Economics Gudbook

Chapter 1
Introduction to economics: scarcity, choice,

and opportunity cost
1.0 Introduction
A lot of statements have been said about economics as a subject. The following are
some of the statements.
a. ‘Economics is the painful elaboration of the obvious.’
b. ‘Economics is everything we know in a language we don’t understand’
c. A Swedish contribution: "Economics is like red whine - you shouldn't smell it
but drink it, but if you drink too much on one occasion, there is a risk for
dizziness"
This introductory chapter will define economics and discuss the central economic
problem which is a problem of scarcity.
1.1 Defining economics

It is quite difficult to define economics as such. According to one standard
definition, economics is concerned with the way in which resources are allocated
among alternative uses to satisfy human wants. Economics therefore can be defined
as a social science that studies how society allocates its scarce resources amongst
competing alternatives.
From the above definition, economics is described as a 'social science'. 'Social' in

that the subject matter is the human being. 'Science' because the approach used has
much in common with that of the natural sciences because economics use scientific
methodologies in its formulation of policies.
1.2 Microeconomics and macroeconomics

It is customary to divide economics into two parts: microeconomics, and
macroeconomics. Microeconomics deals with the economic behaviour of individual
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units such as consumers, firms and households; while macroeconomics deals with
the behaviour of economic aggregates such as national income and the level of
employment. In simple words, it is like in microeconomics, we examine the trees
not the forest while in macroeconomics we examine the forest and not the trees.
1.3 Positive and normative economics

Positive economics refers to that part of economic analysis based on established
facts. Positive economics states ‘what is in existence’ and hence it is descriptive. It
seeks to explain real economic events. For example, it explains that if the price of a
normal good increase, the quantity demanded for that good decrease.
Normative economics refers to that part of economic analysis which deals with
opinions or value judgments about what economic events should be like.
Normative economics goes beyond the descriptions of particular economic
situations and pass judgment. As a result, normative economics is prescriptive. An
example of normative economics is welfare economics.
1.4 The basic economic problem

The science of economics centers upon two basic facts: first, human material wants
are virtually unlimited, second, economic resources are scarce. As a result, the
economic problem is a problem of scarcity and can be described in terms of scarce
resources in relation to unlimited wants.
1.4.1 Scarce resources

Resources are the things or services used to produce goods or services which can be
used to satisfy wants. Economic resources may be classified as property resources -
land and capital - or as human resources - labour and entrepreneurial ability. These
resources are limited in supply and yet society desires more of them than is
available. Thus it can be said that resources are scarce because they are limited in
supply. However scarcity is a relative concept. It relates to the extent of the
people's wants to their ability to satisfy those wants.

Table 1.1 Different types of resources
Type Description Reward
Land All gifts of nature Rent
Labour The physical and mental effort of people Wages
Capital All goods used to produce other goods Interest
Enterprise All managers and organisers Profit
These resources are scarce because they are limited in supply and yet society
desires more of them than is available.
1.4.2 Unlimited wants

Material wants refer to the desires of consumers to obtain and use various goods
and services which provide satisfaction. Desire for material wants is insatiable. The
ends of human beings are without end. The fulfillment of some of the wants on the
list seems to do little more than raise people's expectations of something even
better.
There are three reasons why wants are virtually unlimited:
 Goods eventually wear out and need to be replaced.
 People get fed up with what they already own.
 New or improved products become available.
.
Fig 1.1 The basic economic problem visualisation
Scarce
resource
s------
Unlimite
d wants
The economic problem of scarcity applies to every society whether rich or poor.
Mckenna P.J (1958:2) writes in his book Intermediate Economic Theory, "whatever
the cause, we find ourselves in a situation of scarcity where we can not have all the
things we want, because the resources we have at any time are limited in supply

while our wants appear to be unlimited.” As a result, societies have to make
choices. Economics can also be defined as the study of the ways in which choices
are made.
1.5 Economic choices

The requirement of making a choice is a consequence of the problem of scarcity.
Resources are limited in supply relative to demand for goods and services produced
from the available resources. As a result society and individuals should make
choices. This can be referred to as ‘economising’ – making the little available best
be used to satisfy our wants and needs.
1.5.1 The basic economic problem of choice

The basic economic problem is universal. Any society (rich or poor) faces the
problem of scarcity since resources are limited in supply. No society can produce
all the goods wanted by its people. Society has to decide which commodities to
make. For example, should we produce sugar cane or maize? We have to decide
how to make these commodities. Do we employ more capital or labour? Who is
going to use the goods that are eventually made?
Societies must make difficult choices of: -
 What to produce and in what quantities?
 How to produce?
 For whom to produce?
The way in which different societies answer these questions give rise to different
economic systems. These fundamental economic questions can best be examined
using a production possibilities curve.
1.6 The production possibilities curve (PPC)

A production possibilities curve or frontier shows what the society could produce
with its existing resources at any moment in time. That is, the PPC shows the
maximum output that a society can produce given its existing supplies of land,
labour, capital and technical knowledge. The PPC works on the society's technical

knowledge because another society with greater technical knowledge may be able
to produce more given the same quantities of resources.
1.6.1 An example
Let’s assume the following sample conditions for our illustration: -
a) The society can only produce two types of goods, say consumer goods which
are those goods which directly satisfy our wants and capital goods which are
those goods which satisfy out wants indirectly by permitting further production
of consumer goods.
b) The available supply of resources is fixed both in quality and quantity.
c) The level of technology is fixed, that is, technology does not change during the
course of our analysis.
d) The economy is operating at full employment and is achieving full production.
e) It’s a closed economy, that is, there is no international trade.
With its limited supplies of resources, our society could produce varying combination of
consumer and capital goods. The extreme possibilities are that either all resources are
devoted towards producing consumer goods or the resources are devoted to the production
of capital goods. These are unrealistic possibilities since the society can not survive on
consumer nor capital goods alone and so, some combination is essential.
Table 1.2 The production possibilities table
Type of Product Production alternatives

A B C D E
Consumer Goods 0 4 7 9 10
Capital Goods 4 3 2 1 0
From the production possibilities table it can be concluded that economic resources are
scarce hence the production of one type of goods involves the sacrifice of another. This
can be represented on a diagram as follows:
Fig 1.2 The production possibilities curve

CAPITAL GOODS
5
4 A
3 B
PPF
2 C
1 R .S
(Unattainable
D
combination)
0 2 4 6 8 10 12 CONSUMER GOODS
All points onIdle
theresources
frontier (e.g. point C) show the maximum possible combined outputs of
the two commodities. The society then must choose the product-mix it desires: more
consumer goods mean less capital goods, and vice versa.
It is possible to produce a combination inside the curve (e.g. point R) but this would mean
that resources are underutilized, that is, not fully employed. In such a case, it is possible to
produce more of both goods by moving to a point on the boundary.
However, the limited supplies of resources make any combination of consumer and capital
goods, lying outside the production possibilities curve, such as point S, unattainable.
Hence product-mix represented by point S will only be possible when the productive
capacity increase. Thus, the curve moves outwards.
1.6.2 Application: The PPC and the economic concepts of scarcity, choice
and opportunity cost
A production possibility curve shows that maximum output that a society can produce
with its existing resources at any moment in time. It is often referred to as the
'transformation curve' because in moving from one alternative or product-mix to another,

say, from point B to point C, we are in effect transforming capital goods into consumer
goods, by shifting resources from the production of the latter.
Assuming that the society is producing only two goods, consumer and capital goods using
its available resources and level of technical knowledge, its production possibilities can be
represented by the following boundary.
Fig 1.3 PPC and opportunity cost

CAPITAL GOODS
PPC
R B .D
.A
S C
O T U
CONSUMER GOODS
Points on the curve represent points at which the economy is operating at full productive
capacity, that is, full employment of all available resources. Points lying outside the
production possibilities curve, such as point D, would be superior to any point in the
curve, but such points are unattainable given the current supplies of resources and level of
technology. Conversely, points inside the curve, say, point A are attainable but imply
under utilization of resources, that is, point A mean that some resources are idle or not
fully employed.
The production possibilities curve can be used to explain three economic concepts,
namely choice, scarcity and opportunity cost. Choice is explained by the attainable
combinations on the boundary, for example points B or C. the society has to choose its
desired product mix from amongst the attainable points on the curve. For instance it can

choose optimal mix B and have more capital goods than consumer goods or optimal mix
C where consumer goods are preferred to capital goods.
The economic problem of scarcity is implied by the unattainable combinations beyond the
boundary. Such combinations are superior to those on the curve. However, because
resources available are limited in supply or scarce, the society can not produce the
combination represented by point D.
On the other hand, the scarcity of resources implies that we can only have more of
consumer goods by having less of capital goods. This described an element of sacrifice in
making choices. The next most desired alternative sacrifice is referred to as the
opportunity cost. Thus the concept of opportunity cost can be illustrated by the negative
slope of the boundary from the diagram of the production possibilities curve. Assume a
society currently producing OR units of capital goods and OT units of consumer goods.
Now if OU units of consumer goods are required, the maximum amount of capital goods
that can be produced is OS Thus, additional units of consumer goods (TU) can be
produced only at the expense of RS units of capital goods. Therefore RS units of capital
goods are the opportunity cost of TU units of consumer goods.
In conclusion, the analysis of the production possibility curve is very important because it
illustrates the concepts of choice, scarcity and opportunity cost. On the other hand the
PPC helps to show how economies provide answers to the basic economic questions of
what, how and for whom to produce.
1.6.3 Application: The PPC and the law of increasing opportunity cost
What is the rationale for a production possibility curve that is concave or bowed out from
the origin? The answer to this question is rather complex. But, simply stated, it amounts to
this: Economic resources are not completely adaptable to alternative uses. Thus, say, we
attempt to increase the production of consumer goods, resources which are less suitable to
the production of consumer goods must be induced or 'pushed' into that line of production.
It will obviously take more and more of such resources - and an increasing great sacrifice

of capital goods - to achieve a given increase of one unit in the production of consumer
goods. Thus, a concave production possibility curve represents increasing opportunity
cost. Therefore under the unrealistic assumption of perfect adaptability of resources the
production, possibility curve would be a straight line, implying constant opportunity cost.
1.6.4 Application: The PPC and economic efficiency

Points on the production possibility curve represent points at which the society is operating
at full employment and full productive capacity. By full employment we mean that all the
available resources are employed. On the other hand, full production means that the
employed resources are used to make their most valued contributions to output. This
involves two kinds of efficiency - productive and allocative efficiency.
 Productive efficiency or X-efficiency refers to a situation in which the existing

resources are used in the best way in the production process. It implies that goods
should be produced at the least cost. By definition, points on boundary of the
production possibility curve are productive efficient while points inside are
inefficient.
 Allocative efficiency implies that resources are devoted to the production of
products most wanted by society (consumers). It refers to the actual position on the
production possibility curve, and depends on the society preferences. Of
importance is to note that any point that lies on the boundary is productive efficient
while not all points on the boundary are allocative efficient. An example+e is when
people desire more health services than defence services but yet more of the
country's resources are devoted to producing defence services, such as combination
though productive efficient is not allocative efficient.
 Dynamic efficiency or economic growth which is the ability to produce a larger
CAPITAL GOODS
total output - is reflected in a rightward shift of the production possibilities curve,

as indicated by movement from boundary AB to CD on the following diagram.
Fig 1.4 Dynamic efficiency or economic growth

C
O B D
CONSUMER GOODS
An expanding resource supplies: labour force, stock of capital goods, and/or an
increase in technical knowledge which characterize a growing economy will move
the production possibilities curve outward and to the right. This permits more of
both consumer and capital goods to be produced. Thus the economy will consume
an increased quantity of the goods produced over time and hence standards of
living will improve. Precisely, economic growth or dynamic efficiency makes the
problem of scarcity less acute.
1.7 Opportunity cost

Making of choices imply foregoing other alternatives. That is, sacrificing the other
alternative uses for resources. Opportunity cost refers to the next best alternative
foregone when a choice is made. The opportunity cost principle states the cost of
making a choice in terms of the next best alternative foregone. Therefore it’s the
real cost and not monetary cost. For example, if a gardener decides to grow carrots
on his allotment, the opportunity cost of his carrot harvest is the alternative crop
that might have been grown instead (e.g. potatoes).
Chapter 2
Economic systems
2.0 Introduction
While the nature of choices facing all societies are the same, societies sometimes
adopt different methods of dealing with them One method of answering these

questions is through a market economy where choices are resolved by the free play
of market forces of demand and supply. That is, resources are allocated through the
price mechanism, which simply mean that individuals as consumers freely choose
what they want to purchase and producers freely decide on what they want to
provide. Because of this free play purchase and production, market economies are
often referred to as free enterprise or laissez faire ("leave-well-alone") economies.
An alternative method of allocating resources is through the centrally planned
economy in which the government issues directives of instructions indicating
"what?", "how?", and "for whom?" to produce.
2.1 The market economy

The framework of market economies embodies the following institutions and
assumptions:
a) Private ownership of property,
b) Freedom of enterprise and choice,
c) Self-interest as the dominant motive,
d) Competition,
e) Reliance upon the price system, and
f) A limited role for the government.
Laissez failure mean "leave-well alone' hence market economies are characterized
by an almost total lack of government intervention.
2.1.1 Advantages
a) There is consumer sovereignty, that is, a market economy allocates scarce
resources according to consumers' wants. "The consumer is king". P Samuelson
b) Producers have an incentive through profit to respond quickly to change’s in
consumer demand
c) Competition forces producers to produce high quality products at low cost.
d) Resources are allocated to their most efficient use through the price mechanism.
2.1.2 Disadvantages

a) There is elimination of the poor from consumption. That is, people with no
money to pay for certain goods will be eliminated from the consumption of
those goods and even basic goods.
b) Self interest may lead to great inequalities in the distribution of income and
wealth.
c) There is likely to be exploitation of consumers through overcharging, short
weighing and misleading advertising.
d) Production is for profit, therefore there will be non-production of public goods
and under-production of merit goods.
2.2 The centrally planned economy

Centrally planned economics are characterised by
a) Government ownership of the means of production.
b) Government provision of goods and services.
c) Production is for use rather than for profits.
d) Non-price rationing mechanisms, that is, goods are distributed according to
need and not ability to pay.
e) Government control and planning is through a central planning board credited
to control coordinate and plan all economic activities.
2.2.1 Advantages
a) It is sometimes suggested that centrally planned economies are likely to have
greater equality in the distribution of income and wealth.
b) There is provision of public and merit goods.
c) It is claimed that centrally planned economies are likely to be far more stable
than market economies
d) The production and consumption of demerit goods which impose relatively
large social costs on society can be eliminated or prevented.
2.2.2 Disadvantages

a) There is nobody who has power over the government such that even if it fails, it
is answerable to nobody.
b) Where there are no incentives, people are not motivated to work.
c) Without competition producers will be inefficient and produce poor quality
goods. As result, resources will be utilized inefficiently.
d) Complications in planning for the whole economy arise, that is, planning is a
difficult task and there are too many stages of decision making - bureaucracy or
red tape.
2.3 The mixed economy

Neither pure market economy nor pure centrally planned economy exists in the real
world. This is because political authorities in most countries exercise economic
functions e.g. controlling prices. However, it is useful to study the economic
systems in their extremes such that by making them as models we can approach the
realistic situations step by step.
When we use the term mixed economy, it is usually applied to economies where
there is a significant component of both market and central planning features of
production. The economy allows private ownership of property by allowing a
private sector to exist and provide private goods and services for profit. The public
sector provides public and merit goods.
2.3.1 Reasons for government intervention in a market economy

The government should intervene in the market economy and play the following
roles:
a) Distributive role, that is, to ensure a fair or equitable distribution of income
between the poor and the rich.
b) Allocative role, that is, to allocate some of the economy’s resources to the
production of public and merit goods otherwise not provided in a market
economy.

c) Stabilisation role, that is, to control fluctuations in economic activity such
as stabilising prices and reducing unemployment.
d) Regulatory role, that is, to maintain law and order which create an
environment conducive for business.
The above reasons of government intervention are rooted in the concept of market
failure. Market failure refers to those situations in which the conditions necessary
to achieve efficiency in the allocation of resources in the market economy fail to
exist. It is believed that the market left to it is very unlikely to operate efficiently.
There is a tendency to over produce some goods and under produce others. Factors
that bring about the failure of markets include: -
a) The existence of public goods and externalities.
b) Imperfect competition e.g. monopolies.
c) Imperfect information and uncertainty.
Chapter 3
Demand and supply

3.0 Introduction

According to Carlyle T "it is easy to train an economist; teach a parrot to say,
demand and supply". This could be an understatement of an economics education.
However there is something to be learnt from Thomas Carlyle's statement on the
central role played by demand and supply in economics.
3.1. Theory of demand

Demand is not the same as desire, willingness or want. Economists are interested in
effective demand which can be described in terms of willingness or desire coupled
by the ability to purchase a product or service. Demand is the amount of a good
that consumers are willing and able to buy at a given price. Effective demand =
Willingness + Ability. Willingness only = Latent demand. Ability only = Potential
demand.
3.1.1 The law of demand

It states that, “other things being equal, more will be demanded at a lower price
than at a higher price”. This describes a negative or inverse relationship between
price and quantity demanded. As price falls, the quantity demanded rises.
Conversely, as price increases the corresponding quantity demanded falls. In other
words, the demand curve is downward sloping from left to right indicating that as
price falls, more will be demanded.
Fig 3.1 The demand curve

Price ($)
$10

$5
Demand curve
0 10 20
Quantity Demanded (Units).
The downward sloping demand curve implies that a fall in price from $10 to $5
will lead to an increase in the number of units demanded from 10 units to 20 units.
Why the demand curve is downward sloping

More is demanded at a lower price than a higher price because: -
a) Common sense and ordinary observations tells us that consumers prefer
cheaper products to dearer one. This is because price is often an obstacle
which deters people from buying hence the higher the obstacle, the less
will be bought.
b) At a lower price, a given amount of money will buy more goods than at a
higher price. For instance, $100 can buy 10 mangoes at $10 each while
the same $100 can buy 20 mangoes at a reduced price of $5. Thus the
purchasing power of money (buying power) increases as price decreases.
This increased purchasing power can be equated to an increase in real
income and hence is seen as the 'income effect of a price fall".
c) Consumers tend to substitute cheap products for dear products. For
example, a fall in the price of butter will provide consumers an incentive
to substitute butter for margarine which is now relatively expensive.
Purchases of butter will increase as a result and this is referred to as the
'substitution effect of a price fall".
d) Utility is the satisfaction derived from the consumption or use of a
product as a consumer consumes successive units of a product, the
additional satisfaction derived from that consumption declines. Thus

consumption is subject to diminishing marginal utility hence consumers
will only buy additional units of price is reduced.
3.1.3 Exceptional demand curves

Exceptional demand curve do not confirm with the law of demand. They have a
positive slope, that is, the curve slopes upwards from left to right as follows: -
Fig 3.2 Exceptional demand curve

Price Exceptional
Demand Curve
50
25
0 10 20
Quantity Demanded
The demand curve slopes upward indicating that as the price rises, quantity
demanded will also increase. Examples include: -
i) Ostentatious Goods of Goods with a "Snob - appeal"
Some people buy expensive goods simply because they are expensive. The
ownership of such goods put them in a rather exclusive class. Where goods are
bought for snobbish reasons, a fall in price might cause them to lose their appeal
and hence demand decreases with decreasing price and increases with increasing
price.
ii) Speculation or expectations.

If a price increases in the short term while they are expected to further increase in
the near future, consumers may demand more at the current increased price in order

to beat future price increases. Such is the behaviour of buyers in the stock exchange
market where falling share prices will lead to a decline in demand because people
expect the trend to continue that is, they expect to buy at even lower prices. An
increasing share prices will lead to an increase in demand with people expecting the
bull-run to continue, that is, they expect to sell at a much higher price.
3.1.4 The determinants of demand

The amount of a good demanded depend on:
 The price of the good (PX) – the higher the price the lower the quantity
demanded and vice-versa.
 The price of other goods (substitutes and complements) (P y). Substitute
goods serve the same purpose and are competitive in demand e.g. tea and
coffee, while complementary goods are jointly demanded e.g. camera and
film. An increase in the price of tea will increase demand for coffee while
an increase in the price of cameras will lead to a reduced demand for films.
Thus, the price of one affects the demand for the other.
 The income of consumers (Y) – a rise in income increases demand for
superior or normal goods while demand for inferior goods will decrease.
 Consumer tastes and preferences (T) – changes in fashion may reduce
demand.
 Advertising (A) – its purpose is to increase sales by increasing demand
 Availability of hire purchase finances (H) – e.g. 0% deposit scheme
increases demand for durable goods such as TV sets.
 Population size and composition (N).
 Expectations on future price increases or shortages (E) raise current
demand, as people want to beat the expected shortage or price increase.
All this can be summarised in the demand function:
Qd = f (Px, Py, Y, T, A, H, N, E)
3.1.5 Changes in the quantity demanded

For any product a change in quantity demanded is always caused by a change in its
price. A change in quantity demanded therefore refers to a movement along an
existing demand curve. That is it refers to the nature of the demand curve's slope.
For example movement from point A to B along the same demand curve is
described as a change in quantity demanded.
A change in price never shifts the demand curve for that good. It results in a
movement up or down the demand curve and is referred to as a change in quantity
demanded.
Fig 3.3 Decrease in quantity demanded

Price
P2 ------------------- B
“Decrease in quantity demanded”
P1 -------------------------------- A
O Q2 Q1 Quantity Demanded
Price reinforces the law of demand. A movement down the demand curve is an
increase in quantity demanded, while a movement up the demand curve is a
decrease in quantity demanded
3.1.6 Changes in demanded

This does not refer to the nature of the demand curve's slope but to the movement
of the curve either to the right - meaning an increase in demand or to the left -
implying a decrease in demand. An increase in demand means that more is now
demanded at each and every price than before while a fall in demand means that
less is demanded at each and every price than before.

A demand curve shifts only if there is a change in factors influencing demand other
than the price of the commodity. For example, changes in consumer income,
consumer tastes and preferences, prices other goods, advertising etc. A shift to the
right implies an increase in demand while a shift to the left is a decrease in demand.
Fig 3.4 Changes in demand
Price
P0 Increase in demand
D1
D0
D2
O Q2 Q0 Q1 Quantity demanded
A change in demand is always caused by a change in at least one of the conditions
of demand, which are: -
i) Changes in household disposable income (Y)
The level of income determines the demand for most commodities. If
income rises, demand for normal goods will increase while demand for
inferior goods will decrease. However, disposable income is what is
important. It refers to the actual amount that a household has to spend on
purchasing goods. Changes in government policy on taxation can cause
changes in demand since it influences disposable income.
ii) Changes in prices of other goods
Goods are related as substitutes or complements. Substitute goods are
competitively demanded that is they serve the same purpose and therefore
can be used interchangeably for example beef and chicken. Complementary
goods are those goods used or consumed jointly such as cameras and films.
When two products are substitutes, the price of one product and the demand
for the other are directly related. For example, an increase in the price of

beef will force consumers to buy less beef and this will increase the demand
for chicken.
When two products are complements, the price of one product and the
demand for the other are inversely related. For example if the price of
cameras falls, demand for cameras will increase and as a result demand for
films will also increase with people wanting to use their cameras.
iii) Advertising
A successful advertising campaign will move the demand curve to the right
because advertising aims at increasing consumption by the regular
customers as well as to more in more new customers.
iv) Changes in tastes and fashion
For certain goods such as clothing, changes in fashion can bring about
marked demand changes. The more fashionable a good becomes the more
demand for it will increase and vice versa.
v) The availability of hire purchase finance
The demand for most durable commodities such as television sets depend
very much on the availability of hire purchase facilities. Any changes in the
terms in which this type of finance is obtained will have a marked effect on
demand for such goods as TV sets.
vi) Changes in population
This has a long term effect and changes in the size and age distribution will
affect both the total demand of goods and the composition of demand. For
example if the proportion of children increase in a society, more education
will be demanded.
3.2 Theory of supply

We now look at what quantity is going to be supplied at any given price during a
period of time. The producer is out interest. It does not mean that one offers all that
has been produced for sale. Supply is the amount of a product a producer is willing
and able to produce and make available for sale at a given price during a specified
period.

3.2.1 The law of supply
It states that, "Other things being equal, more is supplied at a higher price than at a
lower price". This implies a positive or direct relationship between price and
quantity supplied. As a result the supply curve is upward sloping from left to right.
Fig 3.7 Supply curve

Price
Supply Curve
10
10
0 30 40 Quantity Supplied (Units)

A price increase from $10 to $15 will lead to an increase in quantity supplied from
30 units to 40 units.
2.3.1. Why the supply curve is upward sloping

a) It is assumed that firms produce for profit and other things being equal, at
higher prices it becomes more profitable to expand and supply more.
b) At higher prices, it becomes profitable for marginal firms, that is, firms which
can not cover their costs at lower prices, to undertake production. Therefore as
price rises more firms will enter the industry and market supply will increase.
3.3.1. Determinants of supply

Supply if influenced by (a) price of the commodity and (b) conditions of supply.
Price determines the shape of the curve that is, its upward slope from left to right.
Conditions of supply determine the position of the curve within the axes.
(a) Price of the commodity.
This factor reinforces the law of supply normally more of a commodity is supplied
the higher its price. A change in a commodity's price will lead to a contradiction or

extension of supply that is a movement along the existing supply curve. Therefore
price is a determinant of quantity supplied.
Fig 3.8 Increase in quantity supplied

Price
S
B
P2
P1 A
A
0 Q1 Q2 Quantity Supplied
If the price increases from P1 to P2, quantity supplied will increase from Q1 to Q2.
This is termed an extension of quantity supplied. Conversely, a change in quantity
supplied from Q2 to Q1 is a contraction in quantity supplied.
(b) Conditions of supply

When conditions of supply change, then supply will either increase or decrease. An
increase in supply means that more is supplied at each and every price than before
while a decrease in supply would mean that less is supplied at each every price.
Fig 3.9 Changes in supply

Increase in supply
Price
S2
S0 S1
P Increase in supply
0 Q2 Q0 Q1 Quantity

Note that in the case of a change in supply, price does not change but it is the
supply curve which either shifts to the left or to the right. A leftward shift from S 0
to S1 is a decrease in supply while a rightward shift from S 0 to S1 represents an
increase in supply. Changes which bring about changes in supply include: -
(i) Change in the level of technology
Improvements in the level of technology reduces the cost of production and
increases productivity hence more will be produced so that more is likely to
be supplied at any price.
(ii) Change in the price of factors of production (cost of production)
Other things being equal, a change in costs will change the level of profit
available from producing any particular commodity specifically a rise in
costs will reduce profits and cause some firms to cut back on output while
other firms will stop producing altogether. Thus, a rise in the price of
factors of production will lead to a decrease in supply. (a shift to the left ).
Conversely a fall in costs will lead to higher profits at any given price
leading to an increase in supply (a shift to the right).
(iii) Entry by new firms into the industry
As new firms start producing a particular product, market supply will
increase. If firms leave the industry, e.g. during a recession when some
firms may close down, the supply curve will shift to the left.
(iv) Government policy
Taxation can be regarded as an increase in the cost of production and hence
shifts the supply curve to the left. On the other hand, subsidies are seen as a
reduction of the cost of production thereby they shift the supply curve to the
right.
(v) Weather and other changes resulting from nature
Agricultural commodities are subject to the weather prevailing during
production. Production will fluctuate because of drought years and good
year and supply will change following these fluctuations. Thus changes
from nature such as floods, droughts etc. cause the shifting of the supply

curve of agriculture produce to the left. Human conditions such as war, fire
and political unsuitability also affect supply.
(vi) Prices of other goods
When the price of a commodity does not change while that of another
commodity increases, it means that its now profitable to produce the
commodity whose price has gone up. Resources will be shifted from the
production of the commodity whose price remains unchanged to the
production of the more profitable commodity. This shifts the supply curve
of the static-price commodity to the left.
3.3 Determination of equilibrium price and quantity

Price is not the same as value because value is relative from one individual to
another. In economics the price of a commodity or service is measured in terms of
what is offered in exchange for it (price = value in exchange). Economists view the
value of exchange as the price. Within markets, prices serve the important functions
of: -
 Signalling the information that allows all the traders in the market to plan
and co-ordinate their economic activities.
 Creating incentives for buyers and sellers to behave in a manner which
allows the market to operate in an orderly and efficient manner and;
 Rationing and allocating scarce resources between competing uses.
4.3.1. Market equilibrium price and quantity

The price where the amount consumers want to buy equals the amount producers
are prepared to sell, or where quantity demanded equals quantity supplied (Q d = Qs)
is the market price. Graphically the intersection of the demand curve and the
supply curve for a product will indicate the equilibrium price and quantity.

Fig 3.10 Market equilibrium
Price Excess S
Supply
Pe
Excess
Demand
O Qe Quantity
At prices above the equilibrium (Pe) there is excess supply while at prices below the
equilibrium (Pe) there is excess demand. The effect of excess supply is to force the
price down, while excess demand creates shortages and forces the price up. The
equilibrium price (Pe) is unique in that it is the only price that can be maintained for
long.
3.3.2. Changes in market equilibrium conditions

The market equilibrium condition can only be disturbed if there are changes in
either the conditions of demand or the conditions of supply. In which case the
demand curve or supply curve will shift to the left or to the right, changing the
equilibrium price and quantity in the process.
a) Changes in Demand Conditions

If the demand curve shifts to the right, for example, due to a rise in consumer
income, the equilibrium price and quantity will increase while a shift of the demand
curve to the left will result in a decrease in equilibrium price and quantity.

Fig 3.11 Effect of changes in demand conditions on market equilibrium
Price S
P1
P0
D1
P2 D0
D2
O Q2 Q0 Q1 Quantity
b) Changes in Supply Conditions

A shift of the supply curve to the right, for example, as a result of an improvement
in the level of technology will reduce equilibrium price and increase the quantity
while a shift to the left increases the price and reduces the equilibrium quantity.
Fig 3.12 Effect of changes in supply conditions on market equilibrium

Price
S2
So
P2
P0 S1
P1
D
O Q2 Q1 Q0 Quantity
The government can offset movements towards the market equilibrium price by
imposing price controls or regulations.
Chapter 4

Demand and supply: policy analysis and
elasticity
4.0 Introduction
In the last chapter, we learnt that demand and supply are powerful tools in the
determination of price. Prices fulfill an allocative function in distributing scarce
goods between different users or consumers. The present chapter applies demand
and supply analysis to a number of practical cases, which are chosen to illustrate
the use of price theory and to give practice using it.
4.1 Price controls

Price control or regulations refers to the setting of an upper or lower limit on the
price at which a particular product can be bought or sold. An upper limit is a price
ceiling and a lower limit is referred to as a price floor.
The objectives of price controls include:
(i) To keep the prices of products at levels which can be afforded by most
people especially prices of basic goods such as cooking oil.
(ii) The maintenance of incomes of producers at higher levels than that which
would be produced by market forces, e.g. incomes of farmers.
(iii) To stabilize prices that is to control the persistent increase in the
general level o prices.
4.1.1 Price ceiling or maximum price

In October 2001, the government brought back price controls (ceilings) on basic
commodities such as bread, mealie-meal, cooking oil, soap and sugar. Those in
support of price ceilings argue that they ensure a minimum standard of living to the
majority poor who would afford to buy the basic commodities at the controlled
price than the market price. However those who oppose the policy argue that it
causes shortages.
Fig 4.1 The effect of a price ceiling

Price
P2 S maximum price
permitted
P0
P1 Shortage
0 Q2 Q0 Q1 Quantity
Although the equilibrium price is OP0, the government sets a maximum price of
OP1. At the maximum price OP1, the quantity demanded (OQ1 exceeds the quantity
supplied (OQ2) in other words, there is a shortage of the commodity.
Since the price is not allowed to rise above OP 1, there is no incentive to increase
quantity so as to reduce the shortage. Some suppliers may exit the industry causing
the supply curve to shift to the left thus the shortages might be even worse. On the
demand side, more of the commodity is consumed than if market prices were
charged.
To allocate the limited supply among the many buyers who want to purchase the
good, the government may resort to some form of rationing e.g. issuing ration
coupons. Frequently, black markets develop under these circumstances, and the
commodity is sold illegally at a price higher than the legal maximum. Black
marketers would buy OQ2 at the controlled price of OP1. They would sell at the
price OP2 which is even higher than the market price OP0.
4.1.2. Price floor or minimum price

A price floor has an opposite effect to that of a price ceiling. It is set at a level
above the equilibrium price below which it may not fall. The most common reason
for imposing a price floor is to guarantee some minimum income to the supplier of
the product. This is the reason why the government imposed price floors on

agriculture produce. Similarly, supporters of minimum wage legislation argue that
incomes of the poor are raised by introducing a floor below which wages may not
fall.
Fig 4.2 The effect of a price floor
S
Price Exceptional
Excess Supply
Pf Minimum price permitted
Pe
D
0 Qd Qe Qs Quantity
As is evident, the equilibrium price of the commodity is OP 2. Nonetheless, the
government sets a minimum price of OP f. At the minimum price, the quantity
supplied (OQs) exceeds the quantity demanded (OQd); in other words excess supply
will result.
Consider a minimum wage policy as an example of the minimum price. At the
market wage rate OPe, the level of employment is OQe. With the introduction of the
minimum wage at Pf, the demand for labour and the level of employment will fall
to OQd. The number of workers who are involuntarily unemployed is Q dQs,, that is
people who are willing to work in the industry but are not employed.
4.2 Excise tax

Excise tax is a tax levied on expenditure hence it’s a type of indirect taxes. It is
levied on goods such as alcohol, spirits and cigarettes. In this case, we will use
demand and supply analysis to demonstrate the incidence of such a tax as excise
tax. The term 'incidence of taxation' means the individual where the tax falls upon,
that is who is legally responsible for paying it. In the case of cigarettes, for

example, it can be shared between the producer and the consumer. Consumers
usually pay for the tax in the form of a higher price while producers pay in the form
of receiving a lower price. The distribution of the tax burden between the consumer
and the producer can be determined using demand and supply curves.
Fig 4.3. The incidence of an excise tax

Price $
St
$5 S
o
13
10 Consumer burden
8 Producer burden
$5 D
0 Quantity
Suppose that the market demand and supply curves for cigarettes are D and S 0
respectively, the equilibrium price will be $10 per packet. If the government were
to impose an excise tax of $5 per packet, this tax will be collected from the
producer hence the cost of production would increase by the same margin. The
supply curve will be shifted upward by the amount of the tax, from S0 to St.
The post-tax price will be $13 per packet - an increase of $3 over its pretax level.
Consequently, in this case, $3 of the tax is passed on to consumers, who pay $3
more for a packet of cigarettes. And $2 of the tax is swallowed by the producer,
who receives $8 per packet after paying the tax. Therefore the incidence of this tax
is such that consumers pay $3 per packet while producers pay $2 per packet of
cigarettes.
But, is it always true that producers pass part of the tax on to consumers and absorb
the rest themselves? On the contrary, in some cases, consumers may bear almost
none of the tax (and producers may bear practically all of it). The result will depend

on how sensitive the quantity demanded and the quantity supplied are to the price
of the commodity - For example, holding the supply curve constant, the less
sensitive the quantity demanded is to the price of the good, the bigger the portion of
the tax that that is shifted to consumers.
Fig 4.4 Elasticity of demand and the incidence of a tax

Price
St
S
P2
P1
P0
D1
D2
0 Quantity
Before tax the price is OP0 regardless of whether D1 or D2 is the demand curve.
After the tax, the equilibrium price is OP1 if the demand curve is D1, or OP2 if the
demand curve is D2. Clearly the increase in the price to the consumer is greater if
the quantity demanded is less sensitive to price (D2) than if it is more sensitive (D1).
On the other hand, holding the demand curve constant, the less sensitive the
quantity supplied is to the price of the good, the bigger the portion of the tax that is
absorbed by producers.
4.3. Elasticity of demand

From the analysis of the effects on price of an excise tax, we noted that market
demand curves vary in the sensitivity or responsiveness of quantity demanded to
price. The sensitivity or responsiveness to change is what is generally termed
elasticity. Elasticity of demand refers to the responsiveness or sensitivity of
quantity demanded to changes in:

a) price of the commodity,
b) household disposable income and,
c) prices of other related commodities.
It is from this description that we have the following distinct types of elasticity of
demand.
4.3.1. Price Elasticity of Demand (PED)

Price elasticity of demand (PED) measures the degree of responsiveness of the
quantity demanded of a commodity to changes in its price. PED is designed to be
the percentage change in quantity demanded resulting from one percent change in
price. Economists measure PED by the coefficient Ed in this price elasticity
formula.
Ed = % change in quantity demanded

% change in price
= (Q1 – Q0) x P0
(P1 – P0) Q0
We know from the down sloping demand curve that price and quantity demanded
are inversely related. This means that the price elasticity coefficient of demand will
always be negative for normal goods. Economists usually ignore the minus sign
and simply present the absolute value of the coefficient.
Example
Calculate the price elasticity of demand when a change in price from $400
to $350 lead to an increase in quantity demanded from 800 to 1000 units.
The original P = $400 and change in P = 350 - 400 = -50
The original Q = 800 and change in Q = 1000 - 800 = 200
Ed = 200 x 400
-50 800

= -2
However the coefficient of elasticity is a ratio and the following are important
concerning its implications. If:-
1. Ratio is greater that 1, demand is elastic (Ed >1)
2. Ratio is equal to 1 (Ed = 1) demand has unit elasticity (unitary elasticity)
3. Ratio is less than 1 (O< Ed <1) demand is inelastic.
4. Ratio is O (Ed = o) demand is perfectly inelastic.
5. Ratio is infinite demand is perfectly elastic.
These ratios can be represented on diagrams as follows: -
Fig 4.5 Representations of the different elasticties of demand
Price 1) Ed>1 Price 2) Ed=1
P0
P1
D
D
0 Q0 Q1 Quantity 0 Quantity
Price 3) Ed>1 Price 4) Ed=1
D
Po P0
P1 P1 D
0 Q0 Q1 Quantity 0 Q0 Qty 0 Q0 Q1
Demand curves are unlikely to have the same elasticity throughout except were
demand curves have unit elasticity, perfectly inelastic or perfectly elastic.

Normally, on any demand curve, elasticity of demand will be different at different
prices as follows
Fig 4.6 Elasticity along a demand curve

Price
A Elastic demand
Unitary demand
B
Inelastic demand
0 C Quantity
The value of elasticity decreases from infinite at point A through unitary at point B
to zero at point C. Whether demand for a product is elastic or not will depend on:
(a) Availability of substitutes at the ruling price
The greater the number of substitutes available for a product, the greater
will be its elasticity of demand. Also the closer the substitutes are, the
greater the elasticity of demand. For example, demand for products like salt
and insulin which has no close substitutes is relatively inelastic while
demand for margarine which has butter or jam as substitutes tend to be
elastic.
(b) The proportion of income spent on the product
Demand for goods on which a small proportion of income is spent e.g.
match boxes tend to be inelastic while demand for those goods where a
larger proportion of income is spent tend to be elastic. Thus the greater the
proportion of income which the price of the product represents, the more
elastic the demand will tend to be.
(c) Addiction or habit forming

Where a product is habit forming e.g. alcohol or cigarettes, this will tend to
reduce its elasticity of demand. In extreme cases of addition demand may
become perfectly inelastic.
(d) Necessities and luxuries
Demand for luxuries tends to be elastic while that for necessities tend to be
inelastic. Necessities are those goods which people can not do without and
at the same time can not increase consumption even if price falls. For
example, a family which eats three loaves of bread every morning will have
to get the same amount in both the event of a price rise and a price fall.
Luxuries are goods that people can do without and hence a rise in price may
mean that people cut consumption.
4.3.2. Income Elasticity of Demand (YED)

Income elasticity of demand (YED) measures the degree of responsiveness of the
quantity demanded of a product to changes in consumer disposable income. The
value of income elasticity can be calculated by the following formula.
YED = % change in quantity demanded
% change in income
= (Q1 – Q0 ) x Y
(Y1 – Y0 ) Q
Categories of income elasticity of demand
These depend on whether goods are normal or inferior.
(a) Positive Income Elasticity (YED>O)
As income increases, demand also increases while decreasing income lead
to a decreasing demand. This positive relationship shows that the
commodity under consideration is a normal or superior good.
(b) Zero or near zero income elasticity (YED = 0)
In this case, the quantity demanded of a commodity remains constant as
income changes. This is typical of basic goods such as salt and cooking oil.
(c) Negative income elasticity (YED <0)

In this case demand falls with a rise in income. The inverse relationship
between income and quantity demanded shows that the good in question is
an inferior good e.g. black and white TV.
4.3.3. Cross Elasticity of Demand (CED)

Cross elasticity of demand measures the degree of responsiveness of the quantity
demanded of one good A to changes in the price of another good B. It is given by
the formula.
CED = %change in quantity demanded of A
%change in price of B
A positive value shows that the demand for good A rises with a rise in the price of
B and indicates that the two goods are substitutes. A negative value indicates that
the two goods are complements. A zero value indicates that a change in the price of
commodity B will not affect the quantity demanded of commodity A showing that
the goods are not related.
Table 4.1 Summary of the coefficients of elasticity
Terminology Value Verbal description

Price elasticity of demand
Perfectly inelastic Zero Quantity demanded does not change
as price changes
Inelastic Greater than zero but less Quantity demanded changes by a
than one smaller percentage than does price
Unit elasticity PED = 1 Quantity demanded changes by the
same percentage as price
Elastic 1<PED< infinite Quantity demanded changes by larger
percentage than does price
Perfectly elastic PED = Infinite Buyers are prepared to buy all they
can at some price none at any other
price.

Income elasticity of demand
Inferior good YED < 0 Quantity demanded decreases as
income increases
Normal good YED > 0 Quantity demanded increases as
income increases
Cross elasticity of demand
Substitute Positive
Complement Negative
4.3.4 Application of elasticity of demand concepts

a) Price elasticity of demand and the business person
If a firm faces an inelastic demand curve, then pushing up price will always
increase total revenue. Total revenue (TR) or total sales is the amount of money
received from the sale of an output. It is given by price multiplied by quantity (TR
= P x Q).
Fig 4.7 Revenue maximization for inelastic demand

Price
P1
A
P0
B
D
0 Q1 Q0 Quantity
If price is increased from P0 to P1, rectangle B shows the revenue that has been
given up by increasing the price and rectangle A is the revenue gained. Rectangle A
greatly outweigh rectangle B, therefore if demand is inelastic a higher price must be
charged in order to maximise the total revenue.
Conversely, if demand is elastic, then lowering the price will increase total revenue.
Fig 4.8 Revenue maximization for elastic demand

Price
P0
A
P1 D
B
0 Q0 Q1 Quantity
If demand is elastic, total revenue increases as price falls. Rectangle A will be
given up and rectangle B will be gained if price is reduced from P 0 to P1. Thus if
demand is elastic, reduce the price in order to maximise total revenue.
b) Price elasticity of demand and government policy

Government levies indirect taxes such as value added tax (VAT) and excise duty on
expenditure in order to raise revenue. To maximize on revenue collected the
government should levy a low tax on goods with elastic demand while laying a
high tax on goods with inelastic demand such as alcohol and cigarettes.
c) Price elasticity of demand and monopoly price discrimination

A discriminating monopolist will maximise total revenue by charging high price in
the market where demand is inelastic and a low price in the market where demand
is elastic. For instance, ZESA tariffs in high and low density residential areas or
cell phone peak and off peak call charges.
d) Importance of income elasticity of demand

Income elasticity is used when firms are producing or stocking during business
cycles. Business cycles refer to the fluctuations in economic activities through
periods of peak, recession, depression, recovery, peak and so on. Superior goods
will be produced during recovery and peak periods when real incomes rise while

inferior goods are produced during recession and depression periods when real
incomes will be decreasing.
4.5 Price elasticity of supply

Elasticity of supply measures the degree of responsiveness of quantity supplied to
changes in price. It is the relationship between the proportionate change in price
and the associated proportionate change in price and the associated proportionate
change in quantity supplied. The value of elasticity of supply can be calculated by
the formula.
Es = %change in the quantity supplied

%change in price
4.4.1. Classification of the coefficient of elasticity of supply

(a) Where the proportionate change in quantity supplied is greater than the
proportionate change in price, then supply is elastic.
(b) Where the proportionate change in quantity supplied is less than the
proportionate change in price, then, supply is inelastic.
(c) Where the quantity supplied does not change as price changes, supply is
perfectly inelastic.
(d) Where the quantity supplied is infinity then supply is perfectly elastic.
(e) Where the quantity supplied changes by the same proportionate as does
proportionate change in price, then supply has unitary elasticity.
Graphically, any straight-line supply curve that meets the vertical axis will be
elastic and its coefficient of elasticity value will be between one and infinity. A
straight-line supply curve that meets the horizontal axis will be inelastic and its
coefficient of elasticity value will lie between zero and one. Any straight-line
supply curve through the origin will have unitary elasticity.
Fig 4.9 Diagrammatic representations of elasticity of supply

Price (a) Elastic supply Price (b) Inelastic supply
S S
0 Quantity 0 Quantity
Price (c) Perfectly Inelastic Price (d) Perfectly elastic

S
S
0 Quantity 0 Quantity
Price (e) Unitary elastic supply
0 Quantity
4.4.2. Determinants of elasticity of supply

a) Elasticity of supply tends to increase with time. In the immediate market period
or momentary period, there is insufficient time to change output and so supply
is perfectly inelastic. In the short-run, plant capacity is fixed but output can be
altered by adding increasing amounts of variable factors. Therefore supply is
elastic. In the long run, all desired adjustments including changes in plant
capacity can be made and supply becomes still more elastic.

b) The higher the factor mobility, the greater will be the elasticity of supply. That
is the ease at which factors or production can be moved from one use to another
affect elasticity of supply.
c) The more willing entrepreneurs are to take risks, the greater will be the
elasticity of supply.
d) Where suppliers are holding large stocks supply will be elastic.
e) Natural constraints such as drought place restrictions on the elasticity of supply.
4.5 Consumer and producer surplus

Consumer surplus is the difference between what a consumer is willing to pay for a
bundle of goods and what he actually pays, which is less. In other words, it is a
saving for the consumer. Consider the following example that shows the price a
consumer is willing to pay for each successive unit of a good.
Table 4.2 Price schedule

Unit 1st 2nd 3rd 4th 5th
Price $10 $8 $6 $5 $2
Suppose he buys 4 units. He is willing to pay $10 for the first, $8 for the second,
$6 for the third and $5 for the fourth. In total he is willing to pay $29. But when
he buys all units at once, he pays only $5 for each unit. This comes to $20. The
difference of $9, which he does not pay, is consumer surplus.
Consumer surplus represents welfare gain for consumers because it represents
satisfaction gained without having to pay for it. Refer to the following diagram:
Fig 4.10 Consumer surplus
Price
A

D
P1
O Q1 Quantity Demanded
For the quantity OQ1, the consumer was willing to pay ABQ1O. But he pays only
P1BQ1O. Therefore he saves paying ABP 1. When demand for a good is inelastic,
the consumer surplus becomes greater.
The producer surplus is the payment made for any product over and above that,
which is necessary for the supplier to supply the product.
Fig 4.11 Producer surplus
Price S
D
A C
B
D
0 Q0 Quantity
The producer surplus is represented by the shaded triangle ABC.
Maximum prices increase the consumer surplus while minimum prices increase the
producer surplus. Thus maximum prices benefit consumers while minimum prices
benefit producers.

Chapter 5
Theory of consumer behaviour
5.0 Introduction
Consumer behaviour is concerned with the way individuals or consumers behave
when faced with the problem of scarcity. That is, it assesses how individuals try to
maximise their levels of satisfaction using limited resources that they have at their
disposal. The theory is the basis of explaining the law of demand, that is, why the
demand curve is downward sloping or why people buy more at a lower price than a
higher price. In this chapter we are going to outline the two approaches to
consumer behaviour, namely cardinalist approach (marginal utility theory) and the
ordinalist approach (indifference curve analysis). A downward sloping demand
curve will be constructed using each approach as an illustration of why the demand
curve slopes downward from left to right.
5.1 The marginal utility theory of demand
5.1.1. Assumptions
a) Utility can be measured using cardinal numbers. A consumer can be said to derive
10 utils of satisfaction from the first drink, 8 utils from the second and so on. As a
result the theory is also referred to as the cardinalist approach to consumer
behaviour.
b) The consumer is rational, that is, the consumer would want to maximise total
utility, given the level of prices and income. This eliminates monomania which is
behaviour when a consumer spends all his income on one product. A rational
consumer will seek to spread his income over a variety of products in a manner that
gives him the greatest amount of satisfaction.
5.1.2. Definitions
 Utility is the satisfaction people get from consuming (using) a good or a

service. It is subjective that is it depends on the consumer. For example, one

consumer may derive satisfaction from smoking a cigarette while another
person can develop a headache from cigarette smoke. Utility also differs with
situations. An ice cold glass of water can be more satisfying when it is very hot
but the same glass of water may yield less satisfaction when it is very cold.
 Total utility is the sum of the utilities derived from all units consumed.
 Marginal utility is the additional satisfaction people get from consuming an
extra unit of a good. Marginal utility declines as more and more units of the
same commodity are consumed. This is the law of diminishing marginal
utility. The law of diminishing marginal utility states that as more and more
units of the same commodity are consumed, a consumer derives less
satisfaction from an additional unit of the commodity consumed than the
previous unit.
Following is a table and graph of the utilities an individual derives from drinking
Coca-Cola at a birthday party.
Table 5.1 Total utility and marginal utility
Quantity Consumed Total Utility Marginal Utility

0 0 -
1 10 10
2 16 6
3 20 4
4 22 2
5 22 0
6 20 -2
The relationship between total utility and marginal utility as consumption increases
can be reflected on the following diagram.
Total Utility
+ relationship between total utility and marginal utility
Fig 5.1 The
Utility
0
Dembure Page 45 Quantity Consumed ©2005
-
Marginal Utility
5.1.3. The Utility Maximising Combination of Goods
The consumer who aims to maximise his utility will arrange his expenditure so that
he derives the same utility from the last dollar spent on each good. This is
ordinarily referred to as “value for money” in everyday language. This is achieved
when ratio of the MU of the last unit consumed to the price of one good is equal to
the same ratio of another good.
MUA = MUB
PA PB
This is the principle of equi-marginal utility
Example
Consider a woman with a budget of $100 and wants to spend it on apples (A) and
bananas (B). The price of an apple is $20 and that of a banana is $10. If the
woman’s preferences are given in the table, the utility maximising combination of
apples and bananas that exhaust her budget can be obtained as follows:
Table 5.2 Utilities derived from the consumption of bananas and apples
Quantity of Apples MUA MUA Quantity of Bananas MUB
MUA PA=20 PA=10 MUB PB= 10

1 100 5 10 4 40 4
2 60 3 6 5 35 3.5
3 40 2 4 6 30 3
4 30 1.5 3 7 20 2
5 20 1 2 8 10 1
6 10 0.5 1 9 0 0
The woman would consume 2 apples and 6 bananas if the price of an apple is $20
and that of a banana is $10. If the price of an apple is reduced to $10, the woman
would increase her consumption of apples from 2 apples to 4 apples, while her
expenditure on bananas is constant.
The woman’s expenditure on apples at the two prices can be represented on the
demand schedule and curve.
Table 5.3 Demand schedule for the woman
Price of Apples Quantity Demanded

20 2
10 4
Fig 5.2 Demand curve for the woman

Price of apple
P1= 20 --------------- B

P2= 10 ------------------------------------- A
D
Quantity Demanded
O Q1 =2 Q2 = 4
The demand schedule and curve shows the amount of a good one or more
consumers are willing and able to buy at different prices.
5.2. The indifference curve analysis

In the 1930’s, a group of economists came to believe that cardinal measurement of
utility was not necessary. Consumer behaviour could be explained using ordinal
numbers. This is because individuals are able to rank their preferences into first,
second, third and so on. They preferred an ordinalist approach to measurement of
satisfaction. As a result, this theory of consumer behaviour is also referred to as the
ordinalist approach to consumer behaviour.
5.2.1 Indifference curves: What is preferred?

An indifferent curve represents all combinations or bundles of two commodities
that yield the same amount of satisfaction to the consumer. The consumer derives
the same amount of satisfaction from combinations of the two commodities along
an indifference curve. In this way, the consumer will be ‘indifferent’ between these
combinations. That is, the consumer can not prefer one combination to another
simply because he gets the same amount of satisfaction. He can have any of those
combinations on the curve.
Assumptions
a) The consumer buys only two goods, X and Y.
b) The consumer is rational, that is, given an income and a set of prices the
consumer would aim to maximise total utility.
c) The consumer is consistent and transitive in his choice. Given three bundles of
commodities X and Y and the consumer prefers bundle A to B, there will be no

time when the same consumer will prefer B to A (consistency). If the consumer
prefers bundle A to B and B to C, the same consumer will prefer bundle A to C
(transitivity).
d) The consumer always prefer more of a commodity to less (more is better).
Fig 5.3 An indiffence curve
Qty of good X
A
X1
X2 B
Indifference Curve
O Y1 Y2 Quantity of good Y
Quantity o
The consumer derives the same utility from consuming bundle A or B. As a result
he is indifferent between the two bundles A and B. indifference curves have the
following characteristics:
a) They slope downward from left to right.
b) They are convex to the origin.
c) The slope of an indifference curve measures the rate of exchange of X for Y
along the curve (marginal rate of substitution). As more units of good X are
exchanged for additional units of good Y the consumer will prefer to have a
greater amount of good Y to compensate for each unit of good X traded.
d) Different indifference curves constructed on the same plane gives what is
known as an indifference map. On an indifference map, indifference curves to
the right entails a higher level of utility and are preferable. They represent
higher combinations of the two goods and hence more is better.
e) Indifference curves do not cross each other.

5.2.2 The Budget line: What Is Attainable
A budget line shows all the combinations of two commodities which can be
purchased with a given money income. Assuming that a consumer must spend all
of his income on one or two goods X and Y, it will be evident that
QxPx + QyPy = Incomewhere: -
Qx = amount of good X the consumer buys
Qy = amount of good Y the consumer buys
Px = price of good X
Py = price of good Y
This is an equation of a straight line, which can be represented by the following
graph.
Fig 5.4 The budget line

Qty of good X
* Unattainable
* Attainable
O Quantity of good Y
Points outside the budget line, that is, points to the right of the boundary represent
combinations of the two goods that are not affordable given the consumer’ s
income. On the other hand, points inside the boundary are attainable but the
consumer will not be spending all his income. Only points along the boundary
represent combinations of the two goods when the consumer is spending all his
income. Thus the location of the budget line varies with money income and price
levels. Any changes in money income and or prices will change the position of the
budget line.

A change in money income will shift the budget line while a change in price of one
good will pivot the budget line while it remains anchored on the axis of the good
whose price is held constant as illustrated below.
Fig 5.5
a) Increase in Income b) Fall in the price of Good Y
Qty of X Qty of X
O Quantity of Y O Quantity of Y
5.2.3. The Equilibrium of the Consumer
Not all preferred bundles are attainable. Equilibrium will be at the point where the
budget line is tangent to the highest attainable indifference curve
Fig 5.6 Consumer equilibrium
Qty of
Good X
IC3
Dembure Page 51 IC2 ©2005
IC1
Xe E
O Ye Quantity of Good Y
Consumer equilibrium is at point E where Ye units of good Y and Xe units of good
X are consumed. At point E the budget line is tangent to the indifference curve IC2
5.6.3. The derivation of the demand curve

A fall in the price of good Y from P A to PB will cause the budget line to pivot
outward (to the right). Tangency of the budget line will change from being tangent
to indifference curve IC2 to tangent to indifference curve IC3. Consumer
equilibrium will change from point E to E 1 indicating that quantity demanded of
good Y will increase from Ye to Y1.
E1
IC3
IC2
IC1
O Ye Y1 L1 Quantity of Good Y
Fig 5.7 Derivation of a downward sloping demand curve
Quantity of
Good X
Xe E
Demand Curve
O Ye Y1 Quantity of Good Y
Price of good Y
PA
PB
Following the fall in the price of good Y, the quantity demanded of good Y has
increased from Ye to Y1. This implies an inverse relationship between price and
quantity demanded.
Chapter 6
Theory of production
6.0 Introduction
In these remaining sections of microeconomics we are going to examine the
behaviour of firms when allocating their scarce resources towards alternative uses.
What is a firm? Put briefly, a firm is a unit that produce a good or service for sale.

Economists generally assume that firms attempt to maximize profits. However,
firms may have alternative objectives such as sales maximization; the provision of
a service e.g. sports clubs and, establishing a status quo.
6.1 Production defined

Production is the process during which factors of production are combined and
transformed into goods and services. It is the result of making use of the resources
(always in relatively limited supply) available to man for the purpose of supplying
him with goods and services for the satisfaction of his needs and wants.
6.2 Factors of production

Anything, which plays a part in production and makes a contribution to the final
product, is a factor of production. Factors of production are:
(a) Land which refers to all the resources of nature or anything that if God
given. "By land is mean the material and the forces which nature gives
freely for man's aid, in land and water, air and light and heat", Alfred
Marshall.
(b) Labour is all human effort whether of hand or mind, which is undertaken
for a reward.
(c) Capital is all goods, other than land which is used in the production of other
goods. Capital is a result of past labour and for this reason; it is sometimes
referred to as "crystallized labour".
(d) Organisation or entrepreneurship involves the skill and effort put into the
running of a firm. It embodies the acceptance of risks that arise because of
uncertainty.
6.3 Variable and fixed factor inputs

In production, factors of production are the inputs. Input is defined as anything that
a firm uses in its production process. Inputs can be divided into two categories:
fixed inputs and variable inputs. A fixed input is an input whose quantity cannot be
changed during the period of time under consideration. The firm's plant and

equipment are examples of fixed inputs. On the other hand, a variable input is an
input whose quantity can be changed during the relevant period e.g. raw materials,
labour and energy.
6.4 Short run and long run production periods

Whether or not an input is regarded as variable or fixed depends on the length of
the period under consideration. The longer the period, the more inputs are variable,
not fixed. Economists focus on two time period: the short run and the long run. The
short run is defined to be that period of time which some of the firm's inputs are
fixed. More specifically, it is the period of time in which a firm must consider some
inputs absolutely fixed in making its decisions. Therefore in the short run, firms can
only increase output by increasing the input of variable factors. On the other hand,
the long run is that period of time in which all inputs are variable. In the long run,
the firm can make a complete adjustment to any change in its environment. Thus in
the long run, a firm can consider all of its inputs to be variable when making its
decisions.
6.5 Production in the short run

In the short run, the production decision is constrained by the fact that at least one
input is fixed in supply while the other inputs can be varied. By definition, in the
short run, the firm can change its output by adding variable resources to a fixed
plant. But how does output change as more and more variable inputs are added to a
fixed factor? The answer is provided by the law of diminishing marginal returns.
6.5.1 The law of diminishing marginal returns

The law describes what happens to total output when more units of the variable
factors are added to a given quantity of the fixed factor. It states that 'if increasing
quantities of one factor of production which is variable are used in conjunction with
a quantity of other factors which are fixed, after a certain point is reached each
successive unit of the variable factor added to the whole will make a smaller and
smaller contribution to the total product". Put very briefly, this law simply states

that 'as successive units of a variable resource e.g. labour are added to a fixed
resource e.g. land, beyond some point, the extra or additional product (output)
contributed by each additional unit of the variable resource will decline, that is, the
marginal product will diminish.
Example
The following table summarises the output from the employment of labour on a
fixed piece of land. It illustrates that beyond 3 units of labour, the marginal product
of labour decreases, that is, diminishing marginal returns set in after the third unit
of labour is employed.
Table 6.1 TP, AP and MP
Inputs of variable Total Product Average Product Marginal Product
factor – (Labour) (TP) (AP) (MP)
0 0.00 - -
1 6.00 6.00 6.00
2 13.50 6.75 7.50
3 21.00 7.00 7.50
4 28.00 7.00 7.00
5 34.00 6.80 6.00
6 38.00 6.30 4.00
7 38.00 5.40 0.00
8 37.00 4.60 -1.00
The average product (AP) of an input is total product divided by the amount of the
input used to produce this amount of output. That is average product is output per
unit of the variable factor (in this case, called labour productivity).
The marginal product of an input is the addition to total output due to the addition
of the last unit of the input, when the amounts of other inputs used are held
constant. Marginal product shows the change in total output associated with each
additional input of labour.
The relationship between total product and amount of labour used on a piece of
land in the above table can be shown on the following graph.
Fig 6.1 The total product curve

Total Product
40
30
20 Total Product
10
0 2 4 6 8 10
Amount of Labour
The diagram shows that, as a variable factor (labour) is added to fixed amounts of
the fixed factor (land) the resulting total product will eventually increase by
diminishing amounts, reach a maximum and then decline.
From the previous table, it can be noted that marginal product exceeds average
product when the latter is increasing, equals average product when the latter
reaches a maximum, and is less than average product when the latter is decreasing.
This is simply a matter of arithmetic: If the addition to a total is greater (less) than
the average, the average is bound to increase (decrease). This relationship can be
illustrated in the following graph.
Fig 6.2 The relationship between AP and MP

AP / MP
8
7
6 .
5 Average Product
4

3
2
1 Marginal product
0 1 2 3 4 5 6 7 8
Units of labour
The marginal product intersects average product at the maximum average product.
When average product is increasing, marginal product is greater than average
product. When average is decreasing, marginal product is less than average. When
average product is at a maximum, marginal product equals average product.
“If diminishing returns do not occur, the world could be fed out of a flowerpot”
McConnel and Brue. Several things should be noted concerning the law of
diminishing marginal returns.
(a) The law is an empirical generalization, not a deduction from physical or
biological laws.
(b) It is assumed that technology remains fixed. The law of diminishing marginal
returns cannot predict the effect of an additional unit of input when
technology is allowed to change.
(c) It is assumed that there is at least one input whose quantity is being held
constant. The law of diminishing marginal returns does not apply to cases
where there is a proportional increase in all inputs. That is it only applies in
the short run.
(d) The law assumes that all units of variable inputs are of equal quality.
Therefore marginal product ultimately diminishes not because successive
units of the variable input are incompetent but because more of the variable
input is being used relative to the amount of fixed inputs available.
6.6 Production in the long run

We now consider the long run situation in which all inputs are variable. By
definition long run is a variable plant time period. What will happen to output if the
firm increases the amount of all input by the same proportion? This is an important

question, the answer to which help to determine whether firms of certain sizes can
survive in the industry. In other words, long run decisions are important because
today's variable factors are tomorrow's equipped plant will have many alternatives
from which to choose, but once installed the capital is fixed for a long time. If the
firm errs now, its very survival may be threatened.
6.6.1 Returns to scale

To repeat, what will happen to output if the firm increases the amount of all inputs
by the same proportion? Clearly, there are three possibilities: -
(a) Output my increase by a larger proportion than each of the inputs. For
example, a doubling of all inputs may lead to more than a doubling of output.
This is a case of increasing returns to scale.
(b) Output may increase by a smaller proportion than each of the inputs. For
example a doubling of all inputs may lead to less than a doubling of output.
This is the case of decreasing returns to scale.
(c) Output may increase by exactly the same proportion as the inputs. For
example a doubling of all inputs may lead to a doubling of output. This is the
case of constant returns to scale.
6.6.2 Economies and diseconomies of scale

The returns to scale can sometimes be identified as economies and diseconomies of
scale. When a firm is experiencing increasing returns to scale, it is said to be
enjoying economies of scale. While a firm experiencing decreasing returns to scale
will be enjoying diseconomies of scale.
(a) Economies of scale
Economies of scale refer to the advantages of an increased plant size or
benefits of producing on a larger scale. They exist when the expansion of a
firm or industry allows the product to be produced at a lower average cost.
Economies of scale occur within a firm (internal) or outside the firm as a
result its location (external). Internal economies are those benefits obtained

within a firm when it expands its capacity. On the other hand, external
economies are those benefits gained when the industry as a whole expand.
i. Internal economies of scale
These are made within a firm as a result of its expansion in production. As
the firm produces more and more units of output, so average cost begin to
fall because of:
 Technical economies made in the actual production of the good e.g.
large firms can use expensive machinery intensively.
 Managerial economies made in the administration of a large firm by
splitting up management jobs and employing specialist accountants,
salesmen etc.
 Financial economies made by borrowing money at lower rates of
interest than smaller firms borrow.
 Marketing economies made by spreading the high cost of advertising
on television and in national newspapers, across a large level of
output.
 Commercial economies made when buying supplies in bulk and
therefore receiving quantity discounts.
 Research and development economies made when developing new
and better products.
 Risk bearing economies made when diversifying into different
products and markets.
ii. External economies of scale
These are economies made outside the firm as a result of its location and
occur when:
 A local skilled labour force locates in the area.
 An area develop good infrastructure e.g. roads and communications
network.
 Ancillary services can be provided e.g. banking, food courts etc
 Subcontracting of specialist services e.g. photocopying
 By-products can be used as inputs by other firms

b) Diseconomies of scale
There is an optimal level of expansion in the size of a firm or industry
beyond which the firm will suffer diseconomies of scale as represented by a
rise in its long run average costs. Diseconomies of scale refer to the
increase in average cost that comes as a result of the firm producing on a
large scale.
i. Internal diseconomies of scale
These occur when the firm has become too large and inefficient. As the
firm increases production, eventually average costs begin to rise because: -
 The disadvantages of the division of labour and specialisation such
as increased boredom from repeating the same task may start to take
effect.
 Management becomes out of touch with the shop floor because of
the enlarged work force and some machinery becomes over-manned.
 Decisions are not taken quickly due to consulting and there is too
much form filling.
 Lack of communication or double communication in a large firm
means that management tasks sometimes get done twice.
 Poor labour relations may develop in large companies ( low morale
of workers , that is, workers not feeling to be part of the
organisation)
 Dissatisfied customers due to poor customer service
ii. External Diseconomies of Scale
These occur when too many firms have located in one area. Unit costs
begin to rise because: -
 Skilled labour becomes scarcer and firms have to offer higher wages
to attract new workers.
 Local roads become congested and so transport costs begin to rise
(externalities).
 High input prices as firms compete for the scarce inputs.

6.6.3. Economies of scale and returns to scale
In our discussion, we associated economies of scale to returns to scale. An
advanced analysis would however make a distinction between the two. Economies
of scale reduce the unit cost of production as the scale of production increases.
Returns to scale are concerned with physical input and output relationships.
Generally, increasing returns to scale should result in decreasing costs and
decreasing returns to scale should result in increasing costs. Returns to scale refer
to the long run physical output of factors of production or inputs. Conversely
economies of scale refer to long run money costs of production. If physical output
increases more than proportionately as the scale of all the inputs is changed,
increasing returns to scale occur. Increasing returns to scale contribute to
economies of scale (in the form of technical economies) but some economies of
scale are not explained by increasing returns to scale e.g. commercial economies of
scale.
6.7. Size and growth of firms
It is the objective of many firms to grow and expand their size or scale of
operations. The major reason for this growth is the expansion of the market share
which is directly related to profitability.
6.7.1. Ways of measuring the size of a firm

The size of a firm can be measured using at least one of the following indicators
a. Number of workers employed.
b. Capital employed.
c. Value of assets.
d. Market share.
e. Profit before tax.
f. Turnover or sales.
6.7.2. Reasons for the growth of firms

Large size leads to economies of scale which makes a firm more competitive and
have better chances of survival through: -
a. A large market share.
b. The firm can borrow money cheaply.
c. Goodwill.
d. Spreading risks.
e. Diversification.
f. Influencing government on issues relating to business through advocacy.
g. Directors may seek power and status that come from being in charge of a
large firm.
6.7.3. Methods of growth of firms

Firms can either grow through internal expansion or external expansion
i. Internal expansion
Through internal expansion, a firm can grow through: -
a. Producing and selling more of its current products in its existing
market.
b. Selling current products to new markets.
c. Making and selling new products.
However it may be important to note that internal expansion allows firms to
grow rather slowly.
ii. External expansion or integration

Integration occurs when two firms join together to form one new company.
Integration can be voluntary (a merger) or forced (a take-over). A merger
takes place between companies through their agreement where they form a
joint venture and benefit from shared production, research and development
etc. On the other hand a take-over occurs when one company buys enough
shares of voting to allow it to take control of the other company.

There are three types of integration namely vertical integration, horizontal
integration and lateral integration.
a. Horizontal integration occurs between two firms in the same industry that are
at the same stage of production e.g. the merger of First Merchant Bank, Bard
Holdings and UDC into African Banking Corporation (ABC). The
advantages are that the new company will enjoy economies of scale and have
a larger market share.
b. Vertical integration occurs between companies in the same industry but
which are at different stages of production. Vertical integration can either be
backward or forward integration. Vertical backward integration occurs when
a company starts to control firms supplying it with its raw materials, that is,
moving back down the chain of production. For example, if BATA Shoe
Company integrates with South East Leather Tanners, a leather tanning
company in the Lowveld. Conversely, vertical forward integration occurs
where a company merges or take-over firms further along the chain of
production for example if BATA Shoe Company merges with Sole Trader, a
shoe retail shop.
c. Lateral Integration or conglomerate occurs when firms in different industries
merge. For example if BATA Shoe Company merges with Trust Academy,
an educational institution. Conglomerates have advantages in reduced risks
through diversification, good reputation and advocacy.
The three main types of integration: horizontal, vertical and lateral (conglomerate)
are illustrated below
Vertical backward integration
(South East Leather Tanners)
Horizontal BATA
BATA SHOE COMPANY
SHOE COMPANY Horizontal
Integration Integration

CONGLOMERATE
(Trust Academy)
Vertical forward integration

(Sole Trader)
1.6.7.4. Motives for integration
Recently in Zimbabwe particularly in the banking sector most firms has horizontal
integrated or at least made advances towards integration. There are a number of
reasons why firms may decide to integrate. Among them:
a. Integration increases the size and market share of the firm e.g. First Bank
Corporation and Zimbabwe Building Society into FBC Holdings.
b. One firm may need fewer workers, managers, or premises
(rationalisation).
c. Reduce competition by removing rivals e.g. United Bottlers and Punch
Bowel, which was producing RC Cola.
d. Integration allows firms to increase the range of products they
manufacture (diversification) e.g. First Bank Corporation and Zimbabwe
Reinsurance (ZIMRE) that led to the provision of banking and insurance
products.
e. Reducing risk, that is, if the firm is diversified it no longer has “all its eggs
in one basket”.

Chapter 7
Theory of costs
7.0 Introduction
In this chapter, we shall confine our attention to costs. We are going to discover
how costs are related to output. The theory of costs is concerned with all expenses
that a firm incurs during the production process and how these expenses are related.
We will consider costs under three main headings: total costs; average costs and
marginal costs.
7.1. Total Costs (TC)

During the production process, the firm combines fixed and variable factors to
produce its output. By definition fixed factor input remains constant as output is
increased while variable factor input changes in direct proportion to output. The
amount spent on producing a given amount of a product is called total cost (TC).
Total costs are found by adding together total variable costs (TVC) and total fixed
costs (TFC)
TC = TVC + TFC
7.7.1. Total Variable Costs (TVC)

Variable costs are incurred by the firm on the variable factor inputs such as raw
materials and labour. Larger volumes of output require larger variable factor input.
Thus variable costs vary in direct proportion to output. They are zero when output
is zero and rise directly with output e.g. wages paid to shop floor workers and the
cost of buying raw materials.
7.1.2 Total Fixed Costs (TFC)

Fixed costs are totally independent of output, that is, they do not vary with output.
Fixed costs have to be paid out even if the factory stops production; hence they are
the firm’s overheads. Fixed costs include rent paid for the use of premises and
interest paid on loans.

The relationship between TC, TVC and TFC can be illustrated using the following
hypothetical table and graph
Table 7.1 The relationship between TC, TVC and TFC
Units of output Total Fixed Costs Total Variable Costs Total Costs
0 100 0 100
1 100 90 190
2 100 170 270
3 100 240 340
4 100 300 400
5 100 370 470
6 100 450 550
7 100 540 640
8 100 650 750
Fig 7.1 The relationship between TC, TVC and TFC

Cost T.C
700 TVC
600
500
400
300
200
100 TFC
0 1 2 3 4 5 6 7 8 Output
The total cost curve and the total variable cost curve have the same shape, since
they differ by only a constant amount. Thus the total cost curve is simply the total
variable cost curve that has been shifted upward by the amount of the total fixed
costs.

7.2 Average Costs (AC)
Average cost refers to cost per unit of output, that is, total cost divided by output.
There are three average cost concepts corresponding to the three total cost
concepts: average fixed cost, average variable cost and average total cost.
7.2.1 Average Fixed Cost (AFC)

An average fixed cost is total fixed cost divided by output. The average fixed cost
declines with increases in output. Mathematically, the average fixed cost curve is a
rectangular hyperbola, that is, it is asymptotic to the output axis (it approaches the
output axis without ever cutting the axis). This is due to total fixed cost which is
held constant when output is increasing.
7.2.2 Average Variable Cost (AVC)

Average variable cost is total variable cost divided by output. At first, increases in
output result in decreases in average variable cost, beyond a point, they result in
higher average variable cost. Thus average variable costs declines initially, reaches
a minimum, and then increases again, giving them a graphical U-shape.
7.2.3 Average Total Cost (ATC)

The average total cost is total cost divided by output. The average total cost equals
the sum of average fixed cost and average variable cost. This we can state as: -
ATC = AFC + AVC
The relationship between ATC, AVC and AFC can be illustrated on the following
table and graph derived from hypothetical data on costs given above.
Table 7.2 The relationship between ATC, AVC and AFC

Output TFC TVC TC AFC AVC ATC
0 100 0 100 - - -
1 100 90 190 100 90 190

2 100 170 270 50 85 135
3 100 240 340 33 80 113
4 100 300 400 25 75 100
5 100 370 470 20 74 94
6 100 450 550 17 75 92
7 100 540 640 14 77 91
8 100 650 750 13 81 94
Fig 7.2 The relationship between ATC, AVC and AFC

Cost
200
150
ATV
100 AVC
50
AFC
0 1 2 3 4 5 6 7 8 Output
ATC is the vertical sum of AVC and AFC. AFC declines indefinitely since a given
amount of fixed costs is apportioned over a larger and larger output. AVC initially
falls because of increasing marginal returns but then rises because of diminishing
marginal returns.
7.3 Marginal Costs (MC)

The marginal cost is the addition to total cost resulting from the production of an
additional unit of output. In other words, marginal cost is the additional cost of
producing one more unit of output. It refers to the change in total cost that result s
from a change in output by one unit. Algebraically: MC = TC n - TCn - 1, that is,
change in total cost divided by change in output.

MC = Change in TVC + Change in TFC ---- (i)
Change in Q
But since change in TFC is zero (fixed costs being fixed)
Therefore MC = Change in TVC ---- (ii)

Change in Q
Moreover, if the price of the variable input is taken as given by the firm, change in
TVC = P (Change in V). Where change in V is the change in the quantity of the
variable input resulting from the increase of change in Q. Thus the marginal cost
equals.
MC = P Change in V = P 1 ---- (iii)

Change in Q MP
Thus, MC = P ------ (iv) where

MP
MP is the marginal product of the variable input. Since MP generally increases,

attains a maximum and declines with increase in output, it follows then that
marginal cost normally decreases, attains a minimum, and then increases. This
explains the fact that the marginal costs curve is a mirror reflection of the marginal
product curve.
Fig 7.3 The relationship between cost curves and productivity curves
MP
AP

AP
MP
O Units of labour
Costs MC
AVC
O Output
The marginal cost (MC) and average variables cost (AVC) curves are mirror
images of the marginal product (MP) and average product (AP) curves
respectively)
7.4 Short Run Average Costs (SRAC) and Long Run Average
Costs (LRAC)
Average costs can be divided into short run and long run average costs. Both SRAC
and LRAC are U-shaped. However the SRAC are narrow than the LRAC which are
open U-shaped. The SRAC is U-shaped due to the influence of the law of
diminishing marginal returns. While the LRAC is open U-shaped due to economic
and diseconomies of scale.
Fig 7.4 A comparison between SRAC and LRAC
Costs SRAC Costs LRAC
Increasing Diminishing Page 71 Economies Diseconomies

Dembure ©2005
returns to returns to scale of Scale of Scale
scale
0 Output 0 Output
The LRAC curve is downward sloping as a result of economies of scale and
upward sloping due to diseconomies of scale while increasing returns to scale
contribute to the falling portion of the SRAC and diminishing returns to scale
contribute to the upward sloping portion.
7.4.1 Derivation of the LRAC

The LRAC is a planning curve which envelopes various SRATC curves. It is
derived from the SRATC in the following way: -
Assume three plant sizes to which a firm can adjust in the long run to meet its
production requirements, that is, small medium and large plant as represented by
their short-run average total costs demoted by SRATC 1, SRATC2 and SRATC3
respectively. These can be shown on the following diagram.
Fig 7.5 The LRAC curve
Costs SRATC1 SRATC2 SRATC3

C2
LRAC

C1
O Q1 Q2 Q3 Output
The produce output Q1, the firm should use a small plant so as to incur minimum
cost. The plant size is represented by SRATC 1. To produce output Q2, the optimum
plant size is given on SRATC2. However it can use small plant to produce the same
output but will mean higher costs of production (C 2) than if it uses the medium
plant (SRATC2) where it incurs costs C1. The optimum plant size for Q3 is
SRATC3. Joining all these optimal points will give the LRAC curve.
It is important to note that long run is a planning horizon. While operating in the
short-run, the firm must continually be planning ahead and deciding its strategy in
the long run. Its decisions concerning the long run determine the sort of short run
position the firm will occupy in he future. Once a decision on the plant size is
made, the firm is confronted with a short run situation, since the type and size of
equipment is, to a considerable extent, frozen.
7.4.2 Technical progress

While we focus on the shape of the SRAC and the LRAC curves, it is also
important to consider the factors that may cause the shifting of the cost curves. The
major cause is changes in productivity. The productivity of workers depends upon
their innate abilities, cultural background, and levels of education and training
among other factors. Technology in the form of new machines and new production
techniques plays a pivotal role in utilizing existing skills. Technology enables a
firm to produce the same output with fewer inputs or a larger output with the same
inputs – which is another way of saying that it lowers production costs.

Chapter 8
Market structures
8.0 Introduction
In this chapter we will describe a structure or model as a simplified representation
of reality. A model abstracts from reality. A model abstracts from reality by
ignoring the finer details which are not essential to the purpose at hand. An
example is a scale model, which is a miniature of the actual structure of an object

being represented. Scale models are usually used in buildings e.g. architectural
models and maps. Models play a pedagogical role in that they are used as a device
for teaching individuals about the operation of complex systems. On the other
hand, they are an explanatory device since they are a vehicle for relating separate
objects and events in a logical manner. Market models seek to explain how firms
behave in terms of their pricing, output and other forms of non-price competition.
That is, the way in which various firms behave in either their output or pricing
decisions gives rise to different market models. Economists envision four relatively
distinct market situations: perfect competition, monopoly, monopolistic
competition and oligopoly. This classification is base largely on the number of
firms in the industry that supplies the product.
8.1 Objectives of firms

A firm is an entity that produces and sells a product or service to consumers. Firm’s
objectives help to develop theoretical generalisation about how firms behave.
Below are some of the objectives that firms may pursue:
a) To maximize profits where profit is what remains from the firm’s total
revenue (TR) after it has covered all its costs (TC) that is π = TR – TC.
b) Sales revenue maximization especially as viewed by managers who receive
incentives related to their sales performance e.g. sales managers paid on
commission
c) To provide a service e.g. non governmental organisations (NGO)
d) To establish a status quo e.g. some politicians or retirees who may want
to keep themselves doing something.
e) To increase the market share or achieve a certain growth rate.
There are various theories on the above objectives of firms which can be outlined
briefly as follows:
8.1.1 The traditional theory

The theory was based on the assumption that firms will seek to maximise their
profit, that is, they not only attempt to make a profit but attempt to make the last
dollar of profit possible.
8.1.2 The managerial theory

The theory takes as its starting point the split between shareholders as owners and
managers as decision-makers in large modern business corporations. It is argued
that managers aim to maximise managerial objectives such as sales, growth and
managerial career prospects rather than shareholders profits. This often results in
agency problems, that is conflict between shareholder interests and management
interests
8.1.3 Organisational theory

The firm is viewed as an organisation or coalition of different groups such as
managers, shareholders, employees, customers and suppliers. The firm is a satisfier
rather than a maximiser, attempting to satisfy the aspirations of the groups that
make up the coalition. It ensures a satisfactory level of sales, profits, wages or
quality of products sought.
8.2 Competitive versus imperfectly competitive markets

The distinction between perfectly competitive and imperfectly competitive markets
can be made on the basis of;
a. The number of competitors participating in
the market.
b. The ability of new firms to enter the market
(or the presence of entry barriers).
c. The type of product being produced.
d. Information and knowledge on the conditions
of the market.
On these four features, the four distinct market structures can be distinguished as
summarised in the following table:

Table 8.1 Characteristics of the different market structures
MARKET STRUCTURE
Perfect Monopolistic Oligopoly Monopoly
FEATURE
Competition Competition
Number of firms A very large Many but less Few One
number than in perfect
competition
Type of product Homogenous Differentiated Either Unique that
homogeneous is no close
or differentiated substitutes
Conditions of entry Free entry Relatively easy Significant Barriers to
obstacles entry
Control of product None: firms are Some but Made possible Either price
price takers within limits by collusion or output but
not both
Information and Perfect Imperfect Imperfect Imperfect
knowledge
Non-price None Emphasis is on Typically a Mostly
competition advertising great deal with public
brand names product relations
differentiation
Examples Market for agric Retail trade, Market for Local
produce. e.g. clothing shops motor vehicles utilities such
Mbare Msika or bathing soap as NRZ
8.3 Revenue and profit concepts
It is important to define the various revenue and profit concepts before looking at
the individual market models.
8.3.1 Revenue concepts

(a) Total Revenue (TR)
This refers to the total amount of money that the firm receives from the sale
of its output. It is given by: TR = Price x Quantity.
(b) Average Revenue (AR)

This is the total revenue divided by the number of units sold, that is,
AR = PQ / Q. Quite obvious, AR is the price of the commodity, that is,
AR = P.
(c) Marginal Revenue (MR)
This is the change in total revenue resulting from an increase of one unit in
the rate of sales. That is, the extra revenue which results from selling one
more unit of output. The marginal revenue resulting from the sale of the n th
unit of a commodity is thus the change in total revenue when sales rise from
the rate n-1 to n units. MRn = TRn – TRn – 1
8.3.2 Profit concepts

With the costs and revenue concepts we can be able to study how firms behave if
they wish to maximise their profits. Profit is the difference between total revenue
and total cost. It can also be calculated by subtracting average costs from average
revenue. That is, Profit = TR - TC or = AR - AC.
(a) Normal profit

Normal profit is the minimum amount of profit which is necessary to keep a
firm in the industry. It can be referred to as transfer earnings, that is, the
payment which is necessary to keep a factor in its present use. If TR is equal
to TC or AR= AC, the firm will be earning normal profit.
(b) Abnormal profit.

Also known as supernormal profit or economic profit. If TR is more than TC
or AC > AC, the firm will be earning abnormal profits. Abnormal profit
represent economic rent which is any payment made to any factor of
production over and above that which is necessary to keep the factor in its
present use.
8.4 Profit maximization conditions

Profit maximization remains the key objective of the firm. To arrive at the profit
maximization conditions, we apply the concepts of total revenue and total costs.

The firm maximizes profit when it is in equilibrium. At equilibrium, the firm would
produce an output that maximizes the difference between total revenue and total
costs. The equilibrium of the firm may be shown graphically in two ways. Either by
using the TR and TC curves or the MR and MC curves.
8.4.1 Total Revenue and Total Cost approach
Fig 8.1 The TR and TC approach to revenue maximisation

Costs / TC TR
Revenue
Maximum profits TR1
O Xa Xe Xb Output
According to the diagram above, the total revenue curve is a straight line from the
origin showing that the price is constant at all levels of output. Thus the firm is a
price taker and can sell any amount of output at the going market price with its total
revenue increasing proportionately with its sales. The slope of TR curve is the
marginal revenue (MR). MR is constant and equal to the prevailing market price
since all units are sold at the same price. Thus MR = AR=P.
The shape of the total cost curve reflects the law of diminishing marginal returns or
variable proportions. The firm maximizes its profits at output X e, where the
distance between TR and TC curves is greater. At the lower and higher levels of

output, total profit is not maximized. At output level below X a and above Xb the
firm makes losses as shown by the shaded areas.
8.4.2 Marginal Revenue and Marginal Cost approach

From the previous diagram, at output level Xe the slopes of TR and TC curves are
equal as indicated by the tangent TR1. The slope of TR is the MR while the slope of
TC is the MC. Thus at output X e, MR = MC. Therefore the firm maximize its
profits by producing output Xe where MR = MC
Fig 8.2 The marginalist approach to revenue maximisation

Costs MC
P D = AR = MR
O Xe Output
If MR>MC, it implies that an additional unit of output produced adds more to
revenue than to cost and hence the firm will increase its output. Conversely, where
MR<MC it pays the firm to reduce output because the extra unit adds more to cost
than it does to revenue. Thus profits are maximized at an output where MR=MC.
This is the necessary condition. The sufficient condition is that the MC curve must
cut the MR curve from below. Thus the profit maximisation conditions are:
a. The necessary condition is that MR = MC.
b. The sufficient condition is that the MC curve must cut the MR curve from
below.
What is left is to apply these conditions as we investigate how price and output are
determined in different market models.
8.5 Perfect competition

A market is considered to be perfectly competitive when it fulfils the following
conditions:
a. Perfect competition requires large numbers of sellers and buyers such that
each participant in the market, whether buyer or seller, is so small in relation
to the entire market, that he or she cannot effect the product's price. As a
result firms under perfect competition are price takers.
b. Perfect competition requires that the product of any one seller be the same as
the product of any other seller. That is products sold are homogeneous or
perfectly identical and there is no need for non-price competition.
c. Perfect competition requires that firms should be free to enter or leave the
market depending on whether the market is profitable or not.
d. Perfect competition requires that consumers firms and resource owners have
perfect knowledge of the relevant economic and technological information.
e. Perfect competition requires that factors of production be completely mobile.
8.5.1 The output of a firm under perfect competition in the short run
Firms operating in a perfectly competitive market are price takers, that is,
individual firms take price as given by the market. As a result they face a perfectly
elastic demand curve. This horizontal demand curve is also equal to the average
and marginal revenue curves: D = MR = AR = P.
As observed under the MR and MC approach to the derivation of the profit

maximizing conditions, profit is maximized by adjusting output to the point where
MR = MC. In the short run price is likely to be greater than average total cost hence
firms will be earning abnormal profits as represented by the shaded rectangle on the
following diagram.
Fig 8.3 Short run equilibrium of a perfectly competitive firm.

Cost /
Revenue MC ATC

P R R D=MR=AR
T S
O Qe Output
Given the price and cost shown in the diagram, the firm's equilibrium output is OQ e
because this is the output level which equates MR with MC. Details of MR and MC
enables us to determine the firm's profit maximizing output but not the actual level
of profit. It is the total revenue and total cost which can tell us the actual level of
profit. With details shown in the diagram; price OP and output OQe, total revenue is
equal to OP x OQe = rectangle OPRQe while total cost is equal to OT x OQ e =
rectangle OPRQe. Total revenue minus total cost gives total abnormal profit equal
to shaded rectangle PRST. Thus in the short run the firm will produce output OQ e
and charge price OP, making an abnormal profit of rectangle PRST in the process.
8.5.2 The output of a firm under perfect competition in the long run
The existence of abnormal profit in the short run will in the long run attract other
firms into the industry. Perfect knowledge of market conditions will ensure that
firms outside the industry are aware of the level of profits earned and the absence
of barriers to entry will ensure they are able to enter the industry and undertake
production. The entry of new firms in the industry will increase total supply and as
a result prices fall. This may continue until the abnormal profits have been
completed away and firm will earn only normal profit.
Fig 8.4 Long run equilibrium of a perfectly competitive firm

Cost /
Revenue MC AC
P1 U D = MR = AR

O Q1 Output
In the diagram, long run equilibrium is established when output OQ 1 is produced.
Total revenue is equal to OP1 x OQ1 = OP1UQ1. Since profit equals TR minus TC
zero profits are being earned. That is the firm is only earning normal profit. Normal
profit is insufficient to attract additional firms into the industry but just sufficient to
dissuade those firms already in the industry from leaving. Should supply continue
to increase, the price may fall below AC and firms will run at a loss and may leave
the industry, thus bringing the situation under control.
8.5.3 Short run losses and the firm's shut-down position

The short run equilibrium might have losses if price is less than average total cost.
These losses can be minimized by producing an output level where MR = MC.
However, if the price is less than the average variable price (AVC), the firm will
minimise its loss by producing no output.
Fig 8.5 The firm’s shut-down position

Cost / MC
Revenue
ATC AVC
P1 v D1=MR1=AR1
P2 w D2=MR2=AR2

P1 a D1=MR1=AR1
O Q1 Q2 Q2 Q1 Output
If price is between OP1 and OP2 the firms AR will be less than ATC. However the
firm will be earning enough to cover all its variable costs and part of the fixed
costs. To cease production would leave the firm with a loss equal to its fixed costs
whereas if the firm undertakes production, it will at least have a surplus over
variable cots to set off part of its fixed costs.
If price falls to below OP2, AR will be less than AVC and the firm will be better off
by ceasing production altogether. If it produces nothing the firm's total loss is equal
to its fixed costs. This compares with a loss equal to the deficit on variable cost
added to the fixed cost if it undertakes production.
It can therefore be concluded that the minimum acceptable price if the firm is to
undertake production is that price which exactly equals the minimum short average
variable cost of production. It is for this reason that the minimum AVC is
sometimes referred to as the "shut-down' price.
Thus if price falls to levels below W, the firm will shut down the plant or stop
producing. This does not mean that the firm goes out of business, but simply that
the plant remains idle. However, no firm can sustain losses indefinitely and thus in
the long run, loss-making firms will leave the industry.
8.5.4 The short run supply curve of the firm

From the above discussion, we can state that as long as price is equal to or greater
than AVC, the perfectly competitive firm will adjust its output by moving along
that part of its marginal cost curve that lies above its AVC. This part of MC curve
coincides exactly with the definition of a supply curve since the supply curve
indicates the amount of a good that the producer is willing and able to provide to
the market at different prices.

Fig8.6 Derivation of a perfectly competitive firm’s supply curve
Cost / Revenue d MC
ATC
AVC
P3 c D3=MR3=AR3
P2 b D2=MR2=AR2
P1 a D1=MR1=AR1
0 Q1 Q2 Q3 Output
As price rises from OP1 to OP2 to OP3 so the firm expands output from OQ 1 to OQ2
to OQ3 in each case equating MC with MR. the part of the MC curve which lies
above its average variable cost curve is the firm's supply curve.
8.5.5 Perfect competition and resource allocation

Firms that are perfectly competitive allocate scarce resources efficiently between
uses. This is because of the triple equality condition found in the long run, that is, P
(=MR) = AC = MC. Efficiency is achieved when two conditions are satisfied.
(a) P = Minimum AC (Productive Efficiency). In the long rung competition forces
forms to produce at the point of minimum AC of productions and charge that price
which is just consistent with these costs.
(b) P = MC (Allocative Efficiency). Again, the price charged in the long run is
equal to marginal cost, a condition that is known as allocative efficiency.
8.5.6 Critique of perfect competition theory

a. Perfect competition assumes perfect information and knowledge. As a result,
a firm can not expect to gain much competitive advantage over other firms by
developing new technology. There is little incentive to develop new
technologies since other firms can adopt the new technique. Since
technological innovation is considered essential for economic growth, a
perfectly competitive world, while promoting allocative efficiency, may well
retard growth.
b. Perfect competition assumes perfect
information about technology. As a result a firm cannot expect to grow much
competitively over other firms by developing new technology. Thus there
is little incentive to develop new technology in perfectly competitive
markets.
c. Competitive markets values are based on the
private costs and benefits associate with the actions of individual
consumers and producers. External costs and benefits of production and
consumption are not captured. This is referred to as market failure.
8.5.7 Market failure and the role of the government

Market failure refers to the failure by the market or price mechanism to allocate
resources efficiently. The common belief is that if left alone market forces may not
allocate resources efficiently, for example, public goods such as roads may not be
produced. Market failures arise from the existence of externalities and public good
among others.
a. Externalities
Externalities refer to costs and benefits to society that arise from production or
consumption that are not accounted for by the market. Externalities are said to exist
when the action of producers or consumers affects not only themselves but also
third parties, other than through the normal of the price mechanism. Externalities
are referred to as external costs when they are harmful e.g. air pollution and

external benefits when they are beneficial e.g. the reduced chance of spreading a
communicable disease when an individual is inoculated against it.
i. Negative Externalities
The existence of negative or bad externalities suggest an over production or
over consumption of a certain good.
Fig 8.7 Effect of negative externalities

Cost /
Benefit SMC=PMC+SMC
a
PMC
b
D (SMB)
O Q2 Q1 Output
The firm will produce at Q1 where PMC (Private Marginal Cost) equals the D =
PMB (Private Marginal Benefit). The firm considers only costs like cost of raw
materials, labour, rent and utilities. It does not consider external costs such as
pollution, noise and congestion. If forced to do so, that is, if social marginal
cost is considered instead, produced will be Q2. The triangle abc represent the
welfare loss to society at the profit maximizing equilibrium Q1
ii. Positive Externalities
In the case of positive externalities, there would be under production or under
consumption of the goods because firms would consider private benefits only.
Fig 8.8 The effect of positive externalities

Cost/Benefit k
SMC
PMC
h
SMB
PMB
e
O Q2 Q1 Output
Private output will be at Q2. However the optimum social output is at Q1.where
SMB (social marginal benefit) equals the SMC (social marginal cost). The gap
Q1 – Q2 is the under consumption or under production. The shaded area ehk
shows the welfare loss brought about by under production. This represents the
society’s loss due to the missed opportunity of not having the additional output.
b. Public goods
Public goods are defined as products whose consumption is non-exclusive and non-
exhaustive. Non-exclusive means that a producer or seller can not separate non-
payers from benefiting from the good. Non-exhaustive implies that the use by one
person does not reduce the amount available to another. As a result, there is no
rivalry in consumption.
8.6 Monopoly
A monopoly exist when the market is dominated by a single supplier of a product
for which there are no close substitute and in which it is very difficult or impossible
for another firm to exist. Thus, for monopoly to exist the following conditions must
be fulfilled.
(i) The firm must be the only supplier
(ii) No close substitute for the firm's products must be in existence
(iii) There must be restrictions or barriers to entry which make the
survival of potential rivals extremely unlikely.
8.6.1 Reasons for monopoly

Why do monopolies arise? There are many reasons which often are discussed as
barriers to entry. Barriers to entry are obstacles to entry that protect the firm within
a market from the threat of competition by potential entrants
(a) A Single firm may control the entire supply of a basic input that is required
to manufacture a given product. in this case the firm becomes a natural
monopoly for example DeBeers in South Africa which control almost every
piece of land on which diamonds are mined.
(b) A firm may acquire a monopoly over the production of a good by having
patents on the product or on certain basic processes that are used in the
production. The patent laws to make a certain product as a way to
encourage invention.
(c) A firm may become a monopolist because it is protected by an Act of the
Parliament for example government corporations such as ZBH.
(d) When a firm is enjoying economies of scale, it may supply the market
effectively at lowest possible cost making the entry of other firms extremely
difficult.
(e) If production requires an initial large capital requirement for example laying
of rail tracks, a firm that will be ale to source the capital may become a
monopoly e.g. NRZ.
8.6.2 The demand curve for the monopolist

Since the monopolist is the only firm in the industry, it faces the industry market
demand curve which is downward slopping. Thus, to sell an additional unit of
output, the firm has to reduce its price.
Fig 8.9 Monopoly firm’s demand curve

Price

MR D=AR
O Quantity
The MR curve is also downward sloping because the addition to total revenue from
the sale of additional units becomes progressively smaller and smaller with price
being reduced in order to sell on extra unit. Another point to note is that the MR is
less than AR at every level of output except for the first unit. This cane be
illustrated by the following example. Assume a monopolist sells 100 units at a price
of $2.50 each. In order to raise sales to 101 units, the price should be reduced
$2.48. Thus average revenue falls to $2.48 but marginal revenue which is the
difference in total revenue resulting from the increase in sales from 100 to 101 units
can be calculated as:
TR1 = 100 @2.50 $250
TR2 = 101 @2.48 $250.48
Therefore the increase in TR = 48c. Thus MR = $0.48 is less than AR = $2.48.
8.6.3 Monopoly output and price determination

A profit maximizing monopolist will employ the same rationale as a perfectly
competitive firm, that is, it will produce an output level where MR=MC. In the
short run, a monopolist can earn abnormal profits due to the fact that it will be
charging very high prices since it faces no competition.
Fig 8.10 Short run monopoly output and price

Cost/

Revenue
MC
AC
Pm A
C B
MR
MR=MC
MR D =AR
0 Qm Output
A monopolist has the power to determine either the price at which to sell his
product or the quantity he wishes to sell. He can not determine both because he can
not control demand. If he decides on output level OQm using the MR = MC rule,
the unique price at which OQm can b sold is found by extending a vertical line up
from the profit maximizing output and then at right angle from the point at which it
hits the demand curve to the price axis. The indicated price is OP m. At output level
OQm, average costs per unit equals OC. Total revenue equals rectangle OP mAQm
and total cost equals rectangle OCBQm. Therefore the monopolist is making
abnormal profits represented by CPmAB.
NB: Abnormal profits will continue in the long run because of the assumption of
barriers to entry which exist. As a result the long run equilibrium is the same as the
short run equilibrium. However, monopolists may earn losses in the short run, in
which case they would strive to minimise their losses.
Fig 8.11 Monopoly loss

Revenue / Cost
MC AC
C E
LOSSES

Pm F
D=AR
MR
O Qm Output
The absence of a unique price associated with each output level makes it difficult
for use to define the supply curve for a monopolist,
8.6.4 Monopoly and resource allocation

Given the same costs, a monopolist will produce much less desirable results than a
perfectly competitive firm. The monopolists will find it profitable to sell a smaller
output and to charge a higher price than would a competitive producer. Therefore
monopolists are allocative inefficient in the sense that they charge a price which is
above marginal costs, that is P>MC. They are also productive inefficient because
they produce less output at a high cost of production than producing at the
minimum of average cost curve.
8.6.5 Monopoly price discrimination

Price discrimination is a situation where a firm charges different prices for the same
product in different markets when there are no cost differences to justify this. The
different prices are charged for reasons not associated with costs of production, for
example, cell phone peak and off-peak call charges.
The conditions necessary for price discrimination to be successful are that
(i) Buyers fall into classes with considerable differences in the price elasticity
of demand for the product.
(ii) These classes can be identified and segregated at moderate cost and
(iii) Buyers must be unable to transfer the commodity easily from one
class to another, since otherwise it would be possible for persons to make
money by buying the product from the low-price market and selling it tot he
high price market, thus making it difficult to maintain the price differentials
between classes.

The discriminating monopolist will proceed to charge a high price in the market
where demand is inelastic and a low price where demand is elastic in order to
exploit the consumers' surplus.
8.7 Monopolistic competition

Perfect competition and monopoly are two polar extremes. There are an extremely
large number of firms in a perfectly competitive industry but only one firm in
monopoly. During the late 1920s and early 1930s, economists began to stress the
need to develop models that will handle the important middle ground between
perfect competition and monopoly, in which feel practically all of the empirically
relevant cases.
One of the most noteworthy achievements that were then produced was the theory
of monopolistic competition, put forth by Harvard's Edward Chamberlin - The
Theory of Monopolistic Competition (1933)
8.7.1 Assumptions
The basic idea behind Chamberlin's theory is that most firms face relatively close
substitute products and that most products are not completely homogenous from
one seller to another. The assumptions underlying Chamberlin's theory are as
follows: -
(i) He assumes that the product which is produced is differentiated, with each
firms' product being a fairly close substitute for the products of the other
firms in the product group. Product differentiation refers to a situation
where similar products are made distinct through packaging, branding, after
sales services etc. for example, bathing soaps like Geisha, Jade and Image.
(ii) He assumes that the number of firms in the product group is sufficiently
large so that each firm expects its actions to go unheeded by its rivals and to
be unimpeded by any retaliatory measures on their part. Therefore, firms are
price setters in respect of their individual products.
(iii) There are no barriers to entry hence entry or exist in the industry is
relatively easy.

(iv)He assumes that both demand and cost curves are the same for all of the
firms in the group. This, of course, is a very restrictive assumption since if
the products are differentiated; one would ordinarily expect their demand
and cost curves to be different too.
8.7.2 Product differentiation and the firm's demand curve

Product differentiation plays a very important role in Chamberlin's theory in that it
defines the scope of the firm's demand curve. If a product is well differentiated, it
becomes unique and hence would have less close substitutes thus demand curve
will approximate the monopoly's demand curve. On the other hand if products are
less differentiated they tend to be substitutes hence the demand curve will
approximate a perfectly competitive firm's demand curve. Thus the precise degree
of elasticity embodied in the monopolistically competitive firm's demand curve will
depend on the exact number of rivals and the degree of product differentiation. The
large the number of rivals and the weaker the product differentiation the greater
will be the elasticity of each seller's demand curve that is the closer the situation
will be to perfect competition.
8.7.3 Price and output determination

The firm will maximise profits by producing that output level where MR=MC
Fig 8.12 Short run equilibrium of a monopolistically competitive firm
Cost /
Revenue
MC ATC
P A
C B
MR=MC

D=AR
MR
O Q0 Output
On the above diagram the firm produces an output OQ 0 and charges a price OP and
realises a total abnormal profit of the size of the shaded rectangle CPAB. A less
favorable cost and demand situation may exist, putting the monopolistically
competitive firm in the position of realizing losses in the short run. This is
illustrated by the shaded rectangle in the following diagram.
Fig 8.13 Short run loss under monopolistic competition
Cost /
Revenue
MC ATC
C1 A
P1 B
MR=MC

D=AR
MR
O Q1 Output
Total costs are represented by the rectangle OC1AQ1 and total revenue by rectangle
OP1BQ1. The firm is making losses as represented by the shaded rectangle P1C1AB.
Thus in the short run, the firm may either realise an economic profit or loss.
Abnormal profits will attract new rivals. Since entry is relatively easy, new firms
will enter. As the number of rivals increase, the demand curve will become more
elastic and each firm's market share becomes very small. Thus in the long run, the
short run abnormal profits will disappear and firms earn normal profits.
Fig 8.14 Normal profit for a monopolistically competitive firm
Cost /
Revenue MC ATC
P0 A
MR=MC

D=AR
MR
O Q0 Output
When the demand curve is tangent to the average costs curve at the profit
maximizing output as shown in the diagram above, the firm is earning normal
profit. Losses in the short run will lead to an exodus of firms in the long run. Faced
with few substitutes and blessed with an expanded market share, surviving firms
will find that their losses disappear and gradually give way to approximately
normal profit.
8.7.4 Criticisms of the theory of monopolistic competition

A number of important criticisms have been made of the theory.
(i) University of Chicago's George Stigler and others have argued that the
definition of the large group of firms included in the product group is
extremely ambiguous. It may contain only one firm or all of the firms in the
economy. In other words the model assumes a large number of sellers but it
does not define the actual number. How many firms should there be in an
industry in order to classify it as monopolistic competition rather than as
oligopoly? What is the crucial number that determines whether firms act
independently or recognize interdependence? Such problems are not
discussed in the model.
(ii) The assumption of product differentiation is incompatible with the
assumption of free entry. Some forms may achieve a measure of product
differentiation which can not be duplicated by rivals even over a long span of
time. Thus product differentiation can create a barrier to entry for new firms
(iii) The assumption of independent action by the competitors is inconsistent
with reality. In reality firms are continuously aware of the actions of
competitors whose product is close substitute to their own product.

(iv)The assumption of myopic behaviour of business owners is unrealistic. In
reality firms do learn from past behaviour. Those that do not, get competed
out of business.
8.8 Oligopoly
Oligopoly is a market model characterized by a small number of firms and a great
deal of interdependence, actual and perceived among them. Each firm formulates
its policies with an eye to their effect on its rivals. Thus one firm's price decision is
likely to cause a response which often leads to price wars. The interdependence of
firms in oligopoly markets makes them not to depend on market forces. They worry
about prices, spent fortunes on advertising and try to understand the behaviour of
their rivals. Oligopolies may produce homogenous or differentiated. If the firms
produce a homogenous producer, the industry is called a perfect or pure oligopoly.
If the firms produce a differentiated product the industry is called an imperfect or
differentiated oligopoly. It is easier to deal with the case of perfect or pure
oligopoly. When two firms dominate the market as what used to exist when Circle
Cement used to serve the northern part of the country while Portland Cement was
serving the southern part, this is known as duopoly.
The interdependence of firms in oligopoly markets lead to a range of behaviour

patterns bordering on one extreme, firms being engaging in fierce competition and
on another, firms explicitly co-operating. As a result there is no single model of
oligopoly behaviour. Here, we will examine three rather distinct models.
8.8.1 Oligopoly with price leadership

This model of oligopoly behaviour is based on the assumption that one of the firms
in the industry is the price leader. The price leader will set the price and the rest
follow its lead, that is, the followers will adopt this price. Thus the followers
behave like firms in perfect competition while the price leader behaves like a
monopolist in the sense that it has freedom to set price.

Two forms of price leadership can be discussed: the dominant firm and the
barometric - firm. The dominant firm leadership applies to industries in which there
is a single large dominant firm in the industry and a number of minor firms. The
dominant firm sets the price for the industry probably using the marginalist rule for
profit maximization (MR = MC), but the assumption is that it lets the minor firms
sell all they want at that price. Whatever amount the minor firms do not supply at
that price is supplied by the dominant firm.
The barometric firm leadership applies to the industry in which one firm usually is
the first to make changes in price that are generally accepted by other firms in the
industry. The barometric firm may not be the largest or most powerful firm but a
reasonable accurate interpreter of changes in basic cost and demand conditions in
the industry. According to Kaplan, Dirlan and Lanilotti, a firm may emerge as a
barometric firm through experienced stability during a period of violent price
fluctuations and cutthroat competition in the industry during which many other
firms suffer.
8.8.2 The kinked demand curve model

This well known model designed to explain the rigidity of prices in oligopoly
markets was advanced by Paul Sweezy (1939) "Demand under Conditions of
Oligopoly", Journal of Political Economy, August 1939. In his theory he stated that
if an oligopolist cuts its price, it can be pretty sure that its rivals will meet the
reduction. On the other hand, if an oligopolist increases its price, it is likely to find
that its rivals will not change their prices. In such a case, the demand curve for the
oligopolist’s product would be much more elastic for price increases than for price
decreases.
Fig 8.14 The kinked demand curve
Revenue /
Cost

MC1
P0 K MC0
D = AR
MR
O Q0 Output
The kinked demand curve is a combination of two types of demand curves with
different elasticities. Because of the 'kink' in the demand curve, the marginal
revenue curve is not continuous. Given that the firm's marginal cost curve is MC0
marginal cost does not equal marginal revenue at any level of output. However
output OQ0 remains the most profitable output and OP0 the most profitable price
even if the marginal cost curve shifts to MC 1. Thus under these circumstances, one
might expect price to be quite rigid at the level of the kink.
Although this model may be useful under some circumstances in explaining why
price tends to remain at a certain level (OP 0), it is of no use in explaining why this
level, rather than another currently prevails. In other words, the theory does not
explain how the going price gets to be at OP0 in the first place.
8.8.3 Collusion and cartels
Collusion occurs when the few firms composing an oligopolistic industry reach an
explicit or unspoken agreement to fix prices, divide a market, or otherwise restrict
competition among themselves. The advantages to the firms of collusion seem
obvious: increased profits, decreased uncertainty, and a better opportunity to
prevent entry. Conversely, collusive arrangements are often hard to maintain, since
once a collusive agreement is made, any of the firms can increase its profit by
cheating on the agreement. As a result, cartels are very unstable.

When a collusive arrangement is made openly and formally, it is called a cartel. A
cartel is a group of sellers of a product who have joined together to control its
production, sale and price in hope of obtaining the advantages of monopoly. Thus
when a cartel is successful it may end up more of a monopoly, but because they do
not combine to produce together, they do not enjoy economies of scale. An
example of a cartel is the Organisation of Petroleum Exporting Countries (OPEC).
OPEC was formed in 1960 with the objective of controlling crude oil production.
In 1973, members restricted output and prices of crude oil tripled. However, the
cartel failed to keep prices high by the mid 1980s because the OPEC never
established barriers to entry. As a result, when prices rose, non cartel members
increased output and putting a downward pressure on prices. On the other hand,
close substitutes for oil and energy efficient technologies were developed. Thus
demand for oil became more elastic.
Members of the cartel have been in disagreement over quotas. By 1989, cheating
among members became rampant, and production exceeded the total quota, putting
pressure downward on prices. This destroyed the cartel’s ability to maintain high
prices
Chapter 9
National income measurement

9.0 Introduction
During the course of the year economic agents engage in activities that produce
various goods and service or national output. National output and national income
are synonymous. In this chapter, we are going to explore how an economy can
attach a monetary value to its output and outline some of the alternative uses of the
obtained statistic or GDP. The aim of national income measurement or accounting

is to place a monetary value on this year’s output. National income measurement is
important in that it provides us with a basic indicator of the performance of the
economy in the production of goods and services over a given period, usually a
year.
9.1 Methods of measuring national income

There are three methods of measuring national income, namely income method,
output method and expenditure method. These methods must arrive at the same
national income figure because they are measuring the same output in different
ways.
9.1.1Income method
The income method adds together income earnings in the form in which they are
received, that is, income from employment and self-employment (wages and
salaries), rent, interest, profits and dividends. Note that only incomes earned from
supplying factor services are counted. Transfer payments are ignored and incomes
are recorded gross hence the result is national income at factor cost.
9.1.2 Output method

The economy is broken up into different sectors (e.g. manufacturing, agriculture,
mining etc.). The output method adds together the total value of all final goods and
services produced in each sector or adding the value added at each stage of
production to avoid double counting.
9.1.3 Expenditure method

The method adds together all the money spent in buying this year’s output.
National income will be the total of consumption, investment, government
expenditure and net exports (exports less imports). The result is total expenditure
at market prices hence deduct indirect taxes and add subsidies to get national
income at factor cost.

9.2 National income statistics
Gross Domestic Product (GDP) is the primary statistic of national income
measurement and other measures or statistics can be derived from GDP.
9.2.1 Gross Domestic Product (GDP)

GDP is the total value of all the final goods and services produced from all the
resources within Zimbabwe. Final goods refer to goods produced for consumption
unlike intermediate goods which are goods used as inputs to produce other goods
and hence intermediate goods are excluded in the measurement of GDP. GDP
measures the performance of the domestic economy because of its focus on output
from resources located in the domestic economy regardless of their ownership.
9.2.2 Gross National Product (GNP)

GNP is a measure of the total value of all final goods and services produced from
resources owned by Zimbabweans regardless of where they are operating from.
GNP measures the performance of a nation. Resource ownership is important
because it determines the flow on factor income. Foreign ownership implies income
flowing to abroad (factor income to abroad) while Zimbabwean citizens who own
factors of production abroad will remit their incomes aback home (factor inflow
from abroad).
GNP = GDP + Net factor income from abroad
Net factor income form abroad = Factor income from abroad – Factor income to
abroad
9.2.3 Net National Product (NNP)

The word ‘gross’ implies that the costs of producing that output are included. The
cost is depreciation. Depreciation or capital consumption refers to that part of the
year’s output needed to replace obsolete and worn-out capital. Depreciation is a
cost of production and must be deducted from the GNP in order to arrive at the net
national income.
NNP = GNP – Depreciation

The NNP figure will be at market price. That is, it is obtained using the prevailing
market prices for the final goods and services which often are inclusive of indirect
taxes such as VAT while being exclusive of any subsidies. To measure the amount
of income paid to the factors of production for the services rendered in producing
the output (NNP at factor cost), we deduct indirect taxes and add subsidies to NNP
at market prices.
NNP at factor cost = NNP at market price – indirect taxes + subsidies
9.2.4 Personal Income (PY)

Personal income refers to income actually received by households and
unincorporated business (personal sector). PY = NNP at factor cost less company
tax, retained profits and social security payments plus transfer payments.
9.2.5 Personal Disposable Income (PDY)

Personal disposable income is that part of personal income which is finally
available for spending by households.
PDY = PY - Income tax (PAYE) and Property taxes (e.g. rates).
9.3 Problems likely to be encountered when measuring national

income
Estimation of the country’s GDP is the responsibility of the Central statistics Office
(CSO). To obtain the GDP statistic the department conduct national income
surveys through which representative samples of the population (households or
firms in different sectors) make contributions that are then generalised on the
economy. In this process of estimating national income, there are three sets of
problems that are likely to be encountered.
9.3.1 Data Reliability

National income accounts are as good as the data on which they are based. If the
data is inaccurate, the resulting statistic will also be inaccurate. Data can be
inaccurate due to:
a. Sampling technique problems e.g. sampling bias or even bad luck.
b. Individuals giving incomplete or inaccurate information.
c. Guess work, especially in developing countries where there are no means of
gathering the correct data e.g. output from subsistence farming is difficult to
measure in Zimbabwe, resulting in conflicting reports on the contribution of
communal farming to national agricultural output.
9.3.2 Valuation
Final goods and services are measured in various physical units such as kilograms,
hours, dollars etc. As a result, there is need to convert all these measures to
monetary terms in order to come up with a monetary value of the year’s output.
However, when making these valuations the following problems are likely to be
encountered.
a. Double counting which arises when adding the value of intermediate goods
instead of final goods or ‘value added’ at each stage of production. For
example, the value of wheat ($200mln) + value of flour ($500mln) + the
value of bread ($800mln) giving a wrong national income of $1500mln
instead of the correct $800mln which is the value of the final product (bread).
In this case wheat and flour are intermediate goods.
b. Public goods and services (e.g. defence) make a contribution to national
income but they do not have a market value. As a result, it will be difficult to
attach a monetary market value to public goods and services. However, the
contribution of public goods and services should be measured ‘at cost,’ that
is, add the salaries of soldiers as the value of defence’s contribution to
national output.
9.3.3 Omissions

When national income data is collected, several significant contributions to that
income are likely to be omitted partly because of difficulties in measurement and
non-availability of reliable data. The following are some notable omissions which
are usually represented on national income figures by an imputed 10% of the value
of GDP.
a. Self provided goods and services e.g. Do-It-Yourself kits or self provided
services such as a meal prepared at home which is not included in national
income statistics while a meal at a restaurant such as the Silver Spar at
Holiday Inn will be included.
b. Output from subsistence or communal farming which is excluded while
output from the commercial farms is included.
c. Informal sector activities.
d. Black market or illegal activities for example individuals have managed to
built houses and castles from dealing in foreign currency but the same
individuals can not declare this source for fear of prosecution.
It may be important to note that these activities contribute substantially to the
economy’s activities. In Zimbabwe the informal sector employs more than half of
the country’s working population. An imputed 10% will grossly lead to the
underestimation of the country’s GDP.
9.4 National income and standards of living

The standards of living refer to the quality of life in a country or the wellbeing of a
country’s citizens. One reason of measuring national income is that of wanting to
make inference into the standards of living. That is, investigating whether the
people are better off than they were in the previous year or to make comparisons of
standards of living between different countries. Apart from indicating the standards
of living, national income statistics are used for planning purposes.
9.4.1 Measurement of the standard of Living

The value of this year’s national income is a useful measure of how well-off a
country is in material terms. That is, the standard of living can be measured by the
volume of goods and services consumed.
a. According to Alfred Marshall, national income gives a measure of economic
prosperity. A real increase in national income is an essential prerequisite to a
rise in the general standard of living of people.
b. A second method of measuring living standards is to count the percentage of
people owning consumer durables such as cars, televisions, radio and so on.
An increase in ownership indicates an improved standard of living.
c. A third method of calculating living standards is by noting how long an
average person has to work to earn money to buy certain goods. If people
have to work less time to buy goods, then, there has been an increase in the
standard of living.
9.4.2 Using GDP to interpret standards of living in a country over a period

"Economic statistics are like a bikini, what they reveal is important, what they
conceal is vital" - Attributed to Professor Sir Frank Holmes, Victoria University,
Wellington, New Zealand, 1967.
A real increase in national income can, ceteris paribus, be interpreted as
representing an improvement in the people’s standard of living. If real GDP
increases over a given period, this may imply that the volume of goods and services
produced and consumed had increased which is interpreted as an improvement in
the quality of life for the people. On the other hand, it is not automatic that an
increase in national income results in an improvement in the standards of living for
the majority. Increased GDP may not mean a better life style for the majority of
people if:
a. Income is unequally distributed that is, if there is a wide gap between the rich
and the poor. The increased GDP will be in the hands of a few minorities
leaving the majority worse off. Only a small minority of wealthy people
consumes the extra goods.

b. Increased output of certain goods results in more noise, congestion and
pollution (externalities). The quality of life will be reduced by these negative
externalities.
c. Leisure time is reduced to achieve the production increase. That is, if the
increased output was produced as a result of people working over time,
travelling long journeys to work etc, all which reduces leisure which is an
important aspect of the quality of life.
d. Population is growing at a faster rate than the real GDP (population
explosion). In this case, the cake of real GDP will have to be shared among a
large population making the real GDP per head or per capita income small.
e. Increased output is due to production of producer goods instead of consumer
goods. Producer goods such as machines are used to produce consumer
goods. As a result producer goods contribute to the future welfare and not the
present welfare which largely depends on the volume of consumer goods
produced and consumed.
f. There is an increase in the amount of stress and anxiety in society. Increased
output has its own fare share of social health problems which reduce the
quality of life.
9.4.3 Comparing standards of living between different countries.

Fairly accurate comparison of the national income statistics can be carried to
compare the standard of living between different countries. For example a country
with a higher per capita income can be concluded to have better standards of living.
However, the following qualifications need to be made before such a comparison is
made.
a. Income may be fairly distributed in one country than the other. If a country
has a higher per capita income but at the same time the income is unequally
distributed, then the income will be in the hands of a few minorities leaving
the majority worse off.
b. The country with a higher income may be producing producer goods while
the other country is producing consumer goods. The country with a low per

capita income but producing consumer goods will have improved present
standards of living than the country with a high per capita income.
c. Citizens of one country may be working long hours resulting in a high real
GDP per head. An example is the Japanese people who usually work long
hours in shifts e.g. retail shops that open 24 hours a day. By working long
hours, they forego leisure which is an important indicator of welfare.
d. When make international comparisons there is need to first convert the
national income s of the different countries to a convertible currency such as
the United States dollar. The problem is that of the exchange rate to use since
different countries use different exchange rate systems. For example which
exchange rate will be used in Zimbabwe? The auction rate, the parallel market
rate or the official fixed exchange rate?
9.5 Economic growth

Economic growth can be defined as a sustained increase in the level of real national
income (real GDP per head or per capita income). Economic growth implies an
increased ability to produce goods and services. Thus with economic growth, the
quantity of goods and services produced overtime increases hence the people’s
standards of living will improve. Economic growth can be represented by an
outward shifting of the PPC.
Fig 9.1 Balanced economic growth Economic Growth

Capital goods

O Consumer goods
A complete outward shift of the PPC to the right represents balanced economic
growth. This means that the economy can now produce more of both consumer
and capital goods than before. Imbalanced economic growth can be represented by
the pivot of the PPC in favour of the expanding sector while anchored on the sector
with no expansion.
9.5.1 Causes of economic growth

a. Supply factors
Economic growth primarily results from an increase in the quantity of the available
resources and an increase in the productivity of the existing resources. These are
the supply factors. Supply factors that define an economy’s potential to expand
include:
i. An increase in the quantity and quality of an economy’s resources e.g.
discovery of new resources.
ii. Improvement in the quantity and quality of the economy’s human resources.
(Human capital investment).
iii. An increase in the economy’s stock of capital (capital accumulation).
iv. Improvement in the level of technology.
v. Research and development.
b. Demand factors
The supply factors only present an economy with the potential to grow. To realise
growth, the nation must provide for the increased production through a growing
level of aggregate demand in order to clear the production lines, thus facilitating
further production and expansion.
c. Allocative factors
The available resources must be fully employed. Underutilisation of resources
retards economic growth.

d. Government policy
The objective of government policy should be to promote economic growth e.g.
The Growth Point Policy.
9.5.2 Is economic growth desirable or not?

The following arguments can be forwarded in favour of and against economic
growth. The benefits are that economic growth,
a. Is a path to material abundance hence the standards of living will improve
where an economy experiences growth. In other words, economic growth is
a prerequisite to an improvement in the standards of living.
b. Reduces poverty. If developed countries do not experience growth, no
excess income will result and hence there would be no means by which to
provide funding in order to reduce poverty.
c. Decreases unemployment. As the economy expands through increased
economic activity, more job opportunities will be created.
d. Increases ability to support a growing population. As the population
increases the only feasible way to feed the increased population will be
through economic growth. Without economic growth the population will be
doomed according to Thomas Malthus.
e. Is a catalyst to changing life styles or civilisation. TVs, DVDs, movies,
mobile phones and other modern life items result from economic growth
f. Widens the tax base hence tax rates will fall. That is, as the economy
expands, other players come into production and the government stand to
easily collect its tax revenue requirement which may culminate into lower
individual taxation rates.
On the other hand the case against economic growth is that:

a. If economic growth is caused by an improvement in technology, labour may
become obsolete (technological unemployment). That is, machines will end
up doing the jobs that people used to do. This may increase the levels of
unemployment in the economy.

b. Economic growth implies an increased use of the available resources some
of which are non-renewable. Thus economic growth results in the depletion
or exhaustion of natural resources.
c. Growth results in serious problems of noise, ugly cities and other
disamenities of modern life (externalities).
d. Growth permits us to make a living but does not give us a good life.
Economic growth gives us a bed but does not give us sleep. Good life is not
measured in terms of wealth or riches or material things but other social
elements including having a peace of mind or lack of anxiety. Sometimes
poor people are the happiest persons in life.
e. Economic growth is a catalyst to civilisation which may results in the
destruction of the moral fibre.
f. Increased anxiety hence health problems e.g. stress, ulcers, diabetes and
high blood pressure.
9.6 Economic development

Economic development is a multidimensional phenomenon that captures various
aspects of improvement which are economic, social and political. Development
includes improvement in the living standards, sanitary conditions and other welfare
indicators in the economy. Thus, economic growth, which refers to a sustained
increase in real GDP, is only a branch of economic development.
9.6.1 Developed and less developed countries

World economies can be classified into developed countries (DCs) and less
developed countries (LDCs). Developed countries are those that have taken
significant steps towards developmental expectations such as achieving an
economic growth rate above population growth rate, a high level of
industrialisation and reducing poverty, unemployment and inequality. It is
however, impossible to eradicate unemployment, poverty or inequality, but the
developed countries have surpassed minimum expectations. Developing countries

are those that are still striving to record positive changes towards development and
have not met the minimum expectations.
9.6.2 Characteristics of developing countries

Developing countries are characterised by
a. High unemployment levels.
b. Poor standards of living.
c. Low levels of industrialisation.
d. Poor infrastructures such as roads and communication networks.
e. Poverty, the majority of the people live below the poverty datum line.
f. Population explosion, that is, population growing at a rate faster than
growth in national income.
g. Poor sanitary conditions (decaying health sector and over-crowding).
h. Poor export base, that is, they export raw materials and other primary
products instead of processed or manufactured goods. Primary products
tend to have huge volumes but being of little value.
i. High budget deficits and BOP deficits.
j. Inappropriate economic reform programmes and sometimes lack of
implementation of these programmes.
9.6.3 Possible solutions to LDCs developmental problems

a. Encourage foreign direct investment (FDI).
b. Export promotions e.g. through trade exhibitions.
c. Import substitution, that is, producing products that are close substitutes of
the imported products.
d. Stabilising the political situation and increasing investor confidence.
e. Stabilising the exchange rate or removal of exchange controls.
f. Expanding the manufacturing sector.
g. Moral and infrastructure support to the growing informal sector.
h. Promoting investment e.g. through policies such as growth point policy

Chapter 10
National income determination

10.0 Introduction
In chapter 9 we discussed how to attach a monetary value to the year’s output of
final goods and services. In this way the economy will be measuring its GDP. Once
the figure is arrived at, it can be manipulated into various other statistics such as
GNP. These statistics will then be used to indicate whether the standards of living
in a country are improving or not. The question now is what determines the value
of national income? In other words, how did the economy achieve GDP equivalent
to $10bln instead of $15bln? What determines the size of our national income? This
chapter will help us answer these questions. In addition the chapter gives a historic
account of the development of macroeconomics.
10.1 Keynes and the classical school

The term macroeconomics is a fairly recent addition to economics vocabulary.
Macroeconomics is largely associated with the works of John M Keynes (1883-
1946). Before Keynes, most economists belonged to a school of thought now
known as the classical school. Classical economists were largely concerned with
microeconomics. They believed in the dictum or Say’s law named after the 19 th
century French economist Jean Baptiste Say who stated that “supply creates its own
demand”. The classical school believed that market forces operating in competitive
markets would provide a self-adjusting mechanism that, in the long run, would
automatically ensure full employment and economic growth. Unemployment,
when it exists was considered not only temporary in nature but also largely
voluntary.
Opposing these classicals Keynes believed that “demand creates its own supply”.
Keynes argued that although forces of supply and demand work very well to
establish equilibrium in individual markets, the economy as whole could
experience periods of severe instability. Thus Keynes rejected the idea of an

automatic adjustment process, believing that without government intervention, an
unregulated market economy can quite easily settle into an under full employment
equilibrium. Thus the debate between the classicals and Keynes was whether, if
left alone the economy can achieve full productive capacity.
The great depreciation which started in 1929 and lasted until the onset of World
War II seems to have settled the debate. Given the circumstances of the time e.g.
In USA, GNP fell by 30% between 1929 –1933, agricultural prices fell by 60% and
unemployment approached 1/3 of the working population. The so-called classical
view was simply not sustainable. The publication of Keynes’ great and influential
book The General Theory of Unemployment, Interest and Money (1936), brought
in a new era of macro economics. Indeed until the development of monetarism in
the 1970’s and supply side economies around the end of the 1980’s,
macroeconomics and Keynesian economics was much the same thing.
The debate between the Keynesians and the classicals can best be summarised by a
simplified version of the circular flow model where the terminology has been
changed to suit our purpose.
CLASSICAL DICTUM: KEYNESIAN DICTUM:

“Supply creates its own demand” “Demand creates its own supply”.
HOUSEHOLDS
AGGREGATE AGGREGATE
SUPPLY (AS) EXPENDITURE (AE)
FIRMS
The income flow is called AGGREGATE SUPPLY (AS) in the sense that income
is generated during the production of goods and services. The expenditure flow is

referred to as AGGREGATE EXPENDITURE (AE). The question is which of the
two happens first and how can the government stimulate or slow down economic
activity? The classical school believes that the supply side of the production
process is the most important feature of the macro economy. Supply creates its
own demand in the sense that production gives rise to consumption. The policies
which emerged from this basic view are those that stimulate production such as
deregulation and privatisation.
Keynesians, on the other hand argued that demand is more important than supply.
Thus if aggregate demand can be stimulated by means of appropriate policy
interventions, it can be expected that supply, income and employment all be
stimulated (increased). The policies that emerged under this view are changes in
government expenditure and the level of taxation.
10.2 The Keynesian model

The Keynesian model is based upon the following simplifying assumptions:
a. Prices are constant. This implies that the model is a short run model and this
assumption means that, in the short run, producers will respond to changes in
demand by changing the quantity they produce rather than price.
b. Producers attempt to keep a constant level of stocks. Should stock level fall,
production will increase and if they increase, production will be reduced.
This implies that the economy is at less than full employment.
c. Where people receive income most of it is spent on goods and services
produced locally but some will leave the circular flow in the form of savings,
taxes and expenditure of imports. These are withdrawals from the circular
flow of income.
d. Changes in investment, exports and government expenditure are assumed to
be autonomous (independent), that is, these are not related to changes in
national income. This means that investment (I), government expenditure (G)
and exports (X) are independent of income changes. Government spending is
determined by government policy, investment depends to some extent on the

rate of interest and business expectation, exports depend on such factors as
income from other countries and the exchange rate.
10.2.1 Aggregate supply (AS)

The Keynesian model is developed by using the income and expenditure variables.
Expenditure is presented along the vertical axis of the graph while income is
measured on the horizontal axis. If we assume that the economy is at less that full
capacity as implied in the model, then if there is an increase in expenditure, there
would be sufficient resources available to produce goods and services to satisfy the
increased demand. Thus the aggregate supply function is a 45o line drawn from the
origin implying that at all points along this AS function, income is equal to
expenditure(Exp = Y).
Fig 10.1 The aggregate supply function
Expenditure AS = (Exp=Y)
C
O B D Income
When the level of national income is OB aggregate expenditure will be OA. If

expenditure increases to OC the level of national income will increase to OD.
According to Keynes an increase in aggregate expenditure leads to an increase in
the production of goods and services and increase in income generated from
production.

10.2.2 Aggregate expenditure (AE)
Aggregate expenditure refers to total expenditure by all spending units in the
economy. It records expenditure by household (C), Government (G), firms (I), and
foreign sector (X-M). There are four components of aggregate expenditure, AE = C
+ G + I + (X – M).
a. Consumption (C)
There are many theories that attempt to explain consumption patterns. Of these
theories we will adopt the income hypothesis which outlines that consumption
depends on the level of income. To show the relationship we will define the long-
term consumption function and the short-term consumption function.
i. Long term consumption function
The long-term consumption function is plotted on the income and expenditure axis.
It shows that assumption is an increasing function of income, that is, if income
rises, consumption will increase. However, if the consumption function lies below
the aggregate supply function, that is, its slope is less than that of the aggregate
supplies function.
Fig 10.2 The long term consumption function
Expenditure AS (Exp =Y)
C C=bY
O A Income
Not all income is spent in the form of consumption. Part of our income goes to
taxation, savings and expenditure on imports. For example, a level of income equal
to OA can be divided into OB consumption and BC withdrawal in the form of

savings, taxes and imports. The portion of income OA that goes to financing
expenditure OB depends on the marginal propensity to consume (MPC). MPC
refers to the proportion out of an additional $1 that is spent. MPC refers to the
proportion out of an additional $1 that is spent. MPC measures the slope of the
consumption function. It can be defined as the change in consumption resulting
from a small change in income.
MPC = C
Y
ii. Short term consumption function
In the short term it is possible that consumption exceeds income. This implies that
a consumer will be consuming from past savings. This consumption which is
independent of changes in income is called autonomous consumption. The short-
term consumption function does not start at the origin but at the level of
autonomous consumption.
Fig 10.3 The short term consumption function
AS (Exp =Y)
Expenditure
C = a +bY
O Income
The short-term consumption function does not start at the origin but at the level of
autonomous consumption. This means that if income is zero the level of
consumption will be equal to a. The slope of the consumption function (MPC) = b.

iii. The relationship between income and savings
The short term consumption function can be used to show the relationship between
the level of income and savings.
Fig 10.4 The relationship between income and savings
Expenditure AS (Exp=Y)
M C = a + bY
B
D
a
E
O C A Income
At point M where income is OA and expenditure is OB, there are no savings

because income is equal to expenditure. To the left point M e.g. when income is
OC, expenditure is greater than income (OD OE) thus expenditure ED has to
come from past savings, thus it represents the level of dissavings (negative
savings). Points to the right of point M are points where income is greater than
expenditure, hence there are positive savings.
NB* Consumption is the largest component of aggregate expenditure therefore it is

very significant (more important). The slope of the consumption function
significantly contributes to the slope of the aggregate expenditure function.
b. Investment (I)
According to simplifying assumption number (d), investment is not related to
changes in income. It is determined outside the model, therefore it is exogenous.
Investment depends to some extent on the rate of interest and the firm’s expectation

of the future. If plotted against income on a graph, investment will be represented
by the horizontal straight line equal to OI.
Fig 10.5 The investment function
Expenditure
G G0
I I0
O Income
c. Government expenditure (G)

As with investment, government expenditure is assumed to be independent of
changes in national income. It is determined by government policy and can be
represented by a horizontal line equal to OG.
d. Net exports (Xn =X - M)

The export function is also horizontal due to the fact that exports depend on the
changes in national income of other nations and not our own income. It is equal to
OX. Imports depend on Y inside the country. As our income increases our
expenditure on imports will tend to increase thus the import function can be
expressed as M = m Y where m = MP.

Fig 10.6 The net export function
M=mY
Expenditure
X X0
O A Xn Income
The net export function is the difference between exports and imports. It has a
negative slope. Xn is equal to total exports when income is zero and declines as
income increases. At level of income OA, X = M thus net exports is equal to zero.
NB* The total aggregate expenditure function is defined as AE = C+I+G+(X-M).

Where national income is zero, aggregate expenditure will be equal to autonomous
consumption expenditure (a), investment expenditure (I), government expenditure
(G), and exports (X) that is AE = a + I + G + X. The slope of the aggregate
expenditure function is equal to (b-m).
10.2.3 Keynesian equilibrium

Equilibrium is a state of no change. It is a condition that can be maintained over
time. In the simple Keynesian model equilibrium occurs when aggregate supply
(AS) is equal to aggregate expenditure (AE). That is Y = C + G + I + X - M

Fig 10.7 Determination of the equilibrium national income
AS (Exp=Y)
Expenditure D
AE = C+I+G+(X-M)
B E C
O Y1 Y0 Y2 Income
Aggregate expenditure is equal to aggregate supply when national income is valued
at OY0. To the left of point E aggregate supply is less than aggregate expenditure.
That is expenditure exceeds supply. As a result the level of stocks will be depleted.
The distance AB is to extend to where stocks are being depleted (inflationary gap).
As a result producers must respond by producing more goods and services, thus
they will demand more factors of production and therefore generate more income.
As production increases AS also increases and producers move from A to E.
Conversely points to the right of the point E represent points at which AS is greater
than AE (deflationary gap).
10.2.4 Equilibrium and Keynesian unemployment

According to the classical school unemployment when it existed was viewed as
frictional (temporary) or voluntary. It was believed that voluntary unemployment
would force down wages and retain the labour market to full employment. Keynes
suggested that it is possible for an economy that is at equilibrium to experience
levels of unemployment. In his explanation of unemployment Keynes introduced
the concept of full employment which can be represented by a full employment line
(fe) which is similar to the PPF. OY f will be generated if all the resources or factors
of production in the economy are employed.

Fig 10.8 Keynesian unemployment
fe
Expenditure AS
AE2
R AE1
Q
O Ye Yf Income
OYe is the equilibrium value national income which is less than the full
employment level implying that there are idle factors of production, that is, there is
unemployment. (The fact that the economy is operating below full employment
indicates that there is unemployment). This was the situation during the great
depression. Keynes suggested that demand management policies such as increasing
government expenditure, reducing the level of taxation, and reducing the rates of
interest, could be the only appropriate policy measure. If any of these policies is
implemented e.g. if government expenditure is increased, the aggregate expenditure
function will shift from AE1 to AE2 thus increasing national income form OY e to
OYf and eradicating unemployment since equilibrium national income will equal
the full employment level of income, there will be no unemployment.
10.3 The concept of the multiplier

The multiplier exists whenever a change in one variable induces or causes multiple
and successive stages of change in a second variable. The multiplier process arises
because the expenditure of one firm is the income of another. The additional
income is used to boost expenditure that fuels the increases in national income.
The multiplier analysis indicates that the change in expenditure and a change in
investment will give rise to a change in national income greater than the initial
change in expenditure that brought it about.

Fig 10.9 The Keynesian multiplier
Expenditure AS
F AE1
AE2
E
 in I
I I0
O Y1 Y2 Income
If the economy is at equilibrium with an initial aggregate expenditure function of

AE1 and national income OY1 , that is, an initial equilibrium at point E. Suppose
also that at point E private investment is zero. If new investment equal to OI is
introduced to AE the function will shift to AE 2. Equilibrium will change from E to
point F. It can be observed that a relatively small change in investment (I) has led
to an increase in national income (Y1-Y2) which is many times greater than the
initial change in investment. So we can say we have multiplied change in
investment to get a change in income (Y= kI)
10.3.1 How the multiplier works

Let us now use a mathematical example to illustrate how the multiplier works.
Assume that an economy is at equilibrium. The economy receives an autonomous
investment expenditure of $1000m. The marginal propensity to consume (MPC) is
0.9 and the marginal propensity to import MPM is 0.1. Assuming that taxes are
paid in lump sum and that the marginal propensity to withdraw (MPW) is 0.2, what
will be the change in national income generated by the initial change in investment
expenditure of $1000m?
Y = 1 = 1 = Multiplier
I MPW MPS + MPM

Since the investment expenditure of one firm becomes the income of another firm,
the multiplier process can be summarised by the following table.
I = $1000m
MPC = 0.9. Therefore MPS = 0.1
MPM = 0.1
MPW = MPS+MPM = 0.2
Stage I Y E W
1 1000m 1000m 800m 200m
2 800m 640m 160m
3 640 512m 128m
4 512m 409.6m 102.4
5 409.6 327.68 -
6 327.68 262.144 -
7 262.144 209.7152 -
8 - - -
9 - - -
10 - - -
TOTALS 1000m 5000m 4000m 1000m
Each succeeding stage of change is usually smaller than the previous one so that the
total change induced in the multiplier process comes effectively to an end when
further stages approach zero. The total income can be calculated as follows:-
Y = 1000 + 800 + 640 + 512 + ……………
= 1000 + (0.8) 1000 + (0.8)2 1000+ (0.8)3 1000 +(0.8)3 1000 + …….
= 1000[1+0.8+0.82+0.83+0.84+0.85+0.86+0.87
This is an infinite series whose summation is given by:-
Y = a 1
1-r
Where a = initial change in investment

r= common ratio (0.8)
Therefore Y = 1000 1
1-0.8
Y = 1000
1
0.2
Y = 1000 x 5
= $5000m
Thus, Y = 5 x I
Y = 5
I
Therefore multiplier = _____1____

MPM + MPS
= 1
MPW
EXAMPLE
In a closed economy with no government interventions MPC is 0.7. If the
economy receives an injection in investment expenditure equal to $1000 what will
be the result and Y?
I = $1000
MPC = 0.7. Therefore MPS = 0.3
1
Y = a
1-r
= 1000 1
1-0.7
= 1000 1
0.3
= 3.33
NB* The multiplier comes into operation for any autonomous change in
expenditure. So, autonomous changes in investment, government expenditure,
exports and consumption will have the same multiplier effect on an economy’s
national income. A multiplier equal to 1 / (MPS + MPM) is derived on the
assumption that taxes are lump sum only.
10.3.2 The multiplier in an open economy

In an open economy, the size of the multiplier depends on:
a. The marginal propensity to save (MPS) – you should also be aware of factors
b. The marginal propensity to import (MPM)
c. Tax rates, because taxes reduce the ability of people to consume and so are
likely to affect the marginal propensity to consume and the marginal
propensity to save.
Thus for the open economy:
Multiplier = ___1___
s+m+t
Where, s is the marginal propensity to save
m is the marginal propensity to import
t is the marginal propensity to tax, that is, the amount of an
increase in income that will be paid in taxes.
Whereas the multiplier in a closed economy is the reciprocal of the MPS, the
multiplier in an open economy, taking into account government spending and
taxation, and imports and exports, will be less. This is because government taxation
and spending on imports reduces the multiplier effect on a country’s economy.

10.3.3 The importance of the multiplier
The importance of the multiplier is that an increase in one of the components of
aggregate demand will increase national income by more than the initial increase
itself. Therefore if the government takes any action to increase expenditure (for
example by raising government current expenditure, or lowering interest rates to
raise investment) it will set off a general expansionary process, and the eventual
rise in national income will exceed the initial increase in aggregate demand. This
can have important implications for a government when it is planning for growth in
national income. By an initial increase in expenditure, a government can ‘engineer’
an even greater increase in national income, (provided that the country’s industries
can increase their output capacity), depending on the size of the multiplier.
10.3.4 Limitations of the multiplier

Keynes developed the concept of the multiplier in order to argue that extra
government spending on public works, financed by a budget deficit, would have a
‘pump-priming’ effect on a demand deficient economy so that demand would be
increased and national income would increase by more than the amount of the
initial injection into the economy of the extra government spending and because
demand would be increased, unemployment would be reduced. However, there are
several important factors that limit the significance of the multiplier for economic
management
a. The multiplier is of more relevance to a demand deficient economy with high
unemployment of resources than to an economy where there is full
employment. If there is full employment, any increase in demand will be
inflationary.
b. The leakages from the circular flow of income might make the value of the
multiplier very low, and so ‘pump-priming’ measures to inject extra spending
in the economy would have little effect. This is relevant to Zimbabwe were
there is a high marginal propensity to import.

c. There may be a long period of adjustment before the benefits of the multiplier
are felt. If the government wants immediate action to improve the economy,
relying on demand management and the multiplier could be too slow.
10.4 Investment
The process of gross investment is the acquisition of new stock of capital by firms.
Gross investment can be classified into replacement investment (depreciation or
capital consumption allowance) and net investment. Replacement investment refers
to a situation where firms buy new stock of capital to replace worn-out existing
stock. Conversely, net investment or additional investment refers to the addition to
the real capital stock of the economy and this addition is measured as a flow of
expenditure over time.
10.4.1 The importance of investment in Zimbabwe.

There are two reasons why investment is very important in Zimbabwe:
a. The act of investment represents consumption forgone now in order to
increase the capacity to produce and therefore to consume in the future. It is
through investment (or lack of it) that the future shape and pattern of
economic activity is pre-determined.
b. The growth rate of the economy is determined not only by the technological
progress or the increase in the size and quality of the labour force but also by
the rate at which the capital stock is increased or replaced. Investment
represents an addition to the existing capital stock. If that addition is greater
than the amount by which capital stock depreciates, then the capital stock of
the economy is growing and so is the capacity of the economy to produce
more goods and services. Hence investment is an important determinant of
the long-term growth rate of an economy.
10.4.2 Factors that influence the level of investment in an economy

The total value of desired investment in the economy depends on factors similar to
those influencing ‘micro-level’ investment decisions by firms:
a. The rate of interest on capital – high interest rates should make firms less
willing to invest because the marginal efficiency of capital will have to be
higher to justify the higher interest cost. Lower interest rates should have the
opposite effect.
b. Expectations about the future and business confidence – if businessmen hold
a pessimistic view of the future they will be reluctant to invest.
c. The levels of profits – if the level of profits is high firms are able to invest
more from retained profits. Retained profits are an important source of funds
for investment especially when interest charges are very high.
d. The strength of consumer demand for goods – strong consumer demand
should result in higher business profits and a greater willingness by firms to
invest in more plant and equipment (etc) to meet the demand.
e. Technological developments – when new technology emerges which changes
methods of production (such as robotics) or provide opportunities to produce
new types of good, there will be a boost to investment. Firms will be forced to
acquire the new technology for them to remain competitive.
f. Government policy – the government can influence the level of investment in
several ways, for example, controlling of interest rates, or providing tax
incentives to investors in the form of capital allowances or tax holidays, or the
government can spend money itself and higher government spending might
stimulate investment by the private sector etc.
g. Political stability – political instability drive away foreign direct investment.
10.5 The accelerator principle

The accelerator principle is concerned with the size of changes in investment
pending. The accelerator effect on investment comes into effect as a consequence
of changes in the rate of consumer demand. The accelerator principle states that if
there is a small change in the production output of consumer goods, there will be a
much greater change in the production output of capital goods required to make

those consumer goods. This change in production of capital goods (investment
spending) speeds up the rate of economic growth.
A numerical example might help to illustrate this principle. Suppose that a firm
bakes bread and has 100 ovens in operation. If the life of each oven is 5 years, 20
ovens must be replaced each year. Assuming a constant capital-output ratio:
a. If the demand for the consumer good (bread) is constant, 20 items of the
capital good (ovens) will be made each year.
b. If the demand for bread now increases by, say, 10% the firm will need 110
ovens in operation. During the first year of the increase, the demand for ovens
will be 30 units consisting of ;
i. Replacement of 20 ovens, and
ii. Extra requirement of 10 ovens to bring the total to 110 ovens.
Thus a 10% rise in demand for consumer goods resulted in a 50% rise in demand
for capital goods – in the short term. The accelerator principle indicates how, when
the demand for consumer goods rises, there will be an even greater proportional
increase in the demand for capital goods. This speeds up growth in national
income.

Chapter 11
Public finance
11.0 Introduction
Governments play significant roles in the economy. As outlined in Chapter 2 the
government allocate some of the society’s resources towards the production of
public and merit goods, regulates the economy and make it conducive for business,
formulate economic policies that are meant to improve the welfare of the society,
levy a tax on incomes of the rich and distribute income to the poor through social
services to ensure an equitable distribution of income in the economy among other
functions. This chapter discuss how the government can raise revenue much needed
to finance its activities as well as the formulation and implementation of fiscal
policy. By government, we refer to the central government (ministries and
government departments), local government (municipalities and town councils) and
government corporations (parastatals).
11.1 National budgets

The Ministry of Finance is in charge of the Treasury. The minister announces how
much the government is going to spend over the next twelve months, sometime in
November through the presentation of the national budget. A national budget is an
outline of government expenditure and how it is going to raise the money to pay for
its expenditure. It is used to influence economic activity. The level of economic
activity depends on the level of aggregate demand. The government can hence
influence the level of economic activity by varying its expenditure. There are three
types of national budgets
11.1.1 Reflationary or deficit budget

A reflationary or deficit budget refers to a situation where government expenditure
is greater than revenue before borrowing. The government will be planning to
spend more than what it intends to collect in the form of revenue. This is very
normal for all governments including the governments of United States, United

Kingdom and other rich nations. The reason to plan for a deficit budget is because a
deficit budget increases total demand within the economy, that is, it is expansionary
or it boosts the level of economic activity in the economy. In addition, the
government can over spend while investing in capital e.g. the construction of
schools or universities. The idea is that the government will benefit from a future
stream of tax revenue paid by those students who would have benefited from the
school or university. Thus these students will help the government to repay the
amount borrowed to finance the capital expenditure.
On the other hand, a deficit budget leads to crowding out of private investment
which is interest sensitive when compared to government borrowing. That is by
borrowing on the market, the government increases demand for funds thereby
pushing the level of interest rates up. The cost of borrowing or interest rate will end
up being pushed to levels that are uneconomic to the private borrower especially
when it becomes impossible to increase the mark up on prices. The private will
withdraw from the market leaving the government as the sole borrower because the
government can repay the loan by printing of new notes.
11.1.2 Deflationary or surplus budget

A deflationary or surplus budget refers to a situation where government
expenditure is less than revenue. A surplus budget reduces total demand within the
economy and hence reducing economic activity (deflates economic activity). It is
very rare for a government to achieve a deficit budget with the exception of
Botswana, United States and United Kingdom all of whom experienced a surplus
budget only but once.
11.1.3 Neutral budget

A neutral budget refers to a situation where government expenditure and revenue
are the same and total demand in the economy remains constant.

11.2 National debt
An accumulation of budget deficits over the years is called a national debt or public
debt. The national debt is the total amount owed by the government to the
Zimbabwean citizens and foreigners at a particular moment in time (domestic and
foreign debt, respectively). Interest has to be paid on the debt.
11.2.1 Problems of national debts

A large national debt is a problem if: -
a. Interest has to be paid to overseas citizens, so that the balance of payments
suffers.
b. Taxes have to be increased to meet interest payments.
c. The concern is that with budget deficit, we will be consuming now while
passing the responsibility to pay to future generations.
11.2.2 Composition of the national debt

The national debt can be classified into domestic debt (internal) and foreign debt
(external).
a.Domestic debt
The domestic debt is the amount of money the government owes the local citizens
of that country. It is expressed and repaid in the local currency. The advantages of
the government borrowing from local sources include:
i. Domestic debt is relatively easier to source.
ii. The terms of repayment are relatively easier since repayment doesn’t
necessarily have to be made in foreign currency.
On the other hand borrowing from local sources is discouraged because:
i. It could be inflationary especially if the government borrows from the
banking sector. Borrowing from the banking sector fuels money or credit
creation by the financial institutions and hence increasing the level of
money supply in the economy.
ii. It can push out private sector borrowing by increasing interest rates in the
market to beyond sustainable levels (crowding out effect). Government

borrowing is interest insensitive while private sector borrowing is interest
sensitive.
iii. The availability of local funds makes local borrowing a big source of
blowing government budget deficit. The government will continue to
borrow without restrain basing on the misconception that the government
can not be broke and that it can always repay.
b. External debt
The total amount of money the government owes to foreigners is the external or
foreign debt. External debt is expressed in foreign currency especially the United
States dollar which is the most convertible currency. Borrowing from foreign
individuals, governments and financial institutions has the following benefits:
i. It’s a source of funds to correct balance of payment deficit. That is, if the
country is importing more than its export it can repay for the extra imports
using funds borrowed externally.
ii. Foreign debt is a source of finance to buy items that require use of foreign
currency e.g. Zimbabwe is known to borrow from countries such as Libya
in order for the country to use the foreign currency to import fuel.
On the other hand an external debt has the following disadvantages:
i. A huge external debt could seriously strain the government in repayment
because repayment has to be made in foreign currency. This may drive the
country into a debt trap, that is, a situation where the government has to
borrow money to service interest on debt.
ii. State sovereignty could be mortgaged where the indebtedness is too heavy
for the country to meet the repayment commitment.
11.3 Government borrowing

There are various sources of government revenue. Among them is taxation,
national insurance contributions, borrowing, charging for services, selling-off state
owned assets (privatisation), profits from public corporations, donations and grants.

11.3.1 The public sector borrowing requirement
If the government spends more than its collected revenue, it will have to borrow the
difference. The amount the government needs to borrow in a given time period is
called the Public Sector Borrowing Requirement (PSBR). Since government
consists of three sections, the PSBR consists of: -
a. The Central Government Borrowing Requirement which is the amount of
money to be borrowed by the central government (ministries and government
departments).
b. Local Authorities Borrowing Requirement which is the amount of money to
be borrowed by local authorities (city councils, rural districts and town
councils).
c. The Public Corporation Borrowing Requirement which is the amount of
money government companies or parastatals requires borrowing.
11.3.2 How the government can borrow

The government can borrow through: -
a. Selling National Savings Certificates.
b. Selling Treasury Bills, which usually mature in 90 days.
c. Selling Securities which earn interest and will be bought back sometime in
the future. Securities are sometimes called gilts, stocks or bonds. Government
securities are risk free, that is, there is no chance that the government will fail
to repay. As a result government securities are referred to as gilt-edged.
11.4 Taxation
A tax is a compulsory contribution to government and this contribution is made
without any reference to potential benefits received by the taxpayer.
11.4.1 Reasons for paying taxes

Taxpayers view taxes as bad, in the sense that they do not enjoy paying them.
Surely no one enjoys paying taxes especially income tax (pay as you earn). The
government still has to collect taxes in order:

a. To raise money to pay for government spending (taxes are a major source of
government revenue especially in developing countries like Zimbabwe where
taxes contribute more than 80% of the revenue..
b. To discourage people from buying harmful goods like cigarettes that is, it
tries to change consumption patterns by making the harmful commodity or
demerit good expensive.
c. To influence the level of total demand in the economy e.g. to reduce the level
of total demand in the economy the government can increase the level of
income tax. This will in turn reduce disposable income where disposable
income (Yd) is obtained by deducting taxes (T) from the gross income (Y).
Yd=Y-T. Taxation is one of the fiscal policy tools.
d. To redistribute income from the rich to the poor especially progressive
taxation that taxes heavily the high income earner and lightly the low income
earner. This way the gap between the rich and the poor is reduced.
e. To modify the price mechanism e.g. correcting market failures such as
externalities that can be reduced by levying a pigovian tax paid on the polluter
of the environment.
11.4.2 Principles of taxation

Taxpayers view taxes as bad, in the sense that they do not enjoy paying them.
However, the government can make tax payment tolerable to the tax payer by
ensuring that the tax system conforms to the following principles or canons.
a. A tax should be certain so that everyone knows the amount, method and
when to make the tax payment
b. A tax should be convenient so that tax collection is at a time and in a form
suitable to the taxpayer. Income tax (PAYE) which is deducted before
salaries are paid score highest.
c. A tax should be economical with the cost of collection being less than
revenue and something being left out to offset the vexation caused. That is, it
should be easy to administer and cheap to collect.

d. A tax should be equitable (fair) that is it must be based on the ability to pay
so that wealthy people pay more than poor people (vertical equality) and
people under the same circumstances pay equally (horizontal equality).
e. A tax should be efficient by achieving its intended objective without acting as
a disincentive and stop people from working.
f. A tax should be flexible so that it is capable of variation and must
complement other government policies.
11.4.3 Methods of collection

Tax collection can either be direct or indirect. Direct taxes are paid straight to the
Zimbabwe Revenue Authority. They are therefore taxes on income or wealth and
the transfer of capital. For example, income tax (P.A.Y.E), capital gains tax,
company tax etc. Each individual’s tax liability is assessed separately. Conversely
indirect taxes are first collected by the seller and then passed on to the revenue
authority. For example VAT which is paid to the seller such as the retail shop
before the retail shop submits the revenue to ZIMRA. Direct taxes are therefore
taxes on expenditure.
11.4.4 The burden of taxation

Some taxes are fairer than others. However, taxpayers view taxes as bad, in the
sense that they do not enjoy paying them. A tax can be described as a: -
a. Progressive tax where the percentage of income taken in tax rises as income
rises. The rich pay more than the poor. It is based on the ability to pay
principle. Income tax (PAYE) is an example of progressive taxation.
b. Regressive tax where the percentage of income taken in tax falls as income
rises. It results in the richer people paying a smaller proportion of their
income in tax. Rates are an example of regressive taxation.
c. Proportional tax where the percentage of income taken in tax is constant as
income rises. Sales tax is an example of proportional taxation. It takes the
same proportion of income at all levels of income.

Fig 11.1 The classification of taxes according to the burden of the tax
Progressive tax
% Tax
Rate
Proportional tax
Regressive tax
O Income
11.4.5 Tax incidence and tax shifting

Tax incidence refers to the final resting place of the tax. It can be divided into
statutory incidence which refers to the individual who is legally liable to paying the
tax and economic incidence which is the final resting place of the tax. When there
is a difference between economic and statutory incidence, it implies that the tax
burden has been shifted. Tax shifting occurs through a change in prices of
economic goods. There are two types of tax shifting:
a. Forward shifting which refers to the passing of the tax burden to consumers
from the producers in the form of higher prices and,
b. Backward shifting which refers to when consumers pass the tax burden
back to the supplier. This leads to a fall in the price of a factor of production
e.g. P.A.Y.E where the supplier of labour eventually receives less from the
consumer of labour (employer).
The ability to shift the burden of tax forward or backwards depends on three
factors, namely;
a. The price elasticities of demand and supply.
b. Market structure e.g. it is difficult in perfect competition than in monopoly.
c. Nature of the tax for example direct taxes are difficult to shift as compared
to indirect taxes.
11.4.6 Structure of taxation

Taxes are structured along the method of payment into direct and indirect taxes.

a. Direct taxes
Direct taxes are paid straight to ZIMRA and therefore are taxes on income, wealth
and transfer of capital. Examples include income tax (PAYE), capital gains tax,
corporation tax and inheritance tax. Direct taxes have the following advantages:
i. They are progressive in nature and hence there is equality of sacrifice.
ii. Direct taxes collect more revenue especially income tax which raise more
than half of the Zimbabwean government’s revenue.
iii. Direct taxes are convenient, that is, tax collection is at the time and in a
form suitable to the tax payer.
iv. They act as built in stabilisers, that is, during an inflationary period the
higher income group automatically move into the highest tax bracket and
pay a higher rate of tax which reduces their disposable income. As a result
of a fall in the disposable income the level of aggregate demand in the
economy decreases leading to a reduction in the inflationary pressure in the
economy. Thus the inflationary period will automatically be curbed.
Conversely, direct taxes have their own disadvantages which can be outlined as
follows;
i. Direct taxes are a disincentive to work, saving and investment especially
where the tax rate is very high..
ii. They are very unpopular as their impact on income is direct.
iii. Direct taxes are deflationary that is they reduce the level of aggregate
demand in the economy.
b. Indirect taxes
Indirect taxes are first collected by the seller and then passed on to the revenue
authority. They are taxes on expenditure. Examples include sales tax, VAT, excise
duty and customs duty. The advantages of direct taxes include;
i. Indirect taxes are easy to administer and to collect because they are
collected by the seller from numerous consumers and the seller will make
one bulk remittance to ZIMRA. Thus the seller will collect at their expense
and capital outlay hence direct taxes are economical to the tax authority.

ii. They are based on the benefit principal, that is, one who consumes more
pays more. As a result they can be avoided by not consuming the product.
On the other hand, indirect taxes have disadvantages in that;

i. They raise the final price of the product and hence they are inflationary.
ii. They discourage the consumption of certain goods such as demerit goods,
thus affecting consumption patterns.
11.4.7 Effects of taxation

Taxes have various economic and welfare effects: -
a. Taxes especially indirect taxes raise the final price of products and hence they
are inflationary.
b. Indirect taxes on demerit goods affect consumption patterns.
c. High rates on direct taxes such as income tax are a disincentive to work,
effort, saving and investment.
d. Taxation reduces aggregate demand in the economy.
e. Taxation may fall heavily on some households than others thus altering the
distribution of income.
f. Some households may be pushed into a poverty trap, that is, with higher
income a family faces both a rising tax bill and the withdrawal of its social
security benefits.
g. Since taxation may be a disincentive to investment it may contribute to a
reduced output and level of employment.
11.5 Privatisation
Privatisation involves an attempt to increase reliance on the market forces and on
private sector initiative. It encompasses three processes;
a. The selling of some state owned assets such as the disposal of government
shareholding in COTTCO and DZL.
b. All the different means by which the disciplines of the free market in the
provision of goods and services can be applied to the public sector e.g.

commercialisation which happens when a government corporation is
structured to operate just like any private corporation. The former PTC was
disbundled into three business units namely; Net-One, Tel-One and
ZIMPOST).
c. Subcontracting of government services e.g. catering and security at
government institutions.
There are various reasons why the government may want to privatise some of its
enterprises. Among them are the following benefits:
i. The government revenue much needed to finance its activities such as
capital expenditure when constructing schools and hospitals..
ii. Privatisation of loss making parastatals reduces the burden on the public
purse since loss-making public corporations are financed from public funds.
iii. If a public corporation is privatised its given freedom from detailed political
interference. For once the corporation will be expected to operate on a
commercial basis without politicians interfering in its operations e.g. no
political appointments to office will be made.
iv. Commercialisation improves the efficiency of the corporation through
competition in the market.
v. The privatised corporation stands a high chance of making a profit and
hence the tax base is widened in addition to that as a public corporation the
company was previously exempted from taxes.
vi. Operating for profit motive will urge innovation inn the privatised
corporation.
vii. Privatisation policy can be used to empower the indigenous people e.g.
through the ‘employee share ownership scheme’ where priority will be
given to the employees to buy shares in the new privatised corporation.
On the other hand the privatisation may be considered as an unnecessary evil. For
example the process which was being carried out by the Privatisation Agency of
Zimbabwe (PAZ) was halted in 2002 for the following reasons;

i. Once the corporation is privatised it will charge economic or market prices
for its products a situation which is likely to see the poor not being able to
buy the product. This is a major draw back especially where the product is
essential e.g. ZESA Holdings will end up charging electricity tariffs that are
beyond the rich of most rural consumers and small scale farmers.
ii. Privatisation has been likened to a farmer selling a heifer which is about
deliver. Through privatisation, potential blue chips are sold off to
individuals for example COTTCO which emerged as blue chip companies
soon after privatisation.
11.6 Fiscal policy

Fiscal policy refers to attempts to influence aggregate demand by altering
government expenditure and/or revenue in order to bring about desired changes in
the economy. This is deliberate manipulation and hence it is discretionary.
Discretionary fiscal policy can be expansionary if it aims to raise aggregate demand
in the economy and contractionary if it aims to reduce the level aggregate demand.
Fiscal policy is outlined through the presentation of the national budget by the
Ministry of Finance.
11.6.1 Tools of fiscal policy

There are three tools of fiscal policy
i. Taxation
The government can manipulate the level of taxation in order to change the
level of aggregate demand in the economy. An increase in taxation will
reduce aggregate demand while a reduction in taxation will increase
aggregate demand. This is because people consume from disposable income
(Yd) where Yd = Gross Income (Y) – Taxes (T).
(Yd = Y – T).
ii. Government expenditure
Government spending is a direct component of aggregate demand (AD). Ad is
given by the equation AD = C + I + G + X – M. An increase in government

spending directly increases the level of aggregate demand while a reduction in
government expenditure reduces demand.
iii. Borrowing
If the government budgets for a deficit (budget deficit) it will have to borrow
the extra expenditure over and above its revenue. The government can borrow
from the non-bank sector which is not inflationary. Alternatively it can
borrow from the banking sector which is inflationary and is equivalent to
printing new notes and coins.
11.6.2 Problems of discretionary fiscal policy

Compared to monetary policy, fiscal policy is less flexible and requires the
approval of parliament before it becomes effective. In addition the effectiveness of
fiscal policy in addressing macroeconomic problems is affected by the following
problems.
i. Timing
Fiscal policy can only become operational when approved by the
parliament. As a result it is not flexible and is affected by time lags. There
can be considerable time delays between the beginning of an economic
disturbance and the impact of the change in fiscal policy. Economists
distinguish between several kinds of delays.
 Recognition lags occur when there are delays between changes in
economic disturbances and the actual recognition of these changes,
especially due to delays in reporting procedures.
 Administration lags refer to the time delay that can occur between an
economic problem being recognised and administrative actions taken to
correct the problem. Correcting the problem is usually through the
national budget that is an annual event.
 Implementation lags refer to the delay between action taken to correct
some economic disturbance (e.g. an economic downturn) and the impact
of the action on the economy.

ii. Business uncertainty
Sudden and unexpected changes of fiscal policy either on expenditure or
revenue side may create uncertainty among businesspersons causing them
to revise their plans.
iii. Expenditure inflexibility
Government expenditure is sticky downwards. That is government
expenditure can easily be increased but can be reduced with great difficulty.

Chapter 12
International trade
12.0 Introduction
No country is an island. The world is more and more becoming one global village.
The actions of one nation affect others, not just near neighbours but countries
across the globe. International trade refers to a situation when two or more
countries trade with each other. The term ‘international trade’ can loosely be
translated to ‘trade between nations’. In this chapter we are going to discuss the
reasons why countries engage in international trade, trade protectionism, the
balance of payments accounts and the various exchange rate regimes.
12.1 Reasons for international trade

Countries trade with each other for the following reasons: -
a.To gain access to those products which are not found naturally within their
geographical boundaries e.g. Zimbabwe need to import fuel from countries
that are richly endowed in petroleum deposits.
b. To share cultural heritage and historical experiences e.g. tourists will love to
visit the Great Zimbabwe ruins in Masvingo for them to appreciate the life of
the great Rozvi Empire.
c.To foster political relations, that is, countries trading with each other consider
themselves to be partners and hence will be less likely to engage each other in
a war situation. This explains why upon signing political agreements
countries proceed to sign trade agreements.
d. To introduce new technology and ideas, for example, developing countries
have to import modern technology from the developed countries.
e.Trade stimulates competition that may lead to reduction in prices and
improvement in the quality of goods produced.
f. The volume of goods consumed in a country will increase hence the standard of
living of the people will improve.

12.2 Gains from trade theories
International trade makes the problem of scarcity less acute or less severe. The
following theories illustrate how countries may gain from specialisation and
international trade. They are also used to illustrate situations when countries should
trade with each other. In other words, countries should trade with each other if there
is an absolute advantage or a comparative advantage.
12.2.1 Simplifying assumptions

For the purpose of our discussion, we assume that:
a. There are only two countries in the world, Country A and Country B.
b. Each of these two countries produces two goods, Good X and Good Y.
c. In each of the two countries, there are only two factors of production
available, Labour and Capital.
d. There are no barriers to trade and no transport cost that is goods are free to
move from one country into another country without for example being
charged customs duty or transport cost.
e. Factors of production within each country are perfectly occupationally mobile
but can not move from one country to another.
Basing upon these simplifying assumptions we can illustrate absolute and
comparative advantages analysis.
12.2.2 The absolute advantage theory

An absolute advantage exists when a country is more efficient than the other in the
production of one of the commodities. For example, if with two units of resources ,
country A produces 20 units of good X and 100 units of good Y, while country B
produces 10 units of good X and 150 units of good Y as summarised by the
following production possibilities table and frontier.

Table 12.1 Production possibilities before specialisation
Output per unit resources
Country Unit of Good X Units of Good Y
A 20 100
B 10 150
Total World Output 30 250
Fig 12.1 The production possibilities frontiers before specialisation
150
Country B
Good Y
100
Country A
O 10 20 Good X
The diagram shows that with one unit of resources, country A is more efficient in
the production of good X, while with the same quantity of resources, country B is
more efficient in the production of good Y. Thus country A has an absolute
advantage in good X production while country B has absolute advantage in good Y
production. Country A must specialise in good X production while country B
specialises in good Y production. Each country will move its two units into the
production of the good it has absolute advantage in producing. The changes in total
world production would be represented by the following production possibilities
table.
Table 12.2 The production possibilities table after specialisation

A 40 0
B 0 300
Total World Output 40 300
Net Gain +10 +50
By allowing for specialisation the world total output of both goods has increased.
The two countries can trade with each other with each county exporting its surplus
in exchange for that commodity it does not produce. For example country A will
export surplus units of good X in exchange for units of good Y from country B.
12.2.3 The comparative advantage theory

Comparative advantage analysis arises from a situation when one country has
absolute advantage in the production of both commodities. A comparative
advantage exists when a country can produce a certain good at a lower opportunity
cost than the other country. For example if with its units of resources country A
produces 10 units of good X and 8 units of good Y while with the same amount of
resources country B produces 2 units of good X and 4 units of good Y as
represented by the following production possibilities table and frontier.
Table 12.2 The production possibilities table before specialisation

A 10 8
B 2 4
Country A
Fig 12.2 The production possibilities frontier before specialisation

Good Y
8
Country B

4
O 2 10 Good Y
The diagram shows that country A has an absolute advantage in the production of
both goods. To determine the basis for trade we look at the opportunity cost of one
good in terms of units of the other in each country. The opportunity cost of one
unit of good X in terms of good Y and that of one unit of good Y in terms of good
X, in each country is as follows: -
Opportunity cost table

In country A: 1X = 0.8Y and 1Y = 1.3X
In country B: 1X = 2.0Y and 1Y = 0.5X
Country A has a comparative advantage in the production of good X while country

B has comparative advantage in the production of good Y. Therefore country A
specialises in good X and country B in good Y production.
12.2.4 Causes of cost differences

There are mainly two reasons why the cost of producing one commodity differs
from one country to another.
a. Some countries are endowed in certain natural resources or climate conducive
to the production of certain commodities than the others. For example
Zimbabwean climate is favourable to the production of tobacco than
Botswana’s climate.

b. Some people have innate qualities of manual dexterity, scientific ability, and
enterprise and which give them advantages over other countries e.g. the
Japanese.
12.2.5 Limitations of the gains from trade theories

a. The theories are simplistic. They assume the existence of two countries
producing two goods using two factors of productions. In practice there are
more than two goods, two factors and trade is multilateral rather than bilateral.
b. Goods are assumed to be of the same quality, that is, they are homogenous.
This is unrealistic because the quality of goods differs from one country to
another.
c. The theories assume that there are no transport costs and there is free trade. In
reality, the advantages of specialisation can be cancelled by trade restrictions
and transport costs.
12.3 Terms of Trade (TOT)

Terms of trade refers to the quantity of exports that must be exchanged for a unit of
imports. It is the rate at which a country exchanges its exports for imports and it
can be expressed as an index as follows:
Terms of trade = Index of export prices x 100
Index of import prices
If the index is less than 100 it is unfavourable terms of trade while if the index is
greater than 100 it is favourable terms of trade. Terms of trade reflect the
opportunity cost of one good measured in terms of the other. From the previous
opportunity cost table, good X and Y can be exchanged for:
0.8Y < 1X < 2.0Y
0.5X < 1Y < 1.3X
12.4 Trade protectionism

Trade protectionism is where a country erect trade barriers with the purpose of
hampering the free movement of goods into an economy from the rest of the world.
These barriers interfere with the gains from free trade. In other words the gains
from trade theories illustrated how countries stand to benefit if they allow for
specialisation and trade. In practice, these benefits are eroded by the various tariffs,
embargos, etc that are imposed on goods from other countries.
12.4.1 Methods of trade protectionism

The methods that could be used reduce or prevent entry of goods from other
countries into a country include:
a. Tariffs
A tariff is a tax or customs duties levied on imported or exported goods. The
tariff can either be expressed as percentage of value (ad valorem) or per unit of
the imported or exported commodity. The effect of a tariff is that it increases
the final price of the imported or exported commodity. For example a vehicle
imported for US$5 000 may end up costing US$10 000 to a local importer if an
80% customs duty and 20% surtax is added to the import price. Thus tariffs
make imports more expensive.
b. Quota
A quota is a quantitative restriction on imports or exports. Once the quota is
satisfied or met no additional quantity will be imported or exported.
c. Embargo
An embargo is a complete ban prohibition on trade for example trade in hard
drugs such as cocaine.
d. Import controls
Import controls refer to a situation where the government puts in place
legislation or measures that regulates the importation of certain products. For
example agricultural products such as maize and live animals can only be

imported upon receiving the authority in the form of import licenses from the
Ministry of Agriculture and Ministry of Health and the Department of
Veterinary Services.
e. Exchange controls
Exchange controls refer to when the availability of foreign currency is restricted
in order to control the volume of imports. If people do not have the foreign
currency they can not import.
f. Subsidies
A subsidy is the opposite of a tax. A subsidy refers to a situation where the
government pays a part of the production costs for a domestic commodity. If
domestic goods are subsidised, they become cheaper as compared to imports.
12.4.2 Reasons for trade protectionism

Various arguments have been forwarded in favour of the imposition of barriers to
trade. Among them are:
a. Infant industry argument
The argument is that infant industries need to be protected from foreign
competition until growth is attained. An infant industry is a new or emerging
industry that usually face high average costs of production because it will not
be enjoying economies of scale. Because of its high average costs, the firm will
be charging high and uncompetitive prices and can not compete with long
established international firms that will be enjoying economies of scale. Infant
firms need to be protected from such foreign competition until they are able to
compete. However the argument against such protection is that from
experience, firms that enjoy such protection prefer to remain small and continue
to enjoy the protection than to grow and face the competition.
b. Strategic industry argument

Industries which are vital or strategic for the integrity of the country such as the
Zimbabwe Defence Industries or the agricultural industry requires protection
from foreign competition. The idea is to reduce dependence on foreign supplies
which tends to compromise a country’s sovereignty.
c. Revenue argument
Most governments in developing countries raise revenue needed to finance their
expenditure from tariffs such as customs duty. In addition these tariffs earn the
government foreign currency.
d. Anti-dumping argument
Dumping refers to the sale of goods in a foreign country at prices lower than
that in the home country. Rich countries may dump goods which may be
harmful such genetically modified food or untested medical drugs. By imposing
trade barriers such goods may not find their way into the country.
e. Balance of payment argument

A country faced with a BOP deficit can either correct the situation by reducing
the volume of imports through the imposition of tariffs or increase the volume
of exports through export promotions. Thus trade protectionism may be a way
to discourage expenditure on imports and thus correcting a BOP deficit.
f. Employment argument
Trade barriers may seek to switch expenditure from imports to domestically
produced goods. This will increase demand for domestic goods and domestic
production will increase. Thus the level of employment in the country will
increase.
12.5 Economic integration

Economic integration refers to a situation when different countries in different parts
of the world are organising themselves into economic and political blocs. It can be
described as “encompassing measures which are designed to abolish discrimination
between economic units belonging to different national states.” Economic
integration aims at liberalising trade between countries – either generally or with
specific countries.
12.5.1 Criteria for successful integration

A number of common factors stand out as necessary for successful economic
integration. Among them is that,
a.Member countries should be at roughly similar levels of economic
development.
b. Each member country must be satisfied that it is benefiting from the
arrangements.
c.Governments must be prepared to cede some sovereignty to a supranational
institution.
d. Political conflict between members must be containable.
12.5.2 Advantages of economic integration

a. Increased specialisation.
b. Promotes peace, security and political stability.
c. Expanded markets both to sellers and buyers.
d. Improved welfare to the members of the region.
e. Ensures uplifting of tariffs between member countries, thus enhancing trade
links.
f. A stronger bargaining position with the rest of the world.
g. Accelerated rates of investments in the region.
12.5.3 Disadvantages of economic integration

a.There will be increased competition that may injure domestic industries.
b. Loss of state revenue if tariffs are uplifted.

c.Countries that are better than others may dump goods in poor member
countries.
d. Economic domination by those countries which are better than the others e.g.
South Africa in the SADC region.
e.Member countries may follow economic policies that can threat co-operational
e.g. the land redistribution in Zimbabwe in the SADC region.
12.6 Exchange rates systems

An exchange rate indicates the value of one currency relative to some other
currency. It is the amount of Zimbabwean dollars that will be required to buy a
unit of foreign currency. It is the price at which purchases and sales of foreign
currency or claims of it take place and thus exchange rates act as signal and
rationing devices. There are three traditional exchange rate regimes namely
flexible, fixed and managed float exchange rate systems
12.6.1 Flexible exchange rates

This is a system in which the market forces of demand and supply determine the
rates without any government intervention. No reserves are theoretically required
as there is self-adjustment of relative prices of exports and imports through the free
fluctuating rates. Demand for foreign currency arises out of a desire to buy imports
or to invest abroad or to repay our foreign debt. On the other hand the supply for
foreign currency arises from earnings from exports or inflow of capital from
foreign investors. The market exchange rate (e1) will be established at the point
where the demand for foreign currency equals the supply of foreign currency on the
following diagram.
Fig 12.3 Market exchange rates

Exchange Rate
(ZW$ = US$1)
S
e2=$800
e1=$600
eo=$450
O Qty of foreign currency

The equilibrium exchange rate is determined by the intersection of demand and
supply for foreign currency. The equilibrium exchange rate equals e 1 where
ZW$600 = US$1. If the exchange rate is above e1, the supply of US dollars will
exceed the demand forcing down the value of the US$ relative to the ZW$ (the
ZW$ appreciates relative to the US$). The opposite will happen in the case of an
excess demand for US$ (the ZW$ will depreciate relative to the US$).
a. Factors affecting demand for and supply of foreign currency

i. Seasonal fluctuations e.g. in Zimbabwe, the supply of foreign currency
increases during the tobacco selling season.
ii. Changes in consumer preferences e.g. if Zimbabweans start to prefer
American goods demand fro the US$ will increase.
iii. Differentials in interest rates that is if Zimbabwe start to offer high real rates
of interest on short term investment foreigners may increase their deposits
of foreign currency in the country to benefit from the high real returns (‘hot
money’).
iv. Relative price changes (inflation).
v. Granting of foreign loans and developmental aid which directly contribute
to foreign currency supply.

vi. Changes in capital flows (foreign direct investment) - where an increase in
foreign direct investment results in an increased flow of foreign currency
into the country.
b. Advantages of flexible exchange rates

i. There is an automatic correction of BOP disequilibrium through the
automatic appreciation and depreciation of the exchange rate to adjust
imports and exports.
ii. Monetary authorities may devote their effort and resources to other
domestic objectives.
iii. There is no need for foreign currency reserves.
iv. There is little risk of controlling the exchange rate for political or selfish
reasons.
v. The equilibrium exchange rate is the market rate hence there would be no
parallel or black markets.
vi. This market-based rate is a true reflection of economic performance and
thus allows rational decisions.
c. Disadvantages of flexible exchange rates

i. Flexible exchange rates are open to speculation and hence
fluctuate daily, thus are unstable.
ii. Fluctuations in exchange rates tend to add to the uncertainties
of foreign trade.
iii. Fluctuations increase the possibility of domestic inflation, for
example, currency depreciation will raise import prices and hence raise
costs of imported inputs. This will be passed on in the form of imported
cost-push inflation.
iv. Fluctuations may tend to lessen the flow of foreign lending. A
small exchange rate change may wipe out several years’ interest from
foreign lending.

12.6.2 Fixed exchange rates
Fixed exchange rate refers to a situation where the exchange rates are fixed at pre-
announced par values that are only changed when they can no longer be defended.
The exchange rate is therefore determined by the authorities and not by market
forces. An essential precondition of fixed exchange rates is that the Reserve Bank
must be able to buy and sell any quantities of foreign currency necessary to
eliminate excess supply and demand of foreign currency at the controlled rate.
Thus the Reserve Bank should set up a reserve fund of convertible currencies in
order to carry out this intervention policy.
a. Advantages of fixed exchange rates

i. Fixed exchange rates are very stable because they are not open to
speculation and hence they create a certain environment
ii. Stability makes business planning and forecasting a lot easier.
iii. The local currency can be overvalued making foreign currency artificially
cheaper and hence capital intensive investment is promoted.
iv. Because of their fixed exchange rate stability there is limited chances of
importing inflation therefore fixed exchange rates are anti-inflationary.
b. Disadvantages of fixed exchange rates

i. A currency may remain overvalued or undervalued.
ii. Resources that could be used more productively are tied up in foreign
currency reserves needed for the central bank’s intervention policy.
iii. There will be foreign currency shortages causing black and parallel
markets to emerge.
iv. Credibility problems, that is, there may be doubts about the government’s
ability to maintain the exchange rate at its level that leads to speculative
crises.

12.7 Balance of Payments (BOP) Accounts
BOP is an account showing a country’s financial transactions with the outside
world over a given period of time, usually a year. The BOP accounts are made up
of three separate accounts namely, current account, capital account and official
reserves and liabilities account.
12.7.1 Current account

The current account records a country’s commercial transactions, that is, the import
and export of goods and services. It is subdivided into two sections: -
a. Trading account which record transactions in merchandised goods that is
export and import of goods which are tangible or visible. The balance on the
trading account is called the Balance of Trade (BOT). It is obtained by
exports less imports of goods. BOT is favourable if it is positive and
unfavourable if imports exceed exports.
b. Services account which record trade in services which are invisible or
intangible. The balance on the services account is called the Invisible
Balance
NB* The sum of the BOT and the Invisible Balance is the Balance on Current
Account
12.7.2 Capital account

The capital account records the movement of money for non-trade reasons. That is
the inflow and outflow of money for non commercial transactions. The bulk of
these flows are for investment purposes. The capital account is subdivided into: -
a. Short-term capital flow which measures capital flows arising from
investments in assets with contractual maturity of less than one year. These
funds are held in bank accounts or treasury bills and move around the world
in search of relatively high rates of interest and are referred to as ‘hot money’.
b. Long-term capital flow that record capital movements that arise from
investments in assets whose contracts are for more than one year e.g. bonds

and the establishment of industries or construction of factories in foreign
countries (foreign direct investment).
12.7.3 Official reserves and liabilities account

The official reserves and liabilities account serves two purposes in the BOP
accounts:
a. It records a country’s holding of foreign reserves and gold.
b. It serves as the means of correcting imbalances between inflows and outflows
of foreign currency, that is, it is a balancing item. For example, if there were
no capital flows and a country incurs a BOP deficit in one year, the difference
will be made up by a decline in the official reserves. This section provides a
link between the current and capital accounts and hence can be viewed as a
balancing item.
12.7.4 The importance of BOP accounts

A country’s BOP accounts are very important because,
a. They show how a country is performing externally.
b. They reveal the trend of trade and the major trading partners of a country.
c. BOP accounts are a barometer of economic performance e.g. persistent BOP
deficits implies that the economy is not performing well.
d. Government can see where to intervene with trade regulations.
12.8 The IMF and the World Bank

The two Breton Woods sister institutions were incepted at a conference held in
1944 in Breton Woods. However, they started their operations in 1947. The IMF
was created primarily to promote a freer trade and payments mechanism. On the
other hand, the World Bank was created to finance developmental projects and the
eradication of poverty.

12.8.1 Principles of the IMF
a. All members were to contribute to a large pool of foreign currencies and gold.
Each country’s quota was determined by the size of its national income and
its share of the world’s trade. This explains why countries like the USA
dominate the operations of the IMF.
b. All member countries were encouraged to refrain from using any trade
restriction measures that are harmful to trade.
c. Member countries were to adopt an adjustable peg system of exchange rates
were devaluation or revaluation were allowed in order to correct BOP serious
problems.
12.8.2 The role of the IMF

a. The IMF provides short-term assistance to countries facing BOP deficit
problems to enable them to correct the deficit without resorting to harmful
trade restrictions.
b. It gives expert advice to member countries on Economic Reform Programs
such as ESAP.
a. The fund plays a banking role by allowing member countries to withdraw
funds through the Special Drawing Rights (SDR).
b. It encourages that currency of member countries should easily be exchanged
for other currencies (international convertibility of member currencies).

Chapter 13
Money and banking

13.0 Introduction
“Money bewitches people. They fret for it, and sweat for it. They devise most
ingenious ways to get it. Money is the only commodity that is good for nothing but
be gotten rid of. It will not feed you, clothe you, shelter you or amuse you unless
you spend it or invest it. It imparts value only in parting. People will do almost
anything for money and money will do almost anything for people. Money is a
captivating, circulating, masquerading puzzle” Federal Reserve Bank of
Philadelphia, ‘Creeping Inflation’; Business Review, August 1957 p3. In this
chapter among other issues, we are going to define money and discuss its functions.
In addition market equilibrium interest rates will be determined where money
supply equals the demand for money.
13.1 Functions of money

Good money is characterised by stability, scarcity, portability, divisibility,
uniformity, acceptability, and durability. Money can be identified as anything that
is generally acceptable in the settlement of debts. It can be described by what is
does, that is, money can best be described by its functions. Money plays the
following important roles in the economy
13.1.1 Medium of exchange

Money as a medium of exchange allows consumers to exchange their preferences.
That is people exchange their goods and services for money rather than for other
goods and services like what used to happen in barter trade. Thus money is usable
in buying goods and services.
13.1.2 Measure of value

Money as a measure of value becomes a common denominator upon which relative
exchange values can be established. The value of one product can be expressed in

monetary terms (price). For example the value of a vehicle can be expressed as
$200m and not 20 herds of cattle.
13.1.3 Store of wealth

Money presents a convenient form in which to store wealth especially because of
its liquidity, that is, money can easily be used to pay for transactions. People can
prefer to keep their wealth in the form of money which is liquid rather than illiquid
assets such as bonds. One other reason for this preference is because money is not
perishable as compared to some other assets such as cattle.
13.1.4 Standard of deferred payments

Deferred payments are future payments obligations. Money as a standard of
deferred payments allows credit transaction to be undertaken. For example people
can buy on hire purchase and sign a contract to repay in monthly instalments.
NB* Money should maintain a constant purchasing power over a long period if it
were to perform these functions properly. The purchasing power of money is what
a given currency can buy in the domestic economy. The purchasing power or value
money is reduced by inflation. For example, if our Z$ loses its purchasing power,
people would quote their prices in other currencies such as the US$ and they would
prefer to accumulate assets that appreciate in value such as houses rather than
storing their wealth in the form of money.
13.2 Money Supply

The different functions of money give rise to different definitions of money supply
in the economy. The official definition of money supply in Zimbabwe is M3 which
is derived as follows:
13.2.1 Money as medium of exchange (M1)

M1 defines transaction money, that is, money used to pay for day to day
transactions and it is given by;

M1 = Notes and coins in circulation + Demand deposits with financial institutions.
Demand deposits refer to deposits that can be withdrawn without giving notice of
withdrawal to the bank, for example current account deposits which can be
withdrawn by writing a cheque.
13.2.2 Money as a spending potential of the economy (M 2)

This definition identifies all deposits that are easily convertible into cash. These
deposits are made up of notes and coins in circulation, demand deposits with
financial institutions, savings deposits and fixed time deposits that mature within
30 days. Thus M2 is given by;
M2 = M1 + Savings deposits + Fixed time deposits that mature within 30 days.
13.2.3 Money as store of wealth (M3)

This definition includes quasi or near money, that is, assets that are not easily
convertible into cash. This is the official definition of money supply in Zimbabwe
and it is given by;
M3 = M2 + Fixed time deposits that mature after 30 days.
Thus M3 has five items, namely notes and coins in circulation, demand deposits
with financial institutions, savings deposits, fixed time deposits that mature within
30 days and fixed time deposits that mature after 30 days.
NB* The supply of money at any given time is a measurable aggregate. It is

determined by the Reserve Bank and thus can be taken as fixed in the short-term.
The supply of money curve is vertical showing that money supply is independent
interest rates.
13.3 Money Demand

Keynes described the demand for money as “demand for money to hold.” This is
the amount of cash balances people wishes to hold rather than illiquid assets that
yield income such as bonds or government securities. The demand for money is
called liquidity preference. Keynes identified three motives for holding money:

13.3.1 Transactions motive
People hold money to use to buy goods and services, that is, they need money to
pay for day-to-day transactions such as bus fare.
13.3.2 Precautionary motive

In addition to the amount of money they hold to pay for day-to-day transactions,
additional cash is held for precautionary purposes, that is, to make it available in
case of need, not only for the emergency situation such as illness but even to buy a
bargain if it should be available.
NB* The amount of money held as transactions and precautionary balances are
referred to as active balances. The amount held as active balances depend upon the
level of prices, the level of income, the frequency at which income payments are
made and the financial development of the economy.
13.3.3 Speculative motive

People also hold cash balances in order to take advantage of improving interest
rates and prices of financial assets. People holding money for speculative purposes
must be convinced that for the time being, it is more rewarding to hold money than
real income earning assets. People will prefer to hold cash balances than bonds
when the yield on bonds (interest rates) is low. At lower interest rates, less will be
lost by not investing it, whereas the reverse is true for higher interest rates. The
demand for money is positively related to income and negatively related to the rate
of interest. Thus the liquidity preference curve (demand for money curve) is
downward sloping.
13.4 Determination of market interest rates

The intersection of the demand for money curve and the supply of money curve
determine the market equilibrium rate of interest.

Fig 13.1 The market equilibrium rate of interest
Interest rate Ms
i0
Md
O M0 Money Balances
Any changes in the level of income and prices will shift the money demand curve
while money supply changes will shift the money supply curve. The equilibrium
interest rate will change in the process.
13.5 Credit creation by commercial banks

In their duty of lending commercial banks create bank deposits that are directly
related to money supply. To determine the extent to which commercial banks
create credit, we use the credit multiplier.
13.5.1 Simplifying assumptions

i. Assume a multiple banking system that is, assume that there are numerous
banks in the economy..
ii. Assume a 20% cash reserve ratio, that is, 20% of total deposits need not be
advanced as loans but set aside as cash reserve requirement. This amount is
set aside fro client withdrawal and will not be advanced as an overdraft.
iii. Bank transactions are only loans and payments are made and paid by way of
cheques.
iv. There are no cash leakages and banks keep no excess reserves.

13.5.2 Illustration of the credit creation process
Based upon the above assumptions, an initial $100m deposit into CBZ will increase
CBZ’s deposits by $100m. CBZ will have $100m at its disposable and can give out
an 80% overdraft of $80m to Ben by writing a cheque in his favour. Ben will
deposit the cheque into his FBC account where upon FBC’s deposits will increase
by $80m. FBC will give an overdraft of $64m to Chen while reserving $16m for
client withdrawal. Chen will deposit the cheque into his Stanbic account. The
process will continue until further deposits approach zero. The total deposits or
credit generated can be summarised by the following table.
Table 13.1 The credit creation process
Stage Bank Deposit Cash Reserves Overdraft

1 CBZ 100 20 80
2 FBC 80 16 64
3 Stanbic 64 - -
- - - - -
- - - -
Total 5000 1000 4000
The total amount of bank deposits created can be calculated using the credit
multiplier:
Credit multiplier = 1
Cash ratio
Thus, total deposit created = Initial deposit
Cash Ratio
= $100m
0.2
= $100m x 5
= $5 000m
NB* It should be understood that the money supply in this case is not only notes
and coins alone but the ‘invisible money’ called credit. Banks can not create notes

and coins but they can as illustrated, create credit by giving out loans or overdrafts.
The amount of cash money in the system remains the same. The system works
because of a fundamental assumption that the depositor, who is the bank’s creditor,
comes back to withdraw only a little which is catered by 20% cash ratio, in this
case. A bank could collapse if all depositors claimed their money back all at one
time because the bank would not have enough liquidity to pay cash (bank run).
However this seldom happens.
13.5.3 Limitations to the credit creation process

There are four limitations to the ability of commercial banks to increase money
through credit creation.
a. No increase in deposits.
b. Lack of willingness to borrow on the part of the public.
c. Lack of willingness to lend on the part of commercial banks.
d. The cash ratio, the smaller the cash ratio the greater the amount of credit
created and the larger the cash ratio, the smaller the amount of credit created.
This can best be illustrated if you answer the following example.
Example
Given an initial deposit of $200b into the banking system, how much credit or bank
deposits will be created if the cash reserve ratio is 10% and 50%?
13.6 Monetary policy

Monetary policy refers to deliberate attempts to manipulate the rate of interest and
money supply in order to bring about desired changes in the economy.
13.6.1 Aims of the monetary policy

In general terms monetary policy is used to regulate credit conditions and the
supply of money in order to fulfil macroeconomic objectives. The overall objective
is to improve the standards of living within the economy. Alternative objectives can
be listed as follows: -
a. To maintain stable prices, that is, control inflation or deflation.

b. To attain a rising level of employment.
c. To achieve real economic growth which is prerequisite to
improvement in the standards of living.
d. To secure a healthy BOP position.
13.6.2 Targets of monetary policy

To achieve the above objectives of economic policy, the authorities through
monetary policy will seek to manipulate:
a. Interest rates.
b. Growth in money supply.
c. Exchange rate and,
d. Growth in the volume of credit.
13.6.3 Instruments of monetary policy

There are two main categories of monetary policy instruments. On the one hand
there are those instruments of policy that are designed to have a general effect on
the financial sector and through that sector, on the whole economy. On the other
hand there are instruments of control that are specific in their effects on particular
financial organisations.
a. Instruments for general control

General control instruments affect certain key interest rates or the authorities may
directly engage in transactions in key financial markets in order to affect credit
throughout the economy.
i. Open Market Operations

‘Open market operations’ refers to the buying or selling of government securities
(bonds or treasury bills) by the central bank to the public. The principle is to
exchange ‘paper assets’ for ‘cash.’ For example, if there is excess liquidity in the
market the central bank will enter the market selling government securities. People
will exchange their cash for the securities and hence the excess liquidity is mopped

up. Conversely if there is a shortage, the central bank will enter the market buying
the securities from the public thereby injecting liquidity into the market.
ii. Discount policy or accommodation window

The discount policy refers to variations in the rates at which the central bank
discounts first class bills and other terms at which the central bank, as a lender of
last resort, advances funds to certain domestic parties in the money market, usually
to enable those parties to make good a reserve asset deficiency. Holders of first
class bills such as treasury bills can apply to the central bank for the maturity dates
of their bills to be brought forward. This is granted on condition that the holder will
receive an amount less than what they were going to receive upon maturity of the
bill. Thus the central bank will ‘discount’ the bill. For example if an investor holds
a $100m bill that will mature in the next three months, the investor can apply to
liquidate the bill today but instead of receiving $100m the central bank will pay an
amount less than $100m e.g. $80m. The bill would have been discounted by 20%
which is the $20m. Discounting increases the liquidity situation in the market. Thus
if the central bank is pursuing a tight monetary policy it will increase the rediscount
rate or the central bank can close the accommodation window facility.
iii. Non-marketable government debt

The government can seek to borrow direct from the central bank for some general
or specific purpose. In such cases, the terms of the loan are negotiated beforehand
and those negotiating on behalf of government will be anxious to ensure that the
agreed interest rate does not have an adverse influence on the absolute level of
interest rates, in nominal terms.
iv. Public debt management

The Reserve Bank operates a government account through which borrowing and
interest payments pass. Government borrowing or specifically the PSBR directly

fuels credit creation by commercial banks if the government borrows from the
banking sector.
b. Instruments of specific control

Specific instruments of control have their impact on specific financial institutions
and that impact is in the short-term restricted to those specific institutions.
i. Moral suasion
Moral suasion or moral persuasion consists of central bank requests or admonitions
to banking institutions to act or not to act in certain ways and it may cover any of
the bank’s activities e.g. lending policy. Moral suasion in not compulsory and
hence banks may not agree to change. However because of the nature of the
relationship between the central bank and these banks moral suasion has been
successfully implemented in Zimbabwe.
ii. Calling for special deposits with the Reserve Bank

The central bank can wish to make credit tighter and call specifically for a special
deposit from commercial banks. This dampens optimism and so curtails business
spending.
iii. Ceilings and directional controls

This refers to lending ceilings and selective credit controls. It involves the
authorities imposing formal or informal maximum or minimum levels of amounts
banks can lend to certain specific borrowers or categories of borrowers or for
certain specific purposes.
iv. Variable reserve ratio

This refers to attempts to control credit creation by commercial banks by
manipulating the cash ratio. From the illustration on the credit creation process we

concluded that the smaller the cash ratio, the greater the banks’ ability to increase
money supply and vice versa. For example the central bank can increase the cash
ratio if it wants to reduce the level of money supply growth from the creation of
credit.
v. Statutory Reserve Requirement

Banks are required to maintain reserve cash balances with the Reserve Bank for
management purposes. These reserves can be varied depending on the monetary
policy. For example with a tight monetary policy the reserves can be increased so
as to reduce excess cash in the market.
vi. Directives
The central bank can issue directives such as demanding pension funds to hold a
portion of their earnings in prescribed government paper.
13.6.4 Limitations of monetary policy in Zimbabwe

The advantage of monetary policy is that it is flexible and can be applied fairly
quickly unlike fiscal policy that needs to have both cabinet and parliamentary
approval before it can be applied. However the effectiveness of monetary policy in
Zimbabwe is affected by;
a. Financial dualism that is the existence of a monetised and non-monetised
sectors in the economy. The monetised sector uses money fro its
transactions while the non-monetised sectors engage in barter trade. There
is a large non-monetized sector which is little affected by monetary policy.
b. There is a narrow size and inactive money and capital market.
c. There is a limited array of financial stocks and assets.
d. The notes constitute a major proportion of total money supply, which
implies the relative insignificance of bank money in the aggregate supply of
money.

e. Foreign owned commercial banks in Zimbabwe can easily neutralise the
restrictive effects of a strict monetary policy as they can replenish their
reserves by selling foreign assets and can draw on the international market.
13.7 Zimbabwe’s financial system

It has been argued that the Zimbabwean financial system is one of the well
developed, mature, diversified and geographically spread financial system. The
financial system may promote or hinder the process of economic development
depending on its nature. If the financial system is well developed, it may provide
economic development, that is, financial development lead to economic
development. However the financial system in Zimbabwe recently has been
involved in non-core activities such as buying the whole year’s production of
bricks and other speculative activities. This has led to placement of more than five
financial institutions including commercial banks under curatorship and some were
subsequently liquidated. The historic case of ENG and Trust Bank will come to
mind.
13.7.1 The Reserve Bank of Zimbabwe (RBZ)

The RBZ or the central bank is at the apex of the financial institutions. It plays a
supervisory and regulatory role in the financial sector. The RBZ plays important
internal and external roles.
a. Internal functions of the RBZ

The internal functions of the RBZ can be grouped into three classes
i. Banking functions
 Banker to the government – the RBZ operate a government account
through which government revenue, expenditure and borrowing is
processed.
 Banker to other banks - banks are required by statute to maintain reserve
requirement accounts with the central bank for administrative purposes. In

addition the RBZ operates a cheque clearing house through which
cheques from various commercial banks are settled.
 Lender of last resort - the central bank acts a lender of last instance.
 Banker to the nation – Firstly, the RBZ is responsible for the printing and
replacement of notes (money). Secondly, the central bank maintains the
country’s gold and foreign currency reserves.
ii. Regulatory institutions

The RBZ is a licensing authority, that is, it licenses all financial institutions
for example it issues commercial banks with banking licenses. The central
bank is there to supervise the activities of other financial institutions. It
ensures that codes and practices that the government lays down are
conformed to by the financial sector.
iii. Monetary policy function

The central bank formulates monetary policy; supervise the implementation
of the monetary policy and makes periodic evaluations of the monetary policy
(for example quarterly reviews) on behalf of the government.
b. External functions of the RBZ

i. Stabilisation of the exchange rate function
This is done in conjunction with government policy. The central bank can
devalue or revalue the dollar depending on the state of the economy. The
RBZ administers the foreign currency movements.
ii. Interactive function

The central bank is the one that interacts with external financial institutions.
The RBZ represents the government in the international money markets for
example repayment of the government debt to the IMF.
13.7.2 Commercial banks

Commercial banks accept deposits from the public and pay the depositors interest
rates which are the interest earnings of the deposits. They also offer overdrafts and
charge lending rates and these are the cost of borrowing. Commercial banks offer a
variety of services that include, current accounts, ATMs, safe custody of valuables
such as jewellery, financial advice and savings deposits.
13.7.3 Building societies

These basically provide finance for home ownership (mortgage lending) and act as
a medium for small savings through various types of accounts which offer different
rates of interest. However it is now difficult to draw a line between a building
society and a commercial bank because they have the same legal requirements and
building societies can also offer the serves that commercial banks offer.
13.7.4 Merchant banks

Merchant banks offer trade finance and give advice to those companies dealing
with international finance. In addition merchant banks advice companies on
mergers and acquisition. They also underwrite the issue of new shares (Initial
Public Offer). That is, merchant banks guarantee the issue of shares not bought by
the general public in order for the issuing company to raise the required funds.
13.7.5 Discount houses

Discount houses act as intermediaries between other financial institutions and the
central bank. They specialise in the sale and purchase of securities with different
maturities and dates. They operate ‘call accounts’ which form part of the liquid
assets held by banks and other institutions.
13.8 Money and capital markets

Financial markets are the means by which savings are channelled back into the
economy as loanable funds. The process is known as financial intermediation.
Financial intermediation arises because lenders and borrowers have different

requirements in terms of risk and time. One of the more important distinctions
within the financial markets is that between money and capital markets.
13.8.1 Money market

Money market is a submarket of the finance market and specialises in short term
lending or borrowing. That is the money market contracts are up to one year.
Institutions in the money market include commercial banks, savings clubs, micro
finance corporations and individuals. The instruments through which people can
borrow in the money market include treasury bills, trade bills, call loan and
negotiable certificates of deposits. Interest rates in the money market apply to
periods of usually up to twelve months. The interest rate is dependent on the bank
rate, that is, the rate at which the central bank advances loans to financial
institutions as a lender of last resort. Thus interest rates in the money market are
influenced by the central bank (commercial bank lending rate equals bank rate plus
mark-up).
13.8.2 Capital market

The capital market constitute of institutions such as the stock exchange market,
mortgage market, new issues of shares market and the corporate market (bonds
issued by the government).The capital market, unlike the money market, specialises
in long-term lending. Amounts involved are generally bigger and are supposed to
be repaid in more than one year. The capital market deals with long-term private
and government securities and funds. It’s a market for long-term borrowing and
lending using instruments such as bonds, equity shares, debentures and preference
shares. The central bank does not influence interest rates in the capital market. The
market is a free market where the rate of interest is determined by the forces of
demand and supply of securities. As a result, interest rates in the capital market are
one of the best indicators of the market’s current expectations about future interest
rates.

13.8.3 The role of money and capital markets
The money and capital markets are of great importance in Zimbabwe because
a. They promote savings and investment
b. They represent a counter for borrowings (deficit units) hence are a major
source of funding.
c. They offer financial advice
d. They offer banking and financial services to the community
e. Money and capital markets
f. Standards of living are improved through transactions in the money and
capital market
13.9 The quantity theory of money

In the Quantity Theory of Money, Milton Friedman improved Irvin Fisher’s
equation of exchange to illustrate the role of money in the economy.
13.9.1 The Classical Quantity Theory

Fisher thought that money was used only as a medium of exchange. Its sole
function was to act as a means of payment in transactions for goods and services.
According to Fisher, if the number of transactions is independent of the amount of
money, then the total money value of transactions will be given by:
P, the price level of goods and services bought and sold, multiplied by,
T, the number of transactions, to equal PT (P x T = PT)
The amount of money required to pay for these activities is given by:
M, the money supply, multiplied by
V, the velocity of circulation, to give MV (M x V = MV).
The velocity of circulation (V) measures the speed at which money changes hands
in the economy. MV must always equal PT because they are simply two different
ways of measuring the same transactions. MV looks at society as consumers while
PT looks at society as producers.

13.9.2 The new quantity theory
Friedman improved the classical quantity theory of money to
MV = PQ where,
M = Money supply
V = Velocity of circulation
P = General level of prices
Q = National income or real output.
The velocity of circulation (V) is assumed to be fairly constant. The economy is

assumed to be at or near full employment such that it is not possible to increase
output. Thus Q is constant. Given that V and Q are constants, a change in M will
directly affect P. for example, if M doubles, Q must also double for the equation to
remain holding. Thus an increase in money supply will directly result in an increase
in the level of prices (inflation).
13.9.3 Criticism of the quantity theory

a. The assumption full employment of resources is unrealistic. It is true that at
full employment any increase in the money supply can only result in a higher
price level since output cannot expand. With unemployed resources available,
a rise in the amount of money is likely to result in changes in production as
well as prices.
b. Velocity of circulation is unlikely to remain constant. An increase in the
money supply will probably cause an increase in velocity when people expect
a sharp rise in inflation. They will try to spend before prices rise. In every
depressed economy, an increase in the money supply may cause a
compensating fall in velocity as people cut back spending. This leaves the
price level and the number of transactions unaltered.

Chapter 14
Theory of national income distribution

14.0 Introduction
The assumption is that all factor income generated through economic activity will
be distributed among the factors of production used to produce the output. Land
will earn rent, capital earns interest, labour earns wages and salaries and the
entrepreneur will earn profit. The question remaining is how to determine how
much each of the factors of production will receive (pricing of factors of
production). In this chapter we are going to illustrate in theory how wages and
salaries, rentals, interest payments and profits are determined. However, it may be
important to note that in reality these theories are not religiously applied in
determination of the factor earnings.
14.1 The marginal revenue productivity theory of wages

The marginal revenue productivity theory is based on the fact that labour is wanted
not for its own sake but for the sake of the product it can produce. As a result the
payments for labour (wages) are derived from the return from the sale of the
product of labour hence if labour productivity increase, labour tend to enjoy
increased remuneration.
14.1.1 Assumptions
a. Assume a perfectly competitive labour market; for example, assume that there
are very large numbers of employers and workers, that labour is homogenous
and so on.
b. Assume that labour is the only variable factor of production to be applied to
other fixed factors.
c. Assume that the marginal physical product of labour can be measured; that is,
each additional workers contribution total product can be measured.
Given the above conditions, a profit maximising firm will employ additional units
of labour up to the point where MRP = MC.

14.1.2 The marginal revenue productivity (MRP)
Marginal Revenue Product (MRP) of labour is the addition to the firm’s total
revenue that comes as a result of employing one more unit of labour. It is given by,
Marginal Revenue Product = Marginal Physical Product x Price of the Product
The marginal physical product (MPP) of labour is the addition to total product that
comes as a result of the employment of an additional unit of labour. Due to the law
of diminishing returns which maintains that as you add more and more units of a
variable factor, with all other factors held constant, the addition to output (MPP)
becomes smaller and smaller. Thus the MRP curve initially rises, reaches a
maximum and then falls due to the influence of diminishing marginal returns.
Marginal Cost (MC) of labour is the amount that each additional unit of labour
adds to the firm’s total costs. Since we assume conditions of perfect competition,
this is the wage rate and is constant because workers take the wage as given. Under
conditions of perfect competition the price of the product does not change as the
firm changes its output.
A profit maximising firm operating under conditions of perfect competition where
it cannot influence the price of labour will employ additional units of labour up to
the point where the MRP = MC. Infact the MRP curve is the firm’s demand curve
for labour because it indicates to the firm what the additional unit of labour is worth
in terms of revenue.
14.1.3 Demand for labour

The demand for labour is derived demand rather than direct. It is derived from the
demand for the product of labour, that is, the demand for labour just like the
demand for any other factor of production depends on its productivity and on the
price at which the product which is produced is sold. This is because labour does
not directly satisfy consumer need but do so indirectly by producing goods and
services. Demand for labour is downward sloping due to the influence of
diminishing marginal returns and equal to that part of the MRP curve that lies
below the ARP curve.

The demand for labour depends on:
a. The demand for the product of labour and therefore the prices of the product
of labour.
b. The productivity of labour (MRP).
c. The importance of labour costs in total costs of production.
d. The possibilities of substituting labour with other factors as wages rise.
Any changes in these factors will shift the demand for labour curve either to the
right or to the left.
14.1.4 The supply of labour

The supply of labour curve is upward sloping. Justification for the upward sloping
supply curve can be found in the need to pay workers higher wages to induce them
to work longer hours (as illustrated by higher rates on overtime work) and by the
need to pay higher wages to attract new workers into the industry.
The supply of labour to a particular industry depends on:

a. The standard of living and the extent to which workers value leisure relative
to income.
b. The prevailing social attitudes towards the nature of work.
c. The mobility of labour, that is, the extent to which restrictions on entry such
as education, training and skills requirement is applicable.
d. The extent to which trade unions and professional associations are able to
control recruitment.
14.1.5 The equilibrium wage and level of employment

The intersection of the demand for and supply of labour will determine the market
wage rate and the level of employment.

Fig 14.1 Market equilibrium wage rate and level of employment
Wage rate
S
We
D= MRP
O Le No. of workers
Any changes in the factors that affect demand for and supply of labour will change
the equilibrium position. In which case, the curves will shift either to the right or to
the left.
14.1.6 Criticism of the marginal revenue product theory

The theory is based on several assumptions, some of which are not realistic, for
example labour can never be homogeneous and it is difficult to measure the
productivity of each individual labour. In reality the productivity of labour depends
on the productivity of other factors of production such as capital. In addition, the
theory ignores the importance of trade unions and government policy which often
set wages.
14.2 Imperfectly competitive labour markets

The supply of labour is not at all competitive in the labour market. Instead, it is
controlled by a labour monopoly know as a trade union. A trade union is a group
of workers who band together to pursue certain common aims, especially the
achievement of wage increases for their members and the lobbying of government
to pass legislation in favour of workers.

14.2.1 Effects of trade union on wages and the level of employment -
restriction of supply
Workers with specific skills such as doctors and accountants can form a craft union
that can restrict supply by controlling the length of apprenticeship programmes and
restricting membership for example by imposing licensing and other entry
requirements.
Fig 14.2 The effect of restricting labour on wages and the level of employment
S1
Wage rate
S0
W1
W0
D0
O L1 L0 No. of workers
If supply is restricted, the supply curve will shift from S0 to S1 thereby increasing
the wage rate from W0 to W1. However, at the higher wage rate (W 1), it becomes
expensive for firms to hire labour hence the level of employment decreases from L 0
to L1.
14.2.2 Effects of trade union on wages and the level of employment - wage
setting
Workers in a single industry may be represented by an industrial union or workers
union. Such unions derive their strength from numbers of their membership and
hence can force firms in the industry to bargain exclusively with the union over
wages and other conditions of employment. Thus bargaining power enables the
union to obtain wages for its members above the level that would pertain in a
perfectly competitive market.

Fig 14.3 The effect of a minimum wage on wages and the level of employment
Wage Rate
S
W1 Wage floor
W0
D
O L1 L0 Ls No of workers
The perfectly competitive wage rate is W0. If the union gains control of the supply
of labour, it can fix the wage rate at W 1. Given a downward sloping demand curve,
the level of employment will decrease to L 1. Thus involuntary unemployed labour
is Ls – L1.
14.2.3 Effects of trade union on wages and the level of employment -

increasing labour demand
Trade unions may support, or even conduct training courses to increase
productivity and therefore the demand for labour. Unions also have an interest in
supporting employers in lobbying for tariff legislation that protects their industry
from import competition. Tariffs raise the price of imports. This will tend to
increase the demand for domestically produced goods which are substituted for the
more expensive imported goods. Thus the demand for labour used to produce the
domestic goods will increase (the demand curve will shift outwards) as shown on
the following diagram.

Fig 14.4 The effect of increasing labour demand on wages and level of employment
Wage rate S
W1
W0 D1
D0
O L0 L1 No. of workers
An outward shift of the demand curve for labour from D 0 to D1 will raise wages
from W0 to W1 and employment rises from L0 to L1.
14.2.4 Monopsony
A monopsony is a market where one buyer purchases a product or factor of
production from many sellers. It is, in a sense, the opposite of monopoly. A labour
market where one employer confronts a non-unionised group of workers competing
for jobs is a monopsony. To attract additional workers, the monopsonistic firm
must raise wages, that is, it faces an upward sloping supply of labour curve. If we
assume that labour is the only factor of production, the supply curve will be equal
to the AC curve (S=AC). If AC is rising the MC will be rising even faster.
According to the marginal productivity theory, a profit maximising firm will hire
labour by equating MC to MRP. The same will apply for a monopsonist who will
hire L0 units of labour at a wage rate W0 as illustrated in the following diagram

Fig 14.5 Monopsony level of wages and employment
Wage Rate MC
S = AC
W1
D=MRP
W0
O L0 L1 No of workers
The monopsonistic firm will equate MC to MRP to employ L0 number of workers.
The wage is determined from the supply curve, since a point on the supply curve
indicates the wage for which workers are willing to supply their labour services.
Hence, the wage will be W0 per worker. Not only is employment depressed by
monopsony but also the wage rate paid (W0) is lower than would have resulted
under competitive conditions in the labour market (W1).
14.3 Wage differentials in the labour market

Why do workers in the same industry or in the same occupation earn different
wages? Wage differentials can be explained by differences in labour productivity,
that is, highly productive labour will be in great demand and hence will be paid
higher wages. However, other reasons can be cited.
a. Labour markets can be segmented into distinct segments and it is extremely
difficult and costly for an individual to move from one segment to another.
b. Differences in labour market structures - wages in perfectly competitive
labour markets differ markedly form those in monopsony.
c. Institutions in the labour market – trade unions could through a number of
activities ranging from bargaining to a restriction of supply, also alter the
wage rate from that which would hold in a perfectly competitive market.

d. Human capital – education and training impart skills but requires effort, time
and resources. Thus higher wages should be paid for qualified labour.
e. Opportunity cost – acquiring human capital involves foregoing income. As a
result, individuals expect to recover this opportunity cost through higher
incomes on completion of studies.
f. Experience and on the job training – there is a positive relationship between
the individual’s wage and the length of time spent at a specific company.
g. None monetary rewards – such as esteem and social status given to doctors or
the country’s president who happen to earn a salary far less than what most
managing directors in industry get..
h. Discrimination – racial, tribal and gender discrimination.
14.4 The loanable fund theory of interest

The term capital is used either to describe capital goods or to describe financial
resources. Capital is formed by forgoing current consumption and diverting these
resources to the production of future wealth. In other words capital accumulates by
doing without now and using the resources so freed to create more wealth in the
future. Interest is the reward for parting with liquidity for a specified period.
According to the loanable fund theory or classical theory of interest, the interaction
of the savings (supply of loanable funds) and borrowings (demand for loanable
funds) determine the rate of interest. The theory is an alternative to the Keynesian’s
liquidity preference theory looked at in chapter 13.
14.4.1 The supply of loanable funds (savings)

The supply of loanable funds refers to the willingness and ability of households or
firms with excess funds (savings) to make them available to borrowers at a certain
rate of interest. People save from their current incomes and the level of savings will
depend on:
a. The social framework of the society – if the society encourages savings and
there are saving intermediaries such as savings clubs, people will save.

b. The size of the income of an individual – the higher the income the more
likely will the present wants be fully satisfied with some funds being left over
as savings.
c. The preference of individuals for present over future consumption – if people
are impatient to spend their incomes in the present, that is, if they have a
greater preference for present over future enjoyment of goods, then the higher
have to be the rate of interest to induce them to save and lend their money.
d. The degree of uncertainty regarding enjoyment in the future – the more
certain an individual is of the ability to enjoy his income in the future, ceteris
paribus, the less impatient he will be to spent money in the present.
The supply of loanable funds curve is upward sloping showing that higher interest
rates encourage individuals to consume less now and save more.
14.4.2 The demand for loanable funds (borrowings)

The demand for capital refers to the willingness and ability of households, firms
and the government to borrow funds to finance their various consumer needs and
investment projects. Capital is demanded because it makes it possible a much
future output. Firms borrow with the aim that these productive investments will
yield a rate of return that exceeds the cost of borrowing thereby reaping profits for
the firm. Just like the demand for labour, the demand for capital is derived demand
and it depends on the marginal revenue product of capital (the marginal efficiency
of capital).
14.4.3 The market interest rate

The interaction of the supply and demand for loanable funds curves determines the
market interest rate.

Fig 14.6 Determination of the market equilibrium interest rate
Interest rate
Savings
ie
Borrowings (MEC)
O Le Loanable funds
The market interest rate i0 is determined at the intersection of the savings and
borrowings curves. Any changes in the factors that determine the supply and
demand for loanable funds will change the market equilibrium interest rate.
14.4.4 Why interest is paid

a. Lenders want to be compensated for the sacrifice that they make when parting
with liquidity. This sacrifice comes in the form of forgoing present
consumption for that of the future. Utility derived from present consumption
is greater than that of the future.
b. A dollar advanced today as a loan will be worth less than a dollar by the same
time next year due to inflation. To cushion against this, interest rate greater
than the inflation rate must be charged on loans.
c. Lenders should also be paid interest because the loans made to borrowers
carry risk even if the loans are fully secured by collaterals. The interest rate
must vary according to the degree of risk involved.
d. When loans are issued out, administrative costs such as the cost of the loan
application form are incurred. These costs are incorporated in the interest
charge to the borrowers.

14.5 Profit
Profit is defined as the reward for risk-taking or the reward for uncertainty bearing.
There are insurable and non-insurable risks in business. Insurable risks include fire,
theft and accident. Since this risk can be insured against, they are not rewarded by
profit. Profits therefore are rewards for non-insurable risks such as changes in
demand for the product or cost conditions for the product.
14.5.1 The role of profit

a. Profits are the reward to the entrepreneur hence they act as an incentive.
b. Profits influence the level of resource utilisation and the allocation of
resources among alternative uses.
c. It is the profit or the expectation of profit that induces firms to innovate.
Innovation stimulates investment, total output and employment. That is, it is
the pursuit of profit that underlies most innovation.
d. The occurrence of economic profit is a signal that society wants that
particular industry to expand.
e. Profits are the financial means by which firms can add to their productive
capacities, that is, ploughed back profit inject working capital.
14.5.2 Why profits vary from firm to firm in the same industry
Firms in the same industry may earn different profits because
a. One firm may be enjoying economies of scale while the other is not, that is,
cost differences.
b. One firm may have built a reputation by excellent service in the past and
hence the firm may derive advantages from an outstanding goodwill.
c. The nature of the returns in production; firms that are operating under
conditions of increasing returns to scale tend to make greater profits than
those in which diminishing returns are threatening, if not actually operative.

14.5.3 Why profits vary from firm to firm in different industries
a. Differences in degrees of risks for example new industries have high degree
of risk and high profit levels.
b. Market structure for example one firm may be operating in a monopolistic
industry and making great profits than the other firm that may be operating
under a perfectly competitive industry.
c. Differences in the degree of elasticity of demand for the commodity or
service.
14.6 Rent
The meaning of the word ‘rent’, in its everyday usage, is the payment made for the
use of property, usually in the form of land or buildings. The same word is often
used as a synonym for ‘hire’. The rent that is paid in this case is commercial rent.
Any payment made to any factor, therefore, simply for the purpose of retaining, as
it were, possession of it should be regarded as rent; where the supply of the factor is
fixed, and it is specific in its use, so it cannot be used for anything else, any surplus
or extra money paid to it is economic rent. The earnings of most factors of
production consist of economic rent and transfer earnings. Transfer earnings are
defined as the minimum amount that must be earned to prevent a factor of
production from transferring to another use. Economic rent is said to be earned
whenever a factor of production receives a reward that exceeds its transfer
earnings.
14.6.1 Determination of rent

The total quantity of land is fixed in supply. Unlike the other factors of production
such as capital and labour, the available supply of land cannot be increased by
human efforts. Thus, the total quantity of land supplied is the same at every price.
That is, the supply of land is represented by a vertical or perfectly inelastic supply
curve. On the other hand demand for land just like demand for any other factor of
production is derived from demand for its product. It will depend on the quality or
the productivity of the piece of land (fertile versus barren), its location (rural land

versus urban land) and the number of uses for that piece of land. Given these
conditions, the free market rent will be determined by the intersection of the
demand and supply of land curves.
Fig 14.7 Determination of rent

Rent S
R2
R1 D 2
D1
O Q0 Quantity of land
From the diagram, the total supply of land is to a large extent fixed. Increased
demand does not bring increased supply but it increases the rent earnings of those
who are fortunate enough to own land. For example if demand for housing increase
in Harare due to Operation Murambatsvina which destroyed illegal structures, the
demand curve will shift fromD1 to D2 and rentals will increase to R2 .

Chapter 15
Macroeconomic problems
15.0 Introduction
An economist returns to visit his old school. He's interested in the current exam
questions and asks his old professor to show some. To his surprise they are exactly
the same ones to which he had answered 10 years ago! When he asks about this the
professor answers: "the questions are always the same - only the answers change!"
The same can be said of macroeconomic problems. Over the decades Zimbabwe
has faced the same problems of inflation, unemployment and BOP deficits. In this
chapter we are going to explore the theoretical underpinnings of these problems as
well as the probable macroeconomic policies that can be implemented to curb the
problems.
15.1 Unemployment
An unemployed person is someone who is actively searching for a job but unable to
find one within a specified time period. An ‘expanded’ definition of unemployment
includes people who have the desire to work but have become too discouraged to
actively search for a job. The rate of unemployment is defined as the number of
unemployed job seekers divided by the total number of employed and unemployed
persons.
Unemployment rate = Unemployed persons x 100
Labour force
In Zimbabwe the level of unemployment is estimated to be over 80%.
15.1.1 Types, causes and remedies for unemployment

Economists distinguish between three major types of unemployment; namely
frictional, structural or ‘mismatch’ and cyclical unemployment. The following
table summarises the main causes and remedies for the different types of
unemployment.

Table 15.1 Type, causes and remedies of unemployment
Type Description Cause Remedy
FRICTIONAL - People voluntarily remain Difficulty in matching Improve the flow of job
unemployed while they seek out quickly workers with information to make it
and weigh up suitable job suitable jobs due to : easier for job seekers to
vacancies. - Lack of information come into contact with job
- People searching for jobs which concerning jobs. vacancies
exist but where complete - Delays in applying, - Advertising in public media
information concerning these jobs interviewing and accepting e.g. national newspaper
is lacking jobs. - Establishing employment
exchange offices.
STRUCTURAL Skills profile of unemployed - Declining industries and -Subsidise and improve the
persons does not match the skills the immobility of labour. mobility of labour.
demanded by employers - Workers have the wrong - Change the education
skills in the wrong place curriculum to meet the
requirements of industry
TECHNOLOGICAL With improvement in technology, - Technological progress. - Training and retraining the
old skills are no longer required - Automation and labour force.
and machines will do the jobs information technology - Halt the pace of
people used to do (labour saving ) technological development
CYCLICAL Workers with skills will be Periodic downswings in - Increased government

searching for jobs but job the business cycle which spending.
vacancies fall short of the number lead to an insufficient - Reduce taxation.
of job seekers aggregate demand in the - Government can spend
economy more money directly on jobs
(hiring more civil servants)
15.1.2 Consequences of unemployment

Unemployment affects individuals, society, businesses and the government through
the following ways.
a. Loss of output
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The opportunity cost of each unemployed person is his or her foregone output. If
labour is unemployed the economy is not producing as much output as it could.
b. Loss of human capital
The unemployed labour gradually loses its skills because skills can only be
maintained by working.
c. Lost tax revenue
Growing unemployment means less direct and indirect tax revenue because
unemployed people stop paying income tax and their spending will full
considerably.
d. Social Costs
Unemployment brings social problems of personal suffering and distress and
possibly also increases in crime such theft and prostitution.
e. Increasing inequalities in the distribution of income
Unemployed people earn less than employed people and so when unemployment is
increasing the poor get poorer.
Table 15.2 Employment and training schemes to reduce unemployment in Zimbabwe

Scheme Description
Restart Programme Interviews and training for people unemployed for long periods
Community Projects Local projects for the unemployed
New Workers Scheme A subsidy to employers taking on the unemployed youth.
Job Search Scheme Return fare and allowance for job interviews
Job Release Scheme Early retirement with an allowance
Job Splitting Scheme A subsidy to encourage job sharing
15.2 Inflation
Inflation refers to a persistent and continuous rise in the general or average price
level as reflected in changes in the consumer price index (CPI). It refers to the rate
of increase in the general price level and not a price increase per se or to a one-off
increase in the price level.
15.2.1 Types, causes and remedies for inflation
197
Economists distinguish between three different three types of inflation namely
demand pull, cost push and structural inflation. The following table summarises the
main causes and remedies for different types of inflation
Table 15.3 Type, causes and remedies to inflation

Type Cause Remedy
To curb demand pull inflation first

Demand pull inflation can either be from the real sector or identify the source of inflationary
monetary sector pressure
- In the real sector keynesians argue that an increase in - If it is from the real sector, take
aggregate demand not being matched sufficiently by steps to reduce demand in the
DEMAND - PULL increased output usually results in an excess AD which economy through increased
triggers bidding up of prices. taxation, and reduced government
- in the monetary sector monetarists argue that excess expenditure.
supply of money causes too much money to end up - if it is from the monetary sector
chasing too few goods as individuals try to dispose of the reduce growth in money supply
excess cash. through tight monetary policy
The solutions to cost push inflation
A firm passes on an increase in production costs to the resides in
consumer. The inflationary effect of increased costs can - de-regulate labour markets
be a result of: - encourage greater productivity-
COST-PUSH
- increased wages leading to a wage-price spiral or wage- apply controls over wage and price
wage spiral rises e.g. price controls
- increased import prices (imported inflation) - deduce import prices by removing
- unjustified price increases in the case of monopolies tariffs.
The solution to structural inflation
Production constraints or structural rigidities such as resides in making supply more
drought cause output to lag behind demand for the goods. responsive to changes in demand
The resulting shortage will put an upward pressure on through,
STRUCTURAL prices. - the establishment of national
reserves e.g. GMB to minimise
adverse effects of events such as
droughts.
- improve worker productivity.
15.2.2 Effects of inflation
198
Not everyone suffers from inflation. Some parts of society actually benefit for
example
a. The government finds that people earn more and so pay more income tax.
b. Firms are able to increase prices and profits before they pay workers higher
wages.
c. Debtors (borrowers) gain because they have the use of money now when its
purchasing power is greater.
On the other hand some parts of society are disadvantage by inflation for example
a. People on fixed incomes such as pensioners tend to suffer as their incomes are
usually not adjusted for inflation.
b. Creditors lose because the loan will have reduced purchasing power when it is
repaid.
c. Zimbabwean goods may become more expensive than foreign made goods, so
the balance of payment suffers.
d. Industrial disputes may occur if workers are unable to secure wage increases
to restore their standard of living.
e. Investment habits are forced to change from savings to investment in non-
monetary assets such as property, which appreciate in value. Monetisation of
the economy is reduced.
NB* On the basis of these argument it can be argued that inflation tends to
negatively affect living standards of an economy. In the extreme cases of inflation
people will loose confidence in the monetary system of the country and resort to
barter. Germany is a historical example where the mark lost its value due to
hyperinflation which broke the 1000% record to the extent that people resort to
using cigarettes as a medium of exchange.
15.2.3 Measuring inflation - Calculating the consumer price index (CPI)

CPI is a statistical device that indicates the price level at any given time as
compared with the level of prices at some standard time called the base. CPI looks
199
at how prices are changing in retail shops hence it is also referred to as the Retail
Price Index (RPI). The following procedure is used:
Step 1 A basket of goods and services consumed by the average family is listed.
For example food, clothing and transport are included in the basket.
Step 2 The price of items in the basket in the base year is noted. The base year is
the year in which it is assumed that there were no chronic economic problems, that
is, there is no inflation.
Step 3 Each item in the basket is assigned a weight to reflect its relative importance
to the average family, in terms of the proportion of income spend on each item.
For example, food has higher weighting than transport.
Step 4 The price of goods in the basket is recorded in the current year and
compared with base year prices as a percentage (index) using the equation:-
Index = Current price x 100
Base price
Step 5 The index of each item is then multiplied by its weighting to get the
weighted index
Weighted Index = Index X Weight
Step 6 The new CPI is found using the equation:
CPI = Total Weighted Index
Total Weight
Step 7 The value of the CPI in the base year is always 100. The rate of inflation is
the percentage change in the CPI and is calculated using the equation:
Inflation Rate = Current CPI - Base CPI x 100
Base CPI
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The above steps can be illustrated using the follow table
Table 15.4 Calculation of the CPI

Item Price in Base Price in Weight Index Weighted
Year Current Year Index
Food 300 600 5 200 1000
Clothing 50 250 3 500 1500
Transport 10 5 2 50 100
Total 10 2600
CPI = Total Weighted Index = 2600 = 260

Total Weight 10
The rate of inflation is = 260 - 100 x 100
100
= 160%
15.2.4 Problems in using the consumer price index

In Zimbabwe people have doubted the authenticity of the CSO published CPI. In
most cases they would view the prices as having increased by a greater percentage
than the published index. Problem likely to be encountered when computing the
CPI may be outlined as follows;
a. How to define a standard basket, that is, which items should be included in or
excluded from the basket of goods?
b. Different families have different tastes hence different weightings. How is an
average family found?
c. For a while new products (e.g. mobile phones) may not be included in the
basket.
d. Consumption patterns change overtime, thus weights must be altered to
reflect these changes.
e. The quality of goods changes over time but CPI simply monitors price
changes while ignoring quality improvements.
15.3 Balance of Payment (BOP) deficit
201
BOP deficit refers to a situation on the current account when exports are less than
imports. In the short term, a deficit leads to improved standards of living due to
increased consumption of imports but in the long term it may lead to depreciation
of the domestic currency thus leading to deterioration in the standard of living.
15.3.1 Correcting a BOP deficit

The correct measures to correct a BOP deficit will depend upon its causes and the
exchange rate system.
a. Short-term BOP deficit
A short-term BOP deficit may be dealt with by:
i. Running down foreign currency reserves.
ii. Borrowing from international institutions such as the IMF.
iii. Raising real interest rates in order to attract ‘hot money.’
b. A serious BOP deficit

The measures to correct a serious BOP deficit problem can have two effects. They
can either reduce expenditure (cut domestic expenditure on imports) or switch
expenditure (switch expenditure from imports to domestic goods). The various
policy measures include:
i. Devaluation or depreciation of the domestic currency

Devaluation is a deliberate attempt by the authorities to lower the rate at which the
domestic currency exchanges for a unit of foreign currency. The effect of
devaluation is to make our exports cheaper to foreign buyers and holding other
things constant, the demand for our exports is expected to rise while demand for
imports is expected to decrease since they will become expensive. The success of
devaluation in correcting a BOP deficit will depend on:
 Whether the country has the capacity to produce for exports and increased
domestic demand. Zimbabwe currently does not have such a capacity.
 The sum of price elasticities of demand for exports and imports must be
greater than one (Marshal-Lerner condition). That is devaluation can reduce
202
imports or increase exports if demand for imports or exports is elastic. The
demand for imports in Zimbabwe is inelastic because most products produced
in Zimbabwe require imported components.
 The J-curve effect, that is, due to the existence of contracts and other factors
promoting short run inflexibility, measures taken to remedy a BOP deficit
have often led to immediate deterioration of the payment position followed by
subsequent recovery.
Fig 15.1 The J-Curve effect
BOP
D
0 A C
B Time
-
ii. Import controls

Import controls refer to the imposition of direct measures such as tariffs or customs
duties. Such controls tend to discourage imports by either increasing their prices or
reducing their volumes. For example, faced with a BOP deficit a country can
impose high tariffs on imports so as to reduce the volume of imports. However
import controls conflict with a nation’s treaty obligations, for example, SADC
agreement to remove barrier to trade and can be less effective if the other countries
retaliate.
iii. Deflation policy
203
These are measures aimed at reducing incomes for example, wage freezes or
increased taxes on income. If income is reduced, the ability to import is reduced
since imports are an increasing function of income. However deflation policy is
unpopular and can push the economy into other serious problems such as civil
unrest.
iv. Export Promotion

This refers to the carrot and stick methods of increasing export volumes such as:
 Giving export incentives e.g. tax holidays to exporters.
 Establishing Export Processing Zones (EPZ).
 Allowing exporters to retain a percentage of their foreign currency earnings.
 Trade exhibitions such as the ZITF and Travel Expo.
v. Import substitution
To reduce the volume of imports the country can produce goods that are close
substitutes of the imported goods.
15.4 ECONOMIC PROGRAMMES IN ZIMBABWE

The country is best known for the numerous unsuccessful economic reform
programmes most of which were never implemented. Of those implemented, they
were never fully implemented rendering them all ineffective in addressing the
economic problems facing the country.
15.4.1 The Economic Structural Adjustment Programme (ESAP)

Independence in Zimbabwe coincided with the start of the first decade of structural
adjustment in Africa. The economy that we inherited from the colonial government
was highly regulated and inward looking, that is, it had adopted an import
substitution strategy as a way of overcoming the shortages caused by sanctions.
The new government needed to redress the imbalances caused by the colonial past
and this could not be accomplished through market forces. As a result the
government adopted a socialist stance through the Five -Year Developmental Plans.
204
Zimbabwe became a member of the IMF and the World Bank in 1980. These two
institutions and the donor community exerted pressure on the country to adopt a
reform program from the IMF in return for a stand by finance package.
a. Economy under ESAP (1991-5): Economic Policy Statement (1990) and

the Framework for Economic Reform (1991)
The main targets as outlined in the framework for economic reform document
include;
1. A reduction of the budget deficit from about 10% of the GDP in 1990 to
5% by 1995.
2. Complete liberalization of the foreign exchange and trade regime in
1995.
3. Elimination of subsidies, reduction of social expenditure and levying of
cost recovery rates on social services.
4. Rationalization of some public enterprises and privatization of others.
5. Liberalization of prices, interest rates and the exchange rate by 1995.
6. Deregulation of the economy.
7. Liberalization of foreign investment regulations and,
8. Deregulation of the labor market by allowing for free collective
bargaining wage flexibility and abolishing certain restrictions on
retrenchments.
b. The outcomes of ESAP

As a result of ESAP the country’s economy was opened to competition, trade was
liberalized, controls on prices were removed and economic growth was promoted.
On the other hand, companies closed, workers were retrenched, the removal of
price controls witnessed an increase in the rate of inflation, the economy’s capacity
to grow was greatly reduced and the overall standards of living deteriorated.
Uncertainties, drought and the increasing budget deficit sometimes hampered the
promotion of investment, both local and foreign. Retrenchments led to reduced
205
incomes for households and this has increased poverty. ESAP brought more
suffering than help.
c. Why ESAP failed

ESAP did not derive from the prevailing conditions in Zimbabwe. ESAP failed in
Zimbabwe (and elsewhere) partly because it was an externally designed economic
program, which did not suit our local realities. In addition, it failed because of its
total reliance on market forces and its bias towards the formal sector at the expense
of the informal sector of the economy. However, ESAP gave us a framework upon
which our domestically designed policies can be built such ZIMPREST.
15.4.2 ZIMPREST
a. Main components
1. Urgent restoration of macroeconomic stability
2. Facilitation of public and private sector saving and investment needed to
attain growth.
3. Pursuing economic empowerment and poverty alleviation by generating
opportunities for employment and encouraging entrepreneurial initiative.
4. Investing in human resource development
5. Providing a safety net for the disadvantaged.
b. Comment
The program was not successful. The main problem was that the macroeconomic
fundamentals (particularly the budget deficit, inflation and foreign currency) were
not right. Economic empowerment was hampered by lack of credit and high
interest rates. Debt repayments are taxing on the economy and this has meant
reduction in expenditure on other more fundamental areas.
Appendices
206
“Zimbabwe is currently experiencing the stagflation problem.” Discuss and
explain briefly.
Stagflation occurs when high inflation, unemployment and a significant decline in
economic growth occur simultaneously. Signs of a stagflation include:
a) A sudden increase in production costs – higher wages, high energy costs such as
electricity and petrol.
b) Obsolete plant and equipment.
c) Falling aggregate demand.
d) Retrenchment and high unemployment.
e) A significant decline in real GDP.
f) Higher prices (inflation) – decreasing standards of living.
“Price control is a necessary evil.” Analyse Zimbabwe’s economic situation

with respect to the above statement and recommend what the government
may do to solve the problem.
a) The purchasing power of incomes has been eroded in the past few years. Leaving
the producers to increase prices without proper justification would worsen the
situation.
b) Price controls ensure political stability (inflation can lead to civil unrest).
c) Price controls maintain prices at affordable levels thus improving the average
standard of living.
d) Price controls are necessary to control inflation.
On the other hand:

a) Price controls affect the viability of the industries.
b) It is not just the price control in general but the skewed controls in favour of one
stage in the production line- controlling the price of the final product while not
controlling prices of raw materials.
c) Problems of shortages and unemployment tend to arise.
207
d) Emergency of black or illegal markets.
The dilemma is on either removing the controls and sees the worst inflation and labour
unrest or maintain controls and fight the unemployment that may result. Shortages of basic
commodities will also need to be solved.
What were the main causes of the dramatic depreciation of the Zimbabwean
dollar, which started on November 14, 1997?
There are several explanations behind the fast depreciation of the Zimbabwean dollar,
some of which are listed below:
a) Poor export earnings during the first ten months of 1997.
b) Speculative dealing.
c) Weak commodity prices on the international market.
d) Uncertainty about levels of foreign exchange reserves.
e) Foreign debt payment by government.
f) Lack of balance of payment support by foreign donors.
g) Forward importing by industries in anticipation of a faster depreciation towards the
end of 1997.
h) Low foreign investor confidence.
“Blaming weak commodity prices on the international market as the sole

cause of Zimbabwe’s weak balance of payment tantamount to economic
policy short sight.” Comment critically.
While it is true that the commodity prices have been weak for the past years resulting in
declining export earnings for Zimbabwe, there are other important contributors to a weak
BOP position.
a) Declining foreign direct investment due to failing foreign investors’ confidence.
b) Primary commodity export at the expense of imported manufactured goods.
c) Lack of a pronounced export policy for a long run BOP stability.
d) Debt repayments.
e) Speculation.
f) Poor management by the Central Bank.
208
g) High inflation.
h) Reliance on donor funds for stability in the short to medium term.
What role can be played by the informal sector in the development of the
country?
The informal sector is generally characterised by the following: -
a) Ease of entry.
b) Reliance on indigenous resources.
c) Small scale operations.
d) Labour intensity.
e) Adoptive technology.
f) Unregulated and competitive markets.
The promotion of informal sector will go a long way in solving economic and social
problems of development.
a) It supplements income from formal employment where the wage structure is
generally poor. Thus the informal sector will alleviate poverty.
b) Unemployment will be reduced. One of the major roles of the informal sector is
the absorption of labour. Because untrained labour can easily be used, it thus
employs the poor people in the society.
c) Output will be enhanced and the availability of commodities will suppress the
general price level. Goods produced in the informal sector can compete with those
produced in the formal sector because they are cheaper and or more accessible.
d) The sector enhances human capital development, that is, creation of skills. This is
through enlarging people’s choices and creating possibilities for people to expand
their capabilities and opportunities.
e) Although the sector is largely untaxed, it has a potential to become a substantial
government revenue base.
f) High employment from the sector improve earnings and hence savings which are a
source of investment.
However there is need for support of government policies to ensure the success of
the informal sector.
209
a) A reduction in the budget deficit will create an environment conducive for the
operations of the sector.
b) The informal sector can perform well when the formal sector subcontracts some of
its activities to them. In this way, forward and backward linkages will be
promoted.
c) Interest rates and inflation are negatively affected by government expenditure.
What are the barriers to economic development in Zimbabwe? Suggest

ways in which these barriers could be tackled in order to foster economic
development.
The barriers to economic development include: -
a) Excessive government interference.
b) Social and political factors.
c) High levels of population growth.
d) Depletion of natural resources.
e) Higher inflation rates.
f) Inadequate infrastructure.
g) Resource underutilisation particularly labour.
h) Financial institutions that are not supportive of development e.g. NSSA which
develop upmarket office space from contributions by the poor without constructing
low cost housing.
i) Wrong policies and priorities and most times the policies re never fully
implemented.
Discuss the advantages and disadvantages of the low interest rate policy
usually pursued by the Central Bank in Zimbabwe.
Advantages
a) Promote borrowing and so investment will increase.
b) Promote small scale and local investment and thus indigenisation of the economy.
c) This leads to a fall in unemployment, which is a major problem in Zimbabwe.
d) These lead to high growth.
210
e) Promote a situation of reduced inflation.
Disadvantages
a) May reduce short-term foreign investment (‘hot money’).
b) May reduce savings and so funds available for investment are reduced.
c) These may slow down growth, which would worsen Zimbabwe’s problems.
d) May promote inefficiency in investment due to low costs. This leads to low
economic activity.
Explain why Zimbabwe is experiencing some serious foreign currency

shortages and the shortage impact on the economy.
Foreign currency is money from other countries. The amount of foreign currency available
in Zimbabwe is very important because it determines how much of imports the country
will buy. The amount of foreign currency available in a country is determined mainly by
the amount of exports as well as capital transfers and aid from foreign countries. Presently
Zimbabwe has serious foreign currency shortages which have resulted in shortages of most
imported products. The shortage of foreign currency has been caused by several factors:
a) A fall in the country’s export earnings especially due to falling mineral prices on
the international market e.g. gold.
b) Management of the exchange rate which reduces the competitiveness of our
exports.
c) Our political situation which has led to bad publicity abroad. Facts are being
exaggerated in foreign media by pressure groups lobbying the government to
abandon the land redistribution programme. This has affected foreign currency
earning sectors such as tourism.
d) People are speculating on devaluation of the dollar hence they are holding on to
their foreign currency.
e) Our economy is not diversified leading the country to be an exporter of primary
products. This has resulted in a persistent BOP deficit.
f) Donor communities have withdrawn its funding. The country’s relations with
international financial institutions have been severed. The country has been
isolated through smart sanctions.
211
g) The government has been playing for time instead of addressing the country’s
problems.
The foreign currency shortages have led to the following impacts on the economy:-
a) Black market and a thriving parallel market for foreign currency has emerged
b) Firms are sourcing foreign currency on the parallel market, which is expensive and
this has contributed to the increased cost of production. Resulting in
hyperinflation.
c) Due to the development of black and parallel markets, the government has lost a lot
of revenue.
d) The country’s productive capacity has been reduced due to the country’s inability
to import major inputs as a result of the foreign currency shortages.
Zimbabwe is currently in a debt trap. Discuss

A debt trap is a situation where a country has to borrow money to pay interest on debt.
It’s a situation where a country borrows money to service its interests on debt. Public
debt is the total amount of money owed by the government to its citizens (domestic debt)
and foreigners (foreign debt). The public debt consists of the primary budget deficit plus
interest payment. If a government incurs a budget deficit, it has to borrow the finance
the additional expenditure. Interest has to be paid to service the debt. When a country
fails to raise or generate enough revenue to service the interest, it may borrow to repay
the interest.
This is the current situation with Zimbabwe. Interest on past debt rose from $1,6 billion
in 1991/2 to an estimated $55 billion in 2000 and $50 billion in 2002. In the current year
budget (2005) the government made a $750 billion provision for servicing interest on the
public debt. The current interest servicing costs are estimated to be close to $3 trillion.
The implication therefore is that the government is going to borrow the remaining $2, 25
trillion interest servicing costs. Thus the country is facing a serous debt trap. It has to
borrow money in order to service interest payments on the debt.
212
Faced with a serious debt trap, the authorities should undertake the following remedies;
a) Inflating the debt away
During inflationary periods, borrowers gain while lenders lose. Borrowers gain in
the sense that they will repay the money when it is valueless. A dollar loaned today
should worth more than a dollar tomorrow. This is how the government has been
benefiting during the current hyper inflationary environment. Billions of money
are now being repaid but at a value less than 20% of their original value. This is
called inflating the domestic debt away because the foreign debt which is quoted in
foreign currency cannot be inflated away.
b) Seigniorage
The government can simply print new money to be used to repay the interest on
debt. However, this will increase money supply leading to a situation where too
much money will end up chasing too few goods in the economy. Thus inflation will
be fueled.
c) Debt restructuring
The government can negotiate to restructure the domestic debt. This can be
achieved by converting short term debt into long term debt. For example the
government can negotiate with the holders of treasury bills to convert them into
bonds.
d) Debt relief
The government can negotiate for part of the debt to be written off by the
international financing community such as the IMF and the World Bank.
Alternatively, it can negotiate for more time to repay and service its debt. However,
this option is not likely to work in the current situation because of the strained
relations that exist between the international financing community and the country.
In addition, Zimbabwe does not qualify to be classified as a poor country and hence
can not benefit from debt relief in as way as the poor countries like Mozambique.
e) Prudent debt management policy
The country defaulted servicing its debt for the greater parts of 2001 to 2003. No
debt management policy was in place. The default in debt servicing, contribute to
213
the strained relations between the country and the international financing
community. As a way forward, the government should formulate a proper debt
servicing policy with adequate yearly provisions for the servicing of debt.
f) Economic diversification and sustained economic growth
If our economy is diversified it is likely to achieve sustainable economic growth.
Where the economy is growing at a faster rate, it is possible for the government to
collect more revenue from taxes. Thus the government will be able to meet its
expenditure and service interest payments on the debt from revenue.
What is devaluation?
Devaluation refers to deliberate attempts by the authorities to lower the rate at which a
local currency exchanges for a unit of foreign currency. Devaluation is possible under a
fixed exchange rate regime. Fixed exchange rate is a system where the value of a currency
is fixed at pre-announced par values where it is supposed to trade to units of foreign
currencies. The Zimbabwean dollars was previously devalued to the United States dollar as
follows: ZW$37 = US$1 to ZW$38 = US$1 (1999), ZW$38 = US$1 to ZW$55 = US$1
(2000) and a partial devaluation from ZW$55 = US$1 to ZW$824 = US$1 (2003).
After a currency is devalued, more units of that currency will be required to buy a single
unit of foreign currency than before. A devaluation policy is deliberate or discrete. That is,
it is done at the discretion of the government. As such the government may not devalue the
dollar even if there are strong signs that the dollar must be devalued as was the case in the
period 2000 to 2003 when the Zimbabwean dollar traded at a fixed ZW$55 = US$1. The
fall in the value of a local currency in terms of units of foreign currency due to changes in
the market forces of demand and supply is known as depreciation. Depreciation thus
applies in a country were the exchange rate fluctuate according to the levels of demand and
supply ( free floating or market exchange rate).
Why may a country devalue its currency?

Devaluation is an exchange rate policy measure aimed at correcting a balance of payment
(BOP) deficit. BOP deficit refers to a situation on the current account of the balance of
214
payments when import payments exceed exports receipts. This implies that the country
will be importing more than it is exporting. Thus, earnings from exports will be less than
payments for imports. A persistent BOP deficit may result in foreign currency shortages in
the long-run although in the short term standards of living may improve due to the
increased consumption aide by the consumption of imported goods.
A BOP deficit may be temporary (short-term) or structural (long-term). A temporary BOP

deficit occurs when in the short term a country periodically exports less than imports. On
the other hand, a structural BOP deficit is a situation when a country persistently incurs a
BOP deficit. “A short-term deficit might be dealt with by running down reserves or by
borrowing. Another short-term measure might be to raise interest rates to encourage the
inflow of money.” (Beardshaw, et al, 1999:p561).
However, a structural BOP deficit, which is more serious than the temporary BOP deficit
can be dealt with by the implementation of policies that are either expenditure reducing or
expenditure switching. Expenditure reducing measures rectify the deficit by cutting
expenditure on imports. Expenditure switching measures are designed to switch
expenditure from imports to domestically produced goods. According to Beardshaw, et al
(1999), these measures are not alternatives but rather complements. No one measure can
remedy a deficit.
How does devaluation work to correct BOP imbalances?

Devaluation discourages imports by making imports expensive to local buyers while at the
same time it encourages exports by making exports cheaper to foreigners. The following
illustration shows how devaluation reduces imports and increase exports when correcting a
BOP deficit.
Illustration
Ceteris paribus, assuming an exchange rate of ZW$10 = US$1 which is devalued to
ZW$20 = US$1. If there is a company in the business of importing cars from Japan at a
215
price of US$1 000 per vehicle. Before devaluation, the price of the vehicle in local
currency is ZW$10 000. However, after devaluation the same car will cost ZW$20 000.
This means that the price of the imported vehicle in local currency will increase after
devaluation. Imports become expensive and ceteris paribus, demand for imports will fall
and so are import payments.
Assume a foreigner buying bananas from Zimbabwe at a local price of ZW$100 per
kilogram. Before devaluation, the kilogram will cost US$10 while after devaluation; the
same kilogram will cost an equivalence of US$5. Devaluation has the effect of reducing
the foreign currency equivalence price of our exports although the Zimbabwean dollar
price remains unchanged. Exports become cheaper to foreign buyers, ceteris paribus,
demand for exports and export earnings increase.
“A. P. Lerner in his book Economics of control applied Alfred Marshall’s ideas on
elasticity to foreign trade. ….devaluation will increase total earnings from exports only if
demand for exports is elastic and, similarly, expenditure on imports will be reduced by
devaluation only if demand for imports is elastic.” (Beardshaw, et al, 1999:p562). This
brings in an important criterion for the success of devaluation in correcting a BOP deficit
known as the Marshall – Lerner condition. It states that devaluation will improve the
balance of trade only if the sum of the elasticities of demand for exports and imports is
greater than unity.
Can the devaluation of the Zimbabwean dollar correct the current structural
BOP deficit and increase foreign currency earnings?
a). In Zimbabwe demand for imports is inelastic
Devaluation can reduce the demand for imports where the price elasticity of demand for
imports is greater than one (elastic demand). Zimbabwe is a major importer of fuel,
electricity, drugs, and high technology components among other things. Our industry
operates with more than 30% of imported components. We cannot do without these
imports. Demand for imports is highly inelastic. As a result, any devaluation cannot reduce
imports since we cannot afford not to import. The real effect of such devaluation is to
216
increase the domestic prices of the imported components and thus fuelling inflation
(imported inflation). Devaluation of the Zimbabwean dollar will have a ‘knock – on’ effect
on domestic prices given the current conditions.
b). Lack of a capacity to produce for the domestic market and the increased export market
For devaluation to be successful, the country must be in a position to produce enough to
satisfy the domestic market and a surplus to meet the increased foreign market demand. If
the economy is at, or near, capacity devaluation is unlikely to be successful immediately
until capacity is increased. Zimbabwe is an exporter of primary products mainly tobacco
and minerals. The country’s agricultural sector is currently going through structural
changes due to the ‘fast -track land reform program’. Tobacco output has fallen
significantly from above 300 million tones to about 60 million tones per year. Devaluation
will not improve the foreign currency shortages because there would be no increase in
export volumes because there would nothing to export. Our current production capacity is
even failing to satisfy the domestic market as evidenced by shortages of most products
such as mealie-meal, milk and other products
c).The J-curve effect

“Due to the existence of contracts and other factors promoting short-run inflexibility, the
volume of exports and imports may not immediately adjust in the wake of devaluation.”
(Black, et al, 2000: 343). It has frequently been observed that devaluation often lead to an
immediate deterioration in the payments position followed by a subsequent recovery. If the
Zimbabwean dollar is devalued, importers with contractual obligations must still meet
these obligations unfortunately at a much higher domestic price. This will worsen the BOP
position until such a time when imports can be reduced, may be after three months.
Against time, the initial effect on BOP of devaluation is illustrated below.
The J - Curve
BOP Net Exports
217
+
C
O
A TIME
- B
Devaluation of the Zimbabwean dollar when at point A will initially result in the
deterioration of the BOP position to point B after which the BOP position may improve
until it gets to surplus after point C.
“The disadvantages of devaluation are price effects. The price of imports in terms of the
domestic currency will increase whilst the price of exports in terms of domestic currency
will either stay constant in the short-run or rise in the long-run. These inflationary effects
will be immediate. Thus, a country that has devalued is likely to see its total expenditure on
imports increase at a faster rate than the increase in its total receipts from exports. Thus the
balance of trade deteriorates in the short run.” (Beardshaw, et al, 1999: 563).
d). Moral of devaluation

Devaluation is most successful when it is not anticipated. This is not the current situation
in Zimbabwe. People have been speculating about the devaluation for a long time. This
speculation is fuelled by the performance of the Zimbabwean dollar against major
currencies on the parallel and the auction system. To devalue the dollar now would be
simply confirming the anticipation, which would have very little impact on the BOP and
foreign currency position because people have prepared themselves for the devaluation.
e). Increased debt servicing costs

The country is currently reeling under a heavy foreign debt-servicing burden. Zimbabwe is
on the record for failing to service its debt to international financial institutions such as the
218
IMF. Devaluing the local currency will increase the foreign debt servicing requirements in
local currency. The interest repayment, in Zimbabwean dollars will rise in direct
proportion to the devaluation.
f). The effect devaluation is short term

Devaluing the local currency can only have temporary effects on the BOP position. The
BOP problems faced by the country are structural, that is, they are a result of a poor
exchange rate system. The auction exchange rate system has failed to operate effectively in
the country. Recently, foreign currency allocations have fallen to less than 10% of the bids.
Devaluing the dollar will simply push forward the same problems probably by a week.
What other policy options may be used to improve a country’s BOP position
No single policy measure can remedy BOP deficit and increase foreign currency inflows.
Devaluation needs to be complemented by other measures for it to be effective.
“Devaluation may be powerful instrument for improving the trade balance under the right
circumstances, but it can by no means be regarded as a panacea for all that ails a country’s
balance of payments.” (Black, et al, 2000:344). Faced with a structural BOP deficit a
country may implement direct controls such as quantity restrictions on imports, import
licenses and foreign currency rationing or deflation, import substitution and structural
adjustment.
a). Import substitution

Import substitution refers to a situation where the country produces goods that are perfect
substitute to the imported goods. For example, the country may seek to produce petrol
blend from molasses that contains alcohol. This will reduce the country’s fuel imports.
b). Deflation
Deflation refers to a situation where the government seeks to reduce the level of aggregate
demand in the economy. This is achieved if either the government reduces its expenditure
219
directly or reduced income through increased taxation. The assumption is that imports are a
positively related to income, that is the import function can be expressed as M = mY where
M = imports, m = marginal propensity to import and Y = income. Thus if incomes are
reduced, the volume of imports will decrease.
c). Direct controls

Direct controls refer to the situation where imports are controlled directly by imposing
higher tariffs on imports or introducing the requirement to produce import licenses. This
tends to reduce the volume of imports directly and can be very efficient especially on
imports that are not essential such as clothing from China.
d). Remove foreign currency controls and allow the exchange rate to float freely
Current foreign currency controls must be removed. For example, people must be allowed
to receive their foreign payments in foreign currency not at the converted auction rate
equivalence like is currently being exercised for those receiving money from the Diaspora.
The auction exchange rate system has failed as evidenced by the decline in foreign
currency allocations highlighted on above. The Zimbabwean dollar must fluctuate freely
according to the forces of demand and supply. In other words, the country must abandon
the auction exchange rate system and implement a market exchange rate system.
e). Increase foreign investor confidence

Zimbabwe used to get significant foreign currency inflows as foreigners came in to invest
in the country (foreign direct investment). Foreign investment inflow is affected negatively
by the current land policies. There is urgent need to revive the economy by increasing
foreign investor confidence and possibly attract foreign investment and the donor
community. This is achievable if there is a major improvement on governance and
improved relations with the donor community.
f). Promote the export of manufactures especially high tech products.

Manufactures are accounting for over 75% of increased world exports. Unfortunately, the
country has to rely on the export of primary products, which have high volumes but less
220
value. The prices of primary products have declined relative to those of manufactured
products on the international market. The government must promote the export of
manufactures initially by the construction of factory shells. This will provide the facilities
to those who would want to engage formally in manufacturing not to promote the informal
sector. In other words, the current informal sector can be formalised.
THE INSTITUTE OF ADMINISTRATION AND COMMERCE
221
ECONOMICS
MAY 2004 TIME ALLOWED: 3 HOURS
TOTAL MARKS: 100
INSTRUCTIONS
1. Answer according to instructions given in each section

2. Write legibly using good English
3. Planning / Workings must be neatly crossed out
***********
SECTION A
ANSWER ALL QUESTIONS
222
*NB: Make your answers short and precise corresponding with the marks allocated for
each question
1. What is the difference between microeconomics and macroeconomics (10)
2. Define (i) Allocative efficiency

(ii) Productive efficiency (10)
3. Define (i) Marginal Revenue

(ii) Marginal Cost
(iii) Average Variable Cost
(iv) Fixed Cost
(v) Variable Cost (10)
4. State any five characteristics of money (10)
5. What is the difference between GDP and GDP per capita? (10)
SECTION B
ANSWER ANY ONE QUESTION FROM THIS SECTION

*NB: Use of diagrams to reinforce answers is an added advantage.
6(a) How can the concept of price elasticity of demand be used in the revenue
maximization decision of firms? (15)
(b) Explain how the concept of price elasticity can be useful to the government in
its taxation policies. (10)
7. Outline the short run break-even, shut down and abnormal profit conditions for a firm
operating under conditions of perfect competition. (25)
SECTION C

8. (i) Explain clearly the causes of inflation in Zimbabwe (15)

(ii) What are the effects of inflation? (10)
9. (a) Give a detailed explanation of the trade barriers which exist (13)
(b) Why do some countries impose trade restrictions? (12)
223
ECONOMICS
OCTOBER 2004 TIME ALLOWED: 3 HOURS
TOTAL MARKS: 100
INSTRUCTIONS

***********
SECTION A
224
*NB: Make your answers short and precise corresponding with the marks allocated for
each question
1. (a) Define scarcity (5)

(b) What does “ceteris paribus” mean? (5)
2. Distinguish between price ceiling and price floor (10)
3. Briefly outline the functions of a central bank (10)
4. Briefly state any four functions of money (10)
5. State the factors which determine the elasticity of demand for a good (10)
SECTION B

6. “Inflation is everywhere and anywhere a monetary phenomenon”. Discus (25)
7. How can a fiscal deficit be financed and what are the advantages and disadvantages
associated with each financing method? (25)
SECTION C

8. What are the advantages and disadvantages of international trade (25)
9. Explain the short run and long run profit maximizing conditions of a monopoly (25)
225
ECONOMICS
MAY 2005 TIME ALLOWED: 3 HOURS
TOTAL MARKS: 100
INSTRUCTIONS

***********
SECTION A
226
*NB: Make your answers short and precise corresponding with the marks
allocated for each question
1. State the law of diminishing marginal utility (10)
2. Define (a) Price elasticity of demand

(b) Cross price elasticity of demand (10)
3. State the four factors of production that a firm can use (10)
4. Define (a) Trade balance

(b) Current account balance of the balance of payments (10)
5. Define (a) Normal profits

(b) Abnormal profits (10)
6. Distinguish between marginal product and marginal cost (10)
7. Explain the difference between the momentary period and the short run period
of a firm (10)
8. State the quantity theory of money and briefly sate all the variables (10)
SECTION B

9. The exchange rate is determined by speculation. Discuss. (20)
10. Explain whether the current turnaround measures being implemented have been
effective in solving the country’s economic problems. What are the challenges
that the country is likely to encounter in its bid to turnaround its economic
fortunes? (20)
THE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS IN ZIMBABWE
227
EXAMINATION QUESTION PAPER
Date: NOVEMBER 2004 3 HOURS
Part: PART A
Subject: ECONOMICS
Instructions to candidates:
There are seven questions in this paper. Answer any FIVE questions
Mark Allocation
All questions carry 20 marks each.
Total: 100 marks
Question 1
228
a).What is meant by elasticity of demand? Briefly explain how this concept may be used
by the Zimbabwean government and firms. (8)
b) With the aid of diagrams describe a demand curve which:
i) is relatively inelastic (4)
ii) is relatively elastic (4)
iii) has an elasticity of unity (4)
Question 2
Explain the following concepts:

a) real versus money income (6)
b) inferior and normal goods (6)
c) revaluation and devaluation (8)
Question 3
a) Define the term monopoly and explain why the marginal revenue curve lies below the
average revenue curve in a monopolistic firm. (10)
b) Outline the main sources of monopoly power (10)
Question 4
Outline the instruments of monetary policy and their limitations to a developing country
such as Zimbabwe (20)
Question 5
a) Distinguish between Gross National Product (GNP) and Gross Domestic Product (GDP)
(6)
b) What are the limitations of using national income statistics to compare standards of
living in different countries? (14)
Question 6
“Economic analysis is concerned with the means of achieving particular economic

objectives.” Outline these economic objectives. Can they be achieved at the same time?
(20)
Question 7
Define the term “fiscal policy”. Explain how the Zimbabwean government can use fiscal
policy to ease the unemployment problem in the country. (20)
229
THE INSTITUTE OF CHARTERED SECRETARIES AND
ADMINISTRATORS IN ZIMBABWE
EXAMINATION QUESTION PAPER
Date: MAY 2005 3 HOURS
Part: PART A
Subject: ECONOMICS
Instructions to candidates:
There are seven questions in this paper. Answer any FIVE questions
Mark Allocation
All questions carry 20 marks each.
Total: 100 marks
Question 1
230
a. Define the law of demand and state the exceptions to this law (11)
b. The following relations describe the supply and demand of pencils:
Qd = 65 000 – 10 000P Qs = -35 000 + 15 000P
Where Q is the quantity and P is the price of a pencil in dollars
i. What is the equilibrium price? Calculate the quantity demanded and supplied at
equilibrium. (3)
ii. Calculate the quantity demanded and supplied at prices of Z$6.00 and Z$5.00. At each
price level comment on whether there would be a surplus or shortage of pencils in the
market. (6)
Question 2
a. Distinguish between own-price elasticity of demand and cross price elasticity of
demand. (8)
b. Discuss the factors which affect the own-price elasticity of demand. (12)
Question 3
a. The table below shows a firm’s units of output and total costs.
Output 0 1 2 3 4 5 6
Total Costs 50 70 80 85 95 115 160
Using the data in the table compute: fixed costs, variable costs, average fixed costs,
average variable costs, average costs and marginal costs (12)
b. Given the revenue function: TR = 10Q – Q2
i. What is the firm’s marginal revenue (MR) function? (2)
ii. Calculate MR at output levels of 2 and 4 (6)
Question 4
Define the term price discrimination as used in economics. Outline the arguments in favour
of price discrimination. (20)
Question 5
What are the basic functions of banks? Explain the importance of banks to commerce and
industry. (20)
Question 6
Clearly outline the measures recently employed by the Reserve bank of Zimbabwe to
combat inflation. To what extent have they succeeded? (20)
Question 7
Discuss the measures that can be adopted by the government faced with a balance of
payment deficit. (20)
231

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Chapter 1

Introduction to economics: scarcity, choice,

1.1 Defining economics

From the above definition, economics is described as a 'social science'. 'Social' in

1.2 Microeconomics and macroeconomics

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1.3 Positive and normative economics

1.4 The basic economic problem

1.4.1 Scarce resources

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1.4.2 Unlimited wants

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1.5 Economic choices

1.5.1 The basic economic problem of choice

1.6 The production possibilities curve (PPC)

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Table 1.2 The production possibilities table

Type of Product Production alternatives

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Fig 1.3 PPC and opportunity cost

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1.6.4 Application: The PPC and economic efficiency

 Productive efficiency or X-efficiency refers to a situation in which the existing

total output - is reflected in a rightward shift of the production possibilities curve,

Fig 1.4 Dynamic efficiency or economic growth

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1.7 Opportunity cost

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2.1 The market economy

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2.2 The centrally planned economy

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2.3 The mixed economy

2.3.1 Reasons for government intervention in a market economy

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Demand and supply

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3.1. Theory of demand

3.1.1 The law of demand

Fig 3.1 The demand curve

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Why the demand curve is downward sloping

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3.1.3 Exceptional demand curves

Fig 3.2 Exceptional demand curve

ii) Speculation or expectations.

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3.1.4 The determinants of demand

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Fig 3.3 Decrease in quantity demanded

3.1.6 Changes in demanded

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Fig 3.4 Changes in demand

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3.2 Theory of supply

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Fig 3.7 Supply curve