires expertise to grasp. However, no markets
exactly conform to the assumption of the model, with peasant agriculture probably the
nearest to the mark.
We however study the model of perfect competition to enable us to see:

 How competition operates in the real world situation, within a highly simplified
model.
 The advantageous features of perfect competition which governments may wish to
encourage in real world markets.
 The disadvantageous features of perfect competition which the governments may
wish to avoid.
 A standard against which to oil the degree of competition prevailing in a given
market. We can discuss how closely a specific market resembles the perfectly
competitive ideal
 For the student attempting a serious study of economics, a study of the perfect
market is essential since no understanding of the literature of micro-economics
over the century can be achieved without it.
 On a rather more mundane level, students will find themselves confronted with
questions on perfect competition in examinations.
b) Monopoly
Monopoly in the market place indicates the existence of a sole seller. This may take the
form of a unified business organization, or it may be association of separately controlled
firms, which combine, or act together, for the purposes of marketing their products (e.g.
they may charge common prices). The main point is that buyers are facing a single seller.
Sources of Monopoly power:
i. Exclusive ownership and control of factors inputs.
ii. Patent rights e.g. beer brands like Tusker, Soft drinks like Coca Cola etc.
iii. Natural monopoly, which results from a minimum average cost of production. The
firm could produce at the least cost possible and supply the market.
iv. Market Franchise i.e. the exclusive right by law to supply the product or commodity
e.g.
Kenya Bus Service before the coming of the Matatu business in Nairobi.
A monopolist, being the sole (producer and) supplier of the commodity is a price maker
rather than a price-taker as the price and quantity he will sell will be determined by the level
of demand at that price, and if he decided on the quantity to sell, the price he will charge,
will be determined by the level of demand. The monopolist, because he is the sole seller
faces a market demand curve which is downward sloping.
Monopolistic Practices
The following practices may be said to characterize
monopolies. i) Exclusive dealing to supply and collective
boycott
Producers agree to supply only to recognized dealers, normally only one dealer in each
area, on condition that the dealer does not stock the products of any producer outside
the group (or trade association). Should the dealer break the agreement, all members of
the group agree to withhold supplies from the offender. This practice has proved a very

effective restriction on competition
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for it ensures that any new firms would find it extremely difficult to secure market
outlets for their products.
ii) Barriers
The creation of barriers to ensure that there is no competition against them. E.g price
undercutting, individual ensure that actual text printed collective boycott and exclusive
holding of patent rights.
iii) Resale Price Maintenance (PRM)
A monopolistic firm may dictate to wholesalers and retailers the price at which its
products would be sold. This is another way of ensuring that other firms are not
attracted into the industry, if such firms can sell their products at more competitive
prices.
iv) Consumer Exploitation
Perhaps the most notorious practice for which monopolists are known is that of
exploiting consumers by overcharging their products. There are three ways in which the
monopolist can overcharge his products.
v) Profit maximization
The price charged by the monopolists in order to maximize his profits is higher than
would be the case if competitive firm was also maximizing its profits because in the
case of the monopolist, supply cannot exceed what he has produced.
vi) Cartels:
A cartel is a selling syndicate of producers of a particular product whose aim is to
restrict output so that they can overcharge for the product. Thus, they collectively act as
a monopoly and each producer is given his quota of output to produce.
vii) Price discrimination:
There are two forms of price discrimination:
a) The practice employed by firms of charging different prices to different groups of
buyers and
b) That of charging the same consumer different prices for different units of the
same good. In the first case, each group of buyers has a different price elasticity of
demand. The firm can by equalizing the marginal revenue generated by each group earn a
higher level of profits than would be the cases of a uniform price were charged. The
preconditions for the successful operation of this form of discrimination are
 Ability of the monopolistic firm to identify different segments of the market a
according to price elasticity of demand and
 Prevention of resale by those customers who buy at a lower price.
In the second case, the operation involves the firm appropriating all the consumer surplus
that each consumer would have got if the price were constant. This can be achieved by
setting the price of each unit equal to the maximum amount an individual would be willing
to pay as given by the individual‘s demand curve and is therefore to be employed.
Arguments For and Against Monopolies

Although monopolies are hated mainly because of their practice of consumer exploitation,
there are some aspects of monopolies that are favorable. The following arguments can be
put forward in favour of monopoles:
i) Economies of Scale
As it has the whole market to itself, the monopolistic firm will grow to large size and
exploit economies of large scale production. Hence its product is likely to be of higher
quantity than product of a competitive firm that has less changes of expanding and
lowering of the long run
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average cost (LRAC) of the firm. The price charged by the monopolistic firm may not
be as high as is usually assumed to be the case.
ii) No wastage of resources
As there is no competition from other firms, the monopolistic firm does not waste
resources in product differentiation and advertising in an effort to capture consumers
from rival firms.
iii) Price stability
Since the monopolist is price maker, prices under a monopoly tend to be more stable
than in competition where they are bound to change due to changes in supply and
demand beyond the control of the individual firm.
iv) Research
A monopolistic firm is in a better financial position to carryout research and improve its
products than a competitive firm
However monopolies have been accused of the following

weaknesses. i) Diseconomies of scale
While the monopolistic firm can grow to large size and exploit economies of scale, there
is danger that it eventually suffers from diseconomies of scale. This will raise its LRAC
and hence also raise its price.
ii) Inefficiency
Since there is no competition, the firm can be inefficient as it has no fear of losing
customers to rival firms.
iii) Lack of innovation
Although the firm is in a better financial position to carry out research and improve its
product than a firm in a competitive market, it may NOT actually do so because of the
absence of competition.
iv) Exploitation
Exploitation of consumer is the most notorious practice for which monopolists are
known as in over-pricing so as to maximize profits, and price discrimination.
Characteristics of a Monopoly Market

There are a number of characteristics that define a monopoly market. The first is that
there is a single seller or supplier. This means that one firm provides the entire supply of a
market. The second is that there exist no close substitutes. This means that the
monopolist faces no competition. The idea that there exists a good or service which has
no close substitute is difficult to prove. A third characteristic is that there are barriers to
entry. These may be created by circumstance or by law. Examples would be the location of
minerals or a legal barrier like a patent. The last feature is that monopolies have some
control over price.
Types of Monopolies
There are three different types of monopolies which to some degree all receive
government support. They are outlined below.
i. Natural Monopolies
A natural monopoly exists when one firm can supply the entire market at a lower per unit
cost than could two or more separate firms. Natural monopolies exist because of
economies of scale. Costs keep falling as the size of the firm increases. Public utilities,
such as water, gas and electricity, are examples of natural monopolies. It wouldn't make
sense or be economically practical, if there were multiple water or gas lines running under
our streets.

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ii. Government Created or Legal Monopolies
There are times when the government awards a monopoly. This is usually done to
promote and reward new ideas. Examples of government created monopolies are:
 Patents: A patent is an exclusive right to sell a product for a specific amount of
time.
 Copyrights: a monopoly given to an author for their lifetime
 Trademark: a special design, name, or symbol that identifies a product, service or
company, e.g. the Olympic rings or the Nike swoosh.
 Government franchise: when the government designates a single firm to sell a good
or service, such as bandwidth for local radio stations.
iii. Resource Monopoly
The third type, resource monopoly, is rare. This is where a natural resource, because of its
location, is controlled by one company. An example would be DeBeers diamonds. DeBeers
controls about 80% of the world's diamonds. When this occurs there is usually some
government oversight of the industry. Other examples of resource monopolies would be
the Aluminum Company of America (ALCOA) and the International Nickel Company of
Canada.
C. Monopolistic Competition
Monopolistic competition also known as imperfect competition, combines features from
both perfect competition and monopoly. It has the following features from perfect
competition.
 There are many producers and consumers. The producers produce differentiated
substitutes. Hence there is competition between them. The difference from
perfect competition is that the products area not homogeneous
 There is freedom of entry into the industry so that an individual firm can make
surplus profits in the short-run but will make normal profits in the long-run as new
firms enter the industry.
Characteristics of monopolistic competition
Monopolistic competition has the following features from monopoly:
 As the products are differentiated substitutes, each brand or type has its own sole
seller e.g. each brand of toilet soap is produced by only one firm.
 If one firm raises its price it is likely to lose a substantial proportion of its
customers to its rivals. If it lowers price it is likely to capture a proportion of
customers from its rivals. But in the first case some of its customers will remain
loyal to it and in the second case some customers will remain loyal to their
traditional suppliers. Hence, as in monopoly the demand curve for the firm slopes
downwards but it is more elastic than in monopoly. However, the level of elasticity
will depend on the strength of product differentiation.
Product Differentiation
Product differentiation describes a situation in which there is a single product being
manufactured by several suppliers, and the product of each supplier is basically the same.
However, the suppliers try to create differences between their own product and the
products of their rivals. It can be achieved through quality of service, after sales service,
delivery dates, performance, reliability, branding, packaging, advertising or in some cases
the differences may be more in the minds of the customers rather than real differences,
but a successful advertising can create a belief that a service or product is better than
others and thus enable one firm to sell more and at higher price than its competitors.
Advantages of Product Differentiation

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The advantages can be distinguished between those advantages for the firm itself and
those for the consumer:
i) For the firm.
 The ability to increase prices without losing loyal consumers
 The stability of sales, due to brand loyalty. The firm will not be subject to the risks
and uncertainties of intense price competition.
ii) For the Customer
 Consistent Product quality
 Wide consumer choice, between differentiated products.
Disadvantages of product differentiation
i) Product differentiation generally reduces the degree of competition in the market. It
does this in two ways:
 It reduces competition amongst existing firms because consumers are reluctant to
substitute one product for another, since they have developed brand loyalty.
 It makes it more difficult for new firms to enter the industry in the long run if the
consumers are already loyal to existing products.
ii)All the effort and expense that the firms put into product differentiation are wasteful.
Too much is spent on packaging, advertising and design changes. The price of goods
could have been reduced instead.
iii)Too many brands on the market, produced by large number of firms, could prevent the
realization of full economies of scale in the production of goods.
iv) Since the firms cannot expand their output to the level of minimum average cost output
without making a loss, the ―excess capacity theorem‖ predicts that industries marked
by monopolistic competition will always tend to have excess capacity i.e. output is at
less than capacity and price is above the average cost.
Waste in Imperfect Competition
Monopolistic competition involves some degree of waste in two aspects.
 When new firms enter the industry and the demand for the individual firm‘s product
falls it will be forced to reduce productions. This means that part of its plant
equipment will be unused. It is said to be operating under conditions of excess of the
demand or the market for its product.
 In practice, the firm will not allow a situation where it is reduced to a state of lower
than
normal profits. It will try to maintain its customers against new firms through product
differentiation and advertising in an effort to convince customers that its products are
the best. This wastage of resources, which could be used to expand and exploit
economies of scale.
d. Oligopoly
Oligopoly refers to a market where a few large firms sell a product which may be alike or
different which dominates an industry. Steel and aluminum are examples of products that
are alike that make up an oligopoly market. Cars and cigarettes are examples of products
that are different that constitute an oligopoly market. Economists often use a
concentration ratio, to measure if a market is an oligopoly. Economists usually use a four-
firm concentration ratio. If four firms control over 40% of a market, then it is an oligopoly.
For example, in the cigarette industry, the four-firm ratio is 95%. What can increase the
concentration ratio? One way would be through mergers within the industry or a second
way would be if one of the larger firms in the industry gained market share at the expense
of one of the smaller firms.

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Characteristics of an Oligopoly Market
There are a number of characteristics that define an oligopoly market. The first is that
price is not determined by the market, but by the actions of a few large firms. Each firm is
trying to hold onto or enlarge their share of the market. Consequently, each firm is aware
of the actions and reactions of all its competitors. An example of this is how mobile phone
companies in Kenya adjust their prices to those of their competitors. Mutual
interdependence is a term used in economics to describe how an action by one oligopoly
firm will cause a reaction by other oligopoly firms. e.g. If General Motors produces a new
type of vehicle or a price change, it needs to consider how the other automobile
manufacturers will react. In an oligopoly market there also exists price leadership. This is
when a dominant firm sets a price, and others follow. For example, if Phillip Morris decides
to increase the price of cigarettes, other cigarette producing firms will follow. There are
often many barriers that exist to discourage entry into the oligopoly market. Most of these
barriers are related to economies of scale. This is because there are huge stars up costs to
enter an oligopoly market. In summary, Oligopoly in the market describes a situation in
which:
 Firms are price makers
 Few but large firms exist
 There are close substitutes
 Non-price competition exist like the form of product differentiation
 Supernormal profits re earned both in the short run and long run.
Pricing and Output Decisions of the Firm in oligopoly
The price and output shall depend on whether the firm operates in Pure oligopoly or
Differentiated oligopoly
a) Pure Oligopoly
Oligopolists normally differentiate their products. But this differentiation might either
be weak or strong. Pure oligopoly describes the situation where differentiation of the
product is weak. Pricing and output in pure oligopoly can be collusive or non-collusive.
i)Collusive Oligopoly
Collusive oligopoly refers to where there is co-operation among the sellers i.e. co-
ordination of prices. Collusion can be Formal or Informal.
 Formal Collusive Oligopoly: This is where the firms come together to protect their
interests e.g. cartels like OPEC. In this case the members enter into a formal
agreement by which the market is shared among them. The single decision
maker will set the market price and quantity offered for sale by the industry.
There is a central agency which sets the price and quarters produce by the
firms and all firms aside by the decisions of the central agency. The
maximized joint profits are distributed among firms based on agreed formula.
 Informal Collusive Oligopoly: Informal collusive oligopoly can arise into two cases,
namely:
a) Where the cartel is not possible may be because it‘s illegal or some firms
don‘t want to enter into an agreement or lose their freedom of action
completely.
b) Firms may find it mutually beneficial for them not to engage in price
competition. When in outright cartel does not exist then firms will collude by
covert gentlemanly agreement or by spontaneous co-ordination designed to
avoid the effects of price war.

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One such means by which firms can agree is by price leadership. One firm sets the price
and the others follow with or without understanding. When this policy is adopted firms
enter into a tacit market sharing agreement.
There are two types of price leadership, namely:
 By a low-cost firm: When there is a conflict of interests among oligopolists arising
from cost differentials, the firms can explicitly or implicitly agree on how to share the
market in which the low-cost firm sets the price. We can assume that the low cost
firm takes the biggest share of the market.
 Price leadership by a large firm: Some oligopolists consist of one large firm and a
number of smaller ones. In this case the larger firm sets the price and allows the
smaller firms to sell at that price and then supplies the rest of the quantity. Each
smaller firm behaves as if in a purely competitive market where price is given and
each firm sells without affecting the price because each will sell where MC = P = MR
= AR
ii)Non-Collusive Oligopoly
This Operates in the absence of collusion and in a situation of great uncertainty. In this
case if one firm raises price, it is likely to lose a substantial proportion of customers to its
rivals. They will not raise price because it is the interests to charge a price lower than that
of their rivals. If the firm lower price, it will attract a large proportion of customers from
other firms. The other firms are likely to retaliate by lowering price either to the same
extent or a large extent. The first firm will retaliate by lowering the price even further.
As the firms will always expect a counter-strategy from rival firms, each price and output
decision the firms comes up with is a tactical move within the framework of a broader
strategy. This then leads to a price war. If it goes on there will come a time when the prices
are so low that if one firm lowers price, the consumers will see no point in changing from
their traditional suppliers. Thus, the demand for the product of the individual firm will start
by being elastic and it will end by being inelastic. The demand curve for the product of the
individual firm thus consists of two parts, the elastic part and the inelastic part. It is said to
be ―kinked‘ demand curve as shown below. If the firm is on the inelastic part and it raises
price, the others will not follow suit. But on this part prices are so low that is likely to retain
most of its customers. If it raises price beyond the kink, it will lose most of its customers
to rivals. Hence the price p will be the stable price because above it prices are unstable in
that rising price means substantial loss of customers and lowering price may lead to price
war. Below p prices are considered to be too low.
Elastic Demand
p Kink
Inelastic Demand
AR
Barriers to entry in pure oligopoly

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The barriers to entry can be artificial or natural. Artificial Barriers can be acquired through:
 State protection through issuance of exclusive market (franchise) licences and
patent rights.
 Control of supply of raw materials
 Threat of price war, if financial resources can sustain loses temporarily the cartel or
price leader can threaten the new entrant by threatening to lower prices
sufficiently to scare new firms.
Disadvantages of Oligopolies
There are a number of reasons why economists don't like oligopolies. An oligopoly
produces less than it can which means there is a shortage, which means prices will be
higher than in a perfectly competitive market. There is always the temptation to collude,
which would result in lower production and higher prices. Price wars may emerge, which in
the short run benefit consumers, but which in the long run will drive competitors out of the
market and force prices up. There may be waste to society in the form of high advertising
costs. Finally, the size of oligopolies may allow such companies in an oligopolistic industry
to have too much influence on politicians, who might legislate laws in their favor.
e)Duopoly Market
This is a situation in which two companies own all or nearly all of the market for a given
product or service. A duopoly is the most basic form of oligopoly, a market dominated by a
small number of companies. A duopoly can have the same impact on the market as a
monopoly if the two players collude on prices or output. Collusion results in consumers
paying higher prices than they would in a truly competitive market.
The theory of duopoly forms a special ease of the theory of oligopoly, which is applied to
the situation, some way between monopoly and perfect competition, in which the number
of sellers is not large enough to make the influence of any one on the price negligible. A
monopoly exists when there is only one seller, oligopoly when there are few sellers; the
simplest ease of oligopoly is that of two sellers, duopoly.
Duopoly provides a simplified model for showing the main principles of the theory of
oligopoly: the conclusions drawn from analysing the problem of two sellers can be
extended to cover situations in which there are three or more sellers.
If there are only two sellers producing a commodity a change in the price or output of one
will affect the other; and his reactions in turn will affect the first. Thus each seller realizes
that a change in his price or output will set up a chain of reactions. He has to make
assumptions about how the other will react to a change in his policy. The essential
characteristic of the theory of duopoly is that neither seller can ignore the reactions of the
other. The two sellers' fortunes are not independent; neither can take the other's policy for
granted, bemuse it is in part determined by his own.
Under pure competition, or monopoly, price or output can be decided by reference to the
conditions of demand and cost that face individual producers. But there is no simple
answer in duopoly. It will depend upon the assumptions made by each seller about the
reactions of the other. The answer is in this sense 'indeterminate'. Two limiting solutions
are possible. Both sellers may charge the monopoly price as a result of agreement or
independent experience. This supposes that both sell identical products and have the
same costs, and that consumers are indifferent between them when

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both ask the same price. If a duopot moves his price above or below the monopoly price
he will be worse off because profits are maximized at the monopoly price. The two thus
behave as a single monopolist, and the market is shared between them. The other
possible solution occurs when, as a result of a price war, each seller is making only normal
competitive profits. Price is then fixed at the competitive level. Between these two Iimits
there are indeterminate number of possibilities about which theory can say little.
The table below summarizes the characteristics of each of the four main sarket structures;
Market Number of Type of Product Entry Examples

Structure Sellers Condition
Perfect Large Homogenous Very Easy Agriculture
Competition
Monopolistic Many Differentiated Easy Retail trade
Competition
Oligopoly Few Homogenous or Difficult Autos, steel, oil
differentiated
Monopoly One Unique Impossible Public utilities
Market Power
Market power is the ability of a firm to profitably raise the market price of a good or
service over marginal cost. In perfectly competitive markets, market participants have no
market power. A firm with total market power can raise prices without losing any
customers to competitors. Market participants that have market power are therefore
sometimes referred to as "price makers," while those without are sometimes called "price
takers." Significant market power is when prices exceed marginal cost and long run
average cost, so the firm makes economic profits.
A firm with market power has the ability to individually affect either the total quantity or the
prevailing price in the market. Price makers face a downward-sloping demand curve, such
that price increases lead to a lower quantity demanded. The decrease in supply as a result
of the exercise of market power creates an economic deadweight loss which is often
viewed as socially undesirable. As a result, many countries have anti-trust or other
legislation intended to limit the ability of firms to accrue market power. Such legislation
often regulates mergers and sometimes introduces a judicial power to compel divestiture.
Market power gives firms the ability to engage in unilateral behavior. Some of the
behaviours that firms with market power are accused of engaging in include predatory
pricing, product tying, and creation of overcapacity or other barriers to entry. If no
individual participant in the market has significant market power, then anti-competitive
behavior can take place only through collusion, or the exercise of a group of participants'
collective market power.
When several firms control a significant share of market sales, the resulting market
structure is called an oligopoly or oligopsony. An oligopoly may engage in collusion, either
tacit or overt, and thereby exercise market power. An explicit agreement in an oligopoly to
affect market price or output is called a cartel.

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Sources of Market Power
A monopoly can raise prices and retain customers because the monopoly has no competitors.
If a customer has no other place to go to obtain the goods or services, they either pay the
increased price or do without. Thus the key to market power is to preclude competition
through high barriers of entry. Barriers to entry those are significant sources of market power
are control of scarce resources, increasing returns to scale, technological superiority and
government created barriers to entry. OPEC is an example of an organization that has market
power due to control over scarce resources - oil.
Increasing returns to scale are another important source of market power. Firms
experiencing increasing returns to scale are also experiencing decreasing average total
costs. Firms in such industries become more profitable with size. Therefore over time the
industry is dominated by a few large firms. This dominance makes it difficult for startup
firms to succeed. Firms like power companies, cable television companies and wireless
communication companies with large start up costs fall within this category. A company
wishing to enter such industries must have the financial ability to spend millions of
shillings before starting operations and generating any revenue. Similarly established firms
also have a competitive advantage over new firms. An established firm threatened by a
new competitor can lower prices to drive out the competition.
Finally government created barriers to entry can be a source of market power. Prime
examples are patents granted to pharmaceutical companies. These patents give the drug
companies a virtual monopoly in the protected product for the term of the patent.
Ways of Controlling Powers in Market

Structures a) Price control
Price control has been defined as the government effort to restrict the prices of
commodities in the market. The restriction can act on either the lowest prices or the
highest prices. When the government decide to restrict the highest price that a good or
service should be sold at in the market then this type of restriction is known as the price
ceiling. Price floor on the other hand is the restriction imposed by the government on the
minimum prices that a goods or service should be sold at in the market. The government
arguments in support of price control are that;
The government wants to protect consumers from exploitation by the suppliers. This
way the basic goods will become affordable to all the citizens.
The government also sets the prices for commodity to control the rate of inflation in
that economy. The government does this by ensuring that all the producers in the
market has a minimum income for their producers
 The government will also set price controls to ensure there is no gouging when there is
shortage in supply. Price gouging is a term used to refer to the action of the producers
to increase the prices of commodities to unreasonable levels.
Advantages of price control
 Setting the maximum prices will protect consumers from exploitation because prices
cannot rise above a certain limit. This way the consumers purchase commodity at
lower prices.
 Setting the price limit above a certain point will help the producers to increase their
production proceeds. Price floor is mostly used in the farming sectors to protect the
farmers from exploitation by the buyers.

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 Price control eliminates transaction costs in production. This is done by minimizing the
cost incurred in doing business among the companies hence eliminating the
unnecessary costs in production.
 Price control brings in transparency in pricing of commodities. Government will have
set the maximum or the minimum prices for a commodity therefore creating
awareness in the economy on the prices of different commodities.
 Price controls will eliminate the uncertainty caused by the fluctuation in the exchange
rates. Creating a universal currency in a trading bloc will eliminate the uncertainty
caused by exchange rates differences.
Disadvantages of price control.
 Price ceiling will reduce the supply of commodities in the market. The supplier‘s profits
are reduced by the price restriction therefore driving out some suppliers out of the
markets.
 Price floors will affect the market by; increasing the prices for the consumers, the costs
of imports will also increase due to increase in import tariffs, price floors might
encourage inefficiency and oversupply in production
b) Regulation and other measures

To protect consumers, governments often try to control the market power of monopolies.
One way to do this is through regulation. A regulatory agency typically will give privately-
owned firm exclusive rights to a market, but regulate the firm's prices and standards of
service. The agency usually sets the price so as to give the firm a modest profit.
Regulating a monopoly's profit prevents it from exploiting its market power, but it causes
other problems. Most firms are eager to cut costs so that they can earn more profits. But
if a regulated monopoly succeeds in cutting costs, its regulatory agency will often take
away any excess profits that it makes by forcing the firm to lower its price. This means, of
course, that regulated monopolies don't have much incentive to cut their costs. To correct
for this, regulatory agencies often monitor their operations carefully to make sure that
they're being well managed.
Another way to control the market power of monopolies is through nationalization, in

which the government owns and operates the monopoly. Like regulated private
monopolies, nationalized monopolies lack the incentive of profits to spur them to cut
costs. Nationalized monopolies turn any profits they earn over to the government; if they
lose money, taxpayers make up the difference.
c. Taxes and subsidies

Taxes are primarily a source of revenue for Government to fund its activities and services.
Taxes can be indirect and levied on transactions, such as VAT, that do not vary with the
income or status of the consumer, or direct such as income tax, which varies with income
and other characteristics, such as whether a person has children.
Common types of subsidy include direct grants, tax exemptions, capital injections, equity
participation, soft loans, and guarantees. Support can also involve providing economic
advantages, for example allowing a firm to buy or rent publicly owned land at less than the
market price, or by giving a firm privileged access to infrastructure without paying a fee.
Taxes and subsidies can be used to influence the incentives and behaviour of private firms.
There are several reasons why taxes and subsidies might be used in this way, including:

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• To address market failures: common examples include the subsidy of education,
innovation, and low-carbon and environmentally friendly goods or the taxation of
pollution.
• To address cyclical difficulties, subsidies might be used to temporarily s
• To address cyclical difficulties: subsidies might be used to temporarily support
companies in financial trouble, particularly when their collapse would have wide-
ranging
Subsidies can have important effects on competition, particularly where they have a
differential impact on firms in a market. Government should make sure that the benefit of
giving aid outweighs the potential costs of distorting competition. The first risk to
competition is that the subsidy increases the potential for anti-competitive behaviour by
firms. This might be the case if the subsidy results in the recipient firm significantly
increasing its market share to a level where:
• It can act independently of competitive constraints
• There is consolidation amongst competitors that either reduces competition or
increases the risk of collusion, or
• Entry barriers are raised so that potential future competition is prevented.
A second risk is that the subsidy might undermine the mechanisms that ensure efficiency
in the market. For example, the recipient firm could be under less financial pressure to be
competitive or a subsidy may mean that an inefficient firm stays in the market.

1. What is monopolist market?
2. With the help of a well-labelled diagram, explain the relationship between the average
fixed cost, average variable cost, total cost and marginal cost curves.
3. Discuss the necessary and sufficient conditions for profit maximization by a firm.
Support your answer with appropriate illustrations.
4. Outline three strategies that can be used to control market power in an economy
5. Explain three disadvantages of product differentiation
6. State the economic circumstances under which a perfectly competitive market may
tribe.
7. In what ways does a perfect market differ from a monopoly, oligopoly and
monopolistic competition?
References
nd
st
TOPIC 8
8.0 LABOUR MARKET
Labour includes both physical and mental work undertaken for some monetary reward. In
this way, workers working in factories, services of doctors, advocates, ministers, officers

and teachers are all
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included in labour. Any physical or mental work which is not undertaken for getting income,
but simply to attain pleasure or happiness, is not labour.
Labour economics seeks to understand the functioning and dynamics of the markets for
wage labour. In economics, labour is a measure of the work done by human beings. It is
conventionally contrasted with such other factors of production as land and capital.
Labour market is the place where workers and employees interact with each other. In the
labour market, employers compete to hire the best, and the workers compete for the best
satisfying job. The labour market in an economy functions with demand and supply of
labour. In this market, labour demand is the firm's demand for labour and supply is the
worker's supply of labour. The supply and demand of labour in the market is influenced by
changes in the bargaining power.
Characteristics of Labour
Labour has the following characteristics:
a. Labour is Perishable: Labour is more perishable than other factors of production. It
means labour cannot be stored. The labour of an unemployed worker is lost forever
for that day when he does not work. Labour can neither be postponed nor
accumulated for the next day. It will perish. Once time is lost, it is lost forever.
b. Labour cannot be separated from the Labourer: Land and capital can be separated
from their owner, but labour cannot he separated from a labourer. Labour and
labourer are indispensable for each other. For example, it is not possible to bring the
ability of a teacher to teach in the school, leaving the teacher at home. The labour of
a teacher can work only if he himself is present in the class. Therefore, labour and
labourer cannot be separated from each other.
c. Less Mobility of Labour: As compared to capital and other goods, labour is less
mobile. Capital can be easily transported from one place to other, but labour cannot
be transported easily from its present place to other places. A labourer is not ready
to go too far off places leaving his native place. Therefore, labour has less mobility.
d. Weak Bargaining Power of Labour: The ability of the buyer to purchase goods at the
lowest price and the ability of the seller to sell his goods at the highest possible price
is called the bargaining power. A labourer sells his labour for wages and an employer
purchases labour by paying wages. Labourers have a very weak bargaining power,
because their labour cannot be stored and they are poor, ignorant and less organised.
Moreover, labour as a class does not have reserves to fall back upon when either
there is no work or the wage rate is so low that it is not worth working. Poor
labourers have to work for their subsistence. Therefore, the labourers have a weak
bargaining power as compared to the employers.
e. Inelastic Supply of labour: The supply of labour is inelastic in a country at a particular
time. It means their supply can neither be increased nor decreased if the need
demands so. For example, if a country has a scarcity of a particular type of workers,
their supply cannot be increased within a day, month or year. Labourers cannot be
‗made to order‘ like other goods.
The supply of labour can be increased to a limited extent by importing labour from
other countries in the short period. The supply of labour depends upon the size of
population. Population cannot be increased or decreased quickly. Therefore, the
supply of labour is inelastic to a great extent. It cannot be increased or decreased
immediately.
f. Labourer is a Human being and not a Machine: Every labourer has his own tastes,

habits and feelings. Therefore, labourers cannot be made to work like machines.
Labourers cannot work
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round the clock like machines. After continuous work for a few hours, leisure is
essential for them.
g. A Labourer sells his Labour and not Himself: A labourer sells his labour for wages
and not himself. ‗The worker sells work but he himself remains his own property‘.
For example, when we purchase an animal, we become owners of the services as
well as the body of that animal. But we cannot become the owner of a labourer in
this sense.
h. Increase in Wages may reduce the Supply of Labour: The supply of goods increases,
when their prices increase, but the supply of labourers decreases, when their wages
are increased. For example, when wages are low, all men, women and children in a
labourer‘s family have to work to earn their livelihood. But when wage rates are
increased, the labourer may work alone and his wife and children may stop working.
In this way, the increase in wage rates decreases the supply of labourers. Labourers
also work for less hours when they are paid more and hence again their supply
decreases.
i. Labour is both the Beginning and the End of Production: The presence of land and
capital alone cannot make production. Production can be started only with the help
of labour. It means labour is the beginning of production. Goods are produced to
satisfy human wants. When we consume them, production comes to an end.
Therefore, labour is both the beginning and the end of production.
j. Differences in the Efficiency of Labour: Labourer differs in efficiency. Some labourers
are more efficient due to their ability, training and skill, whereas others are less
efficient on account of their illiteracy, ignorance, etc.
k. Indirect Demand for Labour: The consumer goods like bread, vegetables, fruit, milk,
etc. have direct demand as they satisfy our wants directly. But the demand for
labourers is not direct, it is indirect. They are demanded so as to produce other
goods, which satisfy our wants. So the demand for labourers depends upon the
demand for goods which they help to produce. Therefore, the demand for labourers
arises because of their productive capacity to produce other goods.
l. Difficult to find out the Cost of Production of Labour: We can easily calculate the cost
of production of a machine. But it is not easy to calculate the cost of production of a
labourer i.e., of an advocate, teacher, doctor, etc. If a person becomes an engineer at
the age of twenty, it is difficult to find out the total cost on his education, food,
clothes, etc. Therefore, it is difficult to calculate the cost of production of a labourer.
m.Labour creates Capital: Capital, which is considered as a separate factor of
production is, in fact, the result of the reward for labour. Labour earns wealth by way
of production. We know that capital is that portion of wealth which is used to earn
income. Therefore, capital is formulated and accumulated by labour. It is evident that
labour is more important in the process of production than capital because capital is
the result of the working of labour.
n. Labour is an Active Factor of Production: Land and capital are considered as the
passive factors of production, because they alone cannot start the production
process. Production from land and capital starts only when a man makes efforts.
Production begins with the active participation of man. Therefore, labour is an active
factor of production.

The labour supply refers to the total number of hours that labour is willing and able to
supply at a given wage rate. Labor
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demand is a decision by management or ownership concerning how many employees or
labor hours to use to complete a necessary task. Usually, the decision is heavily influenced
by money. It is in the company's best interests to use as little labor as necessary to save
money while still accomplishing the workload that is required.
The demand for labor is derived demand meaning there is no demand for labor apart from
the demand for the goods and services labor can produce. When demand for an output
good or service decreases, total labor income in the affected industry will decrease. As
demand for the good decreases, demand for labor must also decrease. Possible results
include: Workers are laid off;
Workers‘ hours are cut; Workers‘ wages are reduced. The magnitude of the impact on
individuals‘ income depends on the alternatives available to workers in other employment.
An increase in demand for an output good that generates a positive impact on industry
revenue also increases total labor income, the latter by increasing the demand for labor.
Employers demand labor because workers are an important part of the production process.
Workers use tools and equipment to turn inputs into output. Without workers, employers
couldn't produce goods and services and earn profits. When graphed, the demand for labor
looks much like the demand for other goods and services-it has a downward slope. This
indicates that a greater quantity of labor is demanded at lower prices than at higher prices.
That is, in the labor market, employers are willing to buy more hours of labor at lower
wages than at a higher wages.
Although employers, who demand labor, prefer lower wages, workers, who supply that
labor, prefer higher wages. Workers are willing to supply labor because the wages they
earn enable them to buy the goods and services they want. When graphed, the supply of
labor looks much like the supply of other goods and services, it has an upward slope. This
indicates that workers are willing to supply a greater quantity of labor hours—that is, they
are willing to work more—at higher wages than at lower wages.
Like other markets, the demand for labor and the supply of labor interact and result in an
equilibrium price. In this case the price is called a wage. And, like other markets, the
demand for labor and the supply of labor shift, which can cause wages to increase and
decrease.

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8.2 Factors Influencing Demand and Supply of Labour
The demand of labour is influenced by:
a) Derived demand: The demand for labour is always derived from the demand for the
good or service it produces. Thus if the demand for a particular goods or service
increase it will lead to a rise in demand for labour used to produce those commodities.
. For example, the demand for nurses is determined by the demand for healthcare
services. If the demand for healthcare services increased dramatically, the demand for
nurses to provide those services would increase. In such a case, the demand curve
would shift to the right and wages for nurses would increase. On the other hand, if the
demand for healthcare services were to decrease, the demand for nurses would
decrease as well. The demand curve would shift to the left and wages for nurses
would stagnate or even decline over time
b)Wage rates: A fall in wages will cause an extension in the demand for labour while a
rise in wages paid to works will cause a contraction in demand.
c)Technology used: In industries where there is improved technology can be used, the
demand for labour will tend to fall as producers will replace labour with sophisticated
machinery.
Factors affecting the supply for labour

The supply of labour to a particular occupation is influenced by:
a)The wage rate on offer in the industry itself : Higher wages should boost the number of
people willing and able to work. In a strong economy, industries compete with each
other for skilled labor, which drives up compensation costs. The opposite generally
holds true during a recession, when industries are able to negotiate favorable
compensation contracts with labor unions. For example, if higher wages or better
working conditions make nursing more attractive than other jobs, more people may be
willing to work in nursing, which would shift the supply curve for nursing to the right.
This rightward shift would decrease wages for nurses. Likewise, if nursing were to
become a less attractive occupation, some nurses would leave for other professions.
This decrease in supply would result in higher wages for the nurses who remain.
b)Substitution and Income effect: As the price of a good is raised its supply also
increases. Thus we get a normal upward sloping curve. In the same way, a higher
wage rate will influence

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people to work for more hours. This would mean that the worker will spend less on
leisure because the price of leisure has gone up, in terms of opportunity cost. This is
known as Substitution effect. As a result, the supply curve will be sloping upwards. But
when the hourly rate rises above a certain level a worker may wish to work fewer
hours per week, because he can earn higher income within a shorter period of time.
This is known as Income effect. This will result in the supply curve bending backward.
c) Barriers to entry: Artificial limits through the introduction of minimum entry
requirements or other legal barriers to entry can restrict labour supply and force
average pay levels higher. For example, if the government were to require nurses to
have an additional, more difficult to earn, license. This regulation would decrease the
number of nurses able to work at all wage levels. The supply curve for nursing would
shift to the left and wages for nurses would increase. On the other hand, if the
government were to reduce qualifications or subsidize the training of new nurses, the
supply curve would shift to the right and wages would fall.
d) Improvements in the occupational mobility of labour: For example if more people are
trained
with the necessary skills required to work in a particular occupation.
f)Non-monetary characteristics of specific jobs: Include factors such as the level of risk,
the requirement to work anti-social hours, job security, opportunities for promotion
and the chance to live and work overseas, employer-provided in-work training,
subsidised health and leisure facilities and occupational pension schemes.
g) Economy: Macroeconomic conditions affect labor supply and demand. Job losses
during a recession mean less disposable income for consumers and less demand for
goods and services produced, thus industries respond by reducing production, which
leads to layoffs and reduced labor demand. Demand for goods and services usually
increase in a growing economy. Industries increase production levels and hire new
workers, which increases labor demand. However, No-layoff clauses in union
contracts, hiring limits and the tendency of some companies to maintain employment
through downturns have led to employment stability in the some sectors.
h)Net migration of labour :A rising flow of people seeking work in the other countries is
making labour migration an important factor in determining the supply of labour
available to many industries – be it to relieve shortages of skilled labour or to meet the
seasonal demand for workers in agriculture and the construction industry. The
recession has caused inward migration to slow down and in some cases to reverse.
i)Globalization: Globalization involves the import of foreign labour and relocation of
manufacturing facilities overseas. Regional integration trade agreements, such as the
Free Trade Agreement and the European Union, have shifted production to low-cost
locations in the same continent, which reduces labor demand in the home country.
j)Other Factors: Other factors affecting labor supply and demand include new
technologies which my require workers with specialized skills and unforeseen events,
such as the March 2011 earthquake in Japan that disrupted operations in several
industries.
Specialisation / Division of labour

This way of doing the work is called division of labour because different workers are engaged
in performing different parts of production. In the words of Watson, ―Production by division of
labour consists in splitting up the productive process into its component parts.‖ Different
workers perform different parts of production on the basis of their specialisation. The result is
that goods come to the final shape with the cooperation of many workers. Thus, division of
labour means that the main

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process of production is split up into many simple parts and each part is taken up by
different workers who are specialised in the production of that specific part.
Forms of Division of Labour:

The division of labour has been divided into different forms by the economists who explain
it as follows:
i. Simple Division of Labour: When the production is split up into different parts and
many workers come together to complete the work, but the contribution of each
worker cannot be known, it is called simple division of labour. For example, when
many persons carry a huge log of wood, it is difficult to assign how much labour has
been contributed by an individual worker. It is simple division of labour.
ii. Complex Division of Labour: When the production is split up into different parts and
each part is performed by different workers who have specialised in it, it is called
complex division of labour. For example, in a shoe factory one worker makes the
upper portion, the second one prepares the soles, the third one stitches them, the
fourth one polishes them, and so on. In this way, shoes are manufactured. It is a case
of complex division of labour.
iii. Occupational Division of Labour: When the production of a commodity becomes the
occupation of the worker, it is called occupational division of labour. Thus, the
production of different goods has created different occupations. The caste system in
India is perhaps the best example of the occupational division of labour. The work of
farmers, cobblers, carpenters, weavers and blacksmiths is known as occupational
division of labour.
iv. Geographical or Territorial Division of Labour: Sometimes, due to different reasons,
the production of goods is concentrated at a particular, place, state or country. This
particular type of division of labour comes into being when the workers or factories
having specialised in the production of a particular commodity are found at a
particular place. That place may be the most suitable geographically for the
production of that commodity. This is called the geographical or territorial division of
labour.
Advantages of Division of Labour

 Practice makes perfect: Worker specialises in a particular task and gives in the best,
thus producing goods faster and less wastage of material. In addition, When the
worker is entrusted with the work for which he is best suited, he will produce
superior quality goods.
 Use of machinery: The division of labour is the result of the large-scale production,
which implies more use of machines. On the other hand, the division of labour
increases the possibility of the use of machines in the small-scale production also.
Therefore, in modern times the use of machines is increasing continuously due to
the increase in the division of labour.
 Increased Output: with improvement in efficiency and use of machinery output is
increased.
 Saves time: There is no need for the worker to shift from one process to another.
He is employed in a definite process with certain tools. He, therefore, goes on
working without loss of time, sitting at one place. Continuity in work also saves time
and helps in more production at less cost.
 Increase in Mobility of Labour: Division of labour facilitates greater mobility of
labour. In it, the production is split up into different parts and a worker becomes
trained in that very specific task in the production of the commodity which he

performs time and again. He becomes professional, which leads to the
occupational mobility. On the other hand, division
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of labour implies a large-scale production and labourers come to work from far and
near. Thus, it increases geographical mobility of labour.
 Increase in Employment Opportunities: Division of labour leads to the diversity of
occupations which further leads to the employment opportunities. On the other
hand, the scale of production being large, the number of employment opportunities
also increases.
 Saving of Capital and Tools: Division of labour helps in the saving of capital and
tools. It is not essential to provide a complete set of tools to every worker. He needs
a few tools only for the job he has to do. Thus there is the saving of tools as well as
capital. For instance, if a tailor stitches the shirt, he requires a sewing machine,
scissors, etc. But on the basis of division of labour, one can do the cutting and the
other can stitch the clothes. In this way, two tailors can work with the help of one
pair of scissors and one machine only.
 Development of International Trade: Division of labour increases the tendency of
specialisation not only in the workers or industries, but in different countries also.
On the basis of specialisation, every country produces only those goods in which it
has a comparative advantage and imports such goods from those countries which
have also greater comparative advantage. Therefore, division of labour is beneficial
for the development of international trade also.
Disadvantages of Division of Labour

 Boredom: Under division of labour, a worker has to do the same job time and again
for years together. Therefore, after some time, the worker feels bored or the work
becomes irksome and monotonous. There remains no happiness or pleasure in the
job for him. It has an adverse effect on the production.
 Loss of Mental Development: When the labourer is made to work only on a part of
the work, he does not possess complete knowledge of the work. Thus, division of
labour proves to be a hurdle in the way of mental development. Furthermore, though
the number of goods produced increases they are identical or standardized.
 Loss of Responsibility: Many workers join hands to produce a commodity. If the
production is not good and adequate, none can be held responsible for it. It is
generally said that ‗every man‘s responsibility is no man‘s responsibility.‘ Therefore,
the division of labour has the disadvantage of loss of responsibility.
 Reduction in Mobility of Labour: The mobility of labour is reduced on account of
division of labour. The worker performs only a part of the whole task. He is trained
to do that much part only. So, it may not be easy for him to trace out exactly the
same job somewhere else, if he wants to change the place. In this way, the mobility
of labour gets retarded.
 Increased Dependence: When the production is split up into a number of processes
and each part is performed by different workers, it may lead to over-dependence.
For instance, in the case of a readymade garments factory, if the man cutting cloth
is lazy, the work of stitching, buttoning, etc. will suffer. Therefore, increased
dependence is the result of division of labour.
 Danger of Unemployment: The danger of unemployment is another disadvantage of
division of labour. When the worker produces a small part of goods, he gets
specialised in it and he does not have complete knowledge of the production of
goods. For instance, a man is expert in buttoning the clothes. If he is dismissed
from the factory, it is difficult for him to find the job of buttoning. Thus division of
labour has a fear of unemployment.

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 Danger of Over-Production: Over-production means that the supply of production is
comparatively more than its demand in the market. Because of the division of
labour, when production is done on a large scale, the demand for production lags
much behind its increased supply. Such conditions create overproduction which is
very harmful for the producers as well as for the workers when they become
unemployed.
8.3 Types of Reward for Labour

Wages are the price paid for the services of labour. Like any other factor of production,
labour also contributes to production. Wages may also be paid for any type of human
effort, either physical or mental. Wages are based on certain periods of time. It may be a
day, a week, a month or a year. In ordinary language, wages are variously called salaries,
pay, fees, allowances or commission. For higher officers, the term salary is used. Similarly,
fees are paid to professionals like doctors and lawyers while payments made to
middlemen like sales agents is known as commission. Wages are usually expressed as a
rate. When wage payments are based on a day, a week, or a month, such payments are
known as time wages. When wages are paid according to number of units produced, this
mode of payment is called piece rate or piece wages. Wages can also be distinguished as
money wages and nominal wages. The amount of money paid as wages is called nominal
or money wage. Real wages mean the amount of necessaries, comforts and luxuries that
can be purchased with the money wage.
Theories of wage
determination a) Early theories
about wages
The earliest theories about wage determination were those put forward by Thomas
Malthus, David Ricardo and Karl Marx.
i. Thomas Robert Malthus (1766 – 1834) and the Subsistence Theory of Wages:
The germ of Malthus‘ Theory does come from the French ―physioirats‖ who held that
it was in the nature of things that wages could never rises above a bare subsistence
level. When wages did for a time rise much above the bare necessities of life, the
illusion of prosperity produced larger families, and the severe competition among
workers was soon at work to reduce wages again. In a world where child labour was
the rule it was only a few years before the children forced unemployment upon the
parents, and all were again reduced to poverty. Such was the subsistence theory of
wages.
ii. Ricardo and the Wages Fund Theory:

Ricardo held that, like any other commodity, the price of labour depended on supply
and demand. On the demand side, the capital available to entrepreneurs was the sole
source of payment for the workers, and represented a wages fund from which they
could be paid. On the supply side, labour supply depended upon Malthus‘ arguments
about population. The intense competition of labourers one with another, at a time
when combinations of workers to withdraw their labour from the market were illegal,
kept the price of labour low.
iii. Karl Marx (1818 – 83) and the ‘Full Fruits of Production’ Theory of Wages:
His labour theory of value held that a commodity‘s worth was directly proportional to
the hours of work that had gone into making it, under the normal conditions of
production and the worth the average degree of skill and intensity prevalent at that

time. Because only labour created value, the worker was entitled to the full fruits of
production. Those sums distributed
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as rent, interest and profits, which Marx called surplus values, were stolen from the
worker by the capitalist class.
b)Modern theories of wage determination

i. Real and nominal wages
Wages are wanted only for what they will buy, real wages being wages in terms of the
goods and services that can be bought with them. Nominal wages are wages in terms
of money, and the term money wages is perhaps to be preferred. In determining
nominal wages of people in different occupations; account must be taken of payments
in kind, such as free uniform for policemen, railway workers and may others, free travel
to and from work for those engaged in the passenger transport undertakings, the use
of the car by some business executives, free board and lodging for some hotel
workers and nurses. ― The labourer‖, say Adam Smith, ―is rich or poor, is well or ill
rewarded, in proportion to the real, not to the nominal price of his labour.‖
ii. Marginal productivity theory of wages

According to the Marginal theory of distribution, the producer will pay no more for any
factor of production that the value of its marginal product, since to do so will raise his
costs by a greater amount than his revenue. As applied to labour this provides us with
the Marginal Productivity theory of wages.
At this wage rate the firm will employ L units of labour. At this level of employment, R
is the average revenue product. Thus, the total revenue of the firm is represented by
area ORBL, and Labour cost is represented by area OWAL. Thus, the firm makes loss
(on labour above) represented by area RWAB. The firm will, therefore, not employ
labour at wage rates above average revenue product. It follows, therefore, that the
demand curve for labor is that part of the Marginal revenue product curve below the
average revenue product curve, and is generally represented as follows:-
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This theory has been criticized for following reasons
 It is too theoretical a concept, since it does not appear to agree with what actually
takes place.
 In practice it is impossible to calculate the amount or the value of the marginal
product of any factor of production.
 The employment of one man more or one man less may completely upset the
method of production in use at the time. To employ an extra man may simply mean
that there will be more labour than necessary; to take away a man may remove a
vital link in the chain of production. For this reason a small rise or fall in wages is not
likely to bring about an immediate change in the amount of labour employed.
 The productivity of labour does not depend entirely on its own effort and efficiency,
but very largely on the quality of the other factors of production employed, especially
capital.
 According to this theory, the higher the wage, the smaller the amount of labour the
entrepreneur will employ. Surveys that have been taken appear to indicate that not all
employers take account of the wage rate when considering how many men to
employ but are being influenced more by business prospects.
 Lord Keynes said the theory was valid only in static conditions, and therefore, to
lower the wage rate in trade depression would not necessarily increase the demand
for labour.
iii. Market theory of wages

Here the approach is to regard wages as a price – the price of labour – and, therefore,
like all other prices determined by the interaction of the market forces of supply and
demand. In terms of geometry, this corresponds to the point of intersection between
the demand curve and the supply curve
W is the equilibrium wage rate L the equilibrium level of employment of labour. At

and rates above w, there is wage supply over demand, and hence wages will be
excess of downwards. forced

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Below W, there is excess of demand oversupply and hence wages will be
forced
upwards. The Market Theory of Wages, however, does not run counter to the
Marginal Productivity Theory. In the same way that marginal utility forms the
basis of individual demand, so marginal productivity forms the basis of demand
for labour and other factors of production
iv. The institutional intervention theories
Collective bargaining provides an example of what is sometimes called bilateral
monopoly; the trade union being the monopolist supplier and the
employers‘ association the monopolist buyer of a particular kind of labour. Those
who support the Bargaining strength of the trade union concerned, so that,
differences in wages in different occupations are the result of the differences of
the strength of the respective trade unions
v. The comparability principle
Associations representing workers providing services – clerical, postal, teaching,
etc. – have always attempted to apply the ―principle of comparability‖ with wages
of those in similar occupations, though it is often very difficult to compare workers
in different occupations, since no two jobs are alike.
vi. The effect of inventions
In the long run, new inventions will have the effect of increasing output and
lowering prices, with the result that real wages of workers rise and in
consequence their demand for all kinds of goods and services.
Factors Responsible for Wage Differentials between Occupations

The major cause is demand and supply for the particular labour concerned, but other
causes could be:
 Differences in the cost of training: Some occupations require large investments in
training, while others require a much smaller expenditure for training. A physicist
must spend eight years on undergraduate and graduate training. A surgeon may
require ten or more years of training. During this period, income is foregone and
heavy educational costs are incurred.
 Differences in the cost of performing the job: For example dentists, psychologists
and doctors in general require expensive equipment and incur high expenditure for
running their practice. In order for net compensation to be equalized, such
‗workers‘ must be paid more than others.
 Differences in the degree of difficulty or unpleasantness of the wok: For example,
miners work under unpleasant conditions relative to farmers.

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8
Economics Notes. Prepared by Karoki Lawrence

 Differences in the risk of the occupation: For example, a racing driver or an airplane
pilot run more risks than a college teacher.
 Differences in the number of hours required for an “adequate” practice: For example,
doctors are required to put longer hours in practicing their professional than post
office employees.
 Differences in the stability of employment: Construction work and athletic or
football coaching are subject to frequent lay-offs and hence have little job security,
whereas tenure University teachers have a high job security.
 Differences in the length of employment: For example boxers and football players
have a short working-life.
 Differences in the prestige of various jobs: For example a white-collar worker has a
more prestigious position in Society than a truck driver.
 Differences in sex: In most cases occupations which are predominantly
womens‘ occupation tend to pay less than occupations which are predominantly
mens‘ occupations.
 Effectiveness of Trade Unions: If trade unions in one industry or firm are more
effective in their wage negotiations with employers than those in another industry
or firm, the workers in the industry or firm are likely to earn higher wages than those
in the second.
Factors Responsible For Wage Differentials within the Same Occupation

 Differences in the environment: For example a doctor sent to Mandera County may
be paid more than a doctor working in Nairobi to persuade him to go.
 Differences in the cost of living in various areas: Living costs generally are lower in
small towns than in big cities.
 Differences in the price of commodities, which labour produces: For example,
consider two mechanics, one servicing Mercedes car and the other Probox. Both
mechanics are equally skilled, but the value of their output differs because the price
of Mercedes is higher than that of Probox. In this case the difference in wages paid
to the two individuals may be due to the differences in the total value of their output.
 Biological and acquired quality differences: Human beings are born with different
abilities and in different environments, which define largely the opportunities to
develop their inherent qualities. For example, not many people are born with the
biological qualities required for becoming successful tennis players or surgeons,
writers or artist. The marginal productivity of workers thus differs. These
differences are called non-equalizing or non-compensating wage differentials
because they are due to differences in the marginal production of individuals.
 Job Security: Two people may do the same kind of work for different employers and
earn differently if the lower paid person feels safer with present employer. For
example, a doctor may prefer to work in a Government hospital rather than a Private
hospital because there is more job security in the civil service.
 Experience: It is often assumed that if a person does the same job for a long time,
he gets experienced and skilled at it. Hence he is likely to earn more than a person
in the same profession who joined more recently.
 Paid-by-results jobs: There are some jobs which pay according to one‘s output, e.g.
jobs of salesmen and insurance agents. Hence two people may do the same job,
and earn differently if one of them works harder

9
Economics Notes. Prepared by Karoki

Lawrence

1. Define the term derived demand as applied in labour economics
2. Discuss five factors may influence supply of labour
3. Outline ten characteristics of labour
4. Explain four modern theories of wage determination
5. Justify why workers in the same occupations may be paid different salaries.
TOPIC 9
9.0 NATIONAL INCOME
9.1 Meaning of National Income
National Income is a measure of the money value of goods and services becoming
available to a nation from economic activities. It can also be defined as the total money
value of all final goods and services produced by the nationals of a country during some
specific period of time ( usually an year ) and the total of all incomes earned over the same
period of time by the nationals.
Terms used in national income

Gross Domestic Product: The money value of all goods and services produced within the
country but excluding net income from abroad.
Gross National Product: The sum of the values of all final goods and services produced by
the nationals or citizens of a country during the year, both within and outside the country.
Net National Product: The money value of the total volume of production (that is, the gross
national product) after allowance has been made for depreciation (capital consumption
allowance).
Nominal Gross National Product: The value, at current market prices, of all final goods and
services produced within some period by a nation without any deduction for depreciation
of capital goods. Real Gross National Product: This is the national output valued at the
prices during some base year or nominal GNP corrected for inflation.
Circular Flow of Money

The sources of national income can be explained using the Circular Flow of Income and
Expenditure model which illustrates the flow of payments and receipts between domestic
firms and domestic households. The households supply factor services to the firms. In
return, they get factor incomes. With factor incomes, they buy goods and services from the
firms. These flows can be illustrated diagrammatically as follows:
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The points at which flows from one sector meets the other sector and generate other
flows are called critical points. In the above diagram, the critical points are A, B and C. At A,
the flow of factor services from the households sector meets the firm sector and
generates the flow of factors incomes from the firms to the households. At B, the flow of
factor incomes meets the household sector and generates the flow of consumer spending.
At C, the flow of consumer spending meets the firms sector and generates the flow of
goods and services. Therefore, Incomes keep moving from households or the individuals
to the firms to the government and the back in a cycle. However, a country can‘t survive
without international trade (exports and imports).When goods and services are exported,
the country earns income and spends when importing.
Factors that increase income are referred to as injections while those that reduce income
are called withdrawals or leakages.
Examples of withdrawals
i. Savings: Income that is not spent but kept aside. When individuals save incomes, they
reduce the amount of income received by firms.
ii. Government tax: This reduces amount of money available to individuals for spending
iii. Imports: When money is spent on imports, it leaves the economy.
Examples of injections
i. Selling of products to foreign countries
ii. Government spending inform of salaries, projects and construction of roads
ii. Investments by firms and individuals like shares, land, putting up industry etc
9.2 Determination of National Income

The compilation of national income statistics is a very laborious task. The total wealth of a
nation has to be added up and there are millions of nationals. Moreover, in order to double
check and triple check the statistics, the national income statistician has to work out the
figures out in three different ways, each way being based on a different aspect. The three
approaches are:
a. The national output (Output method): The creation of wealth by the nation‘s
industries. This is valued at factor cost, so it must be the same as b) below.
b. The national income (Income method): The incomes of all the citizens.
c. The national expenditure (Expenditure method): because whatever we receive we
spend, or lend to the banks to invest it, so that the addition of all the expenditure
should come to the same as the other two figures. Put in its simplest form we can
express this as an identity:
National output  National Income  National Expenditure
Expenditure approach
The expenditure approach centres on the components of final demand which generate
production. It thus measures GDP as the total sum of expenditure on final goods and
services produced in an economy. It includes all consumers‘ expenditure on goods and
services, except for the purchase of new houses which is included in gross fixed capital
formulation. Secondly we included all general government final consumption. This includes
all current expenditure by central and local government on goods and services, including
wages and salaries of government employees. To these we add gross fixed capital
formation or expenditure on fixed assets (buildings, machinery, vehicles etc) either for
replacing or adding to the stock of existing fixed assets. This is the major part of the
investment which takes place in the economy. In addition we add the value of physical

increases in the stocks, or inventories, during the course of the year. The total of all this
gives us
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Total domestic expenditure (TDE). We then add expenditure on exports to the TDE and
arrive at a measure known as Total Final Expenditure. It is so called because it represents
the total of all spending on final goods. However, much of the final expenditure is on
imported goods and we therefore subtract spending on imports. Having done this we
arrive at a measure known as gross domestic product at market prices. To gross domestic
product at market price we subtract the taxes on expenditure levied by the government and
add on the amount of subsidy. When this has been done we arrive at a figure known as
Gross Domestic Product at factor cost. National Income however is affected by rent, profit
interest and dividends paid to, or received from, overseas. This is added to GDP as net
property income from abroad. This figure may be either positive or negative. When this has
been taken into account we arrive at the gross national product at factor cost. As
production takes place, the capital stock of a country wears out. Part of the gross fixed
capital formation is therefore, to replace worn out capital and is referred to as Capital
Consumption. When this has been subtracted we arrive at a figure known as the net
national product. Thus, summarising the above, we can say:
Y = C + I + G + (X – M)
Disadvantages / problems of expenditure approach

a. No accurate record on expenditure
b. In subsistence sector, the records don‘t exist at all hence approximations are used.
c. There is a problem of double counting i.e. some figures are calculate d more than once
d. When the market prices are used to measure the value of goods and services, they
may not give an accurate figure due to factors like inflation that makes goods more
expensive
e. Fluctuations / changes in value exchange rate may bring about a problem/challenge
when trying to measure imports and exports.
Income approach
A second method is to sum up all the incomes to individuals in the form of wages, rents,
interests and profits to get domestic incomes. This is because each time something is
produced and sold someone obtains income from producing it. It follows that if we add up all
incomes we should get the value of total expenditure, or output. Incomes earned for purposes
other than rewards for producing goods and services are ignored. Such incomes are gifts,
unemployment or relief benefits, lottery, pensions, grants for students etc. These payments
are known as transfer income (payments) and including them will lead to double counting. The
test for inclusion in the national income calculation is therefore that there should be a ―quid
pro quo‖ that the money should have been paid against the exchange of a good or service.
Alternatively, we can say that there should be a ―real‖ flow in the opposite direction to the
money flow. We must also include income obtained from subsistence output. This is the
opposite case from transfer payments since there is a flow of real goods and services, but no
corresponding money flow. It becomes necessary to ―impute‘‘ values for the income that
would have been received.
Similarly workers may, in addition to cash income, receive income in kind; if employees are
provided with rent free housing, the rent which they would have to pay for those houses on
the open market should, in principle, be ―imputed‖ as part of their income from
employment. The sum of these incomes gives gross domestic product GDP. This includes
incomes earned by foreigners at home and excludes incomes earned by nationals abroad.
Thus, to Gross Domestic Income we add Net property Income from abroad. This gives
Gross National Income. From this we deduct depreciation to give Net National Income.
This method takes into account the sum of money received as income by individuals who

contributes to the production of goods and services. It may include;
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a) The estimated income in the subsistence sector
b) Income from formal employment
c) Income from self-employment
d) Profits made by private and public company
e) Rent earned by use of land
f) Government income from fines, taxes etc
g) Interest on money borrowed from banks and other financial institutions.
NB; payments for which no goods/commodities have been received are not included when
calculating national income, this is referred to as transfer payment i.e. money is paid
without any supply of goods or services e.g. a gift from a friends, bursaries to students,
pension to retiring people (these are savings from that person), payment to unemployed
people under insurance, donations to relief programmes etc. These are excluded because
they are incomes transferred from one group to another. Income by foreigners based in
the country is also excluded.
Problems in income approach

i. Inaccurate data; people may not tell the truth on how much money they earn.
Companies may also not tell the truth about their incomes to avoid tax, citizens
working abroad cannot also tell how much they earn.
ii. It‘s difficult to calculate transfer payments e.g. gifts
iii. Inaccurate data on people working abroad
iv. There are so many illegal and unrecorded activities which bring income.
Output approaches
A final method which is more direct is the ―output method‖ or the value added approach. This
involves adding up the total contributions made by the various sectors of the economy.
―Value Added‖ is the value added by each industry to the raw materials or processed
products that it has bought from other industries before passing on the product to the next
stage in the production process. This approach therefore centres on final products. Final
products will include capital goods as well as consumer goods since while intermediate goods
are used up during the period in producing other goods, capital goods are not used up (apart
from ―wear and tear‖ or depreciation) during the period and may be thought of as consumer
goods ―stored up‖ for future periods. Final output will include ―subsistence output‖, which is
simply the output produced and consumed by households themselves.
Because subsistence output is not sold in the market, some assumption has to be made to
value them at some price. We also take into account the final output of government, which
provides services such as education, medical care and general administrative services.
However, since state education and other governmental services are not sold on the
market we shall not have market prices at which to value them. The only obvious means of
doing this is to value public services at what it costs the government to supply them, that
is, by the wages bill spent on teachers, doctors, and the like. When calculating the GDP in
this matter it is necessary to avoid double counting.
Problems in Output approach

a) Inaccurate data i.e. many people don‘t keep records especially in subsistence sector
b) The method is affected by inflation since prices of goods may change due to inflation
c) Sometimes it is difficult to decide what to include in output e.g. services provided by
housewives cannot be measured in terms of money.

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Difficulties in Measuring National Income
National income accounting is generally beset with several difficulties.
These are: a. What goods and services to include
Although the general principle is to take into account only those products which
change hands for money, the application of this principle involves some arbitrary
decisions and distortions. For example, unpaid services such as those performed by a
housewife are not included but the same services if provided by a paid housekeeper
would be.
Many farmers regularly consume part of their produce with no money changing hands.
An imputed value is usually assigned to this income. Many durable consumer goods
render services over a period of time. It would be impossible to estimate this value and
hence these goods are included when they are first bought and subsequent services
ignored. Furthermore, there are a number of governmental services such as medical
care and education, which are provided either 'free' or for a small charge. All these
provide a service and are included in the national income at cost. Finally, there are
many illegal activities, which are ordinary business and produce goods and services
that are sold on the market and generate factor incomes.
b. Danger of Double Counting
The problem of double counting arises because of the inter-relationships between
industries and sectors. Thus we find that the output of one sector is the input of
another. If the values of the outputs of all the sectors were added, some would be
added more than once, giving an erroneously large figure of national income. This may
be avoided either by only including the value of the final product or alternatively by
summing the values added at each stage which will give the same result. Some
incomes such as social security benefits are received without any corresponding
contribution to production. These are transfer payments from the taxpayer to the
recipient and are not included. Taxes and subsidies on goods will distort the true value
of goods. To give the correct figure, the former should not be counted as an increase in
national income for it does not represent any growth in real output.
c. Inadequate Information
The sources from which information is obtained are not designed specifically to enable
national income to be calculated. Income tax returns are likely to err on the side of
understatement. There are also some incomes that have to be estimated. Also, some
income is not recorded, as for example when a joiner, electrician or plumber does a job
in his spare time for a friend or neighbour. Also information on foreign payments or
receipts may not all be recorded. Individuals and firms may not give complete data
about their income, expenditure and output.
d. Activities considered illegal: e.g. illicit brews and prostitution are not counted when
measuring national income and yet they are involved in exchange of money.
e. The value of resources keep on changing e.g. land keep on appreciating while machinery
depreciates which is difficult to calculate. In addition, Change in value of money during
inflation makes goods expensive and it would be wrong to assume that a country has
made money and yet it‘s because of inflation
f. Income from foreign firms: These are firms operating away from their mother country.
The international monetary fund argues that their output should be calculated as
belonging to the host country while the profit goes to the parent countries.
Advantages of using national income data
i. It is used for indicating standards of living of people in a country. This means the type
of life of the citizens can live according to the amount of income they have (NB it

assume proper distribution of income)
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ii. Standards of living in various countries may be compared. a country with high national
income is likely to have high standards of living e.g. developed countries in most cases
have higher national income than developing countries.
iii. It helps to identify which sectors are growing e.g. agriculture, manufacturing, building
etc which helps entrepreneurs decide where they can invest their money
Disadvantages of using national income

i. It does not show proper distribution of income: there may be very few people in country
earning high income and so many people who are poor.
ii. Gross national output is a measure of production and consumption hence it measures
changes in economic activities but not quality of life e.g. if people work extra hours, the
GNP may go up but denies people leisure
iii. Per capita income may not be very god measure of welfare because most of the
time it is calculated using inadequate data.
iv. Production activities bring about income but may not necessarily bring about high
quality of life because of pollution and environmental degradation.
v. Economic growth (increase in GNP) does not necessarily measure economic
development (quality of life of the people), better education, health, sanitation,
infrastructure etc
Importance of National Income Statistics

The following are the importance of national income data;
 National income statistics measures the size of the "National cake' of goods and
services available for competing uses of private consumers, government, capital
formation and exports (less imports).
 National Income statistics are also used in comparing the standard of living of a
country over time and also the standards of living between countries.
 National Income Statistics provide information on the stability of performance of the
economy over time e.g. a steadily increasing income would be indicative of increasing
national income.
 If National Income Statistics enable us to assess the relative importance of the
various sectors in the economy. This is done by considering the contribution of the
various sectors to Gross National Product over time which is crucial for planning
purposes for it reveals to planners where constraints to economic development lie.
 By assessing exports and imports as a percentage of Gross national Product i.e. using
national statistics, it is possible to determine the extent to which a country depends on
external trade.
 National Income Statistics also help in estimating the saving potential and hence
investment potential of a country.
Factors Affecting National Income

The size of a nation‘s income depends on the quantity and quality of the factors of production
at its disposal. A nation will be rich if its endowments of natural resources are large, its people
are skilled, and it has a useful accumulation of capital assets. The following factors affect
national income: a)Natural Resources: These include the minerals of the earth; the timber,
shrubs and pasturage
available; the agricultural potential (fertile soil, regular rainfall, temperature or tropical
climate); the fauna and flora; the fish etc of the rivers and sea; the energy resources,
including oil, gas, hydro-electric, geothermal, wind and wave power.
b) Human Resources: A country is likely to prosper if it has a large population;

literate and
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knowledgeable about wealth creating processes. It should be well educated and skilled,
with a nice mixture of theory and practice. It should show enterprise, being inventive,
energetic and determined in the pursuit of a better standard of living.
c) Capital Resources: A nation must create and then conserve capital resources. This
includes not only tools, plant and machinery, factories, mines, domestic dwellings,
schools, colleges, etc, but a widespread infrastructure of roads, railways, airports and
ports. Transport creates the utility of space. It makes remote resources accessible and
high-cost goods into low-cost goods by opening up remote areas and bringing them into
production.
d) Self-sufficiency: A nation cannot enjoy a large national income if its citizens are not
mainly self-supporting. If the majority of the enterprises are foreign –owned there will be
a withdrawal of wealth in the form of profits or goods transferred to the investing nation.
e) Technology: The development of technology affects the level of national income and
innovation in production i.e. the more the use of technology, the high the national
income.
f) Political Stability:A stable economic and political system helps in the allocation of
resources. Wars strikes and social unrest discourage investment and business activities.
9.3 Indicators of Standards Of Living

Standard of living refers to the level of wealth, comfort, material goods and necessities
available to a certain socioeconomic class in a certain geographic area. The standard of
living includes factors such as income, quality and availability of employment, class
disparity, poverty rate, quality and affordability of housing, people, hours of work required
to purchase necessities, gross domestic product, inflation rate, number of holiday days per
year, affordable (or free) access to quality healthcare, quality and availability of education,
life expectancy, incidence of disease, cost of goods and services, infrastructure, national
economic growth, economic and political stability, political and religious freedom,
environmental quality, climate and safety. The standard of living is closely related to
quality of life.
Indicators of Economic standard of living

Economic standard of living concerns the physical circumstances in which people live, the
goods and services they are able to consume and the economic resources to which they
have access. It is concerned with the average level of resources as well as the distribution
of those resources across the society.
Five indicators are used to provide information on different aspects of economic

standards of living. They are: market income per person, income inequality, the population
with low incomes, housing affordability and household crowding. Together, the indicators
provide information about overall trends in living standards, levels of hardship and how
equitably resources are distributed. All are relevant to the adequacy of people‘s incomes
and their ability to participate in society and to choose how to live their lives.
Market income per person gives an indication of the average level of income and therefore
the overall material quality of life available. This also includes economic value of unpaid
work. It is the total value of goods and services available to citizens, expressed in Dollars
or shillings, per head of population, also known as real gross national disposable income
(RGNDI) per person. A nation with a rising per person RGNDI will have a greater capacity to
deliver a better quality of life and standard of living to its population.

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Income inequality is the extent of disparity between high income and low income
households.
It is measured by comparing the disposable household income distribution of higher
income households (80th percentile) with the incomes of lower income households (20th
percentile). The higher this ratio, the greater the level of inequality .High levels of inequality
are associated with lower levels of social cohesion and overall life satisfaction, even when
less well-off people have adequate incomes to meet their basic needs.
The proportion of the population with low incomes also provides information about how
equitably resources are distributed and how many people may be experiencing difficulty in
participating fully in society through a lack of income. It is argued that having insufficient
economic resources limits people‘s ability to participate in and belong to their community
and wider society, and otherwise restricts their quality of life. Furthermore, long-lasting low
family income in childhood is associated with negative outcomes, such as lower
educational attainment and poorer health.
Housing affordability measures the proportion of the population spending more than 30
percent of their disposable income on housing. Housing costs have a major impact on
overall material living standards, especially for low-income households. Affordable
housing is important for people‘s wellbeing. For lower-income households especially, high
housing costs relative to income are often associated with severe financial difficulty, and
can leave households with insufficient income to meet other basic needs such as food,
clothing, transport, medical care and education. High outgoings-to-income ratios are not
as critical for higher-income households, as there is still sufficient income left for their
basic needs.
The final indicator measures the proportion of the population living in crowded households.
Crowded housing is a well-known health risk and this indicator provides a direct measure
of the extent of this problem over time. Housing space adequate to the needs and desires
of a family is a core component of quality of life. National and international studies show
an association between the prevalence of certain infectious diseases and crowding,
between crowding and poor educational attainment, and between residential crowding and
psychological distress.
Causes of Income Disparities

There are many reasons for economic inequality within societies. Recent growth in overall
income inequality has been driven mostly by increasing inequality in wages and salaries.
Economist argues that widening economic disparity is an inevitable phenomenon of free
market capitalism. Common factors thought to impact economic inequality include:
i)The labor market
A major cause of economic inequality within modern market economies is the
determination of wages by the market. Some small part of economic inequality is caused
by the differences in the supply and demand for different types of work. However, where
competition is imperfect; information unevenly distributed; opportunities to acquire
education and skills unequal; and since many such imperfect conditions exist in virtually
every market, there is in fact little presumption that markets are in general efficient. This
means that there is an enormous potential role for government to correct these market
failures.
In a purely capitalist mode of production (i.e. where professional and labor organizations

cannot limit the number of workers) the workers wages will not be controlled by these
organizations, or by the employer, but rather by the market. Wages work in the same way
as prices for any other good.
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Thus, wages can be considered as a function of market price of skill. And therefore,
inequality is driven by this price. Under the law of supply and demand, the price of skill is
determined by a race between the demand for the skilled worker and the supply of the
skilled worker. "
ii)Taxes
Another cause is the rate at which income is taxed coupled with the progressivity of the
tax system. A progressive tax is a tax by which the tax rate increases as the taxable base
amount increases. In a progressive tax system, the level of the top tax rate will often have
a direct impact on the level of inequality within a society, either increasing it or decreasing
it, provided that income does not change as a result of the change in tax regime.
There is debate between politicians and economists over the role of tax policy in
mitigating or exacerbating wealth inequality. Economists such as have argued that tax
policy in the post World War II era has indeed increased income inequality by enabling the
wealthiest far greater access to capital than lower-income ones.
iii) Education
An important factor in the creation of inequality is variation in individuals' access to
education. Education, especially in an area where there is a high demand for workers,
creates high wages for those with this education, however, increases in education first
increase and then decrease growth as well as income inequality. As a result, those who are
unable to afford an education, or choose not to pursue optional education, generally
receive much lower wages. The justification for this is that a lack of education leads
directly to lower incomes, and thus lower aggregate savings and investment. In particular,
the increase in family income and wealth inequality leads to greater dispersion of
educational attainment, primarily because those at the bottom of the educational
distribution have fallen further below the average level of education. Conversely, education
raises incomes and promotes growth because it helps to unleash the productive potential
of the poor.
iv) Trade Liberization
Trade liberalization may shift economic inequality from a global to a domestic scale. When
rich countries trade with poor countries, the low-skilled workers in the rich countries may
see reduced wages as a result of the competition, while low-skilled workers in the poor
countries may see increased wages. Trade economists estimates that trade liberalisation
has had a measurable effect on the rising inequality. this trend is attributed to increased
trade with poor countries and the fragmentation of the means of production, resulting in
low skilled jobs becoming more tradeable v)Impact of gender
In many countries, there is a gender income gap which favors males in the labor market.
Several factors other than discrimination may contribute to this gap. On average, women
are more likely than men to consider factors other than pay when looking for work, and
may be less willing to travel or relocateGender inequality and discrimination is argued to
cause and perpetuate poverty and vulnerability in society as a whole.
vi) Stages of Development
Economist argues that levels of economic inequality are in large part the result of stages
of development. According to Kuznets, countries with low levels of development have
relatively equal distributions of wealth. As a country develops, it acquires more capital,
which leads to the owners of this capital having more wealth and income and introducing
inequality. Eventually, through various possible redistribution mechanisms such as social
welfare programs, more developed countries move back to lower levels of inequality.
vii) Diversity of preferences
Related to cultural issues, diversity of preferences within a society may contribute to
economic inequality. When faced with the choice between working harder to earn more

money or enjoying
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more leisure time, equally capable individuals with identical earning potential may choose
different strategies. The trade-off between work and leisure is particularly important in the
supply side of the labor market in labor economics.
Likewise, individuals in a society often have different levels of risk aversion. When equally-
able individuals undertake risky activities with the potential of large payoffs, such as
starting new businesses, some ventures succeed and some fail. The presence of both
successful and unsuccessful ventures in a society results in economic inequality even
when all individuals are identical.
viii) Wealth concentration
Wealth concentration is a theoretical process by which, under certain conditions, newly
created wealth concentrates in the possession of already-wealthy individuals or entities.
According to this theory, those who already hold wealth have the means to invest in new
sources of creating wealth or to otherwise leverage the accumulation of wealth, thus are
the beneficiaries of the new wealth. Over time, wealth condensation can significantly
contribute to the persistence of inequality within society.
ix) Single-parent families
There is statistical evidence shows strong links between single-parent families and lower
income. Inspite of the statistical evidence about the economic advantages enjoyed by
married couples and also by their children, evidence that is at odds with ideological
positions of many influential voices, Maranto and Crouch point out that "in the current
discussions about increased inequality, few researchers... directly address what seems to
be the strongest statistical correlate of inequality: the rise of single-parent families during
the past half century."
Measures to Overcome Income Inequalities

Many economists suggest that developing nations must reform their treatment of, and tax
policies towards, big businesses and high net worth individuals, as well as reform a
globally uncompetitive education system, if they hope to unlock their nation‘s suppressed
economic potential. The government should make sure, ―corporations and individuals
whose income is derived from investments pay taxes commensurate with the benefits
they get from the citizenship.‖ Although technological change and globalisation have
played a role in widening the distribution of labour income, the marked cross-country
variation is likely due to differences in policies and institutions.
Generally, developing nations need to implement the following measures in order to

reduce income inequalities;
● Education policies; have policies that increase graduation rates from upper secondary
and tertiary education and that also promote equal access to education help reduce
inequality.
● Well-designed labour market policies and institutions can reduce inequality. A relatively
high minimum wage narrows the distribution of labour income, but if set too high it
may reduce employment, which dampens its inequality-reducing effect. Institutional
arrangements that strengthen trade unions also tend to reduce labour earnings
inequality by ensuring a more equal distribution of earnings.
● removing product market regulations that stifle competition can reduce labour income
inequality by boosting employment. The empirical evidence for the link between
product market reform and the dispersion of earnings is rather mixed.
● Policies that foster the integration of immigrants and fight all forms of discrimination
reduce inequality.
● Tax and transfer systems play a key role in lowering overall income inequality. Three

quarters of the average reduction in inequality they achieve is due to transfers.
However, the redistributive
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impact of cash transfers varies widely across countries, reflecting both the size and
progressivity of these transfers.
● Personal income tax tends to be progressive, while social security contributions,
consumption taxes and real estate taxes tend to be regressive. But progressivity could
be strengthened by cutting back tax expenditures that benefit mainly high-income
groups (e.g. tax relief on mortgage interest). In addition, removing other tax reliefs –
such as reduced taxation of capital gains from the sale of a principal or secondary
residence, stock options and carried interest – would increase equity and allow a
growth-enhancing cut in marginal labour income tax rates. It would also reduce tax
avoidance instruments for top-income earners.

1. Briefly explain the circular flow of money
2. Explain the challenges experienced in measurement of national income
3. Discuss the three methods used in measuring national income
4. Highlight five causes of income inequalities in a country.
TOPIC 10
10.0INFLATION
10.1Meaning of Inflation
The word inflation means a persistent rise in the general level of prices, or alternatively a
persistent falls in the value of money. it can also refer to a situation where the volume of
purchasing power is persistently running ahead of the output of goods and services, so
that there is a continuous tendency of prices – both of commodities and factors of
production – to rise because the supply of goods and services and factors of production
fails to keep pace with demand for them. This type of inflation can, therefore, be described
as persistent/creeping inflation. Inflation can also be runaway inflation or hyper-inflation or
galloping inflation where a persistent inflation gets out of control and the value of money
declines rapidly to a tiny fraction of its former value and eventually to almost nothing, so
that a new currency has to be adopted.
Types of inflation
There are four main types of inflation namely;
Creeping Inflation
Creeping or mild inflation is when prices rise 3% a year or less. when prices rise 2% or less,
it's actually beneficial to economic growth. That's because this mild inflation sets
expectations that prices will continue to rise. As a result, it sparks increased demand as
consumers decide to buy now before prices rise in the future. By increasing demand, mild
inflation drives economic expansion.
Walking Inflation
This type of strong, or pernicious, inflation is between 3-10% a year. It is harmful to the
economy because it heats up economic growth too fast. People start to buy more than
they need, just to avoid tomorrow's much higher prices. This drives demand even further,
so that suppliers can't keep up, neither can wages. As a result, common goods and
services are priced out of the reach of most people.
Galloping Inflation
When inflation rises to ten percent or greater, it wreaks absolute havoc on the economy.
Money loses value so fast that business and employee income can't keep up with costs

and prices. Foreign
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investors avoid the country, depriving it of needed capital. The economy becomes unstable,
and government leaders lose credibility. Galloping inflation must be prevented.
Hyperinflation
Hyperinflation is when the prices skyrocket more than 50% a month. It is fortunately very
rare. In fact, most examples of hyperinflation have occurred when the government printed
money recklessly to pay for war. Examples of hyperinflation include Germany in the 1920s,
Zimbabwe in the 2000s, and during the American Civil War.
10.2 Causes of Inflation

At present three main explanations (causes) are put forward: cost-push, demand-pull, and
monetary.
i) Cost-push inflation:
Occurs when increase in costs of production push up the general level of prices. It is
therefore inflation from the supply side of the economy. It occurs as a result of increase
in:
a. Wage costs: Powerful trade unions will demand higher wages without corresponding
increases in productivity. The employers generally accede to these demands and pass
the increased wage cost on to the consumer in terms of higher prices.
b. Import prices: A country carrying out foreign trade with another is likely to import the
inflation of that country in the form of intermediate goods.
c. Exchange rates: It is estimated that each time a country devalues it‘s currency by 4
per cent, this will lead to a rise of 1 per cent in domestic inflation.
d. Mark-up pricing: Many large firms fix their prices on unit cost plus profit basis. This
makes prices more sensitive to supply than to demand influences and can mean that
they tend to go up
automatically with rising costs, whatever the state of economy.
e) Structural rigidity: The theory assumes that resources do not move quickly from one
use to another and that wages and prices can increase but not decrease. Given these
conditions; when patterns of demand and cost change real adjustments occur very
slowly. Shortages appear in potentially expanding sectors and prices rise because
slow movement of resources prevent the sector and prices rise because of slow
sectors keep factors of production on part-time employment or even full time
employment because mobility is low in the economy. Because their prices are rigid,
there is no deflation in these potentially contracting sectors. Thus the process of
expanding sectors leads to price rises, and prices in contracting sectors stay the same.
On average, therefore, prices rise.
f. Expectational theory: This depends on a general set of expectations of price and wage
increases. Such expectations may have been generated by continuing demand
inflation. Wage contracts may be made on a cost plus basis.
ii) Demand-pull inflation

This when aggregate demand exceed the value of output (measured in constant prices) at
full employment. The excess demand of goods and services cannot be met in real terms
and therefore is met by rises in the prices of goods. Demand-pull inflation could be caused
by:
a) Increases in general level of demand of goods and services. A rise in aggregate
demand in a situation of nearly full employment will create excess demand in many
individual markets, and prices will be bid upward. The rise in demand for goods and
services will cause a rise in demand for factors and their prices will be bid upward as

will. Thus, inflation in the pries of both consumer goods and factors of production is
caused by a rise in aggregate demand.
b) General shortage of goods and services. If there is a general shortage of
commodities e.g. in
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times of disasters like earthquakes, floods or wars, the general level of prices will rise
because of excess demand over supply.
c) Government spending: Hyper-inflation certainly rises as a result of government action.
Government may finance spending though budget deficits; either resorting to the
printing press to print money with which to pay bills or, what amounts to the same
thing, borrowing from the central bank for this purpose. Many economists believe that
all inflation is caused by increases in money supply.
iii) Monetary
Monetarist economists believe that ―inflation is always and everywhere a monetary
phenomenon in the sense that it can only be produced by a more rapid increase in the
quantity of money than in output‖ as Friedman wrote in 1970.
10.3 Effects of Inflation on the Economy

Inflation has different effects on different economic activities on both micro and macro
levels. Some of these problems are considered below:
i. During inflation money loses value. This implies that in the lending-borrowing process,
lenders will be losing and borrowers will be gaining, at least to the extent of the time value
of money. Cost of capital/credit will increase and the demand for funds is discouraged in
the economy, limiting the availability of investable funds. Moreover, the limited funds
available will be invested in physical facilities which appreciate in value over time. It‘s also
impossible the diversion of investment portfolio into speculative activities away from
directly productive ventures.
ii. During inflation more disposable incomes will be allocated to consumption since prices
will be high and real incomes very low. In this way, marginal propensity to save will
decline culminating in inadequate saved funds. This hinders the process of capital
formation and thus the economic prosperity to the country.
iii. The effects of inflation on economic growth have inconclusive evidence. Some scholars
and researchers have contended that inflation leads to an expansion in economic growth
while others associate inflation to economic stagnation i.e. inflation acts as an incentive to
producers to expand output and if the reverse happened, there will be a fall in production
resulting into stagflation i.e. a situation where there is inflation and stagnation in production
activities.
iv. During inflation, domestic commodity prices are higher than the world market prices, a
country‘s exports fall while the import bill expands. This is due to the increased
domestic demand for imports much more than the foreign demand for domestic
produced goods (exports). The effect is a deficit in international trade account causing
balance of payment problems for the country that suffers inflation.
v. During inflation, income distribution in a country worsens. The low income strata get
more affected especially where the basic line sustaining commodities‘ prices rise
persistently. In fact such persistence accelerates the loss of purchasing power and the
vicious cycle of poverty.
vi. Increased production: It is argued that if inflation is of the demand-pull type, this can
lead to
increased production if the high demand stimulates further investment. This is a
positive effect of inflation as it will lead to increased employment.
vii) Political instability: When inflation progresses to hyper-inflation, the unit of currency is
destroyed and with it basis of a free contractual society.
vii. Inflation and Unemployment
For many years, it was believed that there was a trade-off between inflation and

unemployment i.e. reducing inflation would cause more unemployment and vice versa.
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10.4 Measures to Control Inflation
An inflationary situation can effectively be addressed /tackled if the cause is first and
foremost identified. Governments have basically three policy measures to adopt in order to
control inflation, namely:
i) Fiscal Policy: This policy is based on demand management in terms of either raising or
lowering the level of aggregate demand. The government could attempt to influence one
of the components of the aggregate demand by reducing government expenditure and
raising taxes. This policy is effective only against demand-pull inflation.
ii) Monetary Policy: Governments and central banks primarily use monetary policy to
control inflation. Central banks such increase the interest rate, slow or stop the growth of
the money supply, and reduce the money supply. Higher interest rates reduce the amount
of money because less people seek loans, and loans are usually made with new money.
When banks make loans, they usually first create new money, then lend it. A central bank
usually creates money lent to a national government. Therefore, when a person pays back
a loan, the bank destroys the money and the quantity of money falls.
Monetarists emphasize a steady growth rate of money and use monetary policy to control
inflation by increasing interest rates and slowing the rise in the money supply. Keynesians
emphasize reducing aggregate demand during economic expansions and increasing
demand during recessions to keep inflation stable. Control of aggregate demand can be
achieved using both monetary policy and fiscal policy (increased taxation or reduced
government spending to reduce demand).
iii) Direct Intervention: Prices and incomes policy: Direct intervention involves fixing wages
and prices to ensure there is almost equal rise in wages and other incomes alongside the
improvements in productivity in the economy. Nevertheless, these policies become
successful for a short period as they end up storing trouble further, once relaxed will lead
to frequent price rises and wage fluctuations.

1. Outline three causes of demand pull inflation
2. Discuss five effects of inflation
3. Explain three anti-inflationary measures used by governments to mitigate against
inflation
4. Distinguish between moderate and hyper inflation
TOPIC 11
11.0MONEY AND BANKING
11.1Concept of Money
Money may be defined as anything generally acceptable in the settlement of debts. The
development of money was necessitated by specialization and exchange. Money was
needed to overcome the shortcomings and frustrations of the barter system which is
system where goods and services are exchanged for other goods and services.
Disadvantages of Barter Trade
 It is impossible to barter unless A has what B wants, and A wants what B has. This is
called double coincidence of wants and is difficult to fulfill in practice.
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 Even when each party wants what the other has, it does not follow they can agree on a
fair exchange. A good deal of time can be wasted sorting out equations of value.
 The indivisibility of large items is another problem. For instance if a cow is worth two
sacks of wheat, what is one sack of wheat worth? Once again we may need to carry
over part of the transaction to a later period of time.
 It is possible to confuse the use value and exchange value of goods and services in a
barter economy. Such confusion precludes a rational allocation of resources and
promotion of economic efficiency.
 When exchange takes place over time in an economy, it is necessary to store goods
for future exchange. If such goods are perishable by nature, then the system will break
down.
 The development of industrial economies usually depends on a division of labour,
specialization and allocation of resources on the basis of choices and preferences.
Economic efficiency is achieved by economizing on the use of the most scarce
resources. Without a common medium of exchange and a common unit of account
which is acceptable to both consumers and producers, it is very difficult to achieve an
efficient allocation of resources to satisfy consumer preferences.
The Historical development of money

For the early forms of money, the intrinsic value of the commodities provided the basis for
general acceptability: For instance, corn, salt, tobacco, or cloths were widely used because
they had obvious value themselves. These could be regarded as commodity money.
Commodity money had uses other than as a medium of exchange (e.g. salt could be used
to preserve meat, as well as in exchange). But money commodities were not particularly
convenient to use as money. Some were difficult to transport, some deteriorated overtime,
some could not be easily divided and some were valued differently by different cultures.
As the trade developed between different cultures, many chose precious metals mainly
gold or silver as their commodity money. These had the advantage of being easily
recognizable, portable, indestructible and scarce (which meant it preserved its value over
time). The value of the metal was in terms of weight. Thus each time a transaction was
made, the metal was weighed and payment made. Due to the inconvenience of weighing
each time a transaction was made, this led to the development of coin money. The state
took over the minting of coins by stamping each as being a particular weight and purity
(e.g. one pound of silver). They were later given a rough edge so that people could guard
against being cheated by an unscrupulous trade filling the edge down.
It became readily apparent, however, that what was important was public confidence
in the
―currency‖ of money, it‘s ability to run from hand to hand and circulate freely, rather than
its intrinsic value. As a result there was deliberately reduced below the face value of the
coinage. Any person receiving such a coin could afford not to mind, so long as he was
confident that anyone to whom he passed on the coin would also ―not mind‖.
Debasement represents an early form of fiduciary issue, i.e. issuing of money dependent
on the ―faith of the public‖ and was resorted to because it permitted the extension of the
supply of money beyond the availability of gold and silver.
Due to the risk of theft, members of the public who owned such metal money would
deposit them for safe keeping with goldsmiths and other reliable merchants who would
issue a receipt to the depositor. The metal could not be withdrawn without production of

the receipt signed by the
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depositor. Each time a transaction was made, the required amount of the metal would be
withdrawn and payment made.
It was later discovered that as long as the person being paid was convinced the person
paying had gold and the reputation of the goldsmith was sufficient to ensure acceptability
of his promise to pay, it became convenient for the depositor to pass on the goldsmith‘s
receipt and the person being paid will withdraw the gold himself. Initially, the gold would be
withdrawn immediately after the transaction was made. But it was discovered that so long
as each time a transaction was made the person being paid was convinced that there was
gold, the signed receipt could change hands more than once. Eventually, the receipts were
made payable to the bearer (rather than the depositor) and started to circulate as a means
of payment themselves, without the coins having to leave the vaults. This led to the
development of paper money, which had the added advantage of lightness.
Initially, paper money was backed by precious metal and convertible into precious metal
on demand. However, the goldsmiths or early bankers discovered that not all the gold they
held was claimed at the same time and that more gold kept on coming in (gold later
became the only accepted form of money). Consequently they started to issue more bank
notes than they had gold to back them, and the extra money created was lent out as loans
on which interest was charged. This became lucrative business, so much so that in the
th th
18 and 19 centuries there was a bank crisis in England when the banks failed to
honour their obligations to their depositors, i.e. there were more demands than there was
gold to meet them. This caused the government to intervene into the banking system so
as to restore confidence. Initially each bank was allowed to issue its own currency and to
issue more currency than it had gold to back it. This is called fractional backing, but the
Bank of England put restrictions on how much money could be issued.
Eventually, the role of issuing currency was completely taken over by the Central Bank for
effective control. Initially, the money issued by the Central Bank was backed by gold
(fractionally), i.e. the holder had the right to claim gold from the Central Bank. However,
since money is essentially needed for purchase of goods and services, present day money
is not backed by gold, but it is based on the level of production, the higher the output, the
higher is the money supply. Thus, present day money is called token money i.e. money
backed by the level of output.
Characteristics of Money
Over time, therefore, it became clear that for an item to act as money it must possess the
following characteristics.
 Acceptability: If money is to be used as medium of exchange for goods and services,
then it must be generally accepted as having value in exchange. This was true of
metallic money in the past because it was in high and stable demand for its
ornamental value. It is true of paper money, due to the good name of the note-
issuing authority.
 Portability: If an item is to be used as money, it must be easily portable, so that it is a
convenient means of exchange.
 Scarcity: If money is to be used in exchange for scarce goods and services, then it is
important that money is in scarce supply. For an item to be acceptable as money, it
must be scarce.
 Divisibility: It is essential that any asset which is used as money is divisible into small
units, so that it can be used in exchange for items of low value.

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 Durability: Money has to pass through many different hands during its working life.
Precious metals became popular because they do not deteriorate rapidly in use. Any
asset which is to be used as money must be durable. It must not depreciate over
time so that it can be used as a store of wealth.
 Homogeneity: It is desirable that money should be as uniform as possible.
Functions of Money
a. Medium of exchange
Money facilitates the exchange of goods and services in the economy. Workers
accept money for their wages because they know that money can be exchanged for
all the different things they will need. Use of money as an intermediary in
transactions therefore, removes the requirement for double coincidence of wants
between transactions. Without money, the world‘s complicated economic systems
which are based on specialization and the division of labour, would be impossible.
The use of money enables a person who receives payment for services in money to
obtain an exchange for it, the assortment of goods and services from the particular
amount of expenditure which will give maximum satisfaction.
b) Unit of account
Money is a means by which the prices of goods and services are quoted and
accounts kept. The use of money for accounting purposes makes possible the
operation of the price system and automatically provides the basis for keeping
accounts, calculating profit and loss, costing etc. It facilitates the evaluation of
performance and forward planning. It also allows for the comparison of the relative
values of goods and services even without an intention of actually spending (money)
on them e.g. ―window shopping‖.
c) Store of Wealth/value
The use of money makes it possible to separate the act of sale from the act of
purchase. Money is the most convenient way of keeping any form of property which
is surplus to immediate use; thus in particular, money is a store of value of which all
assets/property can be converted. By refraining from spending a portion of one‘s
current income for some time, it becomes possible to set up a large sum of money
to spend later (of course subject to the time value of money). Less durable or
otherwise perishable goods tend to depreciate considerably over time, and owners
of such goods avoid loss by converting them into money.
d)Standard of deferred payment
Many transactions involve future payment, e.g. hire purchase, mortgages, long term
construction works and bank credit facilities. Money thus provides the unit in which,
given the stability in its value, loans are advanced/made and future contracts fixed.
Borrowers never want money for its own sake, but only for the command it gives
over real resources. The use of money again allows a firm to borrow for the payment
of wages, purchase of raw materials or generally to offset outstanding debt
obligations; with money borrowing and lending become much easier, convenient and
satisfying. It‘s about making commerce and industry more viable.
Demand and Supply of Money

Since money is primarily a medium of exchange, the value of money means what money
will buy. If at one time a certain amount of money buys fewer things than at a previous
time, it can be said that the value of money has fallen. Since money itself is used as unit of
account and a means of measuring the ―value‖ of other things, its own value can be seen
only through the prices of other things. Changes in the value of money, therefore, are

shown through changes in prices.
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a) Demand for money
The demand for money is a more difficult concept than the demand for goods and
services. It refers to the desire to hold one‟s assets as money rather than as income-
earning assets (or stocks).
Holding money therefore involves a loss of the interest it might otherwise have earned.
There are two schools of thought to explain the demand for money, namely the Keynesian
Theory and the Monetarist Theory.
The demand for money and saving are quite different things. Saving is simply that part of
income which is not spent. It adds to a person‘s wealth. Liquidity preference is concerned
with the form in which that wealth is held. The motives for liquidity preference explain why
there is desire to hold some wealth in the form of cash rather than in goods affording
utility or in securities.
b) The supply of money

Supply of money refers to the total amount of money in the economy. Most countries of
the world have two measures of the money stock – broad money supply and narrow
money supply. Narrow money supply consists of all the purchasing power that is
immediately available for spending. Two narrow measures are recognized by many
countries. The first, M0 (or monetary base), consists of notes and coins in circulation and
the commercial banks‘ deposits of cash with the central banks.
The other measure is M2 which consists of notes and coins in circulation and the NIB (non-
interest-bearing) bank deposits, particularly current accounts. Also in the M2 definition are
the other interest-bearing retail deposits of building societies. Retail deposits are the
deposits of the private sector which can be withdrawn easily. Since all this money is readily
available for spending it is sometimes referred to as the ―transaction balance‖.
Any bank deposit which can be withdrawn without incurring (a loss of) interest penalty is
referred to as a ―sight deposit‖. The broad measure of the money supply includes most of
bank deposits
(both sight and time), most building society deposits and some money-market deposits
such as CDs (certificates of deposit).
Determinants of money supply

Two extreme situations are imaginable. In the first situation, the money supply can be
determined at exactly the amount decided on by the Central Bank. In such a case,
economists say that the money supply is exogenous and speak of an exogenous money
supply.
In the other extreme situation, the money supply is completely determined by things that
are happening in the economy such as the level of business activity and rates of interest
and is wholly out of the control of the Central Bank. In such a case economists would say
that there was an Endogenous money supply, which means that the size of the money
supply is not imposed from outside by the decisions of the Central Bank, but is determined
by what is happening within the economy.
In practice, the money supply is partly endogenous, because commercial banks are able to
change it in response to economic incentives, and partly exogenous, because the Central
Bank is able to set limits beyond which the commercial banks are unable to increase the
money supply.

Measurement of changes in the value of money
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Goods and services are valued in terms of money. Their prices indicate their relative value.
When prices go up, the amount which can be bought with a given sum of money goes
down; when prices fall, the value of money rises; and when prices rise, the value of money
falls. The economist is interested in measuring these changes in the value of money. The
usual method adopted to measure changes in the value of money is by means of an index
number of prices i.e. a statistical device used to express price changes as percentage of
prices in a base year or at a base date.
In preparing index numbers, a group of commodities is selected, their prices noted in

some particular year which becomes the base year for the index number and to which the
number 100 is given. If the prices of these commodities rise by 1 per cent during the
ensuing twelve months the index number next year will be 101. Examples of Index Number
are Cost-of Living-Index, Retail Price Index, Wholesale Price Index, Export Prices Index, etc.
The construction of Index Numbers presents some very serious problems and, as they
cannot be ideally solved, the index numbers by themselves are limited in their value and
reliability as a measurement of changes in the level of prices. The problems are:
i) The problems of weighting: The greatest difficulty facing the compiler of index number
is to decide on how much of each commodity to select. This is the problem of
weighting.
Different ―weights‖ will yield different results.
ii) The other problem is to decide what grades and quantities to take into account. By
including more than one grade an attempt is made to make a representative selection.
An even greater difficulty occurs when the prices of a commodity remain unchanged,
although the quantity has declined.
iii) The choice of the base year. This would preferably be a year when prices are
reasonably steady, and so years during periods either of severe inflation or deflation
are to be avoided.
iv) Index numbers are of limited value for comparisons over long periods of time because:
 New commodities come on the market.
 Changes in taste or fashion reduce the demand for some commodities and
increase the demand for others.
 The composition of the community is likely to change.
 Changes may occur in the distribution of the population among the various age
groups.
 The rise in the Standard of living.
v) Changes in the taxation of goods and services affect the index.
11.2 Types of Banks

Banking can be defined as the business activity of accepting and safeguarding money
owned by other individuals and entities, and then lending out this money in order to earn a
profit. A bank is therefore a financial institution that undertakes the banking activity ie.
Accepts deposits and then lends the same to earn certain profit. However, with the
passage of time, the activities covered by banking business have widened and now various
other services are also offered by banks. The banking services these days include
issuance of debit and credit cards, providing safe custody of valuable items, lockers, ATM
services and online transfer of funds across the country / world.
Banking activities encourages the flow of money to productive use and investments. This
in turn allows the economy to grow. In the absence of banking business, savings would sit

idle in our homes, the entrepreneurs would not be in a position to raise the money, ordinary
people dreaming for a new car or house would not be able to purchase cars or houses.
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Banking systems can be defined as a mechanism through which the money supply of the
country is created and controlled. The system consists of all those institutions which
determine the supply of money. The main element of the banking system is the
Commercial Bank (in Kenya). The second main element of banking system is the Central
Bank and finally most banking systems also have a variety of other specialized institutions
often called Financial Intermediaries.
Functions of Commercial Banks

In modern economy, commercial banks have the following functions:
i. They provide a safe deposit for money and other valuables. Bank notes and coins
constitute the currency in circulation. But they form only a part of the total money
supply. The larger part of the money supply in circulation today consists of bank
deposits. Bank deposits can either be a current account or deposit account.
ii. They lend money to borrowers partly because they charge interest on the loans,
which is a source of income for them, and partly because they usually lend to
commercial enterprises and help in bringing about development.
iii. They provide safe and non-inflationary means for debt settlements through the use
of cheques, in that no cash is actually handled. This is particularly important where
large amounts of money are involved.
iv. They act as agents of the central banks in dealings involving foreign exchange on
behalf of the central bank and issue travelers‘ cheques on instructions from the
central bank. e.g. the
Barclays Bank (Kenya). This is useful in that it guards against loss and theft for if the
cheques are lost or stolen; the lost or stolen numbers can be cancelled, which cannot
easily be done with cash. This also safe if large amount of money is involved.
v. They offer management advisory services especially to enterprises which borrow
from them to ensure that their loans are properly utilized.
vi. Some commercial banks offer insurance services to their customers eg. The
Standard Bank (Kenya) which offers insurance services to those who hold savings
accounts with it.
Non-banking financial institutions

NBFIs were set up to fill a gap in the financial system and rectify inefficiencies in loan
facilities. These specialized financial institutions supplement the availability of finance
provided by commercial banks. The NBFIs are both public and private. These institutions
mobilize savings, in competition with commercial banks. The savings are then channeled
into credit for commerce, agriculture, industry and household sectors. Kenya continues to
develop a wider range of these financial institutions.
In 1980s, (NBFIS) grew rapidly in number, assets and liabilities. This growth mainly
reflected some defects in the banking act such as:
• The minimum capital required to establish NBFIS was lower than needed by
Commercial banks.
• Unlike banks, NBFIS were not required to maintain cash reserve ratio.
• NBFIs were permitted to impose higher lending rates on their facilities.
• Banks were restricted from undertaking mortgaging lending.
• Banks would only lend the equivalent of 25% or less of their capital to any one
single borrower.

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The growth of non-banking institutions was a development that was so positive. Initially,
they provided financial services that were specialized. This included hire purchase, leasing
and merchant banking. The regulatory differences encouraged commercial banks to set up
non-banking financial institutions to avoid the restrictions enforced on them and benefit
from the higher interest rates. As a result, the restrictions between banks and NBFIs
started to lessen with time, causing the competition between them to increase.
The increasing competition forced many of the NBFIs to become unusually aggressive.
Some undertook risky lending and mismatched maturities whereby they accepted lower
matches. The operation of non-banking financial institutions became unsustainable and
contributed to the collapse of several institutions in mid 1980s and early 1990s. As a result,
there was a flight of equality depository institutions as most depositors shifted funds from
small NBFIs to larger and more established banks.
The Central Bank, on realizing that NBFIs were no longer complimenting activities of
commercial banks, took the following measures:
i. It broadened the definition of money supply so as to include the deposits held at
NBFIs. Ii.With effects from 1995 NBFIs were required to observe cash ratio
requirements at
stipulated levels. They were to do this by involving reserves at the
Central Bank. iii. It adopted the policy of universal banking in 1995.
Since then, the central bank has encouraged NBFIS to convert into Commercial banks and
merge with commercial bank where possible. By August 2000, 25 conversions and 12
mergers had occurred, leaving only 11 institutions still operating as NBFIs.
Role in NBFIs in economic development

NBFIs supplement banks by providing the infrastructure to allocate surplus resources to
individuals and companies with deficits. Additionally, NBFIs also introduces competition in
the provision of financial services. While banks may offer a set of financial services as a
packaged deal, NBFIs unbundle and tailor these services to meet the needs of specific
clients. Additionally, individual NBFIs may specialize in one particular sector and develop
an informational advantage. Through the process of unbundling, targeting, and
specializing, NBFIs enhances competition within the financial services industry and
enhances;
a) Growth: research suggests a high correlation between a financial development and
economic growth. Generally, a market-based financial system has better-developed
NBFIs than a bank-based system, which is conducive for economic growth.
b) Stability: A multi-faceted financial system that includes non-bank financial
institutions can protect economies from financial shocks and enable speedy
recovery when these shocks happen. NBFIs provide multiple alternatives to
transform an economy's savings into capital investment, which serve as backup
facilities should the primary form of intermediation fail. However, in the absence of
effective financial regulations, non-bank financial institutions can actually exacerbate
the fragility of the financial system.
On the other hand, since not all NBFIs are heavily regulated, the shadow banking
system constituted by these institutions could wreak potential instability. In addition,
Due to increased competition, established lenders are often reluctant to include
NBFIs into existing credit-information sharing arrangements. NBFIs often lack the

technological capabilities
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necessary to participate in information sharing networks thus they contribute less
information to credit-reporting agencies than do banks.
11.3 Role of Central Bank in the Economy

Central Banks are usually owned and operated by governments and their functions are:
i. Government‟s banker: Government‘s need to hold their funds in an account into
which they can make deposits and against which they can draw cheques. Such
accounts are usually held by the Central Bank
ii. Banker‟s Bank: Commercial banks need a place to deposit their funds; they need to
be able to transfer their funds among themselves; and they need to be able to borrow
money when they are short of cash. The Central Bank accepts deposits from the
commercial banks and will on order transfer these deposits among the commercial
banks. Thus the central bank acts as the Clearing House of commercial banks.
iii. Issue of notes and coins: In most countries the central bank has the sole power to
issue and control notes and coins. This is a function it took over from the commercial
banks for effective control and to ensure maintenance of confidence in the banking
system.
iv. Lender of last resort: Commercial banks often have sudden needs for cash and one
way of getting it is to borrow from the central bank. If all other sources failed, the
central bank would lend money to commercial banks in temporary need of cash. To
discourage banks from over-lending, the central bank will normally lend to the
commercial banks at a high rate of interest which the commercial bank passes on to
the borrowers at an even higher rate. For this reason, commercial banks borrow from
the central bank as the lender of the last resort.
v. Managing national debt: It is responsible for the sale of Government Securities or
Treasury Bills, the payment of interests on them and their redeeming when they
mature.
vi. Banking supervision: In liberalized economy, central banks usually have a major role
to play in policing the economy.
vii. Operating monetary policy: Monetary policy is the regulation of the economy
through the control of the quantity of money available and through the price of
money i.e. the rate of interest borrowers will have to pay. Expanding the quantity of
money and lowering the rate of interest should stimulate spending in the economy
and is thus expansionary, or inflationary. Conversely, restricting the quantity of
money and raising the rate of interest should have a restraining, or deflationary
effect upon the economy.

1. State five functions of commercial banks in a developing economy
2. Explain three reasons that led to the emergence of Non-banking financial institutions in
Kenya
3. Outline the role of the central bank in an economy
4. State six functions of the money market in a developing economy
5. Describe the history of the development of money
TOPIC 12

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12.0 PUBLIC FINANCE
Meaning of Public Finance
Public finance is a branch of economics that studies the financing of public activities and
the impact of the various ways of raising government revenue and expenditure on a
country‘s economy, individual sectors of the economy and individuals.
Principles of Public Finance

The principles and nature of public finance depends according to the traditional definition
of the subject, that is, branch of Economics which deals with the income and expenditure
of a government. In the words of Adam Smith, the investment into the nature and
principles of state expenditure and state revenue is called classical view of public finance
administration. The earlier economists were perfectly justified in giving this definition of
the science of public finance because the functions of the public authorities in those days
were simply to raise revenue by imposing taxes for covering the cost of administration and
defense.
The scope of the science of public finance now-a-days has widened too much. It is due to
the fact that modern states have to perform multifarious functions to promote the welfare
of its citizens. In addition to maintaining law and order within the country and provision of
security from external aggression, it has to perform many economic and commercial
functions. Due to the increased activities of the state, there has taken place a vast
increase in the expenditure of the public authorities. The sources of revenue have also
increased. Taxes are levied not for raising the revenue alone but are used as an important
instrument of economic policy. Public finance now includes the study of, financial
administration and control as well. Public finance is therefore defined e as that branch of
economics which ‗deals with income and expenditure of public authorities or the state
and their mutual relation as also with the financial administration and control (the term
public authorities includes all bodies which help in carrying on the administration of the
state). The study of public finance is split up into four parts namely: Public Expenditure,
Public Revenue, Public Debt and Budgeting etc
12.1 Sources of Government Revenue

Public revenue is all the amounts which are received by the government from different
sources. The main sources of public revenue are:
(a) Taxes
Taxes are the most important source of public revenue. Any tax can be defined as an
involuntary payment by a tax payer without involving a direct repayment of goods and
services (as a "quid pro quo") in return. In other words, there are no direct goods or
services given to a tax payer in return for the tax paid. The tax payer can, however enjoy
goods or services provided by the government like any other citizen without any
preference or discrimination.
In addition to the above some tax experts define tax as;
i. A compulsory contribution to a public authority, irrespective of the exact amount of
service rendered to the tax payer in return.
ii. A compulsory contribution from a person to the government to defray the
expenses incurred in the common interest of all.
iii. A compulsory contribution of wealth by a person or body of persons for the
service of the public. There is a portion of the produce of the land and labour of
country that is placed at the disposal of the government for the common good of

all.
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(b) Land rent and rates
These are levies imposed on property. Rent is paid to the Central Government on some
land leases while rates are paid to the Local Authority based on the value of property
(c) Fees
Fees is an amount which is received for any direct services rendered by the Central or
Local Authority e.g. television and radio fees, national park fees, airport departure fee,
airport landing and parking fee, port fee by ships, university fee, etc.
(d) Prices
Prices are those amounts which are received by the central or local authority for
commercial services e.g. railway fare, postage and revenue stamps, telephone charges,
radio and television advertisement etc.
(e) External borrowing
This is done from foreign governments and international financial institutions such as
World Bank and International Monetary Fund (IMF).
(f) Fines and Penalties
If individuals and firms do not obey the laws of the country, fines and penalties are
imposed on them. Such fines and penalties are also the income of the government.
(f) State Property
Some land, forests, mines, national parks, etc. are government property. The income
that arises from such property is also another source of public revenue. The income
will arise from payment of rents, royalties, or sale of produce.
Public Debt/Borrowing
Public debt also known as Government debt is the debt owed by a central government or
provincial government, municipal or local government. Public debt is one method of
financing government operations, but it is not the only method. Public debt management is
the process of establishing and executing a strategy for managing a governments' debt in
order to raise the required amount of funding, achieve its risk and cost objectives and to
meet any other debt management goals that a government may have set, such as
developing and maintaining an efficient market for government securities.
Governments usually borrow by issuing securities, government bonds and bills. Less
creditworthy countries sometimes borrow directly from international organizations (e.g.
the World Bank) or international financial institutions. As the government draws its income
from much of the population, public debt is an indirect debt of the taxpayers. Government
debt can be categorized as internal debt (owed to lenders within the country) and external
debt (owed to foreign lenders).
Debt servicing refers to payment of public debt and interest earned by the debts i.e. the
cash that is required for a particular time period to cover the repayment of interest and
principal on a debt. Debt service is often calculated on a yearly basis. Debt service for a
country often includes such financial obligations as a payment of internal and external
debts which may include repayments for outstanding loans or outstanding interest on
bonds or the principal of maturing bonds that count towards the government‘s debt
service.
Among challenges in managing public finance are intra-organisational reforms and

accountability. Many public sector management interventions have been directed at civil
service reform through downsizing, cost containment, and improvements in management
skills and knowledge through

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training. The latter has been a traditional area of activity for bilateral donors in particular.
However, the primacy of training is being challenged by hitherto relatively neglected
avenues of organisational reform. Some of these, like institution building and strategic
management, have a more comprehensive view of factors that influence organisational
performance. This notion of accountability is applicable to all levels of government, public
enterprises, individuals, and groups. Methods of ensuring accountability will naturally differ
between the micro- and macro-levels of government. At all levels, however, public
accountability is intended to ensure close correlation between stated intentions, or goals,
and actions and services rendered to the public, as well as the efficient and effective use
of public resources.
12.2 Government Expenditure

Broadly speaking, government spending is for the purposes of macroeconomic goals. The
spending can be expansionary, that is aimed at growing the economy and increasing
employment, or contractionary (aimed at slowing the growth of the economy).
Expansionary policy features increased government spending and/or decreases in the tax
rates, while contractionary policy is the opposite (lower government spending and/or
higher tax rates).
When governments increase their spending, crowding out can occur i.e. government
spending reduces available funds and increases the cost of capital, leading many
businesses to abandon expansion projects. Likewise, when a government spends in
excess of receipts (a deficit) and must borrow funds to finance that deficit, crowding out
can occur.
From a macroeconomic perspective, government debt can be thought of as future
spending brought forth into present time. Governments incur debt when their spending
desires exceed their receipts from taxes and other income sources, and that debt is
ultimately repaid through a levy of taxes in excess of current spending.
Classification of Public Expenditure

Classification of Public expenditure refers to the systematic arrangement of different
items on which the government incurs expenditure. Different economists have looked at
public expenditure from different point of view. The following classification is a based on
these different views.
a. Functional Classification
Some economists classify public expenditure on the basis of functions for which they
are incurred. The government performs various functions like defence, social welfare,
agriculture, infrastructure and industrial development. The expenditure incurred on
such functions fall under this classification. These functions are further divided into
subsidiary functions. This kind of classification provides a clear idea about how the
public funds are spent.
b. Revenue and Capital Expenditure
Revenue expenditure are current or consumption expenditures incurred on civil
administration, defence forces, public health and education, maintenance of
government machinery. This type of expenditure is of recurring type which is incurred
year after year. On the other hand, capital expenditures are incurred on building
durable assets, like highways, multipurpose dams, irrigation projects, buying
machinery and equipment. They are non recurring type of expenditures in the form of
capital investments. Such expenditures are expected to improve the productive
capacity of the economy.

c. Transfer and Non-Transfer Expenditure
A.C. Pigou, the British economist has classified public expenditure as Transfer
expenditure and Non-transfer expenditure. Transfer expenditure relates to the
expenditure against which there is
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no corresponding return. Such expenditure includes public expenditure on National
Old Age Pension Schemes, Interest payments, Subsidies, Unemployment allowances,
Welfare benefits to weaker sections, etc. By incurring such expenditure, the
government does not get anything in return, but it adds to the welfare of the people,
especially belong to the weaker sections of the society. Such expenditure basically
results in redistribution of money incomes within the society.
The non-transfer expenditure relates to expenditure which results in creation of

income or output. The non-transfer expenditure includes development as well as non-
development expenditure that results in creation of output directly or indirectly. By
incurring such expenditure, the government creates a healthy conditions or
environment for economic activities. Due to economic growth, the government may be
able to generate income in form of duties and taxes.
d. Productive and Unproductive Expenditure
This classification was made by Classical economists on the basis of creation of
productive capacity. Productive Expenditure is Expenditure on infrastructure
development, public enterprises or development of agriculture increase productive
capacity in the economy and bring income to the government. Unproductive
Expenditure is Expenditures in the nature of consumption such as defence, interest
payments, expenditure on law and order, public administration which do not create any
productive asset which can bring income or returns to the government.
e. Grants and Purchase Price
This classification has been suggested by economist Hugh Dalton. Grants are those
payments made by a public authority for which there may not be any quid-pro-quo, i.e.,
there will be no receipt of goods or services. For example, old age pension,
unemployment benefits, subsidies, social insurance, etc. Grants are transfer
expenditures. Purchase prices are expenditures for which the government receives
goods and services in return. For example, salaries and wages to government
employees and purchase of consumption and capital goods
Hugh Dalton further classified public expenditure as follows:-

i. Expenditures on political executives: i.e. maintenance of ceremonial heads of
state, like the president.
ii. Administrative expenditure: to maintain the general administration of the
country, like government departments and offices.
iii. Security expenditure: to maintain armed forces and the police forces.
iv. Expenditure on administration of justice: include maintenance of courts,
judges, public prosecutors.
v. Developmental expenditures: to promote growth and development of the
economy, like expenditure on infrastructure, irrigation, etc.
vi. Social expenditures: on public health, community welfare, social security, etc.
vii. Public debt charges: include payment of interest and repayment of principle
amount. f. Classification According to Benefits
Public expenditure can be classified on the basis of benefits they confer on different
groups of people as follows;
i. Common benefits to all: Expenditures that confer common benefits on all the
people. E.g. expenditure on education; public health; transport; defence; law
and order; general administration etc
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ii .Special benefits to all : Expenditures that confer special benefits on all. For
example, administration of justice, social security measures, community
welfare.
iii. Special benefits to some: Expenditures that confer direct special benefits on
certain people and also add to general welfare. For example, old age pension,
subsidies to weaker section, unemployment benefits.
Reasons for Public Expenditure

a) To supply goods and services that the private sector would fail to do, such as public
goods, including defence, roads and bridges; merit goods, such as hospitals and schools;
and welfare payments and benefits, including unemployment and disability benefit.
b) To achieve supply-side improvements in the macro-economy, such as spending on
education and
training to improve labour productivity.
c)To reduce the negative effects of externalities, such as pollution controls.
d)To subsidize industries which may need financial support, and which is not available
from the private sector. For example, transport infrastructure projects are unlikely to
attract private finance, unless the public sector provides some of the high-risk
Agriculture is also an industry which receives large government subsidies.
e) To help redistribute income and achieve more equity.
f) To inject extra spending into the macro-economy, to help achieve increases in aggregate
demand and economic activity. Such a stimulus is part of discretionary fiscal policy.
National Budget
A national budget is a detailed plan outlining the acquisition and use of financial and other
resources over some period of time in the future or an estimation of the revenue and
expenses over a specified future period of time in a country. A budget can also be made
for a person, family, group of people, business, government, multinational organization or
just about anything else that makes and spends money. A budget is a microeconomic
concept that shows the tradeoff made when one good is exchanged for another.
Role of budgeting in public

finance a. Coordination
The budgetary process requires that visible detailed budgets are developed to cover
each sector, department or function in the country. This is only possible when the effort
of one sector / department‘s budget is related to the budget of another sector/
department. In this way, coordination of activities, function and department is achieved.
b. Communication
The full budgeting process involves liaison and discussion among all levels in
government. Both vertical and horizontal communication is necessary to ensure proper
coordination of activities. The budget itself may also act as a tool of communication of
what is expected of the government. High standards set calls for hard work and more
input in terms of labour, time and other resources.
c. Control
This is the process for comparing actual results with the budgeted results and reporting
upon variances. Budgets set a control gauge, which assists to accomplish the plans set
within agreed expenditure limits. The approach followed in the control process has five
basic steps:
(i) Preparation of budgets based on the predetermined data on performance and

prices.
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(ii) Measurement of actual performance and recording the data.
(iii) Comparing the budget with the actual performance and recording the
difference.
(iv) Ascertaining reasons for the differences through, including others, variance
analysis.
(v) Taking corrective actions through administering of proper strategies and
measures.
d. Motivation
Budgets may be seen as a bargaining process in which ministries compete with each
other for scarce resources. Budgets set targets, which have to be achieved. Where
budgetary targets are tightly set, some individuals will be positively motivated towards
achieving them. Involvement of citizens in the preparation of budgets motivates them
towards achieving the goals they have set themselves. However, imposing budgets on
citizens will be discouraging as they may perceive the targets as unattainable.
e. Clarification of Responsibility and Authority
Budgetary process necessitates the organization of a ministries / Sectors into
responsibility and budget centers with clear lines of responsibilities of each manager.
This reduces duplication of efforts. Each manager manages those items directly under
his or her control. To facilitate effective responsibility accounting, authority and
responsibility relationship must be balanced.
f. Planning
It is by Budgetary Planning that long-term plans are put into action. Planning involves
determination of objectives to be attained at a future predetermined time. When
monetary values are attached to plans they become budgets. Good planning without
effective control is time wasted. Unless plans are laid down in advance, there are no
objectives towards which control can be affected.
12.3 Purpose of Taxation

Taxation is the process of imposing compulsory contribution on the private sector to meet
the expenses which are incurred for a common good.
Purpose of Taxation
The raising of revenue is not the only purpose for which taxes are levied. The taxes are
levied for various purposes as follows:
a. Raising Revenue
The main purpose of imposing taxes is to raise government income or revenue.
Taxes are the major sources of government revenue. The government needs such
revenue to maintain the peace and security in a country, to increase social welfare, to
complete development projects like roads, schools, hospitals, power stations, etc.
b. Economic Stability
Taxes are also imposed to maintain economic stability in a country. In theory, during
inflation, the government imposes more taxes in order to discourage the unnecessary
expenditure of the individuals. On the other hand, during deflation, the taxes are
reduced in order to encourage individuals to spend more money on goods and
services. The increase and decrease in taxes helps to check the big fluctuations in
the prices of goods and services and thus maintain the economic stability.
c. Protection Policy
Where a government has a policy of protecting some industries or commodities

produced in a country, taxes may be imposed to implement such a policy. Heavy
taxes are therefore imposed
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on commodities imported from other countries which compete with local
commodities thus making them expensive. The consumers are therefore encouraged
to buy the locally produced and low priced goods and services.
d. Social Welfare
Some commodities such as wines, spirits, beer, cigarettes, etc. are harmful to human
health. To discourage wide consumption of these harmful commodities, taxes are
imposed to make the commodities more expensive and therefore out of reach of as
many people as possible.
e. Fair Distribution of Income
In any country, some people will be rich and others will be poor due to limited
opportunities and numerous hindrances to becoming wealthy. Taxes can be imposed
which aim to achieve equality in the distribution of national income. The rich are
taxed at a higher rate and the amounts obtained are spent on increasing the welfare
of the poor. That way, the taxes help to achieve a fair distribution of income in a
country.
f. Allocation of Resources
Taxes can be used to achieve reasonable allocation of resources in a country for
optimum utilization of those resources. The amounts collected from taxes are used
to subsidise or finance more productive projects ignored by private investors. The
government may also remove taxes on some industries or impose low rates of taxes
to encourage allocation of resources in that direction
g. Increase In Employment Funds collected from taxes can be used on public works
programmes like roads, drainage, and other public buildings. If manual labour is used
to complete these programmes, more employment opportunities are created.
Principles of Taxation
These are the principles of an optimal tax system, also known as Canons of taxation,
some of which were laid down by Adam Smith.
a. Simplicity: A tax system should be simple enough to enable a tax payer to understand
it and be able to compute his/her tax liability. A complex and difficult to understand
tax system may produce a low yield as it may discourage the tax payer's willingness
to declare income. It may also create administrative difficulties leading to inefficiency.
The most simple tax system is where there is a single tax. However, this may not be
equitable as some people will not pay tax.
b. Certainty: The tax should be formulated so that tax payers are certain of how much
they have to pay and when. The tax should not be arbitrary. The government should
have reasonable certainty about the attainment of the objective(s) of that tax, the
yield and the extent to which it can be evaded. There should be readily available
information if tax payers need it. Certainty is essential in tax planning. This involves
appraising different business or investment opportunities on the basis of the possible
tax implications. It is also important in designing remuneration packages. Employers
seek to offer the most tax efficient remuneration packages which would not be
possible if uncertainty exists.
c. Convenience
The method and frequency of payment should be convenient to the tax payer e.g.
PAYE. This may discourage tax evasion. For example, it may be difficult for many tax
payers to make a lumpsum payment of tax at the year-end. For such taxes, the
evasion ratio is quite high.
d. Economic/Administrative Efficiency
A good tax system should be capable of being administered efficiently. The system

should produce the highest possible yield at the lowest possible cost both to the tax
authorities and the
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tax payer. The tax system should ensure that the greatest possible proportion of
taxes collected accrue to the government as revenue.
e. Taxable Capacity
This refers to the maximum tax which may be collected from a tax payer without
producing undesirable effects on him. A good tax system ensures that people pay
taxes to the extent they can afford it. There are two aspects of taxable capacity.
i) Absolute taxable capacity
ii) Relative taxable capacity
Absolute taxable capacity is measured in relation to the general economic conditions
and individual position e.g. the region, or industry to which the tax payer belongs. If an
individual, having regard to his circumstances and the prevailing economic conditions
pays more tax than he should, his taxable capacity would have been exceeded in the
absolute sense. Relative taxable capacity is measured by comparing the absolute
taxable capacities of different individuals or communities.
f. Neutrality
Neutrality is the measure of the extent to which a tax avoids distorting the workings
of the market mechanism. It should produce the minimum substitution effects. The
allocation of goods and services in a free market economy is achieved through the
price mechanism. A neutral tax system should not affect the tax payer's choice of
goods or services to be consumed.
g. Productivity
A tax should be productive in the sense that it should bring in large revenue which
should be adequate for the government. This does not mean overtaxing by the
government. A single tax which brings in large revenues is better than many taxes
that bring in little revenue. For example Value Added Tax was introduced since it
would provide more revenue than Sales Tax
h. Elasticity or Buoyancy
By elasticity we mean that the government should be capable of varying (increasing
or reducing) rates of taxation in accordance to the circumstances in the economy, e.g.
if government requires additional revenue, it should be able to increase the rates of
taxation. Excise duty, for instance, is imposed on a number of commodities locally
manufactured and their rates can be increased in order to raise more revenue.
However, care must be taken not to charge increased rate of excise duty from year to
year because they might exert inflational pressures on the economy.
i. Flexibility
It means that there should be no rigidity in taxation i.e. the tax system can be
changed to meet the revenue requirement of the state; both the rate and structure of
taxes should be capable of change or being changed to reflect the state‘s
requirements. Such that certain old taxes are discouraged while new ones are
introduced. The entire tax structure should be capable of change.
j. Diversity
It means that there should be variety or diversity in taxation. That the tax base should
be wide enough so as to raise adequate revenue and also the tax burden is evenly
distributed among the tax payers. A single tax or a few taxes may not meet revenue
requirements of the state. There should be both direct and indirect taxes.
k. Equity
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A good tax system should be based on the ability to pay. Equity is about how the
burden of taxation is distributed. The tax system should be arranged so as to result in
the minimum possible sacrifice. Through progressive taxation, those with high
incomes pay a large amount of tax as well as a regular proportion of their income as
tax. Equity means people in similar circumstances should be given similar treatment
(horizontal equity) and dissimilar treatment for people in dissimilar circumstances
(vertical equity). There are three alternative principles that may be applied in the
equitable distribution of the tax burden which are; The benefit principle, The ability to
pay principle and The cost of service principle
Types of Taxes
Taxes can be classified on the
basis of: a. Impact and incidence
of the taxes
Impact of tax means on whom the tax is imposed. On the other hand, incidence of the
tax refers to who had to bear the burden of the tax i.e. who finally pays the tax. In this
case the taxes may be: Direct or Indirect
b. Rates of tax
The rate of tax is the percentage of the tax base to be taken in each situation. In this
case the taxes may be: progressive or proportional or regressive or digestive
i) Direct taxes
A direct tax is one where the impact and incidence of the Tax is on the same person e.g.
Income Tax, death or estate duty, corporation taxes and capital gains taxes. It can also be
defined as the tax paid by the person on whom it is legally imposed.
Merits of direct taxes

a. They satisfy the principle of equity as they are easily matched to the tax payers
capacity to pay once assessed.
b.They satisfy the principles of certainty and convenience to tax payers as they know the
time and manner of payment, and the amount to be paid in the case of these taxes.
Similarly, the government is also certain as to the amount of money it shall receive
from these taxes.
c. They satisfy the Canon Simplicity as they are easy to understand.
d.Because most of them are progressive, they tend to reduce income inequalities as the
rich are taxed heavily through income tax, wealth tax, expenditure tax, excess profit,
gift tax, etc.
e. Because the public are paying taxes to the government, they take an interest in the
activities of the state as to whether the public expenditure is incurred on public
welfare or not. Such civic consciousness puts a check on the wastage of the public
expenditure in a democratic country.
Demerits of direct taxes
a) Heavy direct taxation, especially when closely linked to current earnings, can act as a
serious check to productivity by encouraging absenteeism and making men disinclined
to work.
b) Heavy direct taxation will clearly reduce people‘s ability to save since it leaves them with
less money to spend.
c) Direct taxes possess an element of arbitrariness in them. They leave much to the

discretion of the taxation authorities in fixing the rates and in interpreting them.
d) They are not imposed on all as incomes earned on subsistence and non legal activities are
left out.
e) Cost of collection is generally high.
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f) These taxes are easily evaded either by understating the source of income or by any
other means. Such taxes thus cultivate dishonesty and there is loss of revenue to the
state.
ii) Indirect taxes

These are imposed on an individual mostly producers or traders but they can be passed on
to be borne by others usually the final consumers. They can also be defined as taxes
where the incidence is not on the person on whom it‘s legally imposed. They include excise
duties, sales tax, Value Added Tax and others.
Advantage of indirect taxes
a) They are less costly to administer because the producers and sellers themselves
deposit them with the government.
b)If levied on goods with inelastic demand with respect to price rises, it will result in high
revenue collection.
c)Indirect taxes reach the pockets of all income groups. Thus, they have a wide coverage,
and every consumer pays to the state exchequer according to his ability to pay.
d)They can check on the consumption of harmful goods like wine, cigarettes and other
toxicants.
e) Can be used as a powerful tool for implementing economic policies by the government.
e.g the government wants to protect domestic industries from foreign competition, it
can levy heavy import duties which will help to develop domestic industries.
Disadvantages of indirect taxes
a) Most indirect taxes are regressive as they are based are not based on ability to pay.
The rich and the poor are required to pay the same amount of tax on such
commodities as matches, kerosene, toilet soap, washing soap, toothpaste, blades,
shoes, etc
b) They may lead to inflation as their imposition tends to raise the prices of commodities,
thereby leading to higher costs, to higher wages, and again to higher prices. Thus a
price-wage cost spiral sets in the economy
c) They sometimes have adverse effects on production of commodities, and even
employment. When the price of a commodity increases with the levy of a tax, its
demand falls. As a result, its production falls, and so employment.
d) The revenue from indirect taxes is uncertain because it is not possible to accurately
estimate the effect of such taxes on the demand for products.
iii) Progressive tax

A progressive income tax system is one where the higher the income, the greater the
proportion paid in taxes. This is effected by dividing the taxpayers‘ incomes into bands
(brackets) upon which different rates of tax are paid – the rates being higher and the band
of income. For example, in Kenya, the tax bands are as follows with effect from 2005: First
KShs. 121,968 @ 10%
Next KShs.114, 912 @ 15%
Next KShs.114, 912 @ 20%
Next KShs.114, 9120 @ 25%
Above KShs. 466,704 @ 30%.
Examples of Progressive taxes in Kenya are Income Tax, Estate Duty, Wealth Tax and Gift
Tax.
Advantages of progressive tax
a) It is more equitable. The broader shoulders are asked to carry the heavier burden.
b) It satisfies the canon of productivity as it yields much more than it would under

proportional taxation.
c) It satisfies the canon of equity as it brings about an equality of sacrifice among the
taxpayers.
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d) To some extent it reduces inequalities of wealth distribution.
Disadvantages of progressive tax
a) High progressive tax makes work and extra effort become less valuable.
b) The effect on the willingness to accept risk i.e. High marginal rates of tax are likely to
make entrepreneurs less willing to undertake risks.
c) Effects on mobility i.e. some financial inducement is usually required if people are to
be asked to change their location, or undergo training, or accept promotion.
Progressive taxation by reducing differentials is likely to have some effect on a
person‘s willingness to any of the above.
d) Encourages tax avoidance and evasion.
e) Outflow of high achievers to other countries with lower Marginal tax rates.
d) It can lead to fiscal-drag where wage and price inflation cause people to pay higher
proportion of income as tax.
iv) Proportional tax

Is where whatever the size of income, the same rate or same percentage is charged.
Examples are commodity taxes like customs, excise duties and sales tax. Its
advantage is that it‘s much simpler than progressive taxation.
v) Regressive tax
A tax is said to be regressive when its burden falls more heavily on the poor than on the
rich. No civilized government imposes a tax like this.
vi) Digressive tax
A tax is called digressive when the higher incomes do not make a due contribution or
when the burden imposed on them is relatively less. Another way in which digressive
tax may occur is when the highest percentage is set for that given type of income one
which it is intended to exert most pressure; and from this point onwards, the rate is
applied proportionally on higher incomes and decreasing on lower incomes, falling to
zero on the lowest incomes.
Economic effects of taxation

a) A deterrent to work: Heavy direct taxation, especially when closely linked to current
earnings, can act as a serious check to production by encouraging absenteeism, and
making men disinclined to work. However, indirect taxation may actually increase the
incentive to work, since the more money is then required to satisfy the same wants,
indirect taxes having made goods dearer than they were before.
b. A deterrent to saving: Taxation will clearly reduce people‘s ability to save since it leaves
them with less money to spend. Taxation may, therefore, act as a deterrent to saving.
However, this will not always be the case, as it will depend on the purpose for which
people are saving.
c. A deterrent to enterprise: It is argued that entrepreneurs will embark upon risky
undertakings only when there is a possibility of earning large profits if they are
successful. Heavy taxation of
profits, robs them of their possible reward without providing any compensation in the
case of failure. As a result, production is checked and economic progress hindered
d) Taxation may encourage inflation: Under full employment increased indirect taxation will
lead to demand for higher wages, thereby encouraging inflation. A general increase in
purchase taxes pushes up the Index of Retail Prices, and so brings in its train demands
for wage increase.
e) Diversion of economic resources: Taxation of commodities is similar in effect to an

increase in their cost of production. Thus, the influence of a change of supply has to be
considered, effect
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depending on their elasticity of demand. In consequence of taxation, resources will
move from heavily taxed to more lightly taxed forms of production. This result may, of
course, be desired on Non-economic grounds.
Fiscal Policy
Fiscal policy has been defined in a number of ways. According to Samuelson, by fiscal
policy we mean the process of shaping taxation and public expenditure in order to (a) help
dampen the swings of the business cycle and (b) to contribute to the maintenance of a
growing high employment economy. In the words of Arthur Smith, fiscal policy means
―policy under which the government uses its expenditure and revenue programmes to
produce desirable effects and to avoid undesirable effects on the national income,
production and employment‖. Roger defines fiscal policy as, ―changes in taxes and
expenditure which aim at short run goals of full employment and price level stability‖.
Fiscal policy also called budgetary policy is a powerful instrument in the hands of the
government to intervene in the economy. Fiscal policy relates to a variety of measures
which are broadly classified. as (a) taxation (b) public expenditure and (c) public borrowing.
Fiscal policy is considered an essential method for achieving, the objectives of
development both in developed and underdeveloped countries of the world.
Importance of Fiscal Policy
The role of fiscal policy in less developed countries differs from that in developed
countries. In the developed countries, the role of fiscal policy is to promote fall
employment without Inflation through its spending and taxing powers. On the other hand,
The LDC‘s or developing countries are caught in a vicious circle of poverty. The vicious
circle of low income, low consumption, low savings, low rate of capital formation and
therefore low income has to be broken by a suitable fiscal policy. Fiscal policy in
developing countries is thus used to achieve objectives which are different from the
advanced countries. The principal roles of fiscal policy in a developing economy are:
(i) To mobilize resources for financing development.
The moping up of surplus resources through taxation is an effective means of
raising resources for capital formation. A rise in tax rates causes a reduction in
aggregate demand for three reasons (1) it reduces consumption (2) It reduces
investment and (3) it reduces net exports. A fall in the tax rates has the opposite
.
effect. Agriculture sector is another important source of revenue which can be
tapped for capital formation. With the use of improved methods of cultivation, the
agricultural production has fairly increased. It is, therefore, justified that this largest
sector of the economy should be brought under progressive tax net. The
government will not only raise large amount of revenue but also remove the
disparity between agriculture income and non agriculture income for tax purpose.
(ii) To promote economic growth in the private sector.

In a mixed economy, private sector constitutes an important part of the economy.
While framing fiscal policy, the interests of the private sector should not be ignored.
The private sector should make significant contribution to the development of the
economy. The fiscal methods for stimulating private investment in developing
countries are: exempting Tax on national saving and other approved forms of
saving from taxation, to encourage private savings; raising the rates of return on
voluntary contribution to provident fund, insurance premium etc., as an incentive to
save; offering preferential rates or exempting the retained profits of the public
companies from taxation to boost private investment; Private investment can being
stimulated by giving tax holidays or relief from tax for some specified

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period of time to certain selected industries as well as granting rebates and liberal
depreciation allowances can also be granted to encourage investment in the private
sector.
(iii) To control inflationary pressure in the economy.
In developing countries there is a tendency of the general prices to go up due to
expenditure on development projects, pressure of wages on prices, long gestation
period between investment expenditure and production etc. Fiscal measures are
used to counter act the effect of inflationary pressure. Tax structure is devised in
such a manner that it mops up a major proportion of the rise in income.
Government also tries to reduce its own spending and achieve budgetary surplus.
It helps in reducing inflationary pressure in the economy.
(iv)To promote economic stability with employment opportunities
The ultimate objective of economic development is to increase conditions of
employment and to provide rising standard of living.
(v) To ensure equitable distribution of income and wealth.
A wider measure of equality in income and wealth is an integral part of economic
development and social advance. The fiscal operations if carefully worked out can
bring about a redistribution of income in favor of the poorer sections of the society.
The government can reduce the high bracket incomes by imposing progressive
direct taxes. For raising the income of the poor above the poverty line and
narrowing the gap between rich and poor, the government can take direct
investment on economic and social overheads.
12.4 Review questions

1. Explain four classes of public expenditure
2. Outline five negative effects of taxation
3. Explain the five basic steps of control process in budgeting
4. Distinguish between monetary policy and fiscal policy
6. Discuss five canons of taxation
7. Briefly discuss the role of budget in public finance
TOPIC 13
13.0UNEMPLOYMENT
13.1Meaning of Unemployment
Employment refers to engagement in any type of income generating activity. A country can
be said to have attained full employment if all the people who are willing and able to work
are employed. Unemployment generally refers to a state / situation where factors of
production (resources) are readily available and capable of being utilized at the ruling
market returns/rewards but they are either underemployed or completely unengaged.
Labour unemployment is considered to be a situation where there are people ready, willing
and able to work at the going market wage rate but they cannot get jobs. This definition
focuses only on those who are involuntarily not employed. All countries suffer
unemployment but most developing countries experience it at relatively higher degree.
Employment can be divided into informal and formal. Formal employment is government
regulated, and workers are assured a wage and certain rights. Informal employment takes
place in small, unregistered enterprises and employs the majority of the employees in
Kenya. Self-employment is also mostly informal

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Unemployment rate shows the number of people unemployed expressed as a percentage
of total labour force at a point in time i.e.
Number of people unemployed x100

Total workforce
13.2 Types of Unemployment

a) Open involuntary unemployment: This occurs when a person is willing to work at the
ruling wage rate but is not able to secure a job. This concept is particularly relevant in
modern urban sector where many young people aspire to get jobs and are unable to do
so.
b) Disguised or „hidden‟ unemployment occurs when the work available to a given
workforce is insufficient of keep it fully employed so that some members of the
workforce could be withdrawn without loss of output. E.g. the civil service in many
developing countries often exceeds the required number, hence the marginal product of
labour in these cases is zero and does not contribute to any national output. Disguised
unemployment is also common in rural areas in developing countries where agriculture
is practiced. Many such individuals working in small plots of land are infact in disguised
unemployment since they could be withdrawn without a fall in output because their
marginal product is zero or even negative.
c) General unemployment is that which is spread throughout the economy and not
confined to a particular region or categories of labour.
d) Structural unemployment, unlike general employment, is that which affects particular
regions or categories of labour and results from an imbalance between the supply of a
particular group of workers and the demand for their services. An example of how such
an imbalance can occur is where technological change makes the product on which a
particular industry is based obsolete or new methods of production render labour with
particular skills redundant. On the demand side, changes in consumer taste,
competition from substitute products or new products in different areas may be
responsible.
e) Seasonal unemployment: Regular seasonal unemployment is caused by annual
variations in seasons, which affect economic activities in sectors such as agriculture,
fisheries, construction and tourism. During peak seasons in the season, demand for
labour will be very high whereas during the off-peak season, there will be a significant
drop in this demand.
f) Frictional unemployment: this is unemployment which arises from immobility in the
labour force rather than from lack of demand for labour. It is essentially short term in
nature and includes unemployment which arises when people are changing jobs or
because of lack of knowledge about job opportunities. It usually takes time to match
prospective employees with employers and individuals will be unemployed during the
search period.
g) Demand deficient or cyclical unemployment: This type of unemployment is associated
with the trade cycle. During the recovery and boom phases of the trade cycle, the
demand for output and labour is high and unemployment is low. On the other hand,
during recession and depression, the demand for output and labor falls and
unemployment rises sharply. Demand deficient unemployment can be relatively long
term in nature, however it can be eradicated by demand management policies.
13.3 Causes of Unemployment

It is obvious that the unemployment situation is grim indeed. It has, therefore, to be

tackled with appropriate measures and on an urgent basis. The major causes which have
been responsible for the wide spread unemployment can be spelt out as under.
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a) Rapid Population Growth:
It is the leading cause of unemployment. In many developing countries, particularly in
rural areas, the population is increasing rapidly. This has adversely affected the
unemployment situation largely in two ways. In the first place, the growth of population
directly encourage the unemployment by making large addition to labour force because
the rate of job expansion could never have been as high as population growth would
have required. Increasing labour force requires the creation of new job opportunities at
an increasing rate. But in actual practice employment expansion has not been
sufficient to match the growth of the labor force.
Secondly; the rapid population growth indirectly affect unemployment situation by

reducing the resources for capital formation. It means large additional expenditure on
their rearing up, maintenance, and education. As a consequence, more resources get
used up in private consumption such as food, clothing, and shelter as well as on public
consumption like drinking water, electricity medical and educational facilities. This
reduces the opportunities of diverting a larger proportion of incomes to saving and
investment.
b) Limited land:
Land is the gift of nature. It is always constant and cannot expand like population
growth. Since, population is increasing rapidly, the land is not sufficient for the growing
population. As a result, there is heavy pressure on the land. In rural areas, most of the
people depend directly on land for their livelihood. Land is very limited in comparison to
population. It creates the unemployment situation for a large number of persons who
depend on agriculture in rural areas.
c) Seasonal Agriculture:
In Rural Society agriculture is the only means of employment. However, most of the rural
people are engaged directly as well as indirectly in agricultural operation. But,
agriculture is basically a seasonal affair that depends on rainfall. It provides
employment facilities to the rural people only in a particular season of the year. For
example, during the sowing and harvesting period, people are fully employed and the
period between the post harvest and before the next sowing they remain unemployed.
It has adversely affected their standard of living.
d) Fragmentation of land:
In many developing countries, the heavy pressure on land of large population results to
the fragmentation of land. It creates a great obstacle in the part of agriculture. As land
is fragmented and agricultural work is being hindered the people who depend on
agriculture remain unemployed. This has an adverse effect on the employment
situation. It also leads to the poverty of villagers.
e) Backward Method of Agriculture:
The method of agriculture is very backward. Till now, the rural farmers follow the old
farming methods. As a result, the farmer cannot feed properly many people by the
produce of his farm and he is unable to provide his children with proper education or to
engage them in any profession. It leads to unemployment problem.
f) Decline of Cottage Industries:
Village or cottage industries are the only means of employment particularly of the
landless people. They depend directly on various cottage industries for their livelihood.
But, now-a-days, these are adversely affected by the industrialisation process. Actually,
it is found that they cannot compete with modern factories in matter or production. As
a result of which the village industries suffer a serious loss and gradually closing down.
Owing to this, the people who work in there remain unemployed and unable to maintain

their livelihood.
g) Defective education:
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6

The day-to-day education is very defective and is confirmed within the class room only. Its
main aim is to acquire certificate only. The present educational system is not job
oriented, it is degree oriented. It is defective on the ground that is more general than
the vocational. Thus, the people who have getting general education are unable to do
any work. They are to be called as good for nothing in the ground that they cannot have
any job here, they can find the ways of self employment. It leads to unemployment as
well as underemployment.
h) Lack of transport and communication:
In rural areas, there are no adequate facilities of transport and communication. Owing to
this, the village people who are not engaged in agricultural work remain unemployed
because they are unable to start any business for their livelihood and they are confined
only within the limited boundary of the village. It is noted that the modern means of
transport and communication are the only way to trade and commerce. Since there is
lack of transport and communication in rural areas, therefore, it leads to unemployment
problem among the villagers.
i) Inadequate Employment Planning:
The employment planning of the government is not adequate in comparison to population
growth. The employment opportunities do not increase according to the proportionate
rate of population growth. As a consequence, a great difference is visible between the
job opportunities and population growth. On the other hand it is a very difficult task on
the part of the Government to provide adequate job facilities to all the people. Besides
this, the government also does not take adequate step in this direction. The faulty
employment planning of the Government expedites this problem to a great extent. As a
result the problem of unemployment is increasing day by day.
13.4Ways of Managing Unemployment

The measures appropriate as remedies for unemployment will clearly depend on the type
and cause of unemployment. Broadly they can be divided into: demand management or
demand side policies and supply side policies.
Demand management policies
These policies are intended to increase aggregate demand and, therefore the equilibrium
level of national income. They are sometimes called fiscal and monetary policies. The
principal policy instruments are:
 Supporting declining industries with public funds
 Instituting proper demand management policies that increase aggregate demand
including exploiting foreign and regional export markets. This can be done by
increasing government expenditure, cutting taxation or expanding the money
supply.
 Promoting the location of new industries in rural areas which will require an
improvement of rural infrastructure.
Supply-side policies
Supply-side policies are intended to increase the economy‘s potential rate of output by
increasing the supply of factor inputs, such as labour inputs and capital inputs, and by
increasing productivity. They include:
 Increasing information dissemination on market opportunities.
 Reversing rural-urban migration by making rural areas more attractive and capable
of providing jobs. This particularly is the case in developing countries where rural-
non-farm opportunities offer the longest employment opportunities.

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 Changing attitude towards work i.e. eliminating the white-collar mentality and
creating positive attitudes towards agriculture and other technical vocational jobs.
 Provision of retraining schemes to keep workers who want to acquire new skills to
improve their mobility.
 Assistance with family relocation to reduce structural unemployment. This is done
by giving recreational facilities, schools, and the quality of life in general in other
parts of the country even the provision of financial help to cover moving costs and
assist with home purchase.
 Special employment assistance for teenagers many of them leave school without
having studied work-related subjects and with little or no work experience.
 Subsidies to firms which reduce working hours rather than the size of the workforce.
 Reducing welfare payments to the unemployed. There are many economists who
believe that welfare payments have artificially increased the level of unemployment.
 Reduction of employee and trade union rights.
13.5Review Questions
1. Outline five supply related policies that can be used to reduce unemployment in a
country
2. Briefly explain how a nation can solve its unemployment problems
3. Discuss five factors that may contribute to increase in unemployment in a country
KNEC Revision Papers
KNEC JULY 2011
1.a) Explain the factors that may affect price elasticity of demand for a commodity.
[12marks]
b) One of the factors that can affect the supply of a commodity in a country is
government policy. Outline the ways in which such government policy may negatively
affect supply. [8marks]
2.a) With the aid of a diagram, explain the effect of a positive shift in the demand curve of
a commodity, on equilibrium price and output of the commodity. [10 marks] b)
Outline the assumptions behind the application of the law of diminishing returns in
production. [10 marks]
3. a) Explain the reason that may account for the survival of the small firm despite the
economies
that firm enjoy from large scale production. [10marks]
b) Describe the characteristics of a perfectly competitive market. [10 marks]
4. a) Highlight the factors that may account for the differences in wages paid to different
categories of labour in a country. [12marks] b) Explain
the problems that may be encountered in the measurement of national income using the
[8marks
income approach. ]
5. a) Outline the factors that can lead to demand – pull inflation in a [10
country. marks]
b) One of the stages in the evolution of money was the use of commodity money.
Highlight the
reasons that may have led to the abandonment of the use of this form of
money. [10marks]

6. a) Outline the functions of commercial banks in an economy. [8marks]
b) With the aid of a diagram, explain how a monopolist may earn abnormal
profits. [12marks]
138

7. a) The level of unemployment in country X is about 20% of the working population.
Explain the
possible causes of such high level of unemployment. [12marks]
b) Highlight the sources of government revenue other than taxation. [8 marks]
KNEC NOVEMBER 2012

1. a) Highlight the services offered by merchant banks to corporate customers apart from
taking deposits and giving loans. [12marks] b) Outline the circumstances that may lead
to a shift to the left of the supply curve of a
commodity. [8 marks]
2. a) With the aid of a diagram, explain the effect of fixing the price of a commodity below
the
equilibrium level [12 marks]
b) Outline the sources from which a firm would derive its monopoly power. [8marks]
3.a)With the aid of a diagram explain the relationship between fixed variable and total
costs of a firm. [12marks] b) One of the
methods of measuring the national income of a country is the expenditure approach.
Describe the items of expenditure that should be included in this approach. [8marks]
4. a) With the aid of a diagram, explain the concept of the kinked demand curve as it
applies in an oligopolistic market structure. [8marks]
b) Highlight the factors that determine the efficiency of labour as a factor of production.
[8 marks]
5. a) Outline the reasons that make it necessary for a country to measure its national income.
[10marks]
b) Explain the different forms of unemployment that may be experienced in a country.

[10marks]
7. a) Explain the factors that may determine the supply of labour services in a
country. b) Describe the monetary measures that be used to control inflation in a
6. a) Describe the stages through which money has evolved upto the present form.
[12marks]
b) Highlight the types of non –recurrent expenditures that may be incurred by a government.
[8marks]
[12marks]
[8marks]
139

Economics Notes - Faith

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TABLE OF CONTENTS

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1.1 The Meaning of Economics

There is an economic aspect to almost any topic education, employment, housing,

Reasons for Studying Economics

1.2 The Scope of Economics

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1.3 Human wants

Types of Human wants

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Characteristics of Human Wants:

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1.4 Economic resources

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1.5 scarcity and choice

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1.7 Resource Allocation

Significance of resource allocation

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Economic Systems and Resource Allocation

The features of a free market system are:

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Resource allocation in a free enterprise

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Disadvantages of a Free Economy

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c)The Mixed Economy

Features of this system

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1.8 Review Questions

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2.1 Concept of Demand

Abnormal Demand Curves

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Different types of demand

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Demand Curve Derivation

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Shift and Movement along Demand

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