The University of Zambia

in association with

The Zambia Centre for Accountancy Studies

BACHELOR OF ACCOUNTING WITH EDUCATION

PL 112 INTRODUCTION TO
ECONOMICS

MODULE
BACHELOR OF EDUCATION: ACCOUNTING
AND FINANCE
First year
Second Semester

Author: Chilinda Munthali Muya

Copyright

ALL RIGHTS RESERVED

No part of this publication may be reproduced, stored in a retrieval
system, or transmitted in any form or by any means, electronic or mechanical,
including photocopying, recording or otherwise without the permission of the
Zambia Centre for Accountancy Studies.

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TABLE OF CONTENTS

1.0 INTRODUCTION .......................................................................................................................... 1

1.1 MODULE AIM.............................................................................................................................. 1
1.2 OBJECTIVES ................................................................................................................................. 2
1.3 ASSESSMENT DETAILS ................................................................................................................ 2
1.4 READINGS ................................................................................................................................... 2
1.5 TIME FRAME ............................................................................................................................... 3
1.6 STUDY SKILLS .............................................................................................................................. 3
1.7 NEED HELP? ................................................................................................................................ 3
2.0 UNIT ONE: THE STUDY OF ECONOMICS ..................................................................................... 4
3.0 UNIT TWO: DEMAND AND SUPPLY .......................................................................................... 21
4.0 UNIT THREE: CONSUMER THEORY ........................................................................................... 33
5.0 UNIT FOUR: ELASTICITY OF DEMAND AND SUPPLY ................................................................. 50
6.0 UNIT FIVE: COST AND PROFIT MAXIMISATION ........................................................................ 58
7.0 UNIT SIX: MARKET STRUCTURE ................................................................................................ 76
8.0 UNIT SEVEN: MARKET FAILURE AND GOVERNMENT INTERVENTION .................................... 104
9.0 UNIT EIGHT: NATIONAL INCOME ........................................................................................... 133
10.0 UNIT NINE: FISCAL AND MONETARY POLICIES ....................................................................... 146
11.0 UNIT TEN: TRADE .................................................................................................................... 159
12.0 UNIT ELEVEN: EXCHANGE RATE AND OPEN ECONOMY ......................................................... 170
13.0 UNIT TWELVE: UNEMPLOYMENT AND INFLATION ................................................................ 184

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1.0 INTRODUCTION

Welcome! You are about to embark on the study of Introduction to economics.

Economics is a discipline which deals with the broad issue of resources allocation.
Within it, an ongoing debate is raging over the question of how best to organise economic
activities such that the allocation of resources will achieve that which society desires. This
study exposes all members of society to the consequences of economic analysis. Economics
affects our livelihood as we all make decisions on how our resources can be allocated.

To some of you, economics is not the main area of study and this introductory course is just
one of those things which you have to endure in order to receive the academic qualification.
May I remind you that the purpose of an academic programme is not to tell you what various
things are; instead, its aim is to help you develop academic skills, the most important of
which is a creative and critical way of thinking about almost anything. Learning what things
are will provide you with some knowledge but will not provide you with the skill of
analytical thinking. Therefore, the academic programme has been carefully design to provide
students with the necessary exposure to the more fundamental methods of analysis that will,
hopefully, equip you for life with an ability to understand the broad dimensions of society
contribute to it and benefit from it. The implication of this is that the course which you are
now beginning to study is indeed a complex subject. Still, it is our view (and experience) that
with patience and work everyone can gain the necessary command over it.
I would therefore strongly advise against picking a single textbook and concentrating one’s
effort on it. Instead, you should conduct your study along the lines and recommendations of
this subject guide. In it you will find a well-focused organisation of the subject which will
highlight those things which are deemed to be important. You will find, on each topic,
references to readings from a set of textbooks which will help you understand each topic
through the use of different methods of exposition.

1.1 MODULE AIM

The course introduces students to major principles of economics and business. It

also exposes students to quantitative economics used in solving problems. It

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further aims to give the students an understanding of how the economy functions.

1.2 OBJECTIVES

By the end of the course, students should be able to:

 Demonstrate knowledge in the key concepts in economics for business objective

 Discuss the principles of microeconomics and macroeconomics.

 Explain how quantitative techniques can be used to resolve economic problems.

 Explain how economics works in society.

1.3 ASSESSMENT DETAILS

o Continuous Assessment Contributes 50% to Final Mark out of

100%

 Continuous assessment 50%

2 tests of equal weight 30%
2 assignments of equal weight 20%

 Final examination 50%

 Total 100%

1.4 READINGS
Prescribed Reading

1) McConnell, B., Stanley and Flynn, S. (2008) Economics.

McGraw-Hill/Irwin

2) Begg, D., Vernasca, G. Economics. (McGraw Hill, 2011) tenth

edition [ISBN 9780077129521].

Recommended Reading

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1) Hazlitt, H. (1988) Economics in One Lesson: The Shortest and Surest
way to Understand Basic Economics. Amazon Publishers.

1.5 TIME FRAME

The total time required for the student to complete the;

 Exercises; for each exercise, you need to take a minimum of three

hours, meaning you need a total of 36hours.

 In total the module should take you a minimum of 48hours to complete.

1.6 STUDY SKILLS

For you to be able successfully complete this module, you will need do the
following:

 <State what student should do in order to successfully complete the module>

1.7 NEED HELP?

If you need help on the module, please use the following contacts:

Course Tutor

Email: [email protected]

Zambia Centre for Accountancy Studies (ZCAS)

Dedan Kimathi Road, P O Box 35243, Lusaka, Zambia

Tel: +260 1 232093/5, Fax: +260 1 222542

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2.0 UNIT ONE: THE STUDY OF ECONOMICS
2.1 INTRODUCTION

This unit will introduce you to the study of economics. How scarce resources’ are
allocated amongst unlimited wants.

2.2 AIM

The aim of this is to introduce you to;

 The concept of economic problem and scarcity

 The concept of opportunity cost
 The concept of comparative advantage and the gains from trade

2.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Define the fundamental economic problem, and describe its economic good, scarcity
of resources.
 Be able to define and draw the production possibility frontier and the concept of
efficiency.
 Be able to define and compute opportunity cost.
 Be able to determine and compute absolute and comparative advantage

2.4 TIME REQUIRED

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This unit should take you at most 4hours to complete.

2.5 REFLECTION

Think about the number of things you would want to have to make your
living better, think about the amount of money you earn, can you afford to
have all your wants? How then can you decide to allocate your finances to
your unlimited wants?

2.6 READINGS
Begg et al chap 1

Sloman and Garrat, chap 1

Brue et al chap 1

2.7 Defining Economics

Economics is a study of human behaviour, how they allocate limited resources to their
unlimited wants. (Begg et al, 2011. P3). It is mainly concerned on how society makes
choices under the conditions of scarcity of resources. Economics is about deciding what, how
and for whom to produce.

According to Brue et al (2010, p43) a market system will have to decide on the specific types
and quantities of goods to be produced. Therefore only goods and services that are produced
at continuing profit will be produced. The “How” question is a decision based on what
combinations of resources and technologies will be used to produced goods and services,
how will the production be organised?

What do you think are human wants?

Biologically human beings need air, water, food, clothing and shelter. But in modern society
people desire goods and services that make their livelihood better what we deem as
comfortable e.g. bottled water, plasma TV, iPhones, burgers and pizzas.

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What are the resources available?

Society possesses productive resources such as labour and managerial skills, tools and
machinery, land and mineral deposits that are used in the production of goods and services
that satisfy our wants.

Unfortunately, the reality is that our wants exceed the productive capacity of our resources.
We have limitless wants and limited resources. For example the income we have is not
enough to buy what we need. Therefore, scarcity restricts options and demand choices.
Because we can’t have it all we must decide what we will have and what we will forgo.

Opportunity cost

In economics there is no ‘‘free lunch’’. According to Sloman and Garratt (2010, p7) making
a choice involves sacrifice. You buy yourself some food, the money spent could have been
used to buy something else which you have forgone just to buy the food. On the other hand
the resources (land, equipment, labour) which have been used to prepare that very lunch
could have been used to produce something else instead. Such sacrifices are what we call
opportunity costs. Opportunity cost is the value of the good, service, or time forgone to
obtain something else. To obtain more of one thing, society forgoes the opportunity of
getting the next best thing.

Rational behaviour

The viewpoint that guides individuals to make rational decisions is comparing the marginal
benefits and marginal costs of their actions. Human behaviour reflects rational behaviour.
This implies that Individuals look for and purse opportunities that increase their utility,
pleasure, satisfaction. Begg et al (2011, p92) defines Utility as the satisfaction obtained from
consuming a good or service. We allocate our time, energy and money to maximise our
satisfaction. Therefore we weigh our costs and benefits to make rational (sensible) choices.
Consumers are rational on what to buy; firms are rational on what to produce and how to
produce it. Rational behaviour doesn’t mean you cannot make a mistake with your choices
but it means people make decision with some desired outcome in mind. Self -interest does
not mean selfishness it means that each economic unit tries to achieve its own particular goal,
which usually requires delivering something of value to others.( Brue et al , p 38). For

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example, you want to get a raise on your salary then you would need to work hard and satisfy
the employer’s wants.

Microeconomic and macroeconomics

Economics has two branches- microeconomics and macroeconomics. Micro means small and
macro means big.

Microeconomics is concerned with individual units such as a person, a household, a firm or

an industry. At this level, details of economic units or a very small segment of the economy
are observed under a figurative microscope. In microeconomics we look at the decision
making of the units.

Macroeconomic examines aggregate units such as the economy, business sectors and the
government. Aggregate is the collection of specific economic units as if they were one. This
is to obtain an overview or a general outline of the structure of the economy and the
relationships of its major aggregates.

INDIVIDUALS ECONOMIC PROBLEM (budget line)

Having learnt that our wants are limitless and that our resources are limited, consumers have
to make a decision on what to buy and forgo. This is because our wants go beyond our basic
needs of food shelter, clothing. The economic problem can be depicted by a budget line/
budget constraint. Our individual budgets are constrained by our income. You can only buy
what your income can allow you to buy. The budget is also constrained by the prices of the
good and services.

For example you have K 50 and you have two things you would want to buy; apples and note
books. Apples are selling at K2.5 each and books K5 each. The choices you can make are;

 You can decide to spend all your money on apples and you will buy 20 apples and no
books bought.

 You can decide to just buy books and you buy 10 books and no apples bought.

 If you only bought apples, you can decide to give up 2 apples so that you can buy a
book. You will buy 18 apples remaining with K5 to buy one book at K5 each.

 On the other hand if you bought books only, you may decide to give up one book to
buy apples. You will buy 9 books remain with K5 and buy two apples.
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From table 1.1 below we see how we can combine apples and book with the available
income of K50. The budget line shows all the combinations of any two products that can be
purchased, given the prices of the products and the consumers’ income.

Table 1.1

Units of apples Units of books(price=k5/unit) Total expenditure

(price=k2.5/unit)

20 0 20*2.5 + 0*55=50

18 1 18*2.5 +1*55=50

10 5 10*2.5 + 5*5=50

8 6 8*2.5 + 6*5=50

6 7 6*2.5 +7*5=50

4 8 4*2.5 +8*5=50

2 9 2*2.5 + 9*5=50

0 10 0*2.5 + 10*5=50

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y=books,
x=apples

From the graph every point shows the combination of apples and books, including fractions,
which can be bought with the income of K50. The slope of the graph measures the ratio of
the price of apples (pa) to the price of books (pb), slope = pa/ pb=-(K2.5/K5) = -1/2. Therefore
you need to give up one book to get two apples.

All combinations of books and apples on and inside the budget line are attainable from the
income available. This means that whatever combination or point on the budget line and
anywhere under the curve is affordable to this consumer. The combinations on the line
exhaust all the available income while the combinations under the curve leave the consumer
with some change. Let’s assume tomorrow you will not be able to find the two goods
available for sell, to maximise your utility you will spend all your income today. Contrary,
the combinations above the curve are not attainable. This means that the consumer cannot
afford the combinations above. He/she will need extra income to afford them but
unfortunately K50 is the only available income at the moment.

Now let us apply the concept of opportunity cost to our example. Remember the definition of
opportunity cost. Therefore in our example, for us to buy the first book we give up 2 apples.
We trade off 2apples for a book. So the opportunity cost of a first book is 2 apples. To obtain
the opportunity cost of a second book we still give up another two apples. Therefore the
opportunity cost remains the same for an extra book we buy. This is what is called constant
opportunity cost. This is why we have a constant slope for the budget line. A straight budget
line has a constant slope. Choices are different among consumers, each consumer picks a
combination that is best for them. One that maximises their marginal benefit.
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To get opportunity cost for buying one apple = what you give up in terms of books/what you
gain in terms of apples=1 book/2apples= ½

This means the opportunity coat of buying one apple is ½ the book forgone.

What shifts the budget line? An increase in income moves the budget line upwards or
outwards. This is because your income is now enough to buy you more of both goods. On the
other hand a reduction in income shifts the budget line inwards or downwards. This is
because the income is now little.

From our example suppose your income increased to K100. The prices of apples and books
remain the same. How will the new budget line shift?

x-axis =apples
y-axis=books

The budget line shifts upwards. This is because an increase in income makes you afford to
buy more of both goods. With an income of K100 you now are able to buy 20books only or
40 apples only. The combination of the two goods are now more than before.

This comes to a conclusion that higher budget lines imply higher incomes and lower budget
lines implies lower income.

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Homework; using the example above, answer the following question for each given scenario.
Explain the changes in the movement in the graph.
1. Recalculate the table and draw the graph, assuming that the price of apples increase to
Kr4 each while price of books and income (K5 and K50) remains the same.
2. Recalculate the table and draw the graph, assuming that the price of the book reduces
to kr3 each and the price of apples and income (K2.5 and K50) remains the same as
before.
3. Recalculate the table and draw the graph assuming that both the price of apples and
books increase to K3/apple and K6/book.

SOCIETY’S ECONOMIC PROBLEM (production possibility frontier)

Let us now look at how society makes decision under scarcity. Society has to decide what
goods to produce and what services to provide. They have to decide what to produce given
the limited resources available. The economic resources available to society are; land, labour,
capital and entrepreneurial skills. Economic resources are all the natural, human and
manufactured resources that can be used to produce goods and services. This may include
equipment, tools, machinery, building, farms, factory, agricultural products, transportation,
and all types of labour and mineral resources. All these are called factors of production
(F.O.P).

 Land is all natural resources used in the production such as arable land, forests,
mineral and oil deposits and water resources.
 Labour this involves physical and mental talents of individuals used in the production
of goods and services
 Capital is all manufactured aids used in producing consumer goods and services. This
includes all factory, storage, transportation, tools and machinery. The purchase of
these goods is what is called investment.
 Entrepreneurial ability. This is a special form of human resource. he innovates, makes
decisions, risk bear

Production possibility model;

Under this model we will assume

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 Full employment meaning society is using all the resources available in the
production process
 Fixed resources-the quantity and quality of F.O.P are fixed.
 Fixed technology the state of technology is constant
 Two goods. Society is only producing two goods i.e. clothing and food.

A production possibility table lists the different combinations of two products that can be
produced with a specific set of resources, assuming full employment.

Table 1.2

Type of products A B C D E

food(hundred 0 1 2 3 4
thousand)

clothing 10 9 7 4 0
products(thousands)

At alternative A all resources are employed to produce clothing and at E all resources are
employed to produce food products. These are very unrealistic extremes, an economy will
produce both food products and clothing as at B, C, and D. As we move from A to E we
increase the production of food and giving up the production of clothing.

Plotting the data above we have a production possibility curve.

Figure 1.2

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y=clothing
x=food products

Each point on the production possibility curve represents some maximum combination of
two products that can be produced if resources are fully and efficiently employed. As you
move down the curve society is shifting resources from the production of clothes to the
production of food thus, producing more of food products and less of clothing and vice versa.
The curve is a constraint because it shows the limit of attainable outputs. Points on the curve
are attainable because society uses all the available resources in production of the two goods.
Points under the curve are attainable but are not efficient this is to say that they are using
less of the resources or rather some resources are not fully utilised, thus these points are not
desirable as those on the curve. Points beyond the curve are not attainable with the current
available resources and technology.

Let us apply the principle of opportunity cost on this scenario.

Scenario TWO

At point A society is producing o units of food and 10 units of clothing. To produce one unit
of food society shifts resources from clothing to food production thus giving up one unit of
cloth. Therefore the opportunity cost of producing the first unit of food is one, which is the
unit of cloth forgone. To produce the second unit of food society gives up 2units of cloth.
The opportunity cost of producing an additional unit of food is increasing. This is what is
called increasing opportunity cost. To have more of food society has to give up more units of
clothes. From the shape of the curve is shows that society must give up greater amounts of
cloth to acquire equal increments of food products.

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Why is this so? This is because economic resources are not completely adaptable to
alternative uses. Many resources are better at producing one type of good that at producing
others.

Let’s relax the assumption that quantity and quality of resources and technology are fixed.
When the amount of resources changes the PPF shifts positions and the potential maximum
output of the economy changes.

Although resources are fixed at a particular time, over time they increase. For example an
increase in labour and entrepreneur skills due to an increase in population, there’s also a new
discovery of mineral resources, new and many more. The net result is the ability to produce
more of both goods. The economy will grow by expanding its output. This will result in the
PPF shifting outwards as in the graph above.

An advancing technology also brings both new and better and improved ways of producing
the good. Therefore economic growth is as a result of increases in supplies of resources,
improvement in resource quality and technological advancement.

OPPORTUNITY COST, ABSOLUTE AND COMPARATIVE ADVANTAGE

When two individuals (or firms and nations) have different opportunity costs of performing
various tasks, they can always increase the total value of available goods and services by
trading with one another. The idea of opportunity cost can provide a reason why individuals
trade and why trade can be mutually beneficial.

Let us consider an example.

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We have two individuals’ martin and Natasha. They both can produce two different goods,
wheat and cotton on one acre piece of land.

YIELD PER ACRE OF WHEAT AND COTTON

MARTIN NATASHA

WHEAT 6 2

COTTON 2 6

Martin can produce three times the wheat that Natasha can on one acre of land, and Natasha
can produce three times the cotton. We say that Natasha has absolute advantage in the
production of cotton and Martin has absolute advantage in the production of wheat.

Absolute advantage is when a country/individual uses fewer resources to produce that

product than the other country does. (Begg et al, 2011. P12)

We suppose that they both use the one acre of land to produce both wheat and cotton. They
divide the land in half to produce the two products; martin will produce 3bushels of wheat
and 1 bale of cotton, Natasha will produce one bushel of wheat and 3bales of cotton.

Cotton

Wheat

They consume exactly what they produce; martin 3wheat and 1cotton and Natasha 1 wheat
and 3cotton. This can be seen from the graph above.

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Because both individuals have absolute advantage in the production of one product
specialisation and trade would be of benefit. Martin can specialise in the production of wheat
only and Natasha can produce cotton only and they can exchange in trade.

For martin if he gets the half acre that is used in the production of cotton and uses it to
produce wheat. He will produce 6bushels of wheat. The same applies to Natasha if she uses
the half acre of land for wheat to produce cotton, she will produce 6bushels

YIELD PER ACRE OF WHEAT AND COTTON

MARTIN NATASHA

WHEAT 6 0

COTTON 0 6

They can trade 2bushels of wheat for 2bales of cotton. This is more than their initial
consumption of 3 to 1.

Cotton

Wheat

We see from the graph that they are consuming way beyond their budget line. This is what
we call gains from trade. Martin has gain one more bale of cotton and one bushel of whea.
This is as a result of specialising in the production of a good he has absolute advantage in
and trading it for a good he has no absolute advantage in.. The same applies to Natasha.

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A person or a nation has a comparative advantage in the production of a product when it
can produce the product at a lower domestic opportunity cost than can a trading partner. The
real cost of producing cotton is the wheat that is sacrificed to produce it.

To illustrate comparative advantage lets look at this example.

YIELD PER ACRE OF WHEAT AND COTTON

MARTIN NATASHA

WHEAT 6 1

COTTON 6 3

Martin has absolute advantage in producing both cotton and wheat. This is because he is
producing more of both goods on an acre piece of land than Natasha. Who has comparative
advantage?

The opportunity cost of producing wheat by martin is 1bale of cotton. This is because martin
is sacrificing the 6bales of cotton to produce 6bushels of wheat. His opportunity cost of
producing cotton is also 1. He is sacrificing 6bashels of wheat to gain 6bales of cotton.

Natasha’s opportunity cost for producing wheat is 3 bales of cotton. She is sacrificing 3bales
of cotton to produce 1bushel of wheat. Then, her opportunity cost of producing cotton is 1/3
bushel of wheat. She is sacrificing 1 bushel of wheat to gain 3bales of cotton.

OPPORTUNITY COST

MARTIN NATASHA

WHEAT 1 3

COTTON 1 1/3

The opportunity costs shows that martin has a lower cost in producing wheat and Natasha has
a lower cost in producing cotton. Therefore they can specialize in the product of their
advantage.

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If they used half the acre to produce both goods, they would consume exactly what the
produce.

YIELD PER ACRE OF WHEAT AND COTTON

MARTIN NATASHA

WHEAT 3 1/2

COTTON 3 1.5

They need to specialize in the product of comparative advantage. However martin will not
fully specialize. He will produce both goods.

YIELD PER ACRE OF WHEAT AND COTTON

MARTIN NATASHA

WHEAT 4.5 0

COTTON 1.5 3

Martin is willing to sacrifice 1bushel of wheat for 1bale of cotton. He would even be happy if
he got more of cotton for 1 bushel of wheat. As for Natasha she is willing to sacrifice 3bales
of cotton to have 1 bushel of wheat. She would be happy if she could give less cotton for 1
bushel of wheat. Therefore martin will trade 1 bushel of wheat for 2bales of cotton. Natasha
would be happy to give 2bales of cotton for 1 bushel of wheat.

YIELD PER ACRE OF WHEAT AND COTTON

MARTIN NATASHA

WHEAT 3.5 1

COTTON 3.5 1

They both gain from trade because they move beyond their production possibility frontier.
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The price at which the will trade is 1bushel of wheat for 2bales of cotton. The price of the
product is determined by the opportunity cost of the seller and the buyer.

Sellers opportunity cost < price < Buyers opportunity cost

= =
1cotton per 1wheat Price 3cotton per 1 wheat

Therefore the number between 3 and 1 is 2 therefore Natasha is happy to give less cotton for
one wheat. Martin two is happy to gain 2 cotton for 1wheat.

2.10 ACTIVITIES

Exercise two
1. Robinson Crusoe can bake 10 loaves of bread in one hour or peel 20potatoes. Friday
can bake 5 loaves of bread in an hour or peel 30 potatoes. If they believe in equality
in consumption, would they specialise and trade? If so, at what price will they
exchange bread for potatoes?
2. Under what circumstances would the production possibility curve be (a) a straight
line (b) concave to the origin?
3. Imagine that a country can produce just two things goods and serives. Assume that
over a given period it could produce any of the following.
goods 0 10 20 30 40 50 60 70 80 90 100
Services 80 79 77 74 70 65 58 48 35 19 0
a) Draw the country’s production possibility curve
b) Assuming that the country is currently producing 40 units of goods and
70units of services, what is the opportunity cost of producing another 10units
of goods?
c) Explain how the figures illustrate the principle of increasing opportunity cost?
d) Now assume that technical progress leads to a 105 increase in output of goods
for any given amount of resources. Draw the new PPF. How has the
opportunity cost of producing extra units of services altered?

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2.11 SUMMARY

In summary you have learnt these key concepts

 Economics analyses what, how and for whom society produces. It is

the study of how limited resources are allocated amongst unlimited
wants.

 Microeconomics is the study of small units such as individuals, firm, market and an
industry. Macroeconomics is the study of aggregated units on the economy.

 The production possibility curve or frontier shows the maximum amount of one
good that can be produced given the output of the other good.

 The opportunity cost of a good is the quantity of the other goods sacrificed to make
an additional unit of the good. It is the slope of the PPF

 A country enjoys an absolute advantage over another country in the production of a

product if it uses fewer resources to produce that product than the other country does.

 A country enjoys a comparative advantage in the production of a good if that good

can be produced at a lower cost in terms of other goods.

In the next chapter you will look at how you make a choice of the amount of a good
given its own price, price of amount good, your income levels and many other factors.

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3.0 UNIT TWO: DEMAND AND SUPPLY

3.1 INTRODUCTION

In this unit we will learn how individuals demand and the supply for a particular
good will determine the price at which the good will be sold in the market.

3.2 AIM

The aim for this unit is to introduce you to;

 The law of demand and supply

 The factors that affect how much of a good you will purchase and
consume

 The concept of equilibrium price and quantity.

3.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Define and apply the law of demand and supply

 Draw the demand and supply curves

 Shift the demand and supply curves depending on the factors influencing equilibrium

 To explain the difference between quantity demanded and demand

3.4 TIME REQUIRED

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This unit should take you at least 4hours to complete.

3.5 REFLECTION

 Think of how much of a good you would buy if its price fell or
rose?

 Think of the factors that would affect how much of a good you
would buy apart from its own price?

3.6 READINGS
Begg et al chap 3

Sloman and Garrat, chap 2

Brue et al chap 3

3.7 Demand
Demand is a schedule or a curve that shows the various amounts of product that consumers
will purchase at each of the several possible prices during a specified period of time.
Quantity demanded is the amount consumers are willing and able to buy at a given price over
a period of time. From our example on the budget line we can draw up demand for that
consumer at different prices. As we change the prices of either apples or books the quantity
bought also changes. Thus, the law of demand states that as prices falls, holding all other
things equal or constant, the quantity demanded rises and as prices rise the quantity
demanded falls. This is an inverse relationship. Why are we holding other things equal or
constant? There are many factors that affect the demand of goods purchased. but for now we
look at just prices. What other things do you think will affect the quantity purchased? There
are two reasons for this law;

1. People will feel poorer. They will not be able to buy much of the goods with their
income. Their purchasing power will go down and this is what is called the income
effect of price rise. ***note purchasing power is the amount of goods you can buy in
the income available.

22 | P a g e
2. In comparison to other goods related to it, it will be more expensive and people will
switch to alternative products. This is the substitution effect.

QUESTION. How do you think people will react in the case of a fall in price?

We look at an example.

The table below shows the how many kilos of potatoes per month will bought at various
prices. We have demand schedules for Tracey, Darren and a market demand. The market
demand is the total demand for Tracey and Darren and everyone else in the market.

Price per Tracey’s demand Darren’s demand(kilos) Total market

kilo (kilos) demand(tonnes)

A 20 28 16 44

B 40 15 11 26

C 60 5 9 14

D 80 1 7 8

E 100 0 6 6

We plot the market demand and we have the following;

PRICE PER KILO

QUANTITY
DEMANDED

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The graph is downward sloping showing the inverse relationship that quantity demanded has
with price. From the graph we start at point E where at k100 the total demand is 100 going
down the graph prices are falling and quantity demanded is increasing.

Determinants of demand.

What are the other factors that affect demand?

1. Tastes/preference. Taste is affected by advertising, fashion, observing, health

consideration and experiences of consuming the good. The more desirable people find
the product the more they will demand for it. Therefore a change (let’s say, a
favourable change) in a consumers taste, the demand for that commodity will increase
at each price. Thus, the demand curve will shift outwards. The reverse is true.
2. The number of buyers. An increase in the number of buyers increase the amount
demanded at each price. The individual demand curve is not affect by the number of
consumers but the market demand curve will shift outwards.
3. The number and price of related goods. There are four types of good; substitute
goods, complementary goods, normal goods and inferior goods. Substitute goods are
goods which are considered by consumers as alternatives to each other e.g coffee and
tea. As the price of one goes up, the demand for the other rises. Complementary
goods are goods which are consumed together e.g bread and butter. As the price of
one goes up the demand for both goods reduces.
Therefore demand is affected by the number and the price of substitute and
complementary goods. If the price of a good rises, consumers will buy more of a
substitute good and less of that good, thus, the demand curve will shift downwards. In
reverse a rise in price of a substitute good will increase the demand of the good in
question and the demand curve will shift outwards. For a complementary good a rise
in price will shift the demand for both goods downwards.
4. Income. As peoples income rise, their demand for the good will either rise or fall
depending whether the good is normal or inferior. Normal goods are goods whose
demand rises as income increases. And inferior goods are goods whose demand fall
as income increases. For a normal good the demand curve will shift outwards and
inferior good it will shift inwards.
5. The distribution of income also affects demand. The poor demand for inferior goods
because they cannot afford luxury goods but if income was redistributed from the rich
to the poor, the demand for luxury goods will increase.
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6. Expectations of future price changes. If people thought that the price of a good will
rise in the near future, they will buy more of that good now before it goes up.
7. Advertising; a successful advertising campaign increases the demand for a product or
service

3.8 Supply
We start with an illustration.
Let’s suppose you are a farmer and you have a piece of land which you wish to use to
produce crops for sell. Your decision of what crop to grow will depend on the price of
the commodity in the market. If you notice that the price of apples is high you will
plant cotton. And if the price gets higher you will increase the production of apples.
This illustrates the relationship between supply and price. When the price of a
commodity rises, the quantity supplied increases. This is because as output increase
beyond a certain level, costs raise more and more rapidly, thus the price has to rise so
that it is worth to produce more and incur the higher costs. It has to be profitable for
the producer. And when it is profitable more people will also be encouraged to
produce the good and thus the market supply will increase.
Let us consider the table below. The table shows the quantity of apples that will be
supplied at different prices for an individual supplier and market supply.
Price/kilo Farmer x’s supply Market supply

A 20 50 100

B 40 70 200

C 60 100 350

D 80 120 530

E 100 130 700

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PRICE PER
KILO

quantity
demanded
y=price/ki
lo x=quantity supplied
The market supply curve is the total individual supplies in the market. From the graph
the supply curve is upward sloping showing that as prices rise quantity supplied also
increases.
There are other factors that affect the supply of a commodity. These are;
1. Cost of production. The higher the cost of producing a good the less profitable
it is at any price. Thus producers will cut back on production and shift to
producing goods with lower costs. Costs change because of input prices such
as wages, raw material prices, rent, interest rate etc.; changes in technology,
organisational changes and government policies such as subsidies and tax.
2. Profitability of alternative products. If some alternative products become more
profitable to supply than before, producers will shift resources to produce that
good. The goods become profitable if their prices rise. This is what are called
substitute good. Substitute goods are two goods where an increase in
production of one good means diverting resources away from producing it.
Thus supply of the first good fall and shifts the curve inwards. There are good
that are produced together e.g. sugar and molasses. An increase in profitability
of sugar will increase the production of both sugar and molasses thus shifting
the supply curve outwards.
3. Expected prices changes. When prices are expected to rise, producers may
reduce the amount they sell so that they increase the stock and sell when the
prices go up.

26 | P a g e
4. Number of seller. A greater number of sellers in the market will increase the
supply of the good.
5. Nature, random shocks and unpredictable events. These may include weather,
disease affecting farm outputs, war, earthquakes, breakdown of machinery.
Market equilibrium

Now we see how the decisions of a consumer and a buyer will interact to determine the price
and quantity they will both be happy with. We are assuming that no buyer or seller can set
the price. We get the two examples for apples. The table shows the total market demand and
supply.

Price Total market total Market

per demand(tonnes) supply(tonnes)
kilo

20 700 100

40 500 200

60 350 350

80 200 530

100 100 700

price

Quantity
demanded
y=price/kilo
x=quantity demanded
27 | P a g e
From the graph if we start with price k20, consumers demand 700 while suppliers supply
100. There is too much demand that suppliers cannot supply at that price. This is called
excess demand With this situation consumers will be willing to pay a higher price and
producers are willing to accept a higher price. Therefore, the shortage in the market will
drive the price up. The price will continue to rise, demand will fall and supply will increase
until there is no more shortage at price 60. .If we start at price k100 consumers will only
demand 100tonnes and suppliers will supply 700 but this is too much for the market. This is
called excess supply. There will be excess goods on the market. The farmers will start to
compete with themselves and drive the price down to capture consumers. As the price fall the
demand will increase and supply will reduce until at price 60 where both demand and supply
are equal. Thus the market will clear, there will not be any excess supply neither will demand
be too much. This is what is called the equilibrium price.

The area above the equilibrium is excess supply while the area below equilibrium is excess
demand.

Change in equilibrium

Now let’s put into play changes in demand and supply due to other factors.

A change in demand.

We assume there is an increase in the consumers’ income. The demand curve will shift
outwards to the right.

At price k60 consumers are now demanding 550 which is more than what suppliers are
supplying (350) in the market. This creates a shortage and consumers will be willing to pay a
higher price. Therefore, the new equilibrium is realised at price 70 and the quantity is 500.

28 | P a g e
price

quantity

A change in supply

We assume there is an improvement in technology advance and it has lowered the cost of
production. With a lower cost of production the producer will now produce more goods. This
will shift the supply curve outwards.

price

quantity

At price 60 there is now excess supply of goods. Consumers are demanding 350 whilest
producers are supplying 550. With this excess supply price will be forced to go down to 45
and quantity to somewhere between 400 and 500, so lets says 450.

Now let the changes happen at the same time.

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price

quantity

We have a new equilibrium but the price remains the same although both quantity demanded
and supplied have now increased to 550. This is because the excess supply created by the rise
in supply is cleared by the excess demand created by the rise in income.

We can describe the equilibrium in a given market in a simple mathematical way.

Remember demand function is a relationship between the quantity demanded and the price of
a given good or service, keeping other things equal. The relationship between price and
quantity demanded is negative therefore the equation will take the form;

y d  f ( x)  mx  b

where y represents quantity demanded, -m represents the slope of the curve. Its negative
because the demand curve slopes downward. X represents price of the commodity, b is the
intercept of the equation. This is a direct function. And inverse function is when price is on
the Y axis.

for the supply curve the quantity supplied has a positive relation with the price of the
commodity. Therefore the slope of the supply equation is positive.
y s  f ( x)  mx  b

Equilibrium is met determined when demand is equal to supply.

y d  f ( x)  mx  b  y s  f ( x)  mx  b
Equating the two equations and solving for y and x will give us equilibrium price and
quantity.
We look at an example.

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We have a demand function p  f ( x)  0.04q  72 and a supply function

p  f ( x)  0.04q  5

Find the equilibrium price and quantity.

Since demand= supply in equilibrium we equate the two functions

p  f ( x)  0.04q  72  p  f ( x)  0.04q  5
0.04q  0.04q  72  5
0.08q  67
q  67  0.08
q  837.5

We have found the value of q, we need to replace it in any of the equations to find the value
of p.

p  0.04(837.5)  5  38 Or p  0.04(837.5)  72  38

Therefore, equilibrium price is 38 and equilibrium quantity is 837.5. these are the value at
which the market clears.

3.10 ACTIVITIES
EXERCISE ONE

1. This question is concerned with the supply of oil for central heating .in
each case consider whether there is a movement along the supply curve(and which
direction) or a shift in it(whether left or right). Use Graphs.

1) New oil fields start up in production.

2) b) The demand for central heating rises.
3) The price of gas falls.
4) Oil Company anticipates an upsurge in demand for central heating oil.
5) The demand for petrol rises.
6) New technology decreases the cost of oil refining.
7) All oil products become more expensive.

2. Explain the law of demand.

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3. Why does a demand curve slope downwards?

4. How is the market demand curve derived from individual demand curves?

5. You are given total demand and supply of wheat.

Quantity demanded Quantity supplied price Surplus or shortage

85 72 3.4

80 73 3.7

75 75 4

70 77 4.3

65 79 4.6

60 81 4.9

a) What is equilibrium price and quantity?

b) Calculate and fill in the shortage or the surplus.
c) What is excess demand and excess supply?

3.11 SUMMARY

In summary you have learnt these key concepts;

 Demand curve represents the willingness and ability of a buyer to

purchase a particular commodity at various prices

 Market demand is the horizontal summation of individuals demand curves

 Changes in any of the determinants of demand will shift the demand curve

 Supply curve shows the amount of a product the producers are willing to supply the
market at various prices.

 Equilibrium price and quantity are determined at the intersection of the supply and
demand curves.

In the next chapter you will look at how consumers make decisions on their consumption.
32 | P a g e
4.0 UNIT THREE: CONSUMER THEORY

4.1 INTRODUCTION

In this unit we use consumer choice to explain the demand curves and consumers
tastes and preferences.

4.2 AIM

The aim of this unit is to make you understand how consumers taste and
preferences help them make decisions on what to purchase and consume.

4.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Explain and draw indifference curves

 Explain their properties

 Draw and explain the substitution and income effect of a price change

 Derive the demand curve using preferences.

4.4 TIME REQUIRED

You should take a minimum of 4hours to finish this unit.

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4.5 REFLECTION

Think of how the satisfaction you get from consuming a good will make
you decide on how many of that product to buy.

4.6 READINGS
Begg et al chapter 5

4.7 Concept of utility

Having learnt about the individual and society’s economic problem, the demand and supply
curves , consumer theory adds on to explain how a consumer chooses how much to consume
by understanding the basic mechanism behind the decision process for a consumer.

The main focus will be on;

1. Consumer tastes and utility. Tastes or preferences are the driving force behind what a
consumer chooses to consume. Utility is the satisfaction a consumer gets from
consuming a good.
2. The behaviour assumption that consumers are rational, rational behavior is when a
consumer tries to get the best from the consumption decision by picking a bundle that
maximizes satisfaction.
3. Consumer income. The resources available for consumption
4. Prices at which goods can be bought.

TASTES AND UTILITY

A consumption bundle is what you would like to consume. It contains different quantities of
various goods. If we have two goods in a bundle i.e. mango and jeans. One bundle can
contain 3mangoes and one pair of jeans and another bundle can contain 5 mangoes and 6
pairs of jeans. The problem comes in on how to choose between the bundles.

Utility is obtained after consuming a good. it represents what a consumer achieves by

consuming a particular consumption bundle. If you prefer mangoes to bananas you will gain
more utility when you eat a banana than a mango. Therefore a consumer prefers one bundle

34 | P a g e
of goods to another if the utility gotten from the consumption of that bundle is greater than
consuming the other.

This economic concept of rationality involves two assumptions:

Assumption 1: People know their desires and know the consequences of each choice of
means.

Assumption 2: People will behave in a consistent manner. By this we mean that if people
have two feasible options available and choose one over the other, they should not, at a later
date, choose the other option if both are still feasible.
If for example you have 100 kwacha to buy mangos and bananas at price K2 for mangoes
and K3 for banana, you could buy (4M,3B) or (6M,5B) or (8M,4B). if you decide to buy
bundle (6M,5B) over the other two bundles, if peradventure your income reduce to K50 and
you decide to buy bundle (4M,3B) then you are not consistent because even at K50 you can
still afford the first bundle. You will have to buy and consume (6M, 5B), unless you consume
much more than the first bundle and you could not afford it at first.

Assumption about tastes/preference. For a preference to be rational, it has to be;

A. The completeness; the consumer can always rank alternative bundles of goods
according to the satisfaction or utility they provide. It is unnecessary to quantify this
utility. One bundle is better than another, worse than or exactly as good as the other.
A consumer can make a decision on the bundle he/she prefers.

To expres preference we use binary relation on X to compare or order the bundles

x ≥ y: ‘x is at least as good as y’ → weak preference
x ≻ y iff x ≥ y and y ≥/ x: ‘x is strictly preferred to y’ → strict preference
x ∼ y iff x ≥y and y ≥ x: ‘x is indifferent to y’ → indifference relation
Completeness: ∀x, y ∈ X, either x ≥y or y ≥ x

Completeness is an important assumption which enables us to use a continuous, real number

function to represent preferences. We are always able to rank two or more things in order of
preference, but in most cases, we are not choosing between one thing or the other, but
between complex bundles of goods

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B. Transitivity; we assume that the ranking of possible bundles is internally consistent
which means if a bundle A is preferred to bundle B and B is preferred to bundle C,
then A must be preferred to bundle C.
Transitive: ∀x, y, z ∈ X, if x ≥ y and y ≥ z, then x ≥ z

C. Consumers prefer more to less; if bundles B offers more mangoes but as many
bananas as bundle C, we will assume bundle B is preferred. E.g B(6M,5B) C(5M,5B).

Let us illustrate the three assumptions of rationality on a graph.

Bananas
Preferred
region
d c

b
e
Dominated
region
Mangoes

From the graph point A presents a bundle containing, let’s say, 3Mangoes and 3 bananas. If
we are consuming at point A, and more is preferred to less, then any point beyond point A ,
such as C, will be preferred to A and any combination below point A such as B is not
preferred. A is better than B. therefore by transitivity C is preferred to A, A is preferred to B,
thus C is preferred to B. how do we compare point D and E? D and E both have more of one
good and less of the other. the consumer who likes mangoes would prefer E and the one who
likes bananas who pick D. if point D is as good as point A and A is as good as E, then point
D is as good as point E.

We can clearly see that the implication of rationality and consistency is that individuals will
find points of equal taste arranged along a line by joining the three points. The three points
A,D,E are giving the same utility. Therefore if we keep utility constant, adding an extra
mango means a consumer has to give up some bananas. The opportunity cost of consuming
an extra mango is giving up some bananas. This is called the Marginal rate of substitution.

36 | P a g e
It tells how many mangoes a consumer could exchange for an additional banana without
changing total utility.

For example, if a consumer had 6CDs and no banana. If they played the discs and does not
enjoy the 6th disc much, the utility of this bundle is low. They are hungry and cant enjoy the
music anymore. For the same low amount of utility they could give up a lot of disc for some
bananas. If they now eat a lot of bananas and play a few CDs. They will be reluctant to
sacrifice the discs to gain more bananas . this is called diminishing marginal rate of
substitution. When a person has more of one good, they are willing to give up more of a it to
get the good that is relatively little. The amount sacrificed diminishes as successive units of
the other good increases.

From the figure above the line that pass through point A, D,E is called the indifference
curve. It’s a curve that represents all combination of consumption bundles that provide the
same level of utility for a consumer.
• An indifference curve is the locus of points each of which (point) represents the given
level of satisfaction. Each point represents a bundle of two goods under
consideration; as one moves from one to another point of the curve, the proportion of
the two goods changes as the quantity of one good increases while that of other
decreases. But the increase in one good is just sufficient to compensate the loss of
utility due to the decrease in the quantity of the other good, leaving the consumer
neither better nor worse off than before.
The consumer is indifferent between consuming any bundle on the curve.
Point C is has more of both goods therefore it offers a higher utility than A. it will lie on a
higher indifference curve.
Point B has less of both goods offering lower utility than A. it will lie on a lower indifference
curve.
Point D and E offer the same utility as A, thus they lie of the same curve.
Indifference curves are downward sloping

First and foremost proposition of the alternative approach of ordinal utility is that the
satisfaction or utility derived from the satisfaction of the wants is a mental phenomenon.
Utility is thus subjective and its cardinal measure on an absolute scale is neither feasible nor
is it necessary. It is not feasible to exactly and precisely measure a purely psychological

37 | P a g e
phenomenon which is experienced and recorded only mentally. This aspect makes utility a
purely subjective experience.

Example;
A point like A depicts a bundle which consists of X0 units of X and Y0 units of Y. We write A
as A = (X0, Y0). Similarly, B is a point where we have X1 units of X and Y1 units of Y (B = (X1,
Y1)). The subscripts and so on are ways of identifying different ‘packages’ of X and Y. They
do not indicate the magnitude of X and Y.
 A ≻i B (meaning: A is preferred by individual i to B).
 ‘A ≿ C’ means ‘I prefer or am indifferent between A and C’.
 A ≿ B ≿ C.
 We introduce utility, then the above will read as bundle A gives a greater utility than
B, B gives a greater utility than C. Denote the number by U (for utility). Then,we
clearly have U(A) ≥ U(B) ≥ U(C). We are thus mapping from preferences onto real
numbers.
 We call this mapping the ordinal utility function. Ordinal means that the function only
tells us about
CHARATERISTICS OF INDIFFERENCE CURVES
1. The indifference map of a consumer is expressed through a set of indifference
curves. Each indifference curves in the map is associated with a given level of
satisfaction but the satisfaction level differs from curve to curve.

Bananas

U3

U2
U1
Mangoes

The above diagram highlights two (2) important characteristics of indifference

curves:
38 | P a g e
1. nearly the curve to origin, lower is the satisfaction level and further the curve
away from the origin higher the satisfaction level;
2. the movement from one point to another on the same indifference curve
represents substitution of one for another good so that the loss of utility from the
units of the good given up is just compensated by the additional unit derived from
the extra unit of the other good

2. The slope of a an indifference curve gets flatter as we move to the right. This reflects
DMRS. This is why an indifference curve slopes downwards from left to right. This property
is obvious from the above diagram. The reason of downward sloping indifference curve is
that the consumer has to give up less and less number of units that he gives up in exchange
for an additional unit of the other good. It is because with an increase in the stock of the good
its marginal significance decreases while the marginal significance of the other good whose
stock decreases. Thus the marginal significance of one good in terms of the other decreases
with every increase in its quantity (proportionate share).

Bananas

IC

Mangoes

The consumer gives up an amount of one good to gain an extra amount of the other good that
gives him the exact utility forgone. If the slope of the IC is say 2, the individual is willing to
give up 2 units of y to get a unit of X, keeping utility constant.
3. Indifference curves are parallel to each other. If the curves are not parallel to each
other they intersect each other at some point. At the point of intersection the satisfaction of
both curves shall be equal and quantities both good shall be the same on such a point which
contradicts one of the above properties.

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Bananas
X
Z
Y

Mangoes

From graph X and Y are on the same indifference curve meaning they are giving the same
level of utility. Y and Z are also lying on the same indifference curve. This means that X is
indifferent to Z but this does not follow transitivity as Z has more of both goods than X and
more is preferred to less.

4. The indifference curves are convex to the origin. The downward sloping shape makes it
invertible convex to the origin. A concave curve will loose the property of marginal
significance of one good in terms of another diminishing with an increase in the quantity of
the good. Besides a concave curve will be invertible rising from left to right.

4.7.1 The budget and indifference curves

Remember the slope of the budget line gives us the price ratios for the two goods.

Slope of the budget line= where is the price of the good on the horizontal axis and

is the price of the good on the vertical axis.

Given income M to buy two goods X and Y at price for X and for Y. the budget

constraint would be X and the budget line will be

Y=

40 | P a g e
Characteristics of Utility functions

1. The ordinal utility function, then, simply represents individuals’ preferences

over the space of economic goods. A function u is said to represent these
preferences if A ≻ B implies that U(A) ≥ U(B).
2. u must be increasing in both X and Y : the more we have of either good the
more preferred the bundle is.
MARGINAL UTILITY we mean the net change in total utility by having consumed an
additional unit of a commodity. The extra satisfaction a consumer derives from one
additional unit of that product.

For a given level of, say, Y, we can define the marginal utility of good X
(MUX).Mathematically, this is defined as:

This construct is called the derivative of U with respect to X, keeping Y constant at Y0. It tells
us how utility would change if we changed X, while keeping Y constant. The form which we
give to the utility function reflects our beliefs about how people relate to the world of
economic goods (i.e. their preferences).
Law of Diminishing Marginal Utility; Explains that the more of a good a person gets, the
less utility he gets from each additional unit.

Consumer wants in general are insatiable, but wants for particular items can be satisfied for a
time. The more of a specific product that consumers obtain, the less they will desire more
units of that product
 It is important to note that your marginal utility begins to fall after the very first unit
you consume.
 In other words, your very first mango holds great utility. While you may enjoy your
second mango, it doesn’t bring as much utility as the first. At some point, your MU
becomes negative. (takes away from your total satisfaction).
From the definition we deduce the following:
 Along with increase in use of any commodity, TU increases at a decreasing rate,
hence MU decreases.
 When the total utility reaches maximum, MU becomes zero. This situation is called
point of saturation.
 When total utility itself falls, MU becomes negative.
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4.7.3 Utility maximization and choice.

The objective of the allocation of the budget among different consumption uses is to obtain
the maximum satisfaction from the combination of goods that are allowed to enter the
consumption budget.

But the objective has to be realized within the limit set by the income at the given prices of
the goods. The objective can be realized by locating the purchase decision at the highest
indifference curve that is attainable with the allocated budget for the purchase. The
budgetary limit constrains the consumer to remain within the feasible area delimited by the
budget line. Income will not permit him/her to go to any point that lies above the budget
line. But all the points lying within the area between the two axes and the budget line.

A rational consumer will choose an affordable bundle that maximizes her utility.

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Bananas
A1

Q2 U3

A2
U2

U1
Q1
Mangoes

The consumer is maximizing utility at a point where the budget line is tangent to the
indifference curve. All point on a higher indifference curve are unattainable because its way
beyond the budget.

If we are at point Q2, then all indifference curves below are offering lower utility. Point A on
the budget line lies on a lower indifference curve than point Q2. therefore they will not be
preferred to Q2.

The budget line never crosses a higher indifference curve. At point Q the slope of the budget
line coincides with the slope of the indifference curve.

Slope of the budget line=

Slope of the indifference curve

Maximizing point is

4.7.4 Adjustments to income changes

Given tastes and prices, a higher income will shift the budget line outwards. This means with
a higher income the consumer can buy more of both goods. The new budget line will be
tangent to a higher indifference curve because more is preferred to less.

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The fall in income will result in an inward shift in the budget line and at a lower indifference
curve.

Bananas

b
U2

a
U1
Mangoes

Income expansion path; shows how the chosen bundle of goods varies with consumer
income levels, keeping constant everything else.

4.7.4 Adjustments to price changes

When prices changes the budget line pivots from the axis where prices are constant.

Bananas

c
3
F F’ mangos
2 4
From the graph above, the initial budget line is AF’ with an income of k50 and prices for
bananas and mango are K10 and K5 respectively. The price of mango increases to K10 and
the price of bananas remain the same. The budget line moves inwards to AF. With higher
mango prices, the consumers can now afford fewer mangoes for any given number of
bananas. The bundles between the two budget lines are now unaffordable.

The changes in prices have two effect; the substation and income effect. Substitution effect
of a price change is the adjustment of demand to the relative price changes. When the price
of mangoes increase it becomes expensive so consumers will buy less of the expensive good
and buy more of a cheaper good. They will substitute mangoes for bananas .
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Income effect of a price change is the adjustment of demand to changes in real income alone.
When prices change, the purchasing power of a consumer changes aswel. For instance, when
prices increase the same level of income will not be enough to buy the same bundle.

Substitution effect.

We have two goods X1 and X2. The initial budget line EF , the consumer is maximizing at
point A, where the indifference curve is tangent to the budget line. When the price of good x1
reduces, keeping the price of x2 constant, the budget line pivots to EF’. This shows a
movement from bundle at point A to point B. this is the overall change as a result of a fall in
prices. This is now broken down into substitution and income effect. First, Draw a
hypothetical budget line HH that is tangent to the initial indifference curve at point C. the
line HH restores the consumer to the original utility and standard of living. The line HH is
drawn to show the amount of income that a consumer should have in order to have the same
level of utility as before. This hypothetical income the consumer has in order to have the
same utility as before is called compensating variation.

The movement from point A to point C is the substitution effect. The fall in the price of X1
has made X1 cheaper than before. Consumers will now buy more of X1 and less of X2. They
substitute X1 for X2. Substitution effect is always negative.

H
A
B

H F’

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The movement from point C to B is the income effect. The fall in prices increases the real
income of the consumer. Thus the budget line will shift from HH to EF’. When both goods
are normal goods, an increase in real income will increase the quantity demanded of both
goods. Point B is north east of point C. in the case of an inferior good point B will lie in
between point A and C, which is north west of point C.

Inferior and Giffen goods.

Bananas

c
U2
H
a

U1

Mangoes
Xa Xc F H F’

I.E
S.E

Substitution effect is always negative but income effect is positive for a normal good and
negative for an inferior and giffen good. You saw for the case of normal good the effects are
all in one direction. However, the case of an inferior good results in the two effects be in
different directions. Look at the graph below. The price of mango falls and the budget line
pivots and moves from AF to AF” the optimal choice moves from point a to c. The consumer
is initially at point a where there is maximization of utility consuming mangoes and bananas.

A hypothetical budget line(HH) is drawn and is tangent to the original indifference curve at
point b. the consumer is consuming at point b and is maximizing the same utility as before
the change in prices. A movement from point a to b is substitution effect. You consume more
of a cheaper good and less of an expensive good. The move from point b to c is income
effect. As income increases, the quantity demanded of mangoes decreases. For an inferior
good it is always true that income and substitution effects go in opposite direction. The
income effect is smaller than substitution effect. If it was a giffen good the income effect

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would be larger than the substitution effect and the final result would be a fall in the quantity
demanded.

Demand curve

Bananas

U2

b c

U1

Ma Mb Mc
Mangoes

Pa

Pb

Pc D

Ma Mb Mc

We derive a demand curve for a normal good. The top part of the graph above shows how the
optimal choice of the consumer changes as prices of mangoes changes. We start from point a
and the price of mangoes is Pa, quantity demanded is Ma. now price reduces to Pb and
quantity demanded is Mb .

The bottom part, using information from the top part, we graph prices against quantity
demanded. There is a negative relationship between prices and quantity demanded. This is a
demand curve of an individual.

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4.10 ACTIVITIES

EXERCISE
1. consider a consumer who consumes only two goods :peas and beans. She has an
income of K10, the price of beans is 20ngwee while the price of peas is 40ngwee.

a) Draw the budget line

b) Suppose that the consumer consumes 30kg of beans. Assuming that she
spends all her income, how many kgs of peas is she going to consume?

c) Assume that the price of peas falls from 40ngwee to 20ngwee. Assuming that
the consumer still consumes30kg of beans, find the new quantity of peas.

d) After the decrease in price of peas to 20ngwee, assume that the consumer is
just as well off as she was in (b) if she has an income of K7.60. However, with
that income and the new price of peas, she would have consumed 20kg of
beans. Find the quantity of peas she would have consumed in this case. Show
it on the graph.

e) Find the substitution effect due to the decrease in the price of peas that is the
difference between the solution in (d) and in (b).

f) Find the income effect, which is the difference between solution in (c) and (d).

4.11 SUMMARY

In summary you have learnt;

 Consumer tastes can be represented by a map of indifference curves

 Indifference curves do not intersect and show utility. Higher

indifference curves reflect higher utility.

 Indifference curves exhibit a diminishing marginal rate of substitution.

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 Utility maximising consumers choose a consumption bundle at which the highest
reachable indifference curve is tangent to the budget line.

In the next unit you will learn about the responsiveness of quantity demanded and supplied to
changes in prices and income.

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5.0 UNIT FOUR: ELASTICITY OF DEMAND AND SUPPLY

5.1 INTRODUCTION

This unit will introduce you to the concept of elasticity. You will understand why
buyers of some products respond to price increases by substantially reducing their
purchase. And why price increases on some goods make producers to increase their output
while hikes on other products barely cause any output increase.

5.2 AIM

The aim of this unit is to introduce you to the concept of

1. Own price elasticity

2. Cross price elasticity

3. Income elasticity

4. Supply elasticity

5.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Calculate price elasticity of demand and supply

 Be able to determine the kind of good from the elasticities.

5.4 TIME REQUIRED

You should be able to spend a minimum of 3hours on this unit.

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5.5 REFLECTION

If you heard that the price of fuel, for example, increased by 10%, by how
much do you think the demand for fuel would reduce?

5.6 READINGS
Brue et al, chapter 4 p81-99

Sloman and Garratt, chapter 3, p 56-80

5.7 elasticity of demand

In the previous unit you learnt that the quantity of a product demanded will vary inversely to
the price of that product. That is, the direction of change in quantity demanded following a
price change is clearly stated. However, what is not known is the extent by which quantity
demanded will respond to a price change.

To measure the responsiveness of the quantity demanded to change in price, we use a

measure called price elasticity of demand. Elasticity is a dimensionless measure of the
sensitivity of one variable to changes in another, holding other variables constant. For some
products consumers are highly responsive to price changes. When a small change in price
causes a very large change in quantity demanded, we say demand for the particular good is
elastic. When a substantial change in price causes a small change in the quantity demanded,
we say demand is inelastic. This is because consumers pay less attention to prices changes
for the commodity.

The price elasticity of demand is a measure of the responsiveness of quantity demanded to a

price change. Own Price Elasticity of Demand is the percentage change in the quantity
demanded relative to a percentage change in its own price. The formula for elasticity is given
as;

percentage change in quantity demanded of X

Ed 
percentage change in price of X

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 q  q1   p  p1 
E d   2  100   2  100
 q1   p1 

 current quantityof X  previous quantityof X   current price of X  previous price of X 

E d    100    100
 previous quantity of X   previous price of X 

Since price and quantity demanded generally move in opposite direction, the sign of the
elasticity coefficient is generally negative. When you have price Elasticity of -2.72, the
Interpretation is; a one percent increase in price results in a 2.72% decrease in quantity
demanded.

Lets work out this example together.

quantity Q2-Q1 price P2-P1 Ed

1 - 125

2 1 100 -25 (1/-25)*(125/1)= -5

4 2 50 -50 (2/-50)*(100/2)= -2

5 1 10 -40 (1/-40)*(50/4)= -0.3

Elasticity is interpreted in the following way. All values of elasticity will be taken in absolute
terms meaning we ignore the negative sign.

 When (|ED| < 1): a change in price brings about a relatively smaller change in
quantity demanded (ex. gasoline). This is called Inelastic demand. This makes total
Revenue = P×Q to rise as a result of a price increase

 When (|ED| = 1): a change in price brings about an equivalent change in quantity
demanded. This is called unitary elastic demand. Total revenue TR= P×Q remains
the same as a result of a price increase

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 When (|ED| > 1): a change in price brings about a relatively larger change in quantity
demanded (ex. expensive wine). This is called Elastic demand. Total revenue TR =
P×Q falls as a result of a price increase

 Perfectly Inelastic Demand– Quantity demanded does not respond to a change in

price. Ed=0. the demand curve is vertical

 Perfectly Elastic Demand – Quantity demanded will go from 0 to infinity at a

particular product price. That is, if the price isn’t right, 0 is demanded, as soon as the
price is right, infinite amounts will be demanded. Ed = ∞

price

Perfect elastic perfect inelastic

The relationship between revenue and price elasticity of a p

Price inelastic demand | ED | < 1 Price elastic demand | ED | > 1

P P
Q Q
TR TR

When demand for a good is inelastic, a fall in the price will result in a small increase in
quantity demanded therefore the revenue realized will be less. But when demand is elastic a
small fall in prices results in a huge increase in quantity demanded therefore, revenue is
greater.

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From the graph above, at point P= a/b, Ed = − ∞; at P = 0, Ed = 0; at P= a/2b, Ed = −1
In the region of the demand curve to the left of the mid-point M, demand is elastic, that is −
∞ ≤ Ed < – 1 . In the region to the right of the mid-point M, demand is inelastic, – 1 < Ed ≤ 0
5.7.1 Determinant of price elasticity
There are four determinants of a good’s own-price elasticity of demand

I. Necessities v. discretionary goods (or luxuries): necessities tend to have

inelastic demands; luxuries have elastic demand. Depends on the buyer’s
preferences.

II. Availability of close substitutes: the greater the number of available

substitutes, the more elastic the demand

III. Definition of the market: broad definitions (e .g. food) have less elastic
demands than do narrowly defined markets (e.g. Nestlé’s chocolate) which
have more substitutes.

IV. Time horizon: the greater the time horizon, the easier for consumers to find
substitutes, or make do without, so the more elastic the demand.

V. Proportion of Income – The higher the price of a good relative to consumer

incomes, the greater the price elasticity of demand. Ex/ a 100% increase in the
price of a two penny box of matches is a very low fraction of my annual
salary, compared to a 100% increase in the price of a porshe boxter (60K to
12K) So the price elasticity of demand on the match box will be much more
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inelastic than on the porshe boxter. Price elasticity is importnant in
calculating the price rise required to eliminate a shortage(excess demand) or
the price fall to eliminate a surplus

5.8 Cross price elasticity of demand

Cross price elasticity is the responsiveness of quantity demanded of a good to changes in the
price of another good. It Shows the percentage change in the quantity demanded of good Y in
response to a change in the price of good X.

EDYX = % Change in QDY / % change in PX

Qy Px Qy Px

EdYX    
Qy Px Px Qy

If Edyx = - 0.36: A one percent increase in price of good x results in a 0.36% decrease in
quantity demanded of good Y

Classification:

 If (Edyx > 0): implies that as the price of good X increases, the quantity
demanded of Good Y also increases. Thus, Y and X are substitutes in
consumption (ex. chicken and pork).

 If (Edyx < 0): implies that as the price of good X increases, the quantity
demanded of Good Y decreases. Thus Y & X are Complements in
consumption (ex. bear and chips).

 If (Edyx = 0): implies that the price of good X has no effect on quantity
demanded of Good Y. Thus, Y & X are Independent in consumption (ex.
bread and coke)

5.9 Income elasticity of demand

Income elasticity of demand shows the percentage change in the quantity demanded of good
Y in response to a percentage change in Income. It Measures how far the demand curve shifts
horizontally when income changes

EI = % Change in QY / % change in I

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Qy I Qy I
EI    
Qy I I Qy

If EI = 2.27: A one percent increase in income results in a 2.27% increase in quantity

demanded of good Y

 Classification:

 If EI > 0, then the good is considered a normal good (ex. soap).

 If EI < 0, then the good is considered an inferior good . All inferior goods are
necessities

High income elasticity of demand for luxury goods, income elasticity is above unity. Low
income elasticity of demand for necessary goods, income elasticity are below unity.

5.10 Price elasticity of supply

The price elasticity of supply is the percentage change in quantity supplied per percentage
change in price

Elasticity of supply can be inelastic (Es<1), perfect inelastic(Es=0 vertical), perfectly elastic
(Es=∞ horizontal), elastic (Es>1) . the size of the elasticity of supply depends mainly on the
time horizon: the longer, the more elastic, in general, because firms have more time to adjust
their production processes in order to increase their profits.

5.11 ACTIVITIES

1. Draw a diagram with two supply curves, one steeply sloping and one gently sloping.
Ensure that the two curves cross. Draw a demand curve through the point where they
cross and mark the equilibrium price and quantity. Now assume that the demand
curve shifts to the right. Show how the shape of the supply curve will determine just
what happens to the price and quantity.
2. Assume that a football club has the following demand curve for season tickets

Qd  50,000  50P

a) What quantity of season tickets is demanded when season tickets are free (p=0)?

b) At what price do season tickets cease to be bought (Q=0)?

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c) Using the information from a and b sketch the demand curve for the club.

d) What amount of season tickets is demanded at p=600 and p=700. What revenue is
generated from season ticket sales at each price?

e) Calculate the midpoint price elasticity between 600 and 700.

f) What can you say about the price elasticity of demand between the points on the
demand curve corresponding to season tickets prices of 600 and 700

g) In what price range does raising season ticket prices increase revenues from season
ticket sales.

5.12 SUMMARY

You have learnt the following concepts;

 Elasticity of demand (own price) measures the sensitivity or

responsiveness of quantity demanded to changes in the own price of a
good.

 Elastic quantity is more responsive to price changes

 Inelastic quantity is less responsive to price changes

 Cross price elasticity of demand measure the sensitivity of quantity demanded of one
god to changes in the price of related good.

 Income elasticity of demand measures the sensitivity of quantity demanded to

changes in income holding constant the prices of all goods constant.

In the next chapter you will look at how business make their decisions on what
quantity to produce and what costs to incur to maximise profits.

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6.0 UNIT FIVE: COST AND PROFIT MAXIMISATION

6.1 INTRODUCTION

This unit will introduce you to how firms make their decisions on how much to
produce, cost of production and profit maximisation

6.2 AIM

The aim of this unit is to introduce you to;

 The concept of cost minimization

 Profit maximisation

6.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Calculate marginal revenue, marginal cost, marginal product of labour and profit

 Draw curves associated with costs, revenue, and production

 Determine the output at which firm will maximize their profit

 Determine the level at which a firm will be forced to shut down its operations.

6.4 TIME REQUIRED

This unit should take you at least four hours to finish.

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6.5 REFLECTION

How do you think firms decide on how much output to produce to

maximize their profits?

6.6 READINGS
Begg et al, chapter 6 & 7

Sloman and Garrat, chapter 4

Brue et al , chapter 6

6.7 production

How do firm decide how much to produce and offer to sale? Output depends on the amount
of resources and how they are used. Different combination of inputs will lead to different
amounts of output. The cost of producing any level of output will depend on the amount of
inputs used and the price the firm pays for the inputs.

There are three types of business organisations; sole trader, partnerships and companies. All
these organisation will have to make decision on how much to produce, what revenue and
profit will they get from the output produced.

Economic cost Vs accounting costs.

Accountants track the actual payment and receipt of a company. On the other hand economist
are interested in how revenue and cost affect the firms decision, allocation of resources to a
particular activity. Economist identify the cost of using resources (opportunity cost).

Economic costs include explicit and implicit cost. Explicit cost is the monetary payment a
firm must make to an outside to obtain a resource. Implicit cost is the monetary income that a
firm sacrifices when it uses a resource it owns rather than supplying it in the market.

Example Gomez runs a small pottery firm. He hires one helper at K12, 000 per year, pays
annual rent of K5000 for his shop, and spends K20, 000 per year on materials. He has K40,

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000 of his own funds invested in equipment (pottery wheels, kilns etc) that could earn him
K4000 per year if alternatively invested. He has been offered K15, 000 per year to work as a
porter for a competitor. He estimates his entrepreneurial talents are worth K3000 per year.
Total annual revenue from pottery sales is K72, 000. Calculate the accounting profit and the
economic profit for Gomez’s pottery firm.

The accounts book will show the following;

Total sales revenue………………………………………………………K72, 000

Cost of material…………………………………………….K 20,000

Helpers salary………………………………………………..K5, 000

Rent on shop………………………………………………….K 12,000

Total explicit cost……………………………………………………………….K 37,000

Accounting profit……………………………………………………………..K 35,000

The accounting profit of K 35,000 is a good indication of the firm’s performance. However it
ignores implicit costs and overstates the economic success of the firm. The economic profit is
calculated below;
Accounting profit…………………………………………………………K35, 000

Forgone interest…………………………………………….K 4,000

Forgone entrepreneur skills…………………………..K3, 000

Forgone salary………………………………………………….K 15,000

Total implicit cost……………………………………………………………….K 22,000

Economic profit………………………………………………………………..K 13,000

After considering implicit costs the economic profit is K 13,000, showing the economic
success of the firm.

When a firm wants to produce a product it will make use of the factors of production that
include buildings, machines, land, labour and mineral resources. Some of these factors of
production are called fixed factors because they are not easily replaced nor acquired in a
given period of time. If a firm wants to increase production, building a new factory and
acquiring machinery will take time. But factors of production such as labour and mineral
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resources are easily increased, sourced and replaced. Such are called variable factors.
Therefore, the short run is the time period during which atleast one factor of production is
fixed. In the short run output can be increased using variable factors. The long run is the
time period in which all inputs can be varied. The time frames talked about here are not
fixed; they differ from firm to firm.

Short run production

The firm uses so many fop but for now We will focus on the labour output relationship of
production, holding all other factors equal. In this short run a firm can only change the units
of labour to increase production. Total product (TP) is the total quantity produced for a
particular good. marginal product(MP) is the extra output producing by adding a unit of a
variable input(labour) . average product(AP) is output per unit of an input labour. This is
also called labour productivity.

MP=change in TP/change in labour or ∆TP/∆L

AP=total product/units of labour

Production is subject to diminishing returns in the short run. The law of diminishing
returns states that, assuming technology is fixed, successive units of a variable resource are
added to a fixed resource (capital or land) beyond some point the extra unit of output
attributed to the additional unit of a variable input will decline . Production function is a
function that specifies the output of a firm, an industry, or an entire economy for all
combinations of inputs. This function is an assumed technological relationship, based on the
current state of engineering knowledge; it does not represent the result of economic choices,
but rather is an externally given entity that influences economic decision-making. See graph
below.

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The graph shows diminishing returns at play. As additional labour is increase output
increases up to a certain level, then any additional labour increases output at a declining rate.
The product curve has three phases 1) increasing return 2) diminishing returns and 3)
negative returns. The law of diminishing returns assumes that all units of labour are of equal
quality. Each additional worker is of the same innate ability, motor combination, education,
training and experience.

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Marginal product is the slope of the total product curve. The graph shows several points
where the relative position of the average and marginal product curves tell us something
about how the average product of labour is changing. This illustrates the average-marginal
rule where when a marginal value is less than an average value, the average is falling and
when the marginal value is greater than average value, the average is rising. When the two
are equal, the average is constant - which implies that the average should be at a maximum or
minimum point.

6.8 Short run costs

A firms cost of production depends on its output. The more it produces, the greater the
quantity of fop it must use. The more the fop the greater the cost. The greater the productivity
of factors, the smaller will be the quantity needed to produce a given level of output and
hence the lower the cost of output. The higher the rice of the input the higher the cost of
production.

fixed cost:
Business expenses that are not dependent on the level of goods or services produced
by the business. They tend to be time-related, such as salaries or rents being paid per
month, and are often referred to as overhead costs.
variable cost:
A cost that changes with the change in volume of output of a firm. These include
payment of materials,power, transportation etc. variable cost can be altered or
controlled by changing output levels.
Total cost
Is the sum of fixed and variable cost.
TC=TFC+TVC
average total cost:
Average cost or unit cost is equal to total cost divided by the number of goods
produced (the output quantity,( Q). It is also equal to the sum of average variable
costs (total variable costs divided by Q) plus average fixed costs (total fixed costs
divided by Q).
ATC=TC/Q=AFC+AVC where AFC=TFC/Q AVC=TVC/Q
marginal cost:

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The increase in cost that accompanies a unit increase in output; Additional cost
associated with producing one more unit of output. a change in output due to a unit
change in output.
MC=change in TC/change in Q= ∆TC/∆Q

Output TFC TVC TC AFC AVC ATC MC

0 12 0 12

1 12 10 22 10

2 12 16 28 6

3 12 21 33 5

4 12 28 40 7

5 12 40 52 12

6 12 60 72 20

7 12 91 103 31

Please calculate AFC AVC and ATC

Cost Curve

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MC are costs the firm can control directly and immediately.MC is the cost incurred to
produce one last unit of output. It can also be the cost saved by not producing the last unit.

From the graph MC declines sharply, reaches a minimum then rises abruptly. This is because
total cost rise at a decreasing rate then increases at an increasing rate. Total fixed costs are
horizontal because they do not depend on the level of output.MC cuts the AVC and ATC at
their minimum points. When MC is less than the current average total cost, the ATC is
falling. The reverse is true. At the point of intersection of MC and ATC, average cost has
stopped falling but not yet rising.

Long run production cost

In the LR the firm makes all resource adjustments. There is no distinction between variable
and fixed cost because all factors are variable. There are key assumption made when
constructing a long run cost curve; 1) factor prices are given, 2)the state of technology and
factor quality are given and 3)firms choose the least cost combination of factors for each
output. A firm can choose a production technique that is either labor or capital intensive. A
technique that uses more capital than labour is called capital intensive. A technique that uses
more labour than capital is labour intensive.

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A firm that is expanding has to expand to successively larger plant sizes with larger output.
From the graph SAC1 is the smallest short run average total cost and SAC5 is the largest.
The vertical lines show the outputs at which the firm should change plant size to realise the
lowest attainable average total cost.as we move from SAC1 costs are increasing. With plant
size one the lowest ATC is attain at output 200.. to expand output to 400, the firm constructs
a larger plant size2. Plant size 3 yields the lowest ATC. Tracing these lowest points of SAC
gives us the long run cost curve.

Scale of production.

In the long run all factors vary. If we double the input Does that mean output also doubles.

o Constant returns to scale; a given percentage increase in inputs results in the same
percentage increase in output
o Increasing returns to scale; a given percentage increase in input results in a larger
percentage increase in output.
o Decreasing returns to scale; a given % increase in inputs results in a smaller %
increase in output.

Economies and Diseconomies of Scale

The change in long-run average cost as output increases is the basis for two important
concepts: economies of scale and diseconomies of scale. A firm enjoys economies of scale in

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a situation where average cost goes down when output goes up. By contrast, a firm suffers
from diseconomies of scale in the opposite situation, where average cost goes up when
output goes up. The extent of economies of scale can affect the structure of an industry.
Economies of scale can also explain why some firms are more profitable than others in the
same industry.

Figure above illustrates economies and diseconomies of scale by showing a longrun average
cost curve that many economists believe demonstrates many real-world production
processes. For this average cost curve, there is an initial range of economies of scale (0 to
Q_), followed by a range over which average cost is flat (Q_ to Q__), and then a range of
diseconomies of scale (Q > Q__).
Economies of scale have various causes. They may result from the physical properties of
processing units that give rise to increasing returns to scale in inputs. Economies of scale can
also arise due to specialization of labor. As the number of workers increases with the output
of the firm, workers can specialize on tasks, which often increases their productivity.
Specialization can also eliminate time-consuming changeovers of workers and equipment.
This, too, would increase worker productivity and lower unit costs.

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Economies of scale may also result from the need to employ indivisible inputs. An
indivisible input is an input that is available only in a certain minimum size; its quantity
cannot be scaled down as the firm’s output goes to zero. An example of an indivisible input
is a high-speed packaging line for breakfast cereal. Even the smallest such lines have huge
capacity, 14 million pounds of cereal per year. A firm that might only want to produce 5
million pounds of cereal a year would still have to purchase the services of this indivisible
piece of equipment.
Indivisible inputs lead to decreasing average costs (at least over a certain range of output)
because when a firm purchases the services of an indivisible input, it can “spread” the cost of
the indivisible input over more units of output as output goes up.
.
The region of diseconomies of scale (e.g., the region where output is greater than Q__ in
Figure above is usually thought to occur because of managerial diseconomies. Managerial
diseconomies arise when a given percentage increase in output forces the firm to increase its
spending on the services of managers by more than this percentage. To see why managerial
diseconomies of scale can arise, imagine an enterprise whose success depends on the talents
or insight of one key individual (e.g., the entrepreneur who started the business). As the
enterprise grows, that key individual’s contribution to the business cannot be replicated by
any other single manager. The firm may have to employ so many additional managers that
total costs increase at a faster rate than output, which then pushes average costs up.

Minimum efficient scale

Economies and diseconomies of scale are important determinants of an industry’s structure.
Minimum efficient scale is the lowest level of output at which a firm can minimize long run
average costs. From the figure above the MES level occurs at point Q1, because of the
extended range of constant returns to scale, firms producing substantially greater outputs
could also realize the minimum attainable long run average cost.
In the event where economies of scale continue over a wide range of output and
diseconomies of scale appear at high levels of output. This pattern of declining long run
average cost occurs only to a few large scale producers. Small firms cannot realize the MES.
In cases where economies of scale are few and diseconomies come into play quickly, the
MES occurs at low levels of output.this industry a large number of relatively small
producers.eg agriculture

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The long run average cost curve is determined by technology and economies and
diseconomies of scale

6.9 Revenue
A firms profit is defined as revenue minus cost.

1. Total Revenue – It is the total sale proceeds of a firm by selling a commodity at a

given price. If a firm sells 3 units of an article at $ 24, its total revenue is 3 x 24.

TR = P x Q, where TR is the total revenue, P the unit price and Q the quantity.

2. Average Revenue – It is the average receipts/earnings from the sale of units of the
commodity. It is obtained by dividing the total revenue by the number of units sold.
The average revenue of a firm is in fact the price of the commodity at each level of
output since TR = P x Q, therefore, AR = TR / Q = P x Q / Q = P.

3. Marginal Revenue MR – is the extra total revenue gained by selling one more unit of
the commodity.

MR=change in TR/change in Q=∆TR/∆Q

The relationship between AR,TR, MR and output depends on the condition the firm operates.
If the firm is too small to affect market prices it will face different revenue curves from the
large firms that affect prices.

1. Revenue curves when prices is not affected by the firms output – The average
revenue curve is a horizontal straight line parallel to X axis and the marginal revenue
curve coincides with it. This is since the number of firms selling an identical product
is very huge, the price is determined the market forces of supply and demand so that
only one price tends to prevail for the whole industry.

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Since the demand curve is the firm’s average revenue curve, the shape of AR curve is
horizontal to the X axis at price OP and the MR curve coincides with it. Any change in the
demand and supply circumstances will change the market price of the product and
consequently the horizontal AR curve of the firm.

2. Revenue curves when price varies with output, if a firm has a large market share it
will face a downward sloping demand curve. this implies to sell more it has to lower
the price. Recall that Average revenue equal price, then AR has to fall when more is
sold. So the average revenue curve is the downward inclining industry demand curve
and its related marginal revenue curve lies below it. The marginal revenue is lower
than the average revenue. by lowering the price, marginal revenue also falls but the
rate of fall in marginal revenue is greater than that in average revenue.

In the diagram the MR curve falls below the AR curve and lie half a way on the
perpendicular drawn from AR to Y axis. This relation will always exist amidst straight line
downward sloping AR and MR curves.

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PROFIT MAXIMISATION

How much output should the firm produce if it want to maximize profits?

The profit maximising condition is that marginal revenue should be equal to marginal cost.
The firm should produce output at a point where MR=MC. This is because at output levels
below that point MR>MC, producing more of the output there will be a greater addition to
revenue than to cost. Beyond the profit maximising point MR<MC any additional output
adds more to cost than revenue.

AR and AC are used to measure the amount of profit at the maximum.

We first look at the case when a firm is too small to affect market price.

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From the graph MC=MR at output Q*. at this point the firm is making economic profits
because the AR>ATC. The difference between the two curves gives us the amount of profit
realised. When the AR<ATC the firm is making losses and there is no need to continue
producing output. . When AR=ATC the firm is making normal profits. The firm is just
making enough revenue to cover all its costs.

ATC
Price

AVC
P*
loss P=MR=AR

MC

Quantity
Q*

ATC
MC

price AVC

P*
Loss=TFC
P=MR=AR

Shutdown point

Q*

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Since the firm cannot affect the prices of the commodity, if it makes economic prices, more
firms will enter the market and share the profits. In the end they will all earn zero profits.
they will break even. Firms will continue to operate at zero profits because they are able to
cover their average total costs, for as long as P>ATC. If the firm makes losses in the short
run, in the long run the firm will close down. However, most firms will leave the market and
the remaining firms will earn zero profits. The firm needs to know whether the losses are big
when producing at Q1. Remember, fixed costs are supposed to be paid for even if the output
is zero.

If revenue exceeds variable costs, the firm is earning something towards its overhead costs.
they will produce at Q1 even though they are making losses. if revenue is less than variable
costs the firm will not produce anything at all.firm will decide to shut down at the point
where MR=AVC.

Secondly, revenue when prices vary with output.

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The firm can either make economic profits or losses in the short run. But in the long run it
either makes zero profits or shuts down. For as long as P>ATC. If the firm makes losses in
the short run, in the long run the firm will close down. However, most firms will leave the
market and the remaining firms will earn zero profits. The firm needs to know whether the
losses are big when producing at Q1. Remember, fixed costs are supposed to be paid for even
if the output is zero.

If revenue exceeds variable costs, the firm is earning something towards its overhead costs.
they will produce at Q1 even though they are making losses. if revenue is less than variable
costs the firm will not produce anything at all.firm will decide to shut down at the point
where MR=AVC.

6.10 ACTIVITIES

2.4 EXERCISE.
1. Explain the law of diminishing returns.
2. Explain the difference between explicit and implicit cost.
3. What is economies, constant and diseconomies of scale?
4. Explain, with the aid of a graph, the relationship between a total product curve,
average and marginal product curves.
5. Why does the average revenue and marginal revenue curve slopes downwards for a
firm that has control over price? Show graph.

6.11 SUMMARY

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In summary you have learnt;

 Production functionshows the maximum output that can be produced

using given quantities of inputs

 Total cost curve is derived from the production, for given wages and rental rates of
factors of production.

 Marginal cost curve reflects the marginal product of the variable factor holding other
factors fixed.

In the next unit you will learn of different market structure and how the firms market their
decisions.

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7.0 UNIT SIX: MARKET STRUCTURE

7.1 INTRODUCTION

This unit is about the types of market that are there in an economy. we will see
how a particular firm has influence over the market forces.

7.2 AIM
The aim of this unit is to introduce you to the concept of;

 Perfect competition

 Monopoly

 Monopolistic competition

 oligopoly

7.3 OBJECTIVES

At the end of this unit you should be able to do the following

 explain the characteristics of each market

 draw and explain the graphs associated with each market

7.4 TIME REQUIRED

you should take at least four hours to finish this unit

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7.5 REFLECTION
Think of a situation where there is only one firm in a market producing a
good, how will its decision affect the market demand? Now think of a
situation where there are a number of firm producing the same good, how
will the decision of one firm affect the market demand?

7.6 READINGS
Begg et al, chapter 8

Sloman and Garrat, chapter 5

Brue et al , chapter 7,8, & 9

7.7 The determinants of market structure

Market structure is the interconnected characteristics of a market such as; number and
relative strength of buyers and sellers, degree of freedom in determining price, level and
forms of competition, extent of product differentiation, and ease of entry into and exit the
market.

1. The number of agents in the market

2. Their information set and mobility
3. The nature of the product
4. Entry and exit from the market.

The types of market structure include; perfect completion, monopoly, oligopoly,

monopolistic completion, and duopoly.

7.7. 1 Perfect competition

Characteristics of the market.

1. a large number of firms, each firm has a small market share
2. free entry and exit, and
3. a relatively homogeneous product, the products are identical

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4. price takers
5. buyers and sellers know the prices and the nature of the product.
The key condition for a competitive market, is price taking. Every firm and every consumer
must take the market price of the good as given. No one can unilaterally affect the price by
their choice of how much to buy or sell.
This means the individual firm will face a horizontal demand curve. It will be horizontal at
the market price, established by supply and demand on the market as a whole. Recall, from
the previous lecture, that the perfectly competitive firm will maximize its profits by setting
MC = p*.

(Why? Because profit maximization for any firm means setting MC = MR, and for a
perfectly competitive firm, MR = p*.)
The firm faces a horizontal market demand curve because it’s a price taker. If it charges a
price higher than p It will not sell any output. Buyers will go to other firms whose product is
just as good. It will not charge less than p because all the other firms will know about it.

Firms supply curve

We can use what we know about profit maximization under perfect competition to derive the
firm’s individual supply curve. Remember that a supply curve shows how much quantity is
produced at each price. A market supply curve shows how much quantity all firms together
will produce at each price. An individual firm’s supply curve shows much quantity that firm
will produce at each price. To derive this curve, we need to consider the firm’s response to
different market prices. The profit maximizing point is;
SMC=MR=P

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Consider five different prices, p1 < p2 < p3<p4 < p5. For each of these prices, we can figure
out the quantity that a PC firm will produce. From these choices we can see the firm’s supply
curve taking shape: it looks just like the MC cost curve.

There is one exception to the rule that the firm’s supply curve is identical to the MC: when
p* < AVC, the firm’s shut-down condition is satisfied. If we follow the MC down to the
AVC, we can see that for any price above the minimum point of the AVC will induce the
firm to stay open and produce. But for prices below the minimum AVC, the firm will shut
down and produce q = 0. So it turns out the supply curve has two parts. The upper part
corresponds to when the firm stays open, while the lower (vertical) part corresponds to when
the firm shuts down.
Figure 2. short run supply curve. MC ATC

Cost, revenue
f
P6
AVC e
P5
P4 d
breakeven
P3 c
b
P2
P1 Shut down point
a
Quantity supplied

 At P1, P1<min AVC. Firms will not produce anything at all

 At P2 they will produce Q2 but will be indifferent between shutting down and
producing. Their loss is equal to fixed costs.
 At P3 the firm will supply Q3 and minimise its losses.
 At P5 it will supply Q5 earning normal or zero profits. This is the break even point.
 At P6 it will supply Q5 and realise economic profits.

The market supply curve is the summation of all individual firms supply curves.

Profit maximisation in the short run.

The profit maximisation point of every firm is when MR=MC.

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In this SR equilibrium, we have the firm making a profit.If demand increases or decreases,
this will affect the choices and profits of all the firms in the market. Note that the increase in
price tends to increase profits or reduce losses while a decrease in demand increases losses or
decrease profits.
The long run supply curve
In the SR, this has no effect on the supply curve; but in the LR, firms enter for profits and
leave to escape losses, leading to supply curve shifts. We want to use this information to
derive a LR supply curve. A LR supply curve, just like a SR supply curve, shows the total
quantity that will be supplied in a market at different prices; but unlike the SR supply curve,
it shows the quantity supplied after all long-term changes, including entry and exit of firms,
have been taken into account.
We can come up with a long run supply curve by changing demand, and then finding the
equilibrium points after allowing LR adjustments, including entry and exit. Start with an
initial (short-run) supply and demand. If we are in long-run equilibrium, profits are zero.
Now, let demand shift to the right. In the short-run,
ATC price rises a lot. But the higher price
creates profits, and profits attract entry in the long run. So eventually supply shifts to the
right as well, pushing price back down (though possibly not as low as it was before). Once
profits are back to zero again, you’re in a new long-run equilibrium. Do this all again to find
a third long run equilibrium, and then connect the dots to get the long-run supply curve.

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FIGURE 3. LONG RUN SUPPLY CURVE

S2 S3
S1
LR
prices

P3
P2
P1 D3

D2
D1

Q1 Q2 Q3 Quantity supplied

The interpretation of the LR supply curve is pretty much the same as the SR supply curve: it
shows the willingness of producers to sell at each price. But the LR supply curve measures
this willingness in the broadest sense, including all firms that might potentially supply this
product.

Notice that the LR supply curve is flatter than the SR supply curve. This must be so, since the
LR supply curve takes into account the quantity responses of all firms, not just the ones
currently in the market, but potential firms as well.
The long run MC curve is flatter than the short run MC curve. In the long run a firm will exit
the market if it fails to cover its long run ACs. Therefore at any price below P=LRATC, the
firm exits the market. The firm will produce any output if price is above LRATC. Therefore
the long run supply curve is the LRMC above the LRATC=P.

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Profit maximization in the long run
In the long run, entry and exit become possible. Why? Because potential firms can buy fixed
inputs and become actual firms. And existing firms can sell off or stop renting their fixed
inputs and go out of business.
Firms will choose to enter the industry if the existing firms in the industry are making
economic profits. The profits are an incentive to enter. Now, remember that the market
supply curve is just the summation of all the individual firms’ supply curves. If we add more
firms, therefore, the market supply must shift to the right. But what effect does a right shift of
supply have? It drives down the price on the market, thereby reducing the profits of each
firm.
LRMC
FIGURE 4.
P
S1 LRAC
P S2

P2

P1

Q
Q Q

When few new firms enter the markets, they firms will make profits, but smaller profits than
before. But if there are still economic profits being made, more firms will enter. This must
continue until there are no economic profits. So entry finally stops when the last firm to enter
the market are making normal profits and are producing at their lowest average total cost.
What if typical firm is making losses? Then the reverse process will take place. Firms will
exit the market, causing a left shift of market supply, causing a rise in market price, causing a
reduction of losses. This continues until losses are zero.
Thus, LR competitive equilibrium consists of two conditions:
• p* = MC
• p* = minimum ATC
The first condition is caused purely by profit maximization, and it’s true in both the SR and
the LR. The second condition, however, is caused by entry and exit in the LR. It won’t
necessarily be true in the SR.

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It turns out that the perfectly competitive firm produces not just at the minimum of its
SRATC, but also it’s LRATC. Why? Because any PC firm not at its minimum LRATC will,
in the LR, change its input combination to take advantage of lower average costs. If firms are
able to make positive profits by moving outward on the LRATC curve, those profits will
attract entrants into the industry in the usual fashion. So by the same arguments as before,
profits will eventually dissipate to zero. The price must be at the bottom of the LRATC, not
just the SRATC.

An industry supply curve is the horizontal aggregation of individual firms output at

different prices. And it is flatter. Higher prices do not merely induce firms to expand their
production but new firms also enter. In extreme case the industry long run supply curve is
horizontal if all existing firms and potential entrants have identical cost curves and the
industry’s expansion or contraction will not affect the resource prices and the production
cost. This means the entry or exit of firms will not shift the long run ATC of individual
firms. This is a case where industry’s demand for resources is small in relation to the total
demand for the resources. This is called a constant cost industry.
If the industry in question has a large impact on the markets for its inputs, then the LR supply
curve may slope upwards. If the effect of entry into the industry is to bid up the price of
inputs, so that a firm’s cost curves rise as a result of the entry of new firms, then the market
price after adjustment will be higher than it was before. In this case, the LR supply curve
must be upward-sloping. An increase in market demand results in economic profits and
attract new firms. These new entrant s increase market supply and lowers the profits but
because costs rise, the ATC will shift upwards. The overall results is a higher than original
equilibrium price. the industry will produce larger output at a higher product price because
the expansion has increased resource price and the minimum average cost; this is called an
increasing-cost industry, which results from external diseconomies.

On the other hand, if entry into the industry creates a greater demand for inputs that allows
those inputs to be produced through mass production techniques (i.e., at lower average cost),
then the industry can benefit from lower costs of production. In this case, the LR supply
curve is downward-sloping. This is called a decreasing-cost industry, which results from
external economies.

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An increase in costs.
Consider a higher increase in the input price that hits all the firms in the industry. We assume
all firms have the same cost curves and the long run industry supply curve is horizontal.
Initially the industry is in equilibrium at P1 and Q1 where the long run supply curve meets
the industry demand curve. Individual firms are producing q1* output at the lowest point on
the LAC1.
The increase I the price of inputs will shift the long run ATC from LAC1 to LAC2. In the
short run some factors are fixed, there we have STC2 ,SVC2 and the MC2. New equilibrium is
reached at P2 where SRSS2 intersects the demand curve. At that price a firm equates MC=P2
and supplies q2. This covers variable cost but not fixed costs.
With the passage of time, fixed factors are now varied and some firms leave the industry.
Long run equilibrium moves to P2* since the new LRSS2 intersects demand at P2* and Q*. the
firm produces q2*. As a result of the increase in cost of production equilibrium price rises and
output falls.

FIGURE 7. A cost increase in a competitive industry

SATC1
LAC2
SAVC2

SRSS2
LAC1 SRSS1

LRSS2
P2 P2

P1 P1 LRSS1

A shift in market demand curve.

The demand curve shifts from dd to d1. On the SRSS we move from point A to A’.when
demand rises its takes a big price rise to induce individual firms tto move up their steep short
run supply curves with given fixed factors. In the long run, firms adjust all factors and their
long run supply curves are flatter. The supernormal profits attract new firms into the industry.

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The supply curve is rising either cause it takes higher prices to attract higher costs firms into
the industry or the collective expansion bids up some inputs prices or both. The new long run
equilibrium is at point A’’, with a higher output but a lower price than the short run.
Figure 8. a shift in the demand curve.
SRSS LRSS
prices

P3

P2
P1

D2
D1

Q1 Q2 Q3 Quantity supplied
Perfect competition and efficiency
Two things are required if economic efficiency can be said to exist;

Productive efficiency- Products must be made with the least possible use of scare resources.
This means that goods and services must be produced with the least-cost methods available.
It suggests that we cannot have more of one good without giving up another. Productive
efficiency is achieved when the output is produced at minimum average total cost and it
exists when producers minimise the wastage of resources in their production processes.
Productive efficiency can be shown through the firm’s cost curve. First production must take
place on the lowest possible average cost curve. Secondly production needs to occur at the
lowest point on that lowest cost curve. The lowest point on a firm’s average cost curve is
therefore a point of technical efficiency.
The production possibility curve may also help to clarify productive efficiency. Recall that
the PPF shows the maximum production points for the combinations of any two products.
Given this it must be true that productive efficiency can only exist when an economy is
producing right on the boundary of it production possibility frontier.

Allocative efficiency ; Allocative efficiency is concerned with whether we are producing the
goods and services that match our changing needs and preferences and which we place the
greatest value on. Allocative efficiency has to do with allocating the right amount of scarce

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resources to the production of the right products. This means producing the combination of
the products that will yield the greatest possible level of satisfaction of consumer wants. It
tells us how much of each good we should produce.

Allocative efficiency is reached when no one can be made better off without making
someone else worse off. This is also known as Pareto efficiency.

Consumer and producer surplus.

From market equilibrium we find a measure of gain that consumers and sellers obtain from
trading at the equilibrium price. For consumers the measure of trade gain is called consumer
surplus whilst for producers is called producer surplus.

Consumer surplus is Equivalent to the difference between the maximum price (reservation
price)a consumer is willing to pay for a good and the actual price paid.it is the net gain from
a purchase of a good. For example, you want to buy a pair of jeans trousers. You are willing
to pay K200 for it. If the actual price of a trouser is K150. When you but it you gain a surplus
of K50.

 Total consumer surplus = the sum of all consumer surpluses gained by all buyers of a
good in the market.

Consumer surplus is measured by the area below the market demand curve and above the
equilibrium price. This willingness to pay is nothing else but the slope of the indifference
curve; that is, it is the marginal utility of X measured in terms of the quantity of Y that would
be needed to compensate for a loss of a unit of X. In that sense, the downward sloping
demand schedule represents diminishing marginal utility.

Producer surplus is the difference between the (market) price a seller actually receives and
his/her (seller’s) cost. It is the measure of gain that the sellers obtain from selling a given
quantity of a good at equilibrium price. A seller would not sell below his/her cost, If the
market price is below a seller’s cost the seller will leave the market

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Allocative efficiency occurs when the value that consumers place on a good or service
(reflected in the price they are willing and able to pay) equals the cost of the resources used
up in production.

The condition required for allocative efficiency is that price = marginal cost of supply.

In the diagram above, the market is in equiibrium at price P1 and output Q1. At this point,
the total area of consumer and producer surplus is maximised. If for example, suppliers were
able to restrict output to Q2 and hike the market price up to P2, sellers would gain extra
producer surplus by widening their profit margins, but there also would be an even greater
loss of consumer surplus. Thus P2 is not an allocative efficient allocation of resources for this
market whereas P1, the market equilibrium price is deemed to be allocative efficient.

Pareto efficiency and perfect competition

in what type of economy is the total gain from trading made as large as is possible? This is
the economic efficiency question.
Since in a perfect competition consumers and producers are price takers, the market is in
equilibrium because quantity demanded is equal to quantity produced. The firm’s equate
marginal revenue to marginal cost thus equating price to marginal cost. In the long run price
is equal to the minimum average cost. Marginal cost and average cost are equal. This triple
equality tells us that although a competitive firm may realise economic profits or loss in the
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short run, it will earn a normal profit in the long run. This suggests a great social significance
concerning efficiency of a purely competitive economy. A competitive market uses the
limited resources available to society in a way that maximises the satisfaction of consumers.
There is both productive and allocative efficiency.

Productive efficiency requires that goods are produced in the least costly way whilst
allocative requires that resources be apportioned among the firms and industry to yield the
mix of products that is most wanted by society.

Productive efficiency; p=minimum ATC. This means that unless firms use the best
available(least cost) production methods and combinations of inputs, they will not survive.

Allocative efficiency; p=MC

The money price is of any product is society’s measure of the relative worth of an additional
unit of that product. The price of a product is the marginal benefit derived from it. The
marginal cost of an additional unit of a product measures the values or relative worth, of
other goods sacrificed to obtain it.

Therefore, P=MC. Each item is being produced to the point at which the value of the last unit
is equal to the value of the alternative goods sacrificed by its production. The nature of the
market makes adjustment of firm’s expansion and entry to restore and return to allocative
efficiency point. The invisible hand in a competitive market is at work. Business and
resources suppliers seek to further their self interest which organises the private interests of
producers in a way that is fully in sync with society’s interest in using scarce resources
efficiently.

We can show under some specific (but not too restrictive) conditions that a competitive
outcome where consumers maximize utility subject to their budget constraints, producers
maximize profit subject to their technology, and quantity demanded equals quantity supplied
in all markets is Pareto efficient. This is known as the First Welfare Theorem of Economics.
Note, Pareto efficiency has nothing to do with equity. An allocation where I have all the
goods in the world is indeed Pareto efficient, because in order for someone else to be better
off, say you, I would be made worse off. Some might say this allocation isn’t equitable, but
how do we define equitable? Economists have less to say on this subject

7.7.2 Monopoly.

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Pure monopoly exists when a single firm is the sole producer of a product for which there are
no close substitutes.
Characteristics
1. A single seller: the firm and industry are synonymous/the same.
2. Unique product: no close substitutes for the firm’s product.
3. The firm is the price maker: the firm has considerable control over the price because it can
control the quantity supplied.
4. Entry or exit is blocked.
Barriers to Entry
 High start-up costs. These may cause it to take a very long time for new firms to enter
the market, during which time the market is less competitive than it otherwise would
be.
 Brand loyalty. If people are reluctant to consider new alternatives, the established
firms in an industry face less of a threat from new competitors.
 Government restrictions. These restrict the ability of competitors to contest the
market.
The high start-up costs are due to Economies of scale, the major barrier. This occurs where
the lowest unit cost is attained at a high output. A very large firm with a large market share is
most efficient, new firms cannot afford to start up in industries with economies of scale.
Legal barriers also exist in the form of patents and licenses. Ownership or control of
essential resources is another barrier to entry. It has to be noted that barrier is rarely
complete. Think about the telephone companies a couple decades ago; there was no
substitute for the telephone. Nowadays, cellular phones are very popular. It creates a
substitute for your house phone, causing the traditional telephone companies to lose their
monopoly position.
Demand Curve
Monopoly demand is the industry or market demand and is therefore downward sloping.
Price will exceed marginal revenue because the monopolist will lower price to boost sales.
The lower price of the extra unit of output also applies to the previous units of output. The
firm could have sold those previous units at a higher price if it had not produced and sold the
extra output. The added revenue will be the price of the last unit less the sum of the price cuts
which must be taken on all prior units of output. The marginal revenue curve is below the
demand curve.
Profit –Maximizing Output:
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The MR = MC rule will still tell the monopolist the profit – maximizing output. The
monopolist cannot charge the highest price possible; it will maximize profit where TR minus
TC is the greatest. This depends on quantity sold as well as on price.
The monopolist can charge the price that consumers will pay for that output level. Therefore,
the price is on the demand curve. Losses can occur in monopoly, although the monopolist
will not persistently operate at loss in the long run.
Monopolies will sell at a smaller output and charge a higher price than would pure
competitive producers selling in the same market.

Marginal conditions Short run Long run

MR>MC MR=M MR<MC P>SAV P<SAVC P>LAC P<LAC

C C

Output decision Raise out optimal lower produce shutdow stay exit
put n

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MR= Px (1-1/εx)

When demand is inelastic (lies between 0 and -1), a rise in output reduces revenue. Marginal
revenue is negative. This is because a fall in price exceeds the rise in output.
When demand is elastic (greater than 1), a rise in output increases revenue and marginal
revenue is positive.
Since MC=MR and MC is positive therefore MR must be positive. A monopolist output must
lie on the elastic part of the demand curve. The monopolist never produces on the inelastic
part of the demand curve.
The more inelastic the demand for a monopolist, the more the marginal revenue is below the
price, the greater the excess of price over marginal cost and the more monopoly power it has.
Comparative statics.
Suppose there is rise in costs and shifts the MC and AC curves upwards. The higher MC will
cross the MR curve at a lower output. If the monopolist can sell this output at a price thatr
covers average cost, the effect of the cost increase must reduce the output and a higher
equilibrium output.
A shift in the demand curve outwards will result in a shift in the MR curve too. MR will
cross MC at a higher output and lower price.
Exercise Draw the graphs to shows the changes above.

A MONOPOLY HAS NO SUPPLY CURVE

Given the marginal cost and marginal revenue of the monopolist, it is easy to get the
maximizing output it will produce. Then with a demand curve we can know how much it
would sell at. But to know how much the monopolist will produce at a particular price is
quiet not certain. It all depends on the demand curve its faces.
From the graph below, when demand is DD the firm produces Q1 at price P1. If the demand
is D’D’, the firm produces Q2 but still at price P1.

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MC

P
D’

MR’

D
MR
Q

Q1 Q2

Therefore, a monopolist does not have a supply curve independent of the demand condition
The monopolist costs are different from the perfect competitive firms. They may be larger or
smaller. The four reasons why the costs differ are;
1. Economies of scale; a firm with economies of scale can supply the entire market and
meet the demand than a number of firms in a competitive market. As the firm
expands its cost reduces. Cost can also reduce due to simultaneous consumption and
network effects. Simultaneous consumption is the ability of a product to satisfy a
number of consumers at the same time. Network effects are present if the value of a
product to each user,including existing ones, increases as the total number of users
arises. This drive the market towards monopoly because the consumers tend to
choose standard products that everyone is using.
2. X-inefficiency occurs when a firm produces output at a higher than the lowest
possible cost of producing it. This is because of managers having different goals.
Monopolies tend more toward x-inefficincy than perfect completion. Firms under
perfect completion are under pressure from rivals, forcing them to be internally
efficient to survive.
3. Rent seeking expenditures; an activity that is designed to transfer income or wealth
to a particular firm or resource supplier at someones or societys expense is called rent
seeking behavior. A monopolist can go to a great extent to acquire or maintain a
monopoly granted by government through legislation or exclusive license. Such rent
seeking , add nothing to the firm output but it increases its costs.
4. Technological advances. In the LR firms can reduce costs through discovery and
implementation of new technologies. But a monopoly will not be technologically
progressive due to lack of competition it has no incentive to implement new

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techniques. However Schumpeter argues that a monopolist will invest in research and
developemnet to lower its costs.
Price discrimination
This whole time we have assumed that the monopolist is charging the same price but in
certain conditions it can increase its profit by charging different prices to different buyers.
Price discrimination is selling a good or service at a number of different prices, and the
price differences is not justified by the cost differences. In order to price discriminate, a
monopoly must be able to
1. Be able to segregate the market. The monopolist must be able to segregate the buyers
into distinct classes; each has a different willingness and ability to pay for the
product. This is based on different price elasticities of demand.
2. Make sure that buyers cannot resell the original product or services. If the buyers in
the low price segment are able to resell the product to the high price segment, the
monopolist price discrimination strategy would create competition in the high price
segment. This completion would reduce the price and undermine the discrimination
policy. Examples of products where resell would be impossible are transportation,
medical and legal services. Goods that can discriminated are those goods consumed
on a spot. Standardized commodity are not likely.
Lets look at one example. If a Microsoft has two types of customers, students and small
business customers. The business customers have a very inelastic demand and the student
have an elastic demand. The more inelastic the demand curve is the more the MR curve
lies below the demand curve. To sell an extra unit requires bigger price cuts. Charging
the same price to consumers with different demand elasticities means that the marginal
revenue from the last business customer is less than the marginal revenue from the
student. The firm will gain revenue with no cost by selling computers to one more
student. The firm has to mix the combinations of the two types until the marginal revenue
from the types is equal.
Let’s assume the MC=ATC and is constant. The graph below shows that the monopolist
will charge a high price to the business customers and a lower price to the students. The
student benefit from the lower prices and the monopolist maximizes his profits. This is
called third degree price discrimination. There is no incentive to rearrange the mix by
altering the price differentials between the two groups. The level of price and output is
determined by equating marginal cost to the respective marginal revenues

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PB
PS
MC=ATC
DS

MRS
DB
MRB

QB QS

Perfect price discrimination is a price discrimination that extracts the entire consumer surplus
by charging the highest price that consumers are willing to pay for each unit.this is called
first degree price discrimination. Each customers pays a different price for the same good.
They pay according to their willingness to buy. Charging the same price, the profit
maximizing output is at Q1 ant P1 price and MC=MR. but if it is perfectly discriminating ,
the very first unit can be sold at price E. this is sold to the highest bidder most desperate for
the good, the next unit will be sold to the next highest bidder. Moving down the demand
curve we read off the price for each extra unit sold. The demand curve is the marginal
revenue curve under perfect price discrimination.

MC
E

A
P1
C
P2

B D

MR

Q1 Q2
From the graph above, taking demand curve as MR, the monopolist produces at point c
Q2 where MC=MR. moving from the uniform pricing point A to the price discriminating
point C, the monopolist adds the area ABC to profits when output is increased. The
monopolists makes a second gain, the Q1 output earns more under price discrimination.

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He gains area EP1A by charging different prices on the first Q1 units rather than the
single price.

Monopoly and efficiency.

The efficient outcome of pure competition P=AR =MC=ATC. The MC=S marginal
cost=supply curve. This result in productive and allocative efficiency achieved because of
free entry and exit. However, monopolist do not result in neither productive nor
allocative efficiency because they set MC=MR and p>MC. the output is less than the
output at which average total cost is lowest. Thus the monopolists profit maximising
output results in under allocation of resources, because the find it profitable to restrict
output and employ fewer resources. P>MC, P>ATC.

Due to their market power, monopolist, charge a higher price (P2) than pure competition
(P1) thus transferring income from consumers to the owners of the monopoly. These
stakeholders tend to benefit at the expense of the consumers. Monopoly brings about
inequality because the stakeholders are wealthier than the consumers.

The consumer surplus reduces whiles the producer surplus increases. There is a net loss is
surplus which is not attributed to neither consumers nor suppliers. This is called the
deadweight loss.

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7.7.3 Monopolistic competition
Monopolistic competition refers to a market situation with a relatively large number of
sellers offering similar but not identical products. Examples are fast food restaurants and
clothing stores.
Characteristics
1. A lot of firms: each has a small percentage of the total market. Monopolistic
competition requires not only product differentiation but also limited economies of scale.
With lots of producers each can neglect its interdependence with any particular rival.
Each firm can determine its own pricing policy without considering the possible reactions
of rival firms. It can lower its price but it will trigger no reaction from competitors. The
firms are fewer than those in perfect competition, and the pricing power is little compared
to monopoly.

3. Differentiated products: variety of the product makes this model different from pure
competition model. Product differentiation is when the products have slightly
different characteristics, offer degrees of customer service, provide varying amounts
of locational convenience or proclaim special qualities etc. Product differentiated is
done in style, brand name, location, advertisement, packaging, pricing strategies, etc.
the special feature of a particular shop lets it charge slightly different price from
others without losing all its customers.
 Product attributes; entails physical or qualitative differences. real differences
in functional features, material designs and workmanship. E.g computers
differ in storage capacity, speed etc. debonairs pizza and pizza inn are
different by quality.
 Service. The service and the condition surrounding the sell of a product are
vital.e.g restuarants, dry cleaning etc
 Location. Products are differentiated by location and accessibility of the store
that sell them.
 Brand names and packaging. Trademarks and brand names and celebrity
connections. Some goods are differentiated by celebrity names such as
perfume, watches, clothes etc.

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 Advertising is the key to product differentiation. It would be wasteful if
customers do not know about the product. Advertising makes price be less of
a factor and product differences a greater factor.
3. Easy entry or exit.
4. No collusion. The presence of a relatively large number of firms ensures that collusion
by a group of firms to restrict output and set prices is unlikely.
Monopolistic competition describes an industry in which each firm can influence its
market share to some extent by changing its price relative to its competitors.
Demand Curve
Indeed, the main difference between monopolistic competition and other market structures
lies in the type of demand elasticity which each firm confronts.The firm’s demand curve is
highly elastic, but not perfectly elastic. It is more elastic than the monopoly’s demand curve
because the seller has many rivals producing close substitutes; it is less elastic. the demand
curve is down ward sloping. The firms have some market power and are price setters. A
lower price attracts some customers from another shop but each shop always has some local
customers from whom convenience is more important than a few pence off the price. e.g hair
dressers. The demand curve shows the total quantity demanded at each price if all firms
charge that price. The market share of the firm depends on the price it charges and on the
number of firms in the industry. For a given number of firms , a shift in the industry demand
curve shifts the demand curve for the output of each firm. For a given industry demand
curve, having more firms will shift the demand curve for each firm to the left as its market
share falls and having fewer firms will shift the demand curve of each firm to the right as its
market share rises.
The MR = MC rule will give the firms the profit – maximizing output. The price they
charge would be on the demand curve.

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In the short run the monopolistically competitive firm can maximize its profits or minimize
its losses.
In the long run, the situation will tend to be breaking even for firms. Firms can enter the
industry easily and will if the existing firms are making an economic profit. As firms enter
the industry, the demand curve facing by an individual firm shift down, as buyers shift some
demand to new firms until the firm just breaks even. If the demand shifts below the break-
even point, some firms will leave the industry in the long run.
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Therefore, most monopolistic competitive firms should experience break-even in the long run
theoretically. In reality, some firms experience profit as they able to distinguish themselves
from the others and build a loyal customer base; such as some name brand apparel
companies. Some firms experience lost in long run but may continue the business as they are
still earning normal profit. These firm owners usually like the flexible life style and willing to
earn a normal profit that is lower than their opportunity cost.

7.7.4 Oligopoly
Oligopoly exits where few large firms producing a homogeneous or differentiated product
dominate a market. Examples are automobile and gasoline industries. Firms in oligopoly
have considerable control over price but each firm has to consider the possible reactions of
rivals to its own pricing, output and advertising decisions. It is characterized by strategic
behavior and mutual interdependence.mutual interdependence is a situation in which each
firms profit depends not only on its own price and sales strategy but also on those of others.
Characteristics
1. Few large firms: each must consider its rivals’ reactions in response to its decisions about
prices, output, and advertising.
2. Standardized or differentiated products.
3. Entry is hard: economies of scale, huge capital investment may be the barriers to enter.
Some oligopolies have merged mainly through growth of dominant firms in a given industry.
The combining of two or more firms in the same industry significantly increase market share,
which allow the new firm to achieve greater economies of scale. Merging also increase
monopoly power (pricing power) through greater control over the market supply. The firm
becomes a large buyer of inputs; it may be able to obtain lower prices on its production
inputs thus cost of production lowers.
Strategic behavior.
Since the firms in oligopoly have to guess what the other firms will react and decide, the
involve strategic behavior of game theory. Example of game theory is a prisoner’s dilemma.
we two people francis and Nambela who have committed a crime together and are detained
at central police as suspects. They are both put in two separate rooms for questioning. The
police bets with each one of them to give a lesser sentence if he/she confesses to the crime.
The dilemma here is if nambela does not confess and francis confesses, nambela will end up
with a long sentence. If nambela confesses and francis doesn’t. francis serves longer. Fear
that the other confesses, they both confess, though they would be better off not confessing

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francis Nambela

confess Don’t confess

confess 6,6 2,4

Don’t confess 4,2 5,5,

This same game strategy can be used by oligopolist. Another example

Two firms producing shoes,each has two pricing strategies; high price or low price/. The
profit they earn depends on the strategy the choose.
Nike bata

high Low

High 12/12 6/15

Low 15/6 8/8

From the payoff matrix, if Nike chooses a low price policy and bata chooses high price nike
will earn 15million and bata 6milliom. On the other hand bata will decide to choose low
price policy thinking nike will choose high price so that it earns 15million and Nike 6
million. but if they all decided to choose high price they both make 12million, now because
of drifting to make profits each firm is likely to move to the low price strategy so that it
makes 15million. Therefore they will both end up choosing low-low strategy when they
would be better off choosing high-high strategy.
This suggests that oligopolists can benefit from collusion, that is cooperating with rival
firms. Collusion occurs when the firms in an industry reach an agreement to fix prices, divide
up the market, share profits and restrict competition amongst them.
If the two firms collude they become like a monopolist.

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PM

MC=ATC
PC

D
MR

QM QC

From the graph Qc and Pc is the competitive output and price, assuming constant costs. The
monopoly will produce at Qm, therefore, if the two firm collude to produce Qm, they will
charge price Pm and they will share the market and profits.
However, there are incentives for one firm to cheat. One firm can expand its output to Qc
and charge a lower price than the agreed Pm and make extra profits. This firm will gain at the
expense of the other firm since it charges a lower price it increases its market share while the
other firms’ market share reduces and it suffers. Oligopolists are torn between the desire to
collude, in order to maximize joint profits, and the desire to compete in order to raise its
market share and profits at the expense of rivals. Collusion is hard if there are many firms in
the industry, if the product is not standardized and if demand and cost conditions are
changing rapidly.
Demand Curve
Facing competition or in tacit collusion, oligopolies believe that rivals will match any price
cuts and not follow their price rise. Firms view their demands as inelastic for price cuts, and
elastic for price rise. Firms face kinked demand curves. This analysis explains the fact that
prices tend to be inflexible in some oligopolistic industries.

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MC=ATC

PB

MR

D
MR
Q
Q

The upper part (above A) of the demand curve is elastic, such that any price increase, the
rivals will not follow suit and the firm will lose its market share. From A, the demand curve
is inelastic, this is any price cuts will make all the rival firms to cut their prices as well.
Therefore there is no gain or profits made. This results in lower prices and higher sales. Its
good for the consumer but not good for the firms as they lose profits.
The MR curve is discontinuous for the two parts of the demand curve. The firm jumps from
one part of the MR to the other when it reaches Qo output. If a firm produces below Qo
additional output will not depress the price of existing sales. At Qo the firm hits the inelastic
demand and marginal revenue becomes much lower. Now that demand is inelastic further
output increases require much lower prices to sell the extra output. Qo is the profit
maximizing output.
If MC shifts up or dowm Qo and Po are still optimal.
One disadvantage of the kinked demand is that it does not explain what determines the initial
price Po. What is known is that it’s a collusive monopoly price. If one firm cheats, the other
firms cooperate and retaliate.
Therefore, if the MC of an industry changes then the collusive price and Quantity will
change. And each firm’s kinked demand shifts up since the monopoly price has risen.

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6.10 ACTIVITIES
EXERCISE

1. In what circumstances would government give a firm to be a monopoly?

2. Why is there an incentive for firms to cheat in an oligopolistic market? Illustrate with
a graph.
3. Why is the demand curve in an oligopolistic market kinked? Use a graph to illustrate.
4. Explain first and third degree price discrimination?
5. A firm in a perfect competition market is earning abnormal profits in the short run.
With the aid of the diagram, explain its long run position and how it finds itself there.
6. How is a monopolistic market different from a perfect competitive market?

6.11 SUMMARY

In summary you have learnt;

 In a competitive industry each buyer and seller is a price taker,

individual actions have no effect on the market.

 A pure monopoly is the only seller or potential seller of a good and need not worry
about entry.

 A discriminating monopolist charges different pries to different customers.

In the next unit we will be looking at market failure and government intervention.

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8.0 UNIT SEVEN: MARKET FAILURE AND GOVERNMENT INTERVENTION

8.1 INTRODUCTION

In this unit we look at what happens when markets fail to allocate resources

8.2 AIM

The aim of this introduce you to

 Externality

 Public goods

 Asymmetric information

 Forms of government interventions

8.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Define and draw graphs for negative and positive externality in consumption and
production

 Explain the difference between public goods and private goods

 Calculate the impact of a subsidy and tax on consumer and producer welfare.

8.4 TIME REQUIRED

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You take a minimum of 4hours to finish this module.

8.5 REFLECTION

Why is it hard to pay for services like police, national defense security?

8.6 READINGS
Begg etal. Chapter 13. Page 315

Sloman and Garratt, chapter 7. Page 194

8.7 Distortions

Distortions; A distortion exists whenever society’s marginal cost of producing a good does
not equal society’s marginal benefit from consuming that good.
In general, conditions causing market failure are classified into four categories
 Monopoly power
• Exists when one firm exert some market power in determining prices
 Externalities
• An interaction among agents that are not adequately reflected in
market prices—effects on agents are external to market. e.g. Air
pollution is classic example of an externality
 Public goods
• One individual’s consumption of a commodity does not decrease
ability of another individual to consume it. E.g. Examples are national
defense, and street lights
 Asymmetric information
• When perfectly competitive assumption of all agents having complete
information about commodities offered in market does not hold
Incomplete information can exist when cost of verifying information about a commodity may
not be universal across all buyers and sellers

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For example, sellers of used automobiles may have information about quality of various
automobiles that may be difficult (costly) for potential buyers to acquire
• When there is asymmetry in information buyers may purchase a
product in excess of a given quality
Existence of monopoly power, externalities, public goods, and asymmetric information are
justification for establishment of governments to provide mechanisms to address resulting
market failures
 Governments can regulate firms with objectives of mitigating monopoly
power and negative externalities
 Governments can provide for public goods either by direct production or
private incentives
 Governments can generate information, aid in its dissemination, and mandate
that information be provided in an effort to reduce asymmetric information
• The more a government must intervene in marketplace to correct these
failures. The less dependent will the economy be on freely operating
markets
8.7.1 Externalities and public goods.

The activities of an individual, society or a firm has an effect on another individual, society
or firm is what is called externalities (side effects).externalities can as a result of production
and consumption. When externalities are beneficial is called external benefits. When they are
hazardous it’s called external cost.

Social cost to society for the production of any good is the private cost faced by the firms
plus any externalities (positive or negative). Social benefit is the private benefit enjoyed by
consumers plus any externalities.

External costs of production. (MSC>MSB)

When a chemical firm dumps wastes into the river or pollutes the air, the community bears
costs additional to those borne by the firm. MSC>MPC. Marginal social cost are greater than
marginal private cost.

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The Effect of a Negative Externality

Cost Marginal social cost

Marginal private cost
Marginal cost
P1 from externality
P0
Marginal social
benefit
0 Q1 Q0 Quantity

The firm is maximising profits at price Po and quantity Qo. This is where MSB=MPC. Now
there is negative externality to society which makes the, marginal social costs higher than the
private costs. The MBC curve is above the MPC. We assume no externalities from
consumption, we equate MSB=MSC and we have a socially optimum output Q1 and price
P1. The marginal benefit to consumers is the same as the marginal social benefit. Meaning at
(Po,Qo) the firm will produce more than what is socially optimum. They are producing more
than society’s point of view. By producing less, society saves more in social cost than it loses
in social benefit. It would make some people better off without making anyone worse off.
Producing at Qo is inefficient. The difference between MSC and MPC shows the marginal
social loss of producing the last unit of output by expanding output from Q1 to Q0 society
losses the triangle area.

This problem arises in a free market economy because no one has legal ownership of the air
or rivers and no one can prevent anyone from using them as a dump. Therefore control must
be left to the government.

External benefits of production

If for example a timber processing company plants new trees, there is a benefit to society as
the trees help reduce carbon dioxide in the atmosphere. The MSC of providing timber is less
than the MPC to the company.

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The below shows that MSC is below MPC. Qo is what the company is producing. Q1 is what
society deems optimum. The firm is producing less than what is socially optimal.

The Effect of a Positive Externality

on production

Marginal private
Cost cost
Marginal social
cost
Marginal benefit
P1 from externality
P0
Marginal social
benefit
0 Q0 Q1 Quantity

External costs of consumption

Let us consider an individual who buys a car which emits CO2. The marginal benefit to
society will reduce as the motorist travels. The optimum distance travelled by the motorist
will be Q1 miles. This is where MPB=MSC/MPC. If the marginal benefit of consuming a
good exceeds its price then the consumer will buy ad consume more. If the marginal benefit
is less than the price, the consumer gains by consuming less. When people use their cars,
other people suffer from the exhaust fumes, the congestion, the noise etc. These negative
externalities make the social benefit of using the car less than the marginal private benefits.
The MSB is less MPB. Assuming no externalities in production. The socially optimum

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output is Qo which is less than Q1. Other examples are noise pollution from the radio,

A negative Externality

S = Marginal private and social cost

Cost
P1
D1 = Marginal private benefit
Marginal cost of an externality
P0

D0 = Marginal social benefit

0 Q0 Q1 Quantity

cigarates and litter.

External benefits of consumption

The figure below shows a beneficial consumption externality. Planting roses in your garden
makes your neighbour happy. With no production externality, MPC is both the private and
marginal social cost of planting roses. It is the cost of the plant and the opportunity cost of
your time. Comparing your our cost and benefit you plant Qo roses. The marginal social
benefit exceeds your private benefit. The socially optimum quantity is Q1. Therefore, society
could gain the triangle area, the excess of social benefits over social costs, by increasing the
quantity of roses from Qo to Q1.

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A Positive Externality

S = Marginal private and social cost

Cost
P1
D1 = Marginal social benefit
Marginal benefit of an externality
P0

D0 = Marginal private benefit

0 Q0 Q1 Quantity

COASE THEOREM

According to Ronald coase, externality problems can be resolved through private

negotiations by the affected parties when property rights are clearly established. He says
government is not needed to remedy negative or positive externality as long as property
rights are clearly defined, the number of people involved is small and the bargaining cost are
negligible. However, many externalities involve huge number of people affected, high
bargaining costs and community property such as air and water cannot be priced.

Private goods.

Private goods are goods that are produced through the competitive market system. Private
goods encompass the full range of goods offered for sale in stores. These are goods people
individually buy and consume and private firms can profitably provide because they keep
people who do not pay from receiving the benefits.These goods have two characteristics;
rivalry and excludability.

 Rivalry in consumption means that when one person buys and consumes a product, it
is not available for another person to buy and consume. E.g. buying and consuming a
bar of candy.

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 Excludability means that sellers can keep people who do not pay for a product from
obtaining its benefits. Only people who are willing and able to pay the market price
for bottles of water can obtain these drinks.

The demand we have look at in the beginning was demand for a private good. Consumers
demand for private goods is expressed by the desire and ability to pay for the product. The
demand is an inverse relationship, meaning when the price of a product increases the demand
for it will reduce.

Public goods.

Public goods have the opposite characteristics to private goods. They are 1) non rivalry, 2)
excludability. They cannot be provided for by a private firm because of their nature.

 Non rivalry is where the consumption of the good or service by one person will not
prevent others from consuming it.
 Non excludability is where it is not possible to provide a good or service to one
person without it being available to others. E.g. roads, national defence.

Public goods have larger external benefits relative to private benefits but are unprofitable. No
one is willing to pay for a public good. For example paying to build a pavement along your
street. This is because the private benefit will be too small compared to the cost and yet
social benefit is much more. These two characteristics create a free rider problem. Once a
producer has provided a public good, everyone including non payers can obtain the benefit.
Most people do not voluntarily pay for something they can obtain for free.

EXAMPLE; If I own a farm and build a tarred road to my farm, my neighbours too will
benefit from using that road and I cannot prevent them from benefiting, therefore they will
have no incentive to pay. This is what is called a free rider problem. Such goods only the
government can provide or by subsidising the private firms. Note that not all goods produced
by the public sector fall in the category of a public good e.g education and health.

With this problem, the demand for public good is not expressed in the market. With no
market demand, there is no potential firm to tap the demand for revenues and profits. If
society wants a public good, government will have to provide it. They government can
estimate the demand through surveys or public votes, then it can compare the marginal
benefit t of an added unit of the good against the govts marginal cost of providing it.

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They demand that can be derived from consumers would should their willingness to pay. If a
survey was conducted to find out how much each individual would pay for a road to be built,
the people would indicate how much they would be willing to pay for an extra unit. But once
govt provides the good, because of non-rivalry and non excludability, they would not be able
to pay for it. The only curve that can be derived is a willingness to pay schedule. This curve
is different from the demand curve because its shows the price the consumer would be
willing to pay for an extra unit of a product to be provided, whereas the demand curve shows
us the quantity that would be demanded at each price given.

8.7.3 Monopoly.

It’s a case of one firm existing in the industry. It’s the power it poses in the market which
depends on the closeness of substitutes produced by rivalry industries. Its characterised by

1. Single seller
2. No close substitutes
3. Price maker
4. Blocked entry

For a firm to maintain power there must be barriers to the entry of new firms

1. Economies of scale. Is minimum cost of production due to advanced technology,

cheap resources etc in other words its declining average total cost with added firm
size.. this serves as a barrier to entry because firms that enter as small scale producers
cannot realise the cost economies of the monopolist. They will be cut out of the
market because a monopolist can afford to sell at a low price and still make a profit
2. Network economies. When a product or service is used by everyone in the market
there are benefits to all users from having access to others. E.g ebay.
3. Economies of scope. A firm that produces a range of products is also likely to
experience lower average cost of production.
4. Product differentiation and brand loyalty. When a firm produces a clearly
differentiated produced associated with a brand by consumers, it will be very difficult
for a new firm to break the market e.g Colgate
5. Lower cost for an established firm
6. Ownership of, control over, key inputs or outlets. If a firm has control over major
inputs it can deny access to these inputs to potential rivals. A firm can have control
over the outlets through which the product must be sold.
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7. Legal protection. Monopolies may be protected by patents on essential processes, by
copyright and by various licensing and by tariffs and other trade restriction to keep
away foreign competitors.
8. Mergers and takeovers. A firm can put in takeover bids for every new entrant.

In a monopoly the single firms demand curve is the industry demand curve. The demand is
less elastic at each price. Though it’s a price maker its constrained by the market demand. It
maximises profit where MR=MC.

ATC
price

D
MC MR
Quantity

The efficient outcome of pure competition P=AR =MC=ATC. The MC=S marginal
cost=supply curve. This result in productive and allocative efficiency achieved because of
free entry and exit. However, monopolist do not result in neither productive nor
allocative efficiency because they set MC=MR and p>MC. the output is less than the
output at which average total coat is lowest. Thus the monopolists profit maximising
output results in underallocation of resources, because the find it profitable to restrict
output and employ fewer resources. P>MC, P>ATC.

Due to their market power, monopolist ,charge a higher price than pure competition thus
tranfering income from consumers to the owners of the monopoly. These stakeholders
tend to benefit at the expense of the consumers. Monopoly brings about inequality
because the stakeholders are wealthier than the consumers.

Lets us analyse the welfare loss of a monopoly using the concept of consumer and
producer surplus. See figure below.

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Consumer surplus is the excess of consumer’s total benefit from consuming a good over
their total expenditure on it. While producer surplus is the firms profit.

Consumers total benefit is given by the area under the demand curve.

Consumers expenditure is Pc* Qc

Consumer surplus is the difference between the benefit and the expenditure.

Producer surplus the the difference between total revenue and total cost

Cost is the area under the MC curve.

Revenue is Pc*Qc

Producer surplus is the area between price and MC curve.

Effects of monopoly

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The consumer surplus reduces whiles the producer surplus increases. There is a net loss is
surplus which is not attributed to neither consumers nor suppliers. This is called the
deadweight loss.

8.7.4 Imperfect information.

• Perfectly competitive markets assume perfect information.

• Real-world markets often involve deception, cheating, and inaccurate information.

• When there is a lack of information, buyers and sellers do not have equal information,
markets may not work properly.

• Asymmetric information is where one party in an economic relationship has more

information than another. Asymmetric information brings about the principal agent
problem. An example would be an employer and the employee. The employer is the
principal and the employee is the agent. The employer wants a person who will work
to meet the firms’ objective; he doesn’t know the capabilities of the employee. The
employee knows his capabilities. The seller of a second hand car(agent) has the
information on the state of the car than the buyer. The agent may not act in the best
interest of the principal and can get away with it due to imperfect knowledge the
principal has.

HOW CAN WE TACKLE THE PROBLEM?

• The principal must have some way of monitoring the performance of their agents.
Thus a company might employ efficiency experts to examine the operation of its
management.

• There must be incentives for agents to behave in the principal’s interest. thus
managers salaries could be more closely linked to the firms profitability.

• One policy alternative to deal with information market failures is to regulate the
market and see that individuals provide the correct information. E.g. credit bureaus

• Another alternative is for the government to license individuals in the market and
require them to provide full information about the good being sold. E.g. doctors and
medical personnel licence
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• A market in information is one solution to the information problem. Information is
valuable, and is an economic product in its own right. Left on their own, markets will
develop to provide information that people need and are willing to pay for it.

8.8 government intervention

Government should intervene in the markets to correct such market failure. it can use price
ceiling and floor, taxes, subsidies, laws and regulations, property rights, direct provisions of
goods and services.

Price floor and ceiling

The government or an industry regulator can set a maximum price in an attempt to prevent
the market price from rising above a certain level. One aim of this might be to prevent the
monopolistic exploitation of consumers. This is called price ceiling.

To be effective a maximum price has to be set below the free market price. A price below
or at the ceiling price is legal. Anything above is not legal. the rationale for price ceiling on
products is that they enable consumers to obtain some essential good and services that they
could not afford at equilibrium price.

One example might be when shortage of foodstuffs threatens large rises in the free market
price.

A maximum price seeks to control the price – but also involves a normative judgement on
behalf of the government about what that price should be. An example of a maximum price
is shown in the next diagram.

The normal equilibrium price is shown at Pe – but the government imposes a maximum price
of Pmax. This price ceiling creates excess demand equal to quantity Q2-Q2 because the price
has been held below the equilibrium.

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It is worth noting that a price ceiling set above the free market equilibrium price would have
no effect whatsoever on the market – because for a price floor to be effective, it must be set
below the normal market-clearing price. Price ceiling prevents the usual market adjustments
in which competition among buyers bids up the price, inducing more production and
rationing some buyers out of the market.

How do sellers apportion Q2 among consumers?should it be first come first serve

basis?should it be on favoritism?this might not lead to unequitable distribution of resources.
Government must establish some formal system for rationing it to consumers. One way is to
give ration coupons, which authorizes bearers to buy a fixed amout of the good.

Maximum prices and consumer and producer welfare

How does the introduction of a price ceiling affect consumer and producer surplus? This is
shown in the next diagram. At the original equilibrium price consumer surplus = triangle
ABPe and producer surplus equals the triangle PeBC.

Because of the maximum price ceiling, the quantity supplied contracts to output Q2.
Consumers gain from the price being set artificially lower than the equilibrium, but there is a
loss of consumer welfare because of the reduction in the quantity traded. At P max the new

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level of consumer surplus = the trapezium ADEPmax. Producer surplus is reduced to a lower
level Pmax EC. There has been a net reduction in economic welfare shown by the triangle
DBE.

Black Markets

A black market (or shadow market) is an illegal market in which the market price is higher
than a legally imposed price ceiling. Black markets develop where there is excess demand
for a commodity. Some consumers are prepared to pay higher prices in black markets in
order to get the goods or services they want.

With a shortage, higher prices are a rationing device.

 Good examples of black markets include tickets for major sporting events, rock
concerts and black markets for children’s toys and designer products that are in scarce
supply.

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 There is also evidence of black markets in the illegal distribution and sale of
computer software products where pirated copies can often dwarf sales of legally
produced software.

Another problem arising from the maintenance of a maximum price is that in the long run,
suppliers might respond to a maximum price by reducing their supply – the supply curve
becomes more elastic in the long term. This is illustrated in the next diagram which looks at
the effect of a maximum price for rented properties.

If landlords decide that they cannot make a satisfactory rate of return by selling rented
properties in the market because of the maximum price, they might decide to withdraw some
properties from the market. At the maximum rent, the long run supply curve shows a smaller
quantity of rented properties available for tenants – which with a given level of market
demand cause the excess demand (shortage) in the market to increase.

The quality of rented properties might deteriorate over time because landlords decide to cut
spending on maintenance and improvements. The end result would be a loss of allocative

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efficiency because there are fewer properties on the market and the quality is getting worse –
fewer people’s needs and wants are being met at the prevailing market price.

Price floor

A minimum price is a price floor below which the market price cannot fall. To be effective
the minimum price has to be set above the equilibrium price.The best example of a minimum
price is a minimum wage in the labour market

How does a minimum wage work?

 Employers cannot legally undercut the current minimum wage rate per hour. This
applies both to full-time and part-time workers
 A diagram showing the possible effects of a minimum wage is shown below. The
market equilibrium wage for this particular labour market is at W1 (where demand =
supply)
 If the minimum wage is set at Wmin, there will be an excess supply of labour equal to
E3 – E2 because the supply of labour will expand (more workers will be willing and
able to offer themselves for work at the higher wage than before) but there is a risk
that the demand for workers from employers (businesses) will contract if the
minimum wage is introduced.

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The main aims of the minimum wage

The equity justification: That every job should offer a fair rate of pay commensurate with
the skills and experience of an employee.

Labour market incentives: The NMW is designed to improve incentives for people to start
looking for work – thereby boosting the economy’s labour supply.

Labour market discrimination: The NMW is a tool designed to offset some of the effects
of persistent discrimination of many low-paid female workers and younger employees.

Possible disadvantages of a minimum wage

Although all political parties are now committed to keeping the minimum wage, there are
still plenty of economists who believe that setting a pay floor represents a distortion to the
way the labour market works because it reduces the flexibility of the labour market

 Competitiveness and Jobs: A minimum wage may cost jobs because a rise in labour
costs makes it more expensive to employ people. It will be interesting to observe
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whether the minimum wage is said to have caused extra unemployment during the
current economic downturn.

 Effect on relative poverty: Is the minimum wage the most effective policy to reduce
relative poverty? There is evidence that it tends to boost the incomes of middle-
income households where more than one household member is already in work
whereas the greatest risk of relative poverty is among the unemployed, elderly and
single parent families where the parent is not employed.

Can a minimum wage actually increase employment?

 The Keynesian argument that higher wage rates will increase the disposable
incomes of lower-paid workers many of whom have a high propensity to consume.
Thus they will increase their spending and this will feed through the circular flow of
income and spending
 The efficiency wage argument that raising pay levels for low-paid employees may
have a positive effect on their productivity. In addition to the psychological benefits
of being paid more, businesses may take steps to improve production processes,
workplace training etc if they know that they must pay at least the statutory pay floor.

The importance of elasticity of demand and supply of labour

 The impact of a minimum wage on employment levels depends in part on the

elasticity of demand and elasticity of supply of labour in different industries
 If labour demand is inelastic then the contraction in employment is likely to be less
severe than if employers’ demand for labour is elastic with respect to changes in the
wage level.
 In the next diagram we see the possible effects of a minimum wage when both labour
demand and labour supply are elastic in response to a change in the market wage rate.
The excess supply created is much higher than in the previous diagram.

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Producer subsidy

A subsidy is a payment by the government to suppliers that reduce their costs of production
and encourages them to increase output

The subsidy causes the firm's supply curve to shift to the right

The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output

A direct subsidy to the consumer has the effect of boosting demand in a market

Different Types of Producer Subsidy

 A guaranteed payment on the factor cost of a product – e.g. a guaranteed

minimum price offered to farmers such as under the old-style Common Agricultural
Policy (CAP).
 An input subsidy which subsidises the cost of inputs used in production – e.g. an
employment subsidy for taking on more workers.
 Government grants to cover losses made by a business – e.g. a grant given to
cover losses in the railway industry or a loss-making airline.

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 Bail-outs e.g. for financial organisations in the wake of the credit crunch
 Financial assistance (loans and grants) for businesses setting up in areas of high
unemployment – e.g. as part of a regional policy designed to boost employment.

To what extent will a subsidy feed through to lower prices for consumers?

A subsidy has the effect of causing an outward shift in the market supply curve for a product.
This depends on the price elasticity of demand for the product. The more inelastic the
demand curve the greater the consumer's gain from a subsidy. Indeed when demand is
perfectly inelastic the consumer gains most of the benefit from the subsidy since all the
subsidy is passed onto the consumer through a lower price. When demand is relatively
elastic, the main effect of the subsidy is to increase the equilibrium quantity traded rather
than lead to a much lower market price.

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A subsidy might be justified if it encourages increased supply and consumption of products
that yield high external benefits

Economic and Social Justifications for Subsidies

Why might the government be justified in providing financial assistance to producers in

certain markets and industries? How valid are the arguments for government subsidies?

1. To keep prices down and control inflation – in the last couple of years several
countries have been offering fuel subsidies to consumers and businesses in the wake
of the steep increase in world crude oil prices.
2. To encourage consumption of merit goods and services which are said to generate
positive externalities (increased social benefits). Examples might include subsidies
for investment in environmental goods and services.
3. Reduce the cost of capital investment projects – which might help to stimulate
economic growth by increasing long-run aggregate supply.

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4. Subsidies to slow-down the process of long term decline in an industry e.g. fishing or
mining
5. Subsidies to boost demand for industries during a recession e.g. the car scrappage
scheme

Economic Arguments against Subsidies

 The economic and social case for a subsidy should be judged carefully on the grounds
of efficiency and fairness
 Might the money used up in subsidy payments be better spent elsewhere?
 Government subsidies inevitably carry an opportunity cost and in the long run there
might be better ways of providing financial support to producers and workers in
specific industries.

Free market economists argue that subsidies distort the working of the free market
mechanism and can lead to government failure where intervention leads to a worse
distribution of resources.

 Distortion of the Market: Subsidies distort market prices – for example, export
subsidies distort the trade in goods and services and can curtail the ability of ELDCs
to compete in the markets of rich nations.
 Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary
 Financial Cost: Subsidies can become expensive – note the opportunity cost!
 Who pays and who benefits? The final cost of a subsidy usually falls on consumers
(or tax-payers) who themselves may have derived no benefit from the subsidy.
 Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need
to restructure – i.e. it delays much needed reforms.
 Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments.
 There are alternatives: It may be possible to achieve the objectives of subsidies by
alternative means which have less distorting effects.

Government taxes

An indirect tax is imposed on producers (suppliers) by the government. Examples include

duties on cigarettes, alcohol and fuel and also VAT

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VAT is a tax placed on the expenditure / a tax set as a percentage of the price of a good)

A tax increases the costs of production causing an inward shift in the supply curve

The vertical distance between the pre-tax and the post-tax supply curve shows the tax per
unit

With an indirect tax, the supplier may be able to pass on some or all of this tax onto the
consumer through a higher price

This is known as shifting the burden of the tax and the ability of businesses to do this
depends on the price elasticity of demand and supply

 In the left hand diagram, demand is elastic so the producer must absorb most of the
tax and accept a lower profit margin on each unit. When demand is elastic, the effect
of a tax is to raise the price – but we see a bigger fall in quantity. Output has fallen
from Q to Q1.
 In the right hand diagram demand for the product is inelastic and therefore the
producer is able to pass on most of the tax to the consumer by raising price without
losing much in the way of sales.

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The table below shows the demand and supply schedules for a good:

Price (£) Quantity Demanded Quantity Supplied Quantity supplied

(Pre-tax) (Post-tax)

10 20 1280 600

9 60 1000 400

8 150 850 150

7 260 600 50

6 400 400

5 600 150

4 900 50

1 What is the initial equilibrium price and quantity? Price = £6

Quantity = 400

2 The government imposes a tax of £3 per unit. The new supply schedule is shown in the
right hand column of the table – less is now supplied at each and every market price

3 Find the new equilibrium price after the tax has been New price =£8
imposed

4 Calculate the total tax revenue going to the government Tax revenue = £450

5 How have consumers been affected by this tax?

There has been a fall in quantity traded and a rise in the price paid by consumers – this
leads to a fall in economic welfare as measured by consumer surplus

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Who pays the tax? The burden of taxation

The Government would rather place indirect taxes on commodities where demand is
inelastic because the tax causes only a small fall in the quantity consumed and as a result the
total revenue from taxes will be greater. An example of this is the high level of duty on
cigarettes and petrol.

 Specific taxes: A specific tax is where the tax per unit is a fixed amount – for
example the duty on a pint of beer or the tax per packet of twenty cigarettes. Another
example is air passenger duty
 Ad valorem taxes: Where the tax is a percentage of the cost of supply – e.g. value
added tax currently levied at the standard rate of 15%. In the diagram below, an ad

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valorem tax has been imposed on producers. The equilibrium price rises from P1 to
P2 whilst quantity falls from Q1 to Q2.

Note that the effect of an ad valorem tax is to cause a pivotal shift in the supply curve

This is because the tax is a percentage of the unit cost of supplying the product. So a good
that could be supplied for a cost of £50 will now cost £58.75 when VAT of 17.5% is applied
whereas a different good that costs £400 to supply will now cost £470 when the same rate of
VAT is applied

The absolute amount of the tax will go up as the market price increases

Tobacco is an example of a product on which both specific and ad valorem taxes are applied.

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8.10 ACTIVITY
Exercise

1. A firm producing plastic bags is polluting the air of the neighborhood. In the following
table the marginal private costs (MPC) of the firm for different quantities of plastic bags
are reported together with the inverse demand for plastics bags.
2.4 Quantity 2.4 MPC (£) 2.4 Selling price (£)
2.4 1 2.4 11 2.4 28
2.4 2 2.4 12 2.4 26
2.4 3 2.4 13 2.4 24
2.4 4 2.4 14 2.4 22
2.4 5 2.4 15 2.4 20
2.4 6 2.4 16 2.4 18
2.4 7 2.4 17 2.4 16
2.4 8 2.4 18 2.4 14
2.4 9 2.4 19 2.4 12
2.4 Polluting the air creates an externality. We know that the value of the externality is
£20 for each quantity level. On a graph with Q on the horizontal axis, plot the MPC,
the marginal social costs and the demand. Show the equilibrium in the market. Why is
the equilibrium inefficient?
2. What protection do private property rights in the real world give to sufferers of noise, a)
from neighbors b) from traffic?

3. Assume that a firm discharges waste into a river. As a result the marginal social cost
(MSC) is greater than the firm’s marginal private cost (MPC). The following table
shows how MPC, MSC, AR, TR and MR vary with output.

output 1 2 3 4 5 6 7 8

MPC 23 21 23 25 27 30 35 42

4MSC 35 34 38 42 46 52 60 72

TR 60 102 138 168 195 219 238 252

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AR 60 51 46 42 39 36.5 34 31.5

MR 60 42 36 30 27 24 19 14

Assume that the marginal private benefit (MPB) is give by the price AR. Assume also that
there are no externalities on the consumption side,and that therefore MSB=MPB.

a) How much will the firm produce if it seeks to maximize profits?

b) What is the socially efficient level of output (assuming no externalities on the demand
side?

c) How much is the marginal external cost at this level of output?

d) What size of tax would be necessary for the firm to reduce its output to the socially
efficient level?

e) Why is the tax less than the marginal externality?

f) Why might it be equitable to impose a lump-sum tax on this firm?

8.11 SUMMARY

In summary you have learnt;

 Production externalities occur when actions by ne producer directly

affect the production costs of another producer, as when firms pollutes
another’s water supply.

 Consumption externality mean ones persons decision affects another’s consumers

utility directly, as when a garden gives pleasure to neighbours.

In he next unit we will start looking at macroeconomics. We start with national income of an
economy.

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9.0 UNIT EIGHT: NATIONAL INCOME

9.1 INTRODUCTION

Our focus now is on macroeconomics. We examine the economy as a whole. In

this unit we look at national output or income.

9.2 AIM

The aim of this unit is to make you understand

 What determines the size national output

 What causes it to grow?

 Why do growth rates fluctuate

9.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Calculate GDP,GNP,NI

 To explain and draw the circular flow of income diagram

 To explain the difference between government spending and investment.

9.4 TIME REQUIRED

You should take a minimum of 4hours to finish this unit.

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9.5 REFLECTION

What is Zambia GDP? How is it measured?

9.6 READINGS
Begg et al, chapter 15, 16

Sloman and Garratt, chapter8. Pages 234-264

Brue et al. Chapter 12. Page 282-290

9.7 circular flow of income

Macroeconomics examines economies at the aggregate (international, national, regional)

level. Some aspects of macroeconomics are about comparing two aggregate economies at the
same time.

Much of macroeconomics is concerned with policies such as money supply or tax policy
which is national in scope. Equilibrium effects mean that outcomes are different when we
consider the economy in aggregate.

There are certain phenomenon like economic growth and business cycles which affect the
aggregate economy equally. Most macroeconomic issues include; Economic growth, Price
stability, Reduction of unemployment, Balance of payment(B.O.P) surplus. The focus is to
know what causes national output to grow and fluctuate. What happens in booms and
recessions? What causes unemployment? Why prices rises .why is inflation a problem?

 Economic growth: achieving high and stable rates of growth, sustained over a long
period.

 Unemployment: reducing unemployment to reduce the wastage of human resource

and it is a drain on government revenue.
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 Inflation: government policy is to keep inflation low and stable. It aids the process of
economic decision making E.g. business will be able to set prices and wage rates and
make investment decisions with far more confidence.

 Balance of payment surplus: a country BoP account is a record of all transaction

between the residents of that country and the rest of the world. The aim is to have
more exports than imports so that the country can record a surplus in the B.O.P

How are the four goals related? to pursue one objective may make at least one of the others
worse. If we cut down taxes to boost consumer spending so as to have economic growth and
encourage investment, this may lead to higher inflation.

The objectives are linked through their relationship with aggregate demand. aggregate
demand is the total spending on goods and services made within the country by consumers
(C),firms on investment (I), the government (G), investment and people abroad on
exports(X) and we subtract imports(M). AD  C  G  I  X  M

The Circular Flow,

Wages, rents, interest,

profits

Factor services

Firms (production)
Household Goods

Government

Financial markets
Personal consumption

Other countries

The diagram above show the circular flow of income. Let’s focus on firms and households.
This is the first phase of the circular flow. Firms are producers of goods and services. They
also employ labor and other factors of production. Households are consumers of goods and
services and, they supply labour and various factors of production.

Note that there is a difference between money and income. Money is a stock while income is
a flow.

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If households spend all their income on buying domestic goods and services, and if firms pay
out all this income to households. The flow will continue at the same level indefinitely.
Therefore, income is flowing from firms to households as a payment for using their labour
and other factors of production. Then as households purchase the goods and services, income
flows back to the firms.

However, in real world households and firms are not the only two units that can exist, we
include other sectors of the economy in which some income is withdrawn, while some is
injected into the inner flow. We introduce government, foreigners and financial institutions.
Financial institutions act as a link between those who wish to borrow money and those who
wish to save.

Withdrawal/leakages

The withdrawal or leakages this is money that leaves the inner flow of income. Net
savings(S) is the money deposited in the bank deducting borrowing and drawings. This
money is not spent on goods and services therefore; it is leaked from the flow.

Net taxes (T); VAT, PAYE, excise tax, pension contribution, corporate taxes minus transfer
payment from government e.g. unemployment benefits. This is the money that households
pay as a statutory obligation to the government. This money is also not spent on goods and
services.

Import expenditure (M). Consumers, government and firm spend on imports. When people
spend on foreign gods and service, the money does not end up with domestic firms but
instead leave the country, therefore this money is a withdrawal from the circular flow of
income.

Total Withdrawals are savings, taxes and imports =S + T + M

Injections

Injections is the money that enters the inner flow but not from households. These include;

 Investment (Id) on domestically produced goods. This is the money that firms spend
on expanding their plant so as to produce more and also includes increases in
inventory.

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 Government expenditure (G) on domestic goods and services. The money the
government spends on purchasing gods and services including infrastructure
development.

 Exports expenditure(X). Foreigners abroad buy domestic goods. Foreigner spend

their money on domestic goods and services, this money ends up in domestic firms
hands.

Total Injections are investment, government and exports =I + G + X

Aggregate demand is the household spending on domestic goods and services plus injections.
AD=C + I + G +X

From the inner flow, what constitutes output is the consumption of goods and services and
the investment firm have in inventory GDP=C + I. and household income is the income spent
on goods and services and the money saved. Y=C + S.

We suppose that what is produced is equal to the income of households, then GDP = Y. this
implies that what is saved is exactly equal to the investment by firms. i.e. GDP= C+
I=Y=C+S then I=S

Actual savings=actual investment

This follows that government spends exactly what it collects in tax revenue. G=T. this
applies to imports being equal to exports M=X . this is the equilibrium condition.

It follows that Injections =withdrawals.

If injections are greater than withdrawals, expenditure will rise, Aggregate demand will rise.
This extra spending will increase firm’s sales and encourage them to produce more. Output
rises together with income, as wages, salaries, profits rent and interest rise. Rise in Aggregate
demand results in;

• Economic growth; the greater the initial excess of injection over withdrawals the
bigger will be the rise in national income.

• Fall in unemployment; firms will employ more workers to meet the extra demand for
output.

• Inflation rises. The greater the rise in Aggregate demand relative to the capacity of
firms to produce, firms find it difficult to meet the demand and it is likely prices rise.

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• Current account deteriorates. High demand sucks more imports and higher domestic
inflation makes exports expensive relative to imports.

When injections are not equal to withdraws there is disequilibrium. a chain reaction brings
the economy back to equilibrium. The increase in income results in increase in consumption,
savings, imports, taxes. Withdrawals rise too. Output fall back to its original point.

C,W,J W

a x
J

Y1 Ye Y2

From the graph above we have withdrawals sloping upwards, injections are constants. We
are in equilibrium at point x where withdrawals are equal to injections. At point injections are
more than withdrawals, this will result in economic growth output will rise and we move
from y1 to ye. When withdrawals are more than injections. There is high savings , more
imports. The demand for domestic goods and services reduce therefore firms will reduce
their production and output will reduce from y2 to ye..

National income
National income measures the monetary value of the flow of output of goods and services
produced in an economy over a period of time. Measuring the level and rate of growth of
national income (Y) is important for seeing:

 The rate of economic growth

 Changes to average living standards

 Changes to the distribution of income between groups within the population

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Gross domestic product (GDP) is the total market value of all final output in an economy in a
year. GDP includes the output of foreign owned businesses that are located in a nation
following foreign direct investment.

Gross National Product (GNP) is the aggregate final output of citizens and businesses of an
economy in one year. There difference is that GDP measures the economic activity that
occurs within a country while GNP measures the economic activity of the citizens and
businesses of a country. GDP does not measure total transactions in the economy. It counts
final output but not intermediate goods.

 Final output – goods and services purchased for final use

 Intermediate products are used as inputs in the production of some other product

There are three methods to calculating GDP; value added,income and expenditure approach.

Value added.

We start with an example; A car company in Zambia imports steel and other parts of the car
and assembles it from its plant here. The car is then sold out in the market. The car is a
finished product-final output. The steel and parts are intermediate products. Thus, when
calculating GDP we include the value added to the car i.e. the cost of a car minus the
imported inputs.

Calculating value added to the car helps eliminate double counting. Value added is the
increase in value that a firm contributes to a product or service.

We look at an example that will calculate GDP using all the three approaches.

Example.

A Steel maker mines the iron ore and makes steel out of it, he sells some of the steel to car
maker and machine maker for 3000 and 1000 respectively. He pays out wages and rent worth
K4000.

The machine maker uses the steel to make a machine that he later sells to the car maker for
2000. He pays out K1000 to his employees in wages and salaries.

The car maker buys tyres from the tyre company worth K500 as an addition to the other
inputs, he makes a car that he sells to K 5000 and pays wages and rent worth K1500. The

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tyre maker pays K500 in wages and rent. Calculate GDP using value added, expenditure and
income approaches.

good seller buyer transaction Value Spending Factor

added on final payment
good

steel Steel machine 1000 1000 - 1000

maker

steel Steel Car maker 3000 3000 - 3000

maker

machine Machine Car maker 1000 1000 2000 1000

maker

tyres Tyre Car maker 500 500 - 500

maker

car Car maker households 1500 1500 5000 1500

Total 11500
transaction

GDP 7000 7000 7000

The value added approach gives the same figure for GDP as the expenditure and the income
approach. One of the three approaches can be used to measure GDP.

There are some transactions that are not included in calculating GDP.

 Selling your car to a neighbor does not add to GDP.

 Selling a stock or bond does not add to GDP, though the stock broker's commission
for the sales does add to GDP.

 Pension payments, welfare payments, employment insurance benefits, and other

government transfer payments are not included in GDP.

 The work of unpaid house spouses does not appear in GDP calculations
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Expenditure approach

The expenditure approach is shown on the bottom half of the circular flow. Specifically,
GDP is equal to the sum of the four categories of expenditures.

GDP = C + I + G + (X - IM)

9.7.1 Components of GDP

Consumption;

When individuals receive income, they can spend it on domestic goods, save it, pay taxes,
and buy foreign goods. Consumption is the largest and most important of the flows.

To understand changes in output we understand what affect the purchases of households.

These are;

 Disposable income; is the income available to households after paying tax, napsa
deductions. When disposable income increases, individual spending increases too.

 Expected future incomes; people take into account current and future incomes when
planning. when expecting high future incomes people borrow for current
consumption

 Financial system and consumption. When lending interest rates are high, people
borrow less for consumption but save more. Low interest rates, more borrowing for
consumption and fewer saving.

Investment

The portion of income that individuals save leaves the spending stream and goes into
financial markets and enters the circular flow as investment by the firms. Business spending
on equipment, structures, and inventories is counted as part of gross private investment.

Due to using of these equipment and structures they reduce in value. plant and equipment
wears out. This wearing-out process is called depreciation. There is a difference between
total or gross private domestic investment and the new investment that is above and beyond
replacement investment. Net private investment – gross private investment less depreciation.

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There are factors that affect the level of investment. These are;

 Increased consumer demand. The more the demand for goods and services, the
greater the need to expand and invest.

 Expectations. Investment depend on firms future expectations about future market

condition.

 Cost and efficiency of capital equipment. The lower the cost of capital, or machines
become more efficient the return on investment increases. firms will invest more.

 The rate of interest. Investment is financed by borrowing; firms weigh annual income
against interest payment.

 Availability of finance. A firm cannot invest if it cannot raise the finances.

Government expenditure

Government collects revenue from individuals paying taxes, the taxes are either spent on
goods and services or are returned to individuals in the form of transfer payments.
Government payments for goods and services or investment in equipment and structures are
referred to as government expenditures. Government spending is independent of the level of
national income in the short run. The government can run a budget deficit (G>T) or surplus
(G<T).

In the long run government expenditure will depend on national income. The higher the
levels of income, more income collected in taxes, more spending. Transfer payments is
government spending on pension, unemployment benefits, subsidies etc. these redistribute
existing income.

Exports and imports

Spending on foreign goods escapes the system and does not add to domestic production, thus
spending on imports are subtracted from total expenditures. Exports to foreign nations are
added to total expenditures. These flows are usually combined into net exports (exports
minus imports).

The determinant of net exports are;

 National income; as income rises imports increase.

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 Exchange rate; foreign units per unit of domestic currency.an appreciation of
domestic currency increases imports as foreign goods and services become cheaper. a
depreciation will lead to a fall in imports and a rise in exports as domestic goods
become cheaper for foreigners.

We can move from GDP to national income through the following break down.

 GDP plus factor incomes from abroad minus factor income abroad= GNP

 GNP- depreciation= net national product. NNP

 NNP-indirect taxes-subsidies=national income

 National income-corporate taxes-dividends-social insurance payment+ personal

interest income received from government and consumers + transfer payments to
persons=personal income.

Nominal GDP is GDP measured in current prices, or the current prices we pay for things.
Nominal GDP includes all the components of GDP valued at their current prices. When a
variable is measured in current prices, it is described in nominal terms.

Real GDP is nominal GDP adjusted for inflation. Mainly this is done by choosing one
particular year that would be a base year. A base year is the year chosen for the weights in a
fixed-weight procedure. A fixed-weight procedure uses weights from a given base year e.g.
GDP deflator

Real GDP is calculated by dividing nominal GDP by the GDP deflator.

No min al GDP
real GDP 
GDP deflator

The GDP deflator is one measure of the overall price level. It is hard to compare GDP in
different years as prices are not the same. We can compare GDP in 2000 and in 2008 by
valuing output quantities using 2000 prices as base year.

The table below shows nominal and real GDP calculated at 1995 as a base year.

1960 1995 2008

Nominal GDP 25 750 1471

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GDP deflator 8 100 141

Real GDP 316 750 1043

It can be noted that Nominal GDP increased from 1960 to 2008.but without considering
changes in price we can’t tell what happened to output. The GDP deflator tells us what
percentage increase in prices occurred during the period. with1995 as base year, in 2008
prices where 41% higher than 1995. Taking inflation into account, real GDP gives a true
reflection of changes in output. From 1960 to 2008 GDP tripled.

There some important measurements that are not included in the calculation of GDP. These
are; legal drug sales, Under-the-counter sales of goods to avoid income and sales taxes, Work
performed and paid for in cash, unreported sales, Prostitution, loan sharking, extortion, and
other illegal activities.

A second type of measurement error occurs in adjusting GDP for inflation. If the price and
the quality of a product go up together, has the price really gone up? Is it possible to measure
the value of quality increases?

9.10 ACTIVITIES

EXERCISE
1. Which of the following are included in this years GDP? explain your answer in each
case.

a) The services of a commercial painter in painting the family home

b) An auto dealer’s sale of a new car to a non-business customer.
c) The money received by smith when she sells her biology textbook to a used
book seller.
d) The publication and sale of a new economics text book.
e) A $2billion increase in business inventories
f) Government purchases of newly produced aircraft

2. explain how the following net injections nad net withdrawals will affect the circular
flow of income

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a) firms are forced to take a cut in profit in order to give a pay rise

b) the government increased personal tax allowances

c) the general public invests more money in building societies

d) Zambian investors earn higher dividends on overseas investment

e) People draw on their savings to finance holidays abroad.

9.11 SUMMARY

In summary you have learnt;

 Gross domestic product (GDP) as the value of net output of the factors
of production located in the domestic economy.

 Leakages from the circular flow of income are those parts of payment by firms to
households that do not automatically return to the firms as spending by households
on the output of firms

 Injections are sources of revenue to firms that do not arise from household spending

 Nominal GDP measures income at current prices

 Real GDP measures income at constant prices.

In the next unit we look at fiscal policy and monetary policy as the policies government use
to intervene in the operations of the economy.

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10.0 UNIT NINE: FISCAL AND MONETARY POLICIES

10.1 INTRODUCTION

In this unit we look at the policies that government can use to tackle the problem of
low economic growth, unemployment and inflation

10.2 AIM

The aim of this unit is to introduce you to fiscal and monetary policy so that you
understand government intervention in the operation of the economy.

10.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Explain why government would use the fiscal policy to influence the nation’s output

 Explain the variables instruments that central bank would use to execute monetary
policy

 How many supply affects interest rates

10.4 TIME REQUIRED

You should take a minimum of 4hours to finish this unit.

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10.5 REFLECTION

the government of Zambia has decided to increase its spending to

construct roads in the link Zambia campaign. What is the effect of this
increased spending on the economy’s GDP?

10.6 READINGS
Begg et al, chapter

Sloman and garratt, chapter

Brue et al, chapter

10.7 fiscal policy

There are various types of policy the government or the central bank can use to tackle the
problems of low and fluctuating economic growth, unemployment and inflation. Fiscal
policy refers to the government’s choices regarding the overall level of government
purchases or taxes. It influences saving, investment, and growth in the long run but in the
short run, fiscal policy primarily affects the aggregate demand.

Government can either pursue an expansionary or contractor fiscal policy. An expansionary

fiscal policy will involve raising government expenditure (an injection in the circular flow of
income) or reducing taxes (a withdrawal from the circular flow)

A deflationary or contractionary fiscal policy will involve cutting government expenditure or

raising taxes. Expansionary is meant to increase AD; Y=C + I + G+X-M, whilst Deflationary
is meant to reduce AD and reduce inflation.

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Fiscal policy is used to smooth fluctuations in the economy associated with business cycles.
This is the Stabilisation policy which involves government adjusting the level of AD so as to
prevent output deviating from the potential output. Fiscal policy can also be used to influence
aggregate supply.

Let’s go back to the circular flow. We start with a closed economy with no foreign trade
therefore we do not have exports not imports. We will assume all taxes are direct taxes.

The aggreagate function is AD= Y=C + I + G .

Disposable income is spent on consumption and part on saving. Consumption is broken into
two parts; autonomous consumption (which is consumption that does not depend on the level
of income) and consumption that depends on the level of income.

The consumption function is written as ;

C ( y )  co  c1 y d  co  c1 ( y  yt )
Where co is autonomous consumption, c1 is the proportion of disposable income spent on
consumption called marginal propensity to consume, yd is disposable income after deducting
taxes. Yt is the income paid in taxes. If c1 is the proportion of disposable income spent on
consumption then (1-c1) will be the proportion saved.

G and I are fixed; they do not depend on the level of output and income.

The aggregate demand function is now written as;

AD  co  c1 yd  G  I  co  c1 ( y  yt )  G  I

When government increases it’s spending G, there is an increase in aggregate demand AD.

There are two ways government can raise money to finance its spending. The government
can increase the tax rate, so that it collects more tax revenue or it can borrow money from the
local banks. These two ways have two effects on the economy,which are multiplier effect and
the crowding out effect.

10.7.1 Multiplier effect

We know that the government can use a lump sum tax or a proportional tax. A lump-sum tax
is an amount that is to be paid in tax regardless of the amount of income earned, while a

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proportional tax is a percentage of the income earned that is to be paid in tax. This gives us
twoscenarios for our analysis.

Lump-sum tax

With a lump sum tax the consumption function is given as

C ( y )  co  c1 yd  co  c1 ( y  T )

Where T is the tax amount. The aggreagate demand function is

y  co  c1 ( y  T )  G  I
We put like terms together and make y the subject of the formula
y  co  c1 ( y  T )  G  I
y (1  c1 )  co  c1T  G  I
1
y (co  c1T  G  I )
1  c1

From the equation above, we would want to know how y will change when there is a change
in government spending. To do so we take the derivative of y with respect to G.

y 1  1
 (c o  c1T  G  I ) 
G 1  c1 x 1  c1

1
is the multiplier.
1  c1

Proportional tax

y  co  c1 ( y  yt)  G  I
Where t is the proportional of income to be paid in tax. We put like terms together and make
y the subject of the formula

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y  co  c1 ( y  yt )  G  I
y  co  c1 (1  t ) y  G  I
y  c1 (1  t ) y  co  G  I
y[1  c1 (1  t )]  co  G  I
1
y ( co  G  I )
1  c1 (1  t )

From the equation above, we would want to know how y will change when there is a change
in government spending. To do so we take the derivative of y with respect to G.

y 1  1
 (c o  G  I) 
G 1  c1 (1  t ) G 1  c1 (1  t )

1
is the multiplier when it’s a proportional tax.
1  c1 (1  t )

Income y will increase as a result of an increase in government depending on the size of the
multiplier. The size of the multiplier depends on how much consumers respond to increases
in income through MPC.
Example; tax rate is 20% and mpc=0.9. how much will income, consumption and savings
increase by a K1 increase in government spending? no autonomous consumption
Solution

y  0.9( y  0.2 y )  G  I
y 1 1
   3.57
G 1  c1 (1  t ) 1  0.9(0.8)

A K1 increase in government spending will increase national income by 3.57.

c( y )  c1 ( y  yt )

c( y )  c1 (1  t ) y  c1 (1  t )y
y
150
c(| Pya)g e 0.9(1  0.2)3.57  2.57
Due to an increase in income which was as a result of increase in government spending,
consumption will increase by 2.57
s ( y )  (1  c1 )( y  yt )

s ( y )  (1  c1 )(1  t ) y  (1  c1 )(1  t )y
y
c( y )  0.1(1  0.2)3.57  0.2856

Savings increase by 0.2856

Therefore, the multiplier effect is that when government spending increases by K1, income
will increase by K1 the first round. This K1 increase in income will increase individuals’
disposable income and will spend K0.9 on consumption. The aggregate demand will increase
income by K0.9 this is the second round. Consumption will increase by .09*K0.9=K0.81 as a
result of the second round increase in income. The K0.81 increase in consumption will
increase income by K0.81, this is the third round. This will go on until there is no further
increase income. Multiplier effect: the additional shifts in AD that result when fiscal policy
increases income and thereby increases consumer spending.

A $20billion increase in G (for example) initially shifts AD to the right by $20b.

The increase in Y causes C to rise, which shifts AD further to the right.

P AD1 AD2 AD3

Y
Y1 Y2 Y3

The $20billion will increase in G will shift AD from AD1 to AD2. Output increase from Y1 to
Y2 this increase is by the entire $20billion. This increase in Y causes consumption to increase
which further shifts the AD curve to AD3 .

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10.7.2 Automatic fiscal stabilizer

Government expenditure and taxation will have the effect of automatically stabilising the
economy. As national income increases, the amount of tax people pay automatically rises.
This raises withdrawals and helps dampen the rise in national income until it gets back to
equilibrium. Automatic stabilisers cannot prevent fluctuations, the merely reduce their
magnitude. Government can make deliberate changes in tax rate or government spending in
order to influence the level of AD. This is called discretionary fiscal policy.

Money spent by government is all spent and it boosts the economy, this why cutting taxes
has a smaller effect on national income than raising government expenditure. This is because
cutting taxes increases peoples disposable income which is not all spent on consumption. Not
all the tax cut is passed on round the circular flow of income.

If Government implemented a deflationary fiscal policy by either reducing its expenditure or

increasing taxes, the fall in G will reduce national income which will result in the shift in AD
from ADo to AD-∆E.

This will result in a fall in consumption which will further reduce national income. The AD
shifts to AD1 ,this shift is because of the multiplier effect. Another scenario is where the
economy is operating under full employment and government implements an expansionary
fiscal policy to increase output.
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Potential GDP is $10 trillion, real GDP is $9 trillion, and there is a $1 trillion recessionary
gap.

An increase in government expenditure or a tax cut increases expenditure by ∆E. The

multiplier increases induced expenditure. The AD curve shifts rightward to AD1. The price
level rises to 110, real GDP increases to $10 trillion, and the recessionary gap is eliminated.

10.7.3 crowding out

Fiscal policy has another effect on AD that works in the opposite direction. If government
borrows money from the bank, it competes with firms for finances thus causing interest rate
to increase in the economy. The rise in interest rates, r, reduces investment by the firms has the
cost of borrowing money is high. This reduces the net increase in aggregate demand.

So, the size of the AD shift may be smaller than the initial fiscal expansion. This is called the
crowding-out effect.
Interest rate Ms AD3
P AD2
AD1
rr11

r0 P1
Md
1
Md

M Y
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Y2
The initial $20billion will shift the AD curve to AD3 by $20billion. Bu due to a rise in
interest rate investment reduces shifting the AD curve to AD2 . therefore output increases
from y1 to y2. This is as a result of crowding out.

Government borrowing from banks and rising the interest offered to firms discourages firms
and household to borrow. Thus invest and consumption will reduce aggregate demand.

10.8 monetary policy

How does the interest-rate effect help explain the slope of the aggregate-demand curve? How
can the central bank use monetary policy to shift the AD curve?

The Aggregate demand curve slopes downward for three reasons: The wealth effect, the
interest-rate effect, the exchange-rate effect.

Money demand reflects how much wealth people want to hold in liquid form. For simplicity,
suppose household wealth includes only two assets:

 Money – liquid but pays no interest

 Bonds – pay interest but not as liquid

A household’s “demand for money” reflects its preference for liquidity. The variables that
influence money demand: are income, interest rates and price levels.

Liquidity preference theory

This is a theory that gives the motive for people to hold money, why people demand for
money. There are three motives and these are; transaction, precautionary and speculative
motive.

Transaction motive; people hold money for transaction purposes. This is because they want
to buy goods and services. When their income is high, they will demand for more money so
that they can buy more goods and services. The higher the price the more people need to hold
to afford the previous basket. For example if prices double, the purchasing power of the
income reduces, therefore to buy the same amount of goods as before, income has to double
as well.
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Precautionary motive; people hold money for precautionary purposes. They hold money in
case of certainties. Therefore, when there income increases they will increase the amount of
money they hold for uncertain events.

Asset motive; people hold money when other assets are not profitable. This is derived from
moneys function as a store of value. People can hold money in terms of bonds, stock,
property etc. the want to hold money as an asset. Money is an attractive asset to when the
prices of other assets e.g. bonds are expected to decline. When the interest rates for other
assets like bonds are low, it is therefore more profitable to hold money that to buy bonds. But
when the interest rates are high, it’s not profitable to hold money, therefore buy bonds so that
you have some interest earnings on the money.

Demand for money is affected by the level of income, prices and interest rates in an
economy. The higher the income and the lower interest rate, the more people will demand for
money. The reverse is true.

The supply of Money is assumed fixed by central bank; it does not depend on interest rate.

What consists of money supply?

M1 is what is considered to be money supply, it consists of currency (coins and paper

money) in the hands of the non-bank public and all checkable deposits. This is the most
liquid. Money supply is the money in circulation and deposits at bank.

Ms

r
Md
M
M

Ms curve is vertical implying changes in interest rates r do not affect money supply, which is
fixed by the central bank. Md curve is downward sloping implying a fall in r increases money
demand. A rise in r will increase the cost of holding money, people will hold financial assets
instead, thus demand for money falls.

A change in GDP will shift transaction demand and thus shift the total demand for money
curve.

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Ms
r
r1
P1
r2 Md
P2
AD
Md
M Y
M Y1 Y2

A fall in prices reduces money demand, shifting the Md curve downwards. Interest rate falls
from r1 to r2. This fall in interest rate will increase investment which will increase output of
goods and services.

Tools for monetary policy

The central bank affects money supply by affecting money in circulation or affecting the
number of deposits for any given amount in circulation. They use;

1. Reserve requirement. Central banks use the reserve ratio in order to manipulate
commercial banks’ ability to lend. When the central bank raises reserve ratio reduce
the money available for banks to lend and create money. Thus money supply falls.
Lowering reserve ratio enhances the ability of banks to create new money by lending.
The reserve ratio is a percentage of deposits that the bank should keep in its vaults
and cannot give it out as loans.

2. Discount rate. The central bank as a lender of last resort, lend money to commercial
banks and charge interest on those loans. The interst rate charged is called discount
rate. A lower discount rate increase bank loans thus increasing money supply. A high
discount rate reduces bank loans. Central bank will raise the discount rate to restrict
money supply.

3. Open market operations. The Central bank uses the sell and purchase of securities to
carry out monetary policy. the Central bank sell government bonds to banks and the
public. when the Central bank buys bonds from the banks and the public it increases

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money supply and when the CB sells bonds to the banks and the public it reduces
money supply.

The central bank uses monetary policy to affect AD through affecting money supply using
the policy instruments available.

Suppose there is a recession and central bank wants to increase money supply. It can do this
by;

1. Buying securities

2. Lowering reserve ratio

3. Lowering the discount rate

To reduce inflation the central bank can reduce aggregate demand by limiting money supply
through;

 Sell of securities

 Increase reserve ratio

 Raise discount rate

The central bank implements an expansionary monetary policy

MS1 MS2
AD1
r1
r2 P1
MD
AD2

Y1 Y2
The supply curves shifts outwards to MS2, interest rates fall to r2. The fall in interest rate
will increase investment thus increasing demand for goods and services, shifting the AD
curve to AD2. Output increases to Y2.

The increase in money supply results in lower interest. This affects investment. Firm borrow
more funds to expend the business thus AD increases. This shifts the AD outwards and
output increases.

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10.10 ACTIVITIES

EXERCISE
a) Explain the mechanism and the impact on the equilibrium price level and
output in a domestic economy when the government employs an expansionary
fiscal policy). Show graphs

b)

10.11 SUMMARY

In summary you have learnt

 Demand for money is affected by the price,interst rate and income

levels of an economy

 Money supply is fixed by the central bank. This is liquid money which is the money
in circulation and checkable deposits

 Fiscal policy is the government policy to influence the level of output an dprice levels
in an economy. This can be done by either manipulating government expenditure or
tax levels.

 Monetary policy is the policy government or central bank uses to influence the
interest rate and therefore influence output and price levels.

In the next unit we look at the exchange trade of an economy.

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11.0 UNIT TEN: TRADE

11.1 INTRODUCTION

This unit will look at the trade interactions between nations.

11.2 AIM

This unit will introduce you to the theories of trade and barriers to trade.

11.3 OBJECTIVES

At the end of this unit you should be able to do the following

Explain the difference between absolute and comparative advantage

 Explain the difference between trade regions

11.4 TIME REQUIRED

You should take a minimum of 4hours to complete this unit.

11.5 REFLECTION

why are there so many trade unions like SADC,ECOWAS etc?

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11.6 Readings
Begg et al, chap

Brue etal , chap

Sloman and Garratt, chap

11.7 Absolute and comparative advantage.

According to Adam Smith, trade between two nations is based on absolute advantage. When
one nation is more efficient than (has an absolute advantage over) another in the production
of one commodity but is less efficient than (has an absolute disadvantage with respect to) the
other nation in producing a second commodity, then both nations can gain by each
specializing in the production of the commodity of its absolute advantage and exchanging
part of its output with the other nations for the commodity of its absolute disadvantage.

By this process, resources are efficiently utilized and the output of both commodities will
rise. The growth in output measures the gains from specialization in production available to
be divided between the two nations through trade.

In contrast to the mercantilists, Smith believed that all nations would gain from free trade and
strongly advocated a policy of laissez-faire: As little government interference with the
economic system as possible. Free trade would lead to efficient use of resources and would
maximize world welfare.

However, Countries have different endowment of factors of production. These differences

tend to persist because the factors are relatively immobile between countries. E.g. population
density, labour skills, climate, raw materials, capital equipment etc. This means that the
relative cost of producing goods will vary from country to country.

The Law of Comparative Advantage (LCA)

According to this law, even if one nation has an absolute disadvantage with respect to the
other nation in the production of both commodities, there is still a basis for mutually
beneficial trade. This nation should specialize in the production and export of the commodity

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in which its absolute disadvantage is smaller (this is the commodity of its comparative
advantage) and import the commodity in which its absolute disadvantage in greater (this is
the commodity of its comparative disadvantage).

For example

U.S U.K

WHEAT(bushels/man hour) 6 1

Clothes(yard/man hour) 4 2

The UK has an absolute disadvantage in the production of both commodities with respect to
the US. However, since the UK is half as productive in cloth but 6 times less productive in
wheat, it has a comparative advantage in cloth. The US has an absolute advantage in the
production of both commodities with respect to UK. Since the US absolute advantage is
greater in wheat (6:1) than in cloth (4:2), it has a comparative advantage in wheat.

According the Labour Theory of Value, the value or price of a commodity depends
exclusively on the amount of labor going into its production. This implies that; 1) either labor
the only factor of production or it is used in the same fixed proportion in the production of all
commodities. 2) labor is homogeneous (i.e. of only one type). Since neither of the
assumptions is true, we can’t base the explanation of comparative advantage on the labour
theory of value.

According to the Opportunity Cost Theory, the cost of a commodity is the amount of a
second commodity that must be given up to release just enough resources to produce one
additional unit of the first commodity. Thus, the nation with the lower opportunity cost in the
production of a commodity has a comparative advantagr in that commodity.

For example; we have two countries producing two goods wheat and cloth

Kilos of wheat Metres of cloth

zambia 2 1

malawi 4 8

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Malawi has absolute advantage in both wheat and cloth. For Zambia, the opportunity Cost of
producing a kilo of wheat is ½ a metre of cloth. Because you give up one metre of cloth to
produce 2kilos of wheat. The opportunity cost of producing a metre of cloth is 2kilos of
wheat. For Malawi, the opportunity cost of producing a kilo of wheat is 2metres of cloth.
Because you are giving up 8 metres of cloth to produce 4kilos of wheat. The opportunity cost
of producing a metre of cloth is ½ a kilo of wheat.

Zambia has comparative advantage in wheat and Malawi has comp.adv in cloth. the
opportunity cost of producing wheat in Zambia is lower (1/2) that in Malawi (2) .And the
opportunity cost of producing cloth is lower in Malawi(1/2) than in Zambia(2). According to
LCA, Zambia should specialize in wheat and Malawi should specialize in cloth.

The production possibility frontier (PPF) under constant costs.

The PPF: a curve showing the alternative combinations of the two commodities that a nation
can produce by fully utilizing its resources with the best technology available to it.

Example. Given the information below construction each countries PPF and determine their
basis of trade.

US UK

wheat cloth wheat Cloth

180 0 60 0

150 20 50 20

120 40 40 40

90 60 30 60

60 80 20 80

30 100 10 100

0 120 0 120

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The US has to give up 30W to produce an additional 20C (30W=20C), the opportunity cost
of W is 1W=2/3C. The UK has to give up 10W to produce an additional 20C (10W=20C),
the opportunity cost of W is 1W=2C.

Constant opportunity costs arise when:

1. Resources are perfect substitutes or used in fixed proportions in the production of

both commodities.

2. All units of the same factor are homogeneous.

 While opportunity costs are constant in each nation, they differ among nations,
providing the basis for trade.

The opportunity cost is measured by the slope of the PPF, also known as the marginal rate of
transformation. The figure above shows that the (absolute) slope of the US transformation
curve is 120/180=2/3= opportunity cost of wheat in the US and remains constant. The
(absolute) slope of the UK transformation curve is 120/60=2= opportunity cost of wheat in
the UK and remains constant.

Assuming prices equal costs and the nation produces both commodities, the opportunity cost
of wheat is equal to wheat price relative to cloth price (Pw /Pc). In the US, Pw /Pc=2/3, and
inversely Pc /Pw= 3/2=1.5. In the UK, Pw /Pc=2, and inversely Pc /Pw= ½=1/2.

The lower Pw /Pc in the US reflect its comparative advantage in wheat. The lower Pc /Pw in the
UK reflect its comparative advantage in cloth. The difference in relative commodity prices

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between the two nations is a reflection of their com-adv. and provides the basis for mutually
beneficial trade.

With no trade, the US may produce a combination of (90W-60C) on its PPF (point A in
figure below) and the UK may produce a combination of (40W-40C) on its PPF (point A/ in
figure below). With trade, the US would specialize in producing wheat and produce at point
/
B (180W-0C), then the UK would specialize in producing cloth and produce at point B
(0W-120C).

Suppose they trade 70W for 70C, US consumes 110W-70C (point E), the UK consumes
70W-50C (point E /).

/
The US gains 20W and 10C from trade (E compared to A), UK gains 30W and 10C (E
compared to A /). The increase in consumption resulted from the specialization of the two
nations. Without trade, total production of wheat is 130 (90+40), but with trade it is 180 (all
in the US). Without trade, total production of cloth is 100 (60+40), but with trade it is 120
(all in the UK).

Gains from trade come from the increase in production (50W and 20C) shared by both
nations. Without trade no nation would specialize in production because both need to
consume some of the other commodity.

At what price will they trade? USA will not be willing to buy clothes for more than 3/2 units
of wheat per unit of clothes, because they could have produced it themselves at that price if
they hadn’t specialised. Similarly, UK will not be willing to sell clothes for less than 1/2 unit
of wheat, because this is their opportunity cost of producing Clothes if they hadn’t
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specialised. This means that the price of a good must be less than its opportunity cost to the
buyer, but greater than the opportunity cost to the seller. Hence:

Sellers ≤ price ≤ Buyers opportunity cost

opportunity cost

½ W per cloth price 3/2W per cloth

The equilibrium relative price of Pc/Pw=Pw/Pc=1 with trade. USA gains by exporting wheat
and importing cloth. At an exchange ratio of 1:1 it now has to give up 1kilo of wheat, instead
of 1.5, to obtain a metre of cloth. UK gains by exporting clothes and importing wheat. At an
exchange ratio of 1:1 it now gives up a metre of cloth, instead of 2, to obtain a kilo of wheat.

Other reasons for gains from trade

 Decreasing costs; even if there is no comparative advantage between two countries, it

would be beneficial to specialize in industries where economies of scale can be
gained, and then trade.

 Differences in demand; trade can be beneficial for both countries if demand

conditions differ. For example people in country A like beef more than lamb, and
people in B like lamb more than beef, instead of specializing it would be beneficial to
produce both beef and lamb and to export the one they like less in return for the one
they like more.

 Increased competition; if a country trades, the completion from imports may stimulate
efficiency at home. This prevents monopolies from charging high prices

 Trade as an engine of growth; the demand a country’s exports is likely to grow over
time, especially when exports have a high income elasticity.

 Non-economic advantages; there may be political, social, and cultural advantages to

be gained by fostering trading links between countries.

Barriers to trade

There are barriers to trade that countries erect so as to limit or avoid any imports getting into
the country. These barriers are;

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 Tariffs(customs duty) on imports

 Quotas (restricting on the amount of certain goods that can be imported).

 Subsidies on domestic products to give them a price advantage over imports.

 Administrative regulations designed to exclude imports such as customs delay or

excessive paper work

 Procurement procedures whereby governments favor domestic producers when

purchasing equipments.

Why restrict trade?

 The infant industry argument; some industries in acountry may be in their infancy
but have potential comparative advantage. They are too small to compete with
well established firms abroad,so without protection these infant industries will not
survive the competition.

 To reduce reliance on goods with little dynamic potential; many developing

countries export primary goods like foodstuff and raw materials.the world
demand for such is fairly income inelastic, thus growth is relatively slow. Free
trade is not an engine of growth is such cases.

 To prevent dumping and other unfair trade practices. A country may engange in
dumping by subsidizing its exports, thus prices do not reflect comparative
advantage. The tariff would be imposed to counteract the subsidy.

 To prevent the establishment of a foreign based monopoly. Competition from

abroad could drive out local producers out of business, and have a monopoly.
Restricting import or subsidizing local products could help.

When tariffs and quotas are imposed some of the gains from trade are lost. They impose a
cost on society. For example, we have a small country that cannot affect world price. It is a
price taker. This country is producing textiles and is trading with another. In the domestic
economy without trade the market for textiles is in equilibrium at $4.2 and after trading the
world price is now $2.

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Quantity demand for textile increases to 700 and suppliers reduce their production and
transfer the resources to other use. Supplier are supplying 200, the difference is imported
from other countries.

When a $1 tariff is imposed on the imports, this increases the price to consumers by the
amount of the tarrif, the prices rises to Pw + t=$3. Domestic production increases to 300 and
consumption reduces to 600. The difference between the two output 600-300=300 is the new
import level.

The loss of efficiency from a $1 tariff has two components:

1. Consumers must pay a higher price for goods that could be produced at a
lower cost. Consumer surplus falls

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2. Marginal producers are drawn into textiles and away from other goods,
resulting in inefficient domestic production.

However, the government gains some revenue by the shaded area.

Trading blocks

The world economy seems to be increasingly forming into a series of trade blocs base upon
regional groupings of countries. The blocs are preferential trading arrangments. There are
three forms of trading arrangements

1. Free trade area; members countries remove tariffs and quotas between themselves but
retain whatever restrictions each member chooses with non members. Some provision
has to be made to prevent imports from outside coming into the area via the country
with the lowest external tariff.

2. Customs union; is like a free trade area, but in addition members must adopt a
common external tariff and quotas with non-member countries

3. Common markets; member country operate as a single market. Like customs union
there are no tariffs and quota. It also includes

a) A common system of taxation; involves identical rates of tax in all countries.

b) A common system of laws and regulation governing production, employment

and trade.

c) Free movement of labour, capital and materials, and goods and services.

d) The absence of special treatment by member government of their own

domestic industries.

e) A fixed exchange rate between member countries’ currencies.

f) Common macroeconomic policies.

Customs union results in trade creation and diversion

Trade creation; is where consumption shifts from a high cost producer to a low cost producer.
The removal of barriers allows greater specialization.

Trade diversion; is where consumption shifts from a lower cost producer outside the customs
union to a high cost producer within the union.

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11.10 ACTIVITIES

EXERCISE
1. Go through each argument for restricting trade and provide a counter-argument for
not restricting trade

2. Does the consumer in the importing country gain or lose from dumping?

3. Why will a high exchange rate harm the agriculture sector in a developing country?

11.11 SUMMARY

In summary you have learnt;

 Absolute advantage; a country should specialise and trade in a good

they have less cost of production

 Comparative advantage; a country should specialise and trade in a good they have
less opportunity cost of production.

 Barriers to trade; policies implemented to deter or reduce imports in the country

 Preferential trade arrangements; countries in some regions make a group to remove

trade barriers for each other

In the next unit we look at balance of payment and exchange rate.

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12.0 UNIT ELEVEN: EXCHANGE RATE AND OPEN ECONOMY

12.1 INTRODUCTION

We look at how an economy’s interaction with other nations will affect the price at
which they exchange their currency.

12.2 AIM

the aim of this unit is to introduce you to the balance of payment, exchange rate
and its effect on the economy.

12.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Explain the effects of depreciation on the balance of payment account.

 Explain the effects of an increase in the economy’s income on imports and exchange
rate.

 Explain the effect of changes in interest rate on the exchange rate.

12.4 TIME REQUIRED

This unit should take you a minimum of 4hours to complete.

12.5 REFLECTION

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What affects exchange rate?

12.6 READINGS
Sloman and Garret, chap 14. Page 468

Begg et al, chapter24. Page 549

12.7 Balance of payment

The balance of payments is the record of a country’s transactions in goods, services, and
assets with the rest of the world; also the record of a country’s sources (supply) and uses
(demand) of foreign exchange. The Credit side records receipts from abroad and the Debit
side records all payment to abroad. The balance of payment has three main parts 1) current
account, capital account and financial account.

A country’s current account is the sum of its:

• net exports (exports minus imports),

• net income received from investments abroad, and

• net transfer payments from abroad.

Trade in goods; records imports and exports of physical goods. Exports results in inflow of
money whereas imports are outflow of money. Thus, Exports are on the credit side, imports
are on the debit side.

Trade in services; records imports and exports of services e.g. transport, tourism and
insurance.

The balance of trade is the difference between a country’s exports of goods and services and
its imports of goods and services. Net balance of trade deficit is a net leakage from the
circular flow of income. A trade surplus is a net injection into the circular flow of income. A
trade deficit occurs when a country’s exports are less than its imports. Net exports of goods
and services (EX – IM), is the difference between a country’s total exports and total imports.

Investment income consists of holdings of foreign assets that yield dividends, interest, rent,
and profits paid to domestic asset holders (a source of foreign exchange).
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Transfer payments include government contribution to international organizations and
international transfers of money by private individuals and firms.net transfer payments are
the difference between payments from the domestic country to foreigners and payments from
foreigners to the domestic country, e.g. money sent from USA to a Zambian student in
Zambia will be a credit.

The balance on current account consists of net exports of goods, plus net exports of services,
plus net investment income, plus net transfer payments. It shows how much a nation has
spent relative to how much it has earned.

For each transaction recorded in the current account, there is an offsetting transaction
recorded in the capital account. The capital account records the changes in assets and
liabilities. It records the flow of funds into and out of the country, associated with the
acquisition and disposal of fixed assets.

The balance on capital account is the sum of the following (measured in a given period):

• the change in private domestic assets abroad

• the change in foreign private assets domestically

• the change in domestic government assets abroad, and

• the change in foreign government assets domestically

If the capital account is positive, the change in foreign assets in the country is greater than the
change in the country’s assets abroad, which is a decrease in the net wealth of the country. In
the absence of errors, the balance on capital account would equal the negative of the balance
on current account.

The financial account records cross border changes in the holding of shares, property, bank
deposits and loans, government securities. The following are the parts;

• Direct investment; a foreign company invests money from abroad in one of its
branches in Zambia.. This an inflow of money and it credited in the balance of
payment. Profits from this investment flowing abroad will be recorded as investment
income in the current account. Investment abroad by Zambians is an outflow.

• Portfolio investment; changes in holding of paper assets e.g shares in an overseas

company is an outflow. Portfolio investment is likely to be affected by relative
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interest rates. Other financial and investment flows; short term monetary movements.
E.g deposits by foreign residents in bank

A balancing account of the balance of payment are flows to and from reserves; all countries
hold reserves of gold and foreign currencies. The central bank can sell some of the resources
to purchase the kwacha on the foreign exchange market. This is to support the exchange rate.
Drawing on reserves represents a credit. Reserves can be used to support a deficit elsewhere
in the balance of payment. Reserves also build up when there is a surplus in the balance of
payment. The balance of payment should always balance. Credits=debits

If it doesn’t balance, exchange rate has to adjust until they are equal or government has to
intervene.

Net errors and omissions. When statistics are compiled a number of errors occur. This figure
is to ensure there will be exact balance in the balance of payment.

Below is the layout of the balance of payment.

CURRENT ACCOUNT
Goods exports
Goods imports
(1) Net export of goods
Export of services
Import of services
(2) Net export of services
Income received on investments
Income payments on investments
(3) Net investment income
(4) Net transfer payments
(5) Balance on current account (1 + 2 + 3 + 4)
CAPITAL ACCOUNT
(6) Change in private domestic assets abroad (increase is –)
(7) Change in foreign private assets domestically
(8) Change in domestic government assets abroad (increase is –)
(9) Change in foreign government assets domestically
(10) Balance on capital account (6 + 7 + 8 + 9)
FINANCIAL ACCOUNT
(11) Net direct investment
(12)Portfolio investment balance
(13)Reserve assts
(14)Financial account balance
(11) Statistical discrepancy
(12) Balance of payments (5 + 10 + 11)

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12.8 Exchange rate

The main difference between an international transaction and a domestic transaction

concerns currency exchange. International exchange must be managed in a way that allows
each partner in the transaction to wind up with his or her own currency.

The exchange rate is the price of one country’s currency in terms of another country’s
currency; the ratio at which two currencies are traded for each other. Foreign exchange is
simply all currencies other than the domestic currency of a given country. Thus, foreign
exchange market is a market in which foreign currencies are exchanged and relative prices
established.

Exchange rate can be expressed as; Foreign per unit of domestic currency or domestic per
unit foreign currency’. In our analysis we will take exchange rate as foreign per domestic
currency. In a world where there are only two countries, the United States and Zambia, the
demand for kwacha is comprised of holders of dollars wishing to acquire kwacha. The
supply of kwacha is comprised of holders of kwacha seeking to exchange them for dollars.

Demand for kwacha (supply of dollars) includes

1. Firms, households, or governments that import Zambian goods into USA

2. U.S. citizens traveling in Zambia

3. Holders of dollars who want to buy Zambian stocks, bonds, or other financial
instruments

4. U.S. companies that want to invest in Zambia

5. Speculators who anticipate a decline in the value of the dollar relative to the kwacha

Supply for kwacha ( demand for dollars) includes

1. Firms, households, or governments that import U.S. goods into ZAMBIA

2. Zambian citizens traveling in the United States

3. Holders of kwacha who want to buy stocks, bonds, or other financial instruments in
the United States

4. Zambia companies that want to invest in the United States

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5. Speculators who anticipate a rise in the value of the dollar relative to the kwacha.

The demand for kwacha in the foreign exchange market shows a negative relationship
between the price of kwacha (kwacha per dollar) (ZMW/$) and the quantity of kwacha
demanded.

Price of
kwacha
($/ZMW)

Quantity of
kwacha

When the price of kwacha falls, Zambian-made goods and services appear less expensive to
U.S buyers. If Zambian prices are constant, American buyers will buy more Zambian goods
and services, and the quantity demanded of kwacha will rise.

The supply of kwacha in the foreign exchange market shows a positive relationship between
the price of kwacha (kwacha per dollars) and the quantity of kwacha supplied.

Price of kwacha
($/ZMW)

Quantity of
kwacha

When the price of kwacha rises, the Zambians can obtain more dollars for each kwacha. This
means that U.S.-made goods and services appear less expensive to zambia buyers. Thus, the
quantity of kwacha supplied is likely to rise with the exchange rate.

The equilibrium exchange rate occurs at the point at which the quantity demanded of a
foreign currency equals the quantity of that currency supplied.

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Price of S
kwacha
($/ZMW)
P*
D

Q*
Quantity of
kwacha

An excess supply of kwacha will cause the price of kwacha to fall—the kwacha will
depreciate (fall in value) with respect to the dollar. An excess demand for kwacha will cause
the price of kwacha to rise—the kwacha will appreciate (rise in value) with respect to the
dollar. Thus, Excess supply of kwacha shows that banks would not have dollars to exchange
for all the kwacha. The banks make money by exchanging currency, they will raise the
exchange rate in order to encourage demand for kwacha and reduce excess supply.

The rate below the equilibrium, results in a shortage of kwacha (excess demand for kwacha).
The banks would find themselves with fewer kwachas to meet demand. There is an excess
supply of the dollar. The exchange rate will thus rise until the demand equaled supply.

Depreciation is a decrease in the relative value of a currency relative to another currency.

When a currency depreciates, more units of that currency are needed to buy a unit of another
currency. Appreciation is increase in the value of a currency relative to another. Fewer units
of that currency are needed to buy a unit of another.

If the demand for a nations currency increases, that currency will appreciate. If the demand
falls the currency will depreciate. If the supply of a nations currency increases that currency
will depreciate. If the supply decreases, that currency will appreciate. If a nations currency
appreciates, some foreign currency depreciated relative to it.

Factors that affect exchange rate

There are several factors that affect exchange rate, these include;

• Rates of inflation; changes in the relative prices of two nations change the demand for
and supply for currencies and exchange rate between the two nations. If U.S price
levels rise rapidly relative to Zambia, U.S consumers will seek lower priced goods in
Zambia, increasing the demand for kwacha. Zambian too will buy less of U.S goods
reducing the supply of kwacha.
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A high rate of inflation in one country relative to another puts pressure on the exchange rate
between the two countries, and there is a general tendency for the currencies of relative high-
inflation countries to depreciate.

Price of S’ S
kwacha($/ZMW)
P2

P1 D’
D

Q Quantity of
kwacha

A higher price level in the United States increases the demand for kwacha and decreases the
supply of kwacha. The result is appreciation of the kwacha against the dollar

• The level of a country’s interest rate relative to interest rates in other countries is
another determinant of the exchange rate. If U.S. interest rates rise relative to
Zambian interest rates, Zambian citizens may be attracted to U.S. securities. USA
loans will be more attractive, Zambians will supply the kwacha and demand for
dollar. The supply curve will shift outwards and kwacha will depreciate and dollar
appreciates.

S S’
Price of
kwacha($/ZMW)
P1

P2 D
D’

Q Quantity of
kwacha

A higher interest rate in the United States increases the supply of dollars and decreases the
demand for kwacha. The result is depreciation of the kwacha against the dollar.
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• Relative income; a nations currency is likely to depreciate if its growth of nation
income is more rapid than that of other countries .i.e imports directly vary with
income level. As total income rises Zambians will buy more of both domestic and
USA goods, they will demand more dollars and supply kwacha. This will result in
kwacha depreciating.

• Tastes; any change in consumers tastes for foreign good relative to domestic good
will alter the demand for than nations currency and exchange rate. Due to
technological advances USA goods are preferred to Zambian goods. USA goods are
more attractive. Zambians will supply more kwacha and Americans will demand less
of the kwacha. The supply curve shifts to the right, demand curves shifts outwards.
Resulting in a depreciation of the kwacha.

• Speculation; currency speculators are people who buy and sell currency with an eye
towards reselling and purchasing them at a profit. Suppose speculators anticipate that
the kwacha will appreciate and the dollar will depreciate. Speculators having dollars
will convert them to kwacha. This increases the demand for kwacha. Kwacha
appreciates and dollar depreciates. This is because speculators believe that the
changes will in fact take place. What will happen if the speculate that the kwacha will
depreciate?

• Changes in relative expected returns on stock, real estate and production

facilities. Investment depends on the relative expected returns. To make investment,
investors in one country must sell their currencies to purchase the foreign currencies
needed for investment. Suppose there is positive outlook on expected returns on
stocks, real estate in Zambia, US investors will sell their assets in USA to buy in
Zambia. They will sell their dollar to get kwacha. Increased demand for kwacha will
shift the demand curve outwards causing the kwacha to appreciate and dollar to
depreciate.

The effects of exchange rate.

When a country’s currency depreciates (falls in value), its import prices rise and its export
prices (in foreign currencies) fall. When the U.S. dollar is cheap, U.S. products are more
competitive in world markets, and foreign-made goods look expensive to U.S. citizens.

A depreciation of a country’s currency can serve as a stimulus to the economy, which are;

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• Foreign buyers are likely to increase their spending on zambian goods

• Buyers substitute zambian-made goods for imports

• Aggregate expenditure on domestic output will rise

• Inventories will fall

• GDP (Y) will increase

Depreciation of a country’s currency tends to increase the price level. Export demand rises
and domestic buyers substitute domestic products for the now more expensive imports. If the
economy is operating close to capacity, the increase in aggregate demand is likely to result in
higher prices. If import prices rise, costs may rise for business firms, shifting the aggregate
supply curve to the left.

12.9 exchange rate and the balance of payment

In free float exchange market, the balance of payment will automatically balance. This is
because the credit side of the balance of payment constitutes the demand for kwacha. For
example, when foreigners buy our Zambian goods they demand for kwacha in order to pay
for the goods. The debit side constitutes the supply side of the kwacha. When we buy foreign
goods we are to pay for them in foreign currency.

A floating exchange rate ensures that the demand for kwacha is equal to the supply. Thus
ensures that the credit on the balance of payment equals the debits. A current account deficit
must be matched by a capital plus financial account surplus and vice versa.

Example; suppose interest rates in zambia rise relative to the rest of the world. This
encourages short term financial inflow as people abroad are attracted to deposit money in
zambia. The demand for kwacha rises shifting to the right. It will also cause smaller short
term financial outflows as Zambians keep more money in the country.

The supply curve shifts to the left. The financial account will go into surplus, and exchange
rate appreciates. Exports are now expensive while imports become cheaper. The current
account will move into a deficit. We move up along the new demand and supply curves until
a new equilibrium is reached. Financial account surplus is matched by an equal current
account deficit.

Central bank and government would intervene in fixing exchange rate. This is because free
float causes exchange rate to change frequently and this brings about uncertainty for
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business. Central bank will intervene either to reduce the day to day fluctuations in the
exchange rate or to prevent longer term shifts in the exchange rate.

Assume that government believes that an exchange rate of $0.2/k (i.e.K5/$) is approximately
the long term equilibrium rate. However shifts in the demand and supply of currency are
causing exchange rate to fall below this level. What can government do to maintain the rate
$0.2/k. there are three way to intervene;

1. Using reserves; central bank can sell gold and foreign currency from the reserves to
buy kwacha. This shifts the demand for kwacha back to the right. Why? When
government sells foreign currency it induces a demand for kwacha.

2. Borrowing from abroad; the government can negotiate a foreign currency loan from
other countries or IMF to buy kwacha on the forex market. This shifts the demand for
kwacha to the right

3. Raising interest; if central bank raises interest rates, it encourages people to deposit
money in Zambia and encourage Zambians to keep their money. the demand for
kwacha will increase and supply decreases.

Government can fix exchange rate over a number of months or years. Assuming no
downward pressure on the exchange rate. It uses

a) Contractory policies. It will curtail aggregate demand by either fiscal or monetary

policies or both. Contractory fiscal policy involves raising taxes or reducing
government expenditure.

b) Contractory monetary policy involves reducing the supply of money and raising
interest rates. This is to use higher interest to reduce borrowing and hence dampen
aggregate demand.

A reduction in aggregate demand works in two ways.

1. It reduces the level of consumer spending. This directly cuts imports and the supply
of kwacha decreases.

2. It reduces the rate of inflation making local goods more competitive, thus increasing
demand for kwacha. Zambian now buy more local goods. The supply of kwacha also
reduces.

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Supply side policies this is where the government attempts to increase the long term
competitiveness of Zambian goods by encouraging reduction in costs of production and
improvement in the quality of goods. Controls on imports or foreign exchange dealings.
government restricts the outflow of money by restricting peoples access to foreign exchange

Advantages of fixed exchange rate

Business people prefer fixed or rigid exchange rate because;

• Certainty. With fixed exchange international trade becomes less risky. Since profits
are not affected by movements in the exchange rate.

• Little or no speculation. When the exchange rate is fixed, it remains the same no point
in speculating.

• Prevents government pursuing irresponsible macroeconomic policies.

Disadvantages of fixed exchange rate

If there is a fall in a country's exports as a result of an external shock and government is

forced to raise interest rate. Two adverse effects will affect the economy;

• Higher interest rates may discourage long term business investment. This in turn will
lower firms’ profits in the long term and reduce the long term rate of economic
growth.

• The country’s capacity to produce will be restricted and business are likely to fall
behind in the competitive race with their international rivals to develop new and
improve existing ones.

• Higher interest will have a dampening effect on the economy by making borrowing
more expensive and there by cutting back on both consumer demand and investment.

• This can result in a recession with rising unemployment. However it will improve the
Balance of payment. Financial account will improve, current account will improve
too as import demand reduces and lower inflation is likely to make exports more
competitive and imports relatively more expensive.

Monetary policy with fixed exchange rate

Central banks actions to lower interest rates result in a decrease in the demand for kwacha
and an increase in the supply of kwacha, causing the kwacha to depreciate. If the purpose of

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the central bank is to stimulate the economy, kwacha depreciation is a good thing. It
increases Zambia’s exports and decreases imports.

Flexible interest rates may not help in the attempt by government to cut taxes in order to
stimulate the economy. A tax cut results in increased household spending, but some of that
spending leak out as imports, reducing the multiplier.

As income increases, the demand for money increases. The resulting higher interest rates
cause the dollar to appreciate. Exports fall, imports rise, again reducing the multiplier. If
interest rates rise, private investment may be crowed out, also lowering the multiplier.

Monetary policy has no role in a country that has a fixed exchange rate. For example, an
attempt to lower interest rates results in currency depreciation and a lower (not a fixed)
exchange rate. In the absence of capital controls, the monetary authority loses its
independence.

12.10 ACTIVITIES

EXERCISE

1. Beginning at internal and external balance, an economy devalues its fixed exchange
rate

a) What happens to its interest rate?

b) What happens to its output?

c) How are internal and eternal balance restored?

2. Which of the following are credits and debit on the Zambia balance of payment?

a) The expenditure by Zambian tourist on holidays in Greece.

b) The payment of dividends by foreign companies to investors resident in Zambia

c) Foreign residents taking out insurance policies with Zambian companies

d) Drawing on reserves

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e) Investment by Zambia companies overseas.

12.11 SUMMARY

In summary you have learnt;

 A devaluation is a fall in the value of the fixed exchange rate

 Under floating exchange rate the long run level of nominal exchange
rate achieves external balance

 Under floating exchange rate, monetary policy is a powerful short-term tool

 Fiscal policy is a weaker tool under floating exchange rate.

In the next unit you will look at unemployment and inflation; causes and effects.

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13.0 UNIT TWELVE: UNEMPLOYMENT AND INFLATION

13.1 INTRODUCTION

This unit will give an outline of unemployment and inflation.

13.2 AIM

The aim of the unit is to introduce you the concept of unemployment and
inflation. What are the effects of unemployment on the economy?

13.3 OBJECTIVES

At the end of this unit you should be able to do the following

 Explain the types of unemployment

 Explain the effects on unemployment of the economy?

 Explain the types of inflation

 Explain the effects of inflation on the economy.

13.4 TIME REQUIRED

You should take a minimum of 3hours on this unit.

13.5 REFLECTION

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What is the rate of inflation and unemployment in Zambia?

12.10 READINGS
Begg et al. chap 23

Sloman and Garratt. Chap 339

12.11 UNEMPLOYMENT

Unemployment simply means people do not have jobs. It occurs when people capable of and
willing to work are unable to find suitable paid employment.
Did you know that some people who are unemployed may not be included when the
unemployment rate is calculated?
The employed are individuals who currently have jobs. Therefore, the labour force are the
employed plus the unemployed. The labour force consists of all persons who are either
working for pay of actively seeking paid employment.

Labour force=employed + unemployed

Unemployment rate is the percentage of labour force unemployed and looking for work. It is
measured as;

unemployed
Unemployment rate   100
labour force

The labour force participation rate is the fraction of the population that is over 16years of age
that is in the labour force.

labour force
Labour force participation rate   100
population16 and over

Full employment is when there are more jobs than people. The number of unfilled vacancies
is equal to the number of people out of work. It is the level of national income at which
everyone who wants to work is able to do so, in other words, there is sufficient demand to
employ everyone.
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Classical economists argued that the economy would automatically tend to this equilibrium,
due to the market forces of supply and demand. Keynesians maintain that it is the role of
government, using policy instruments at their disposal, to ensure that there s full employment
in an economy.

13.7.1 CAUSES OF UNEMPLOYMENT

Causes of unemployment can be broadly divided into demand and supply factors:
- Demand deficiency unemployment is caused by lack of demand for goods and services, and
as a result, firms lay off workers. This is usually when the economy is in the recession stage
of the economic or trade cycle and there is little economic activity.
Keynesians argue that a shortage of aggregate demand is one of the key causes of
unemployment.
- Monetarists view Supply side factors such as strong trade unions demanding for high wages
as causes of unemployment as firms employ less labour while the supply of labour increases,
as shown below:
wages S
W1

# of workers
Q1 Q Q2

At a high wage rate of W1, the demands for labour by firms reduces to Q1, supply naturally
increases to OQ2, because individuals who were unwilling to work at wage rate W are now
encouraged by the high wage rate. The difference between Q1 and Q2 is unemployment
caused by the activities of trade unions.
- Firms lay off workers if import prices are too high, like the high price of oil, which reduces
a firms’ competitiveness, and loss of customers.
- State benefits tend to encourage ‘voluntary unemployment’. When the benefits are higher
than the market wage, as in the diagram above, a person feels ‘better off’ being unemployed
earning W1 than earning a low wage (W) while in employment.

13.7.2 TYPES OF UNEMPLOYMENT

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Seasonal unemployment is considered to be temporal and occurs in certain industries where
Economic activity is in specific periods or seasons, examples are tourism, agriculture and
construction industries. There is a high demand for labour during certain periods of the year,
and then most of the workers are laid off during off peak periods.
Frictional unemployment is of a short-term duration. It refers to secondary school or
college graduates who are searching for jobs, as well as individuals who are in between jobs,
the transitional period between workers leaving one job and starting another. Frictional
unemployment is also an indication of imperfections in the market such as lack of
knowledge, the geographical immobility of labour or a mismatch between the requirements
of the employers and the available skills of the unemployed.
The more efficiently the job market is matching people to jobs, the lower this form of
unemployment will be. However, as long as there is imperfect information and people don't
get to hear of jobs available that may suit them then frictional unemployment is likely to be
high.

Structural unemployment refers to long-term changes in the pattern of demand and supply
in an economy. On the demand side, a firm may fail to compete with rival firms, demand for
the company’s product declines and the firm is likely to lay off workers and close the
business.
Changes in the supply of a product, for a example if the product like copper ore is getting
depleted, there is no need to employ miners and this can also lead to unemployment in the
Copperbelt. It may also result from changes in the production methods labour is replaced by
machines or capital equipment, termed technological unemployment. Structural
unemployment also includes regional unemployment, some regions in a country may have
higher unemployment levels compared to other regions because of different regional
economic performances.
Unemployment results because individuals do not respond quickly to the new job
opportunities, they find themselves with no readily marketable talents. Their skills and
experiences are unwanted, as they have become obsolete.
Cyclical unemployment is the same as deficiency in demand unemployment. It is
characterized by fluctuations in economic growth, characterized by booms and recessions,
the trade cycles. During the recession phase, there are high levels of unemployment.

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Voluntary unemployment is a relatively new concept, defined by the monetarists as being
due mostly to high state benefits, either unemployment benefits or being on welfare. This
causes people to be unwilling to work at existing low wage rates. They realize that they are
“better off” not working and receiving state benefits.
Voluntary unemployment also includes individuals who simply do not want to work!

13.7.3 NEGATIVE EFFECTS OF UNEMPLOYMENT

The Economic consequences of unemployment are classified as Economic, financial, social
or political costs.
1. Labour is a factor of production, and due to unemployment, the Economic
resource is not being utilized, this is at a cost, the opportunity cost of goods
and services not produced, quality of workforce diminishes as idleness causes
labour to be less efficient, this in turn increases the cost of retraining it.
2. Government revenue is mostly from taxes, unemployment results in a loss of
government revenue, as the unemployed do not pay any tax, in some rich
countries they receive state benefits, which means that unemployment is a
financial cost to the government.
3. Unemployment may lead to social undesirable behaviour like theft,
vandalism, riots or general discontent. The mental and physical health of the
unemployed tends to deteriorate, the unemployed are more prone to commit
suicide. This is considered to be a social cost.
4. Whenever there are high levels of unemployment in the country, the political
party that forms the government, is likely to lose popularity, this is a political
cost to the government.
12.12 Inflation
Inflation is a sustained rise in the general price level of goods and services. It is measured
using price indices. Deflation is when price levels fall.

Inflation can be classified between two extremes depending on the speed at which prices are
changing. Creeping inflation is when there are small price increases while hyperinflation
is the worst case of inflation. The prices of goods and services change very rapidly.

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Inflation is related to consumer prices. The consumer price index (CPI) is calculated each
month and yearly. A broader measure of inflation relates to the rate at which prices of all
domestically produced goods and services are changing. GDP deflator is also used as an
index.

Real-nominal principle

What matters to people is the real value of money or income-its purchasing power not the
face value of money or income. Economists have developed a number of measures to track
the cost of living over time. The best known of these measures is the consumer price index. It
measure changes in a fixed basket of goods- a collection of items chosen to represent the
purchasing pattern of a typical consumer.
cos t of basket in year k
CPI per year   100
cos t of basketin base year
The percentage change of price index is the inflation rate
CPI 2  CPI 1
inf lation rate   100
CPI 1

13.8.1 CAUSES OF INFLATION

There are three main causes of inflation, one view from the Monetarists, and two views from
the Keynesians. Demand-pull and cost-push are essentially Keynesian explanations of
inflation. Monetarists reject these and believe that inflation is caused by an increase in the
money supply.

Keynesians on their part do not accept that an increase in the money

Supply actually causes inflation.

They believe that an increase in the money supply is an indication that there is inflation in an
Economy. It is not a cause of inflation.
13.8.2 MONETARISTS VIEW AND THE QUANTITY THEORY OF MONEY

Monetarists consider the increase in the money supply as the only cause of inflation. The
argument of the monetarists is based on the quantity theory of money. The theory is
summarized as the fisher equation; Irving Fisher developed the Fisher equation of exchange.
It appears in various guises, the most common is:

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MV = PT

where:
M is the amount of money in circulation.
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

MV = PT states that money supply multiplied by the velocity of circulation equals the price
level multiplied by total transactions. This equation is true by definition since receipts are
equal to expenditure. PT can therefore be thought of as equivalent to National Expenditure.

Assuming that V is constant in the short run as it is determined by the money supply, and T
is also fixed in the short run. Then, an increase in the money supply would lead to an increase
in the general price level.

13.8.3 COST-PUSH INFLATION

This inflation is caused by an autonomous increase in the costs of production, considered as

cost-push factors. These may then cause cost-push inflation. Cost-push factors may be
changes in wages, changes in the exchange rate, which change the price of, imported raw
materials or perhaps changes in indirect taxation. Cost-push inflation occurs when a
company's costs rise and to compensate, a firm has to put prices up. Cost increases may
happen because wages have gone up or because raw material prices have increased. The
increase in the costs, with aggregated demand remaining uncharged, causes the aggregate
supply curve to shift to the left from AS to AS1, and price increases from P to P1.

AS1
Prices
AS0
P2

P1
D
National output,income

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Cost-push factors that can contribute to the increase in the cost of production include:

- Strong, powerful trade viewers who force employers to concede high wage increases,
costs then rise and these are later passed on to consumers in the form of price increases.
This situation is worse during periods of low unemployment.
- Import cost inflation, especially for a country which depends on one or more of the
- Imported raw materials or other imported inputs
- Imported finished products, capital equipment and more especially the ever
- Increasing price of imported fuel.
- High indirect taxes such as when there is an increase in value added tax or excise duties,
consumers simply notice an increase in prices.

13.8.4 DEMAND-PULL INFLATION

If there is an excess level of demand in the economy, this will tend to cause prices to rise.
This type of inflation is called demand-pull inflation and is argued by Keynesians to be one
of the main causes of inflation. Inflation occurs when increases in aggregate demand pull up
prices, with aggregate supply remaining constant.

The aggregate demand is the total demand in an economy, made up of government

expenditure, consumption expenditure, investment expenditure and exports minus imports.
Any increase in one or more of these components of aggregate demand can put pressure on
prices. As demand increases from AD to AD1 there is increasing inflationary pressure on
prices. This is demand-pull inflation - "too much money chasing too few goods."

AS
Price level

P2

P1 AD2
AD1
Real income

Y Yf

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Increase in demand can be caused by either expansionary monetary or fiscal policies. If there
is a high public sector net cash requirement, then total demand in the economy is stimulated.

The Keynesian original aggregate supply curve is an inverse “L”. According to them, the
pressure on prices is when aggregate demand expands after the full employment of resources,
before that point, an increase in aggregate demand acts as an incentive for firms to increase
output. When the resources are fully employed, the aggregate supply curve becomes vertical,
and if aggregate demand increases beyond this point, an inflationary gap is created.

13.8.5 ANTI INFLATIONARY MEASURES

To control inflation, first, it is necessary to know the cause. Unfortunately, this is difficult to
do because inflation tends to feed on itself and there is the price wage spiral.

Suppose the prevailing inflation is demand driven, then, measures to reduce aggregate
demand should be put in place; such as tight fiscal and monetary policies like increasing
direct taxes and interest rates to reduce consumption expenditure and investment expenditure
respectively. Government expenditure should also be reduced. This means that the
government must aim for a budget surplus, by increasing its income through increased taxes,
but reduce government spending; the excess money should be kept frozen at the central bank.

If the inflation is due to an increase in the money supply then the government should attempt
to reduce the money supply by reducing commercial bank lending using the instruments
mentioned under the control of the money supply. These are open market operations,
increasing interest rates and asset ratios to discourage lending. Directing commercial banks
to reduce their lending and requesting them to make special deposits at the central bank.

If the source of inflation is an autonomous increase in the cost of production, then measures
should be taken to stop the wage-price spiral, reducing the power of trade unions or match
the increased costs with increased productivity.

A country’s currency can be allowed to depreciate in order to discourage imports, while

encouraging exports, this means increased production. An increase in supply lowers the
price.

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Prices and incomes policy that is wage and price controls can also be instituted to control
inflation. This means freezing prices and incomes. This may not work well in a liberalized
market economy. It also means controlling the consequence and not the cause of inflation!

13.8.6 ECONOMIC CONSEQUENCES OF INFLATION

A little inflation is considered to be good for any economy as it provides an impetus for firms
to increase output. High prices are a sign that there is a high demand for goods and services
and there is a prospect of higher profits.

Generally, the negative effects of inflation are as follows:

- Inflation redistributes income

- Retired people who are on fixed incomes suffer a lot from inflation. Some people earn
K20 per month as pension. At the time of retirement, they were able to purchase a lot of
goods and services from that amount, but due to inflation their purchasing power and
standards of living falls.
- Inflation distorts consumer behaviour. Consumers purchase a lot of goods because of
expected future price increases. They hoard goods hoping to ‘beat’ inflation and in the
process create shortages.
- Inflation undermines business confidence. Businesses are unable to make concrete future
plans because of uncertainty in price fluctuation in addition, they have to change the
price tags on products on a regular basis and this can be so costly and time consuming.
- Inflation and interest rate and savings. The real rate of interest, which is the money rate
of interest after making an allowance for inflation, is reduced. Lenders demand for high
money rates to compensate for lower real values.
- Lower real interest rates discourage savings and encourage spending. This may have a
long-term effect on long-term finance for investment.
- Inflation reduces a country’s international competitiveness.
- High prices make products (exports) unattractive on the international market, consumers
are likely to prefer cheaper imports to locally produced products. This affects the
balance of payments. A country has an adverse balance of payments when exports are
lower than imports.
- Inflation causes the currency to depreciate when there is a low demand for exports,
therefore, the demand for the currency is low compared to its supply, and the currency
depreciates in value.

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- Inflation redistributes wealth, it causes borrowers to gain at the expense of lenders as it
reduces the value of the debt. The lenders receive less relative to what they had lent.
This is related to the time value of money.
- Inflation leads to uncertainty in price forecasting, both at central government level and at
corporate business level.
- Money is unable to perform its functions properly.
 Inflation has little impact on money’s function as a medium of exchange. Money is
still used to purchase goods and services.
 The use of money as a means of deferred payment is rendered less effective by
inflation. Credit is granted but payment is deferred. This leads to redistribution of
wealth where borrowers or those who purchase goods on credit gain but lenders
lose.
 The greatest effect of inflation on the functions of money is the function of money
as a store of value. The value of money is measured indirectly through prices when
prices rise, it is a sign that the value of money has fallen since few items can be
brought from the same amount of money. Money becomes an ineffective store of
value. Interest rates paid are supposed to compensate, and this is one of the
explanations why interest rates rise during periods of inflation.
 Money is used as a unit of account and as a measure of value. This function is also
hampered by inflation as the relative values of things being compared keep on
changing in monetary terms.

13.10 ACTIVITIES
EXERCISE

1. What would be the benefit and costs of increasing the rate

unemployment benefit?

2. Explain why boosting demand sometimes fails to reduce unemployment?

3. How is high unemployment explained by (a)Keynesians(b)classical

economists

13.11 SUMMARY

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In summary you have learnt;

 People are either employed, unemployed out of the labour force

 Unemployment is classified as frictional, structural, seasonal and

cyclical.

 Inflation is the sustained increase in prices of domestically produced goods and

services

 Demand pull and cost push are causes of inflation

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