CHAPTER 1 (A)

Business Economics
Introduction and meaning of concepts

Meaning of Economics
ECONOMICS: is an area of study concerned with the manner in which the existing resources
are used. It is also concerned with the study of distribution of the resources overtime.
Economics is a branch of social science focused on the production, distribution, and consumption
of goods and services.
Economics can also be defined as a science of how a particular society solves its economic
problems; like scarcity of resources, inflation and unemployment among others.

In a broader perspective, Economics is a science of how man allocates his limited resources
to satisfy his unlimited wants.
Economics is a study of how people make choices under conditions of scarcity and of the
results of those choices for society. Scarcity is one the three basic problems of economics
(scarcity, choice and opportunity cost)
Economics is a social science that studies the production, consumption, and distribution of
goods and services with the aim of explaining how economies work and how their agents interact.

Economics is a study that provides answers to the three major world problems of scarcity, choice
and opportunity cost.
Economics can be defined as the study of how to allocate scarce recourses to satisfy unlimited
wants. It is the study of how people, institutions, and society make choices under conditions of
scarcity.
Scarce resources are such things that command price even though they may be in abundance.

Economics can be broken down into a large number of branches;

 Managerial Economics
 Mathematical Economics
 Urban Economics
 Industrial Economics
 Business Economics
 Public Sector economics
 Health Economics
 Engineering Economics
 Agricultural Economics
 Islamic Economics
 ETC

These branches of Economics are further broken down into Micro and Macroeconimics,
Positive and Normative Economics.
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Business Economics
Business Economics is a field of applied Economics which uses economic theory and
quantitative methods to analyse business enterprises and the factors contributing to the
diversity of organizational structures and the relationships of firms with labour, capital and
product markets.

Business Economics is a field of applied economics that studies the financial, organizational,
market-related, and environmental issues faced by corporations.

Business Economics, encompasses subjects such as the concept of scarcity, product factors,
distribution, and consumption.

According to Investopedia, Business Economics addresses economic principles, strategies,

standard business practices, the acquisition of necessary capital, profit generation, the
efficiency of production and overall management strategy.

Managerial Economics is one of the important offshoots of Business Economics.

Business Economics is a field of study that reviews the implementation of the economic system
in business operations.

Business Economics is a study that assists in utilising the nature the nature and importance
of financial analysis to clarify business problems. Moreover the introduction of this
definition helps balance between limited sources and unlimited aspirations.

Scope of Business Economics

 Demand analysis and forecasting
 Cost and Production analysis
 Costing decisions and strategies
 Profit management
 Wealth management

The nature and importance of Business Economics lie in the future prediction and drafting of
several regulations for profit maximization.

The relevant areas pertained to this discipline are demand analysis and forecasting, Cost and
production analysis, Pricing decisions Profit management, and Wealth governance.

Objectives of Business Economics

 Identification and Resolution of Business problems
 Designing numerous profitable business policies
 Making future predictions
 Building relations between distinct financial aspects

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The Business Economics definition implies blending business processes with economic theories to
simplify the decision-making procedure.
Business Economics or managerial Economics is a discipline that discusses the usage and
importance of Economic policies and concepts in Business governance.
As a matter of fact, Business Economics analyses economic models, approaches, and
philosophies applied to solve rational business issues.

World economic Problems

Scarcity is the inadequacy of resources that are needed to satisfy human needs. It is called the
scarcity principle (the no free lunch principle). Although we have boundless needs and wants, the
resources available to us are very limited. This therefore means, we have to make choice.
Choice is the option taken by an individual or economy. Choice has to be made because of the
insufficient resources to satisfy all that is desired by man or economy. There is need to make
choice beginning with the most pressing need or want. In making choice, sacrifice is made.
Opportunity cost refers to the sacrifice made in order to acquire particular goods or services.
It illustrates the effect of choosing between scarce resources. It can be expressed in terms of the
next best alternative allocation which has been sacrificed e.g. a child with 200/= and is faced with
a desire of an ice cream and chocolate may decide to buy the ice cream. The opportunity cost of
that ice cream to him is chocolate which has been sacrificed. The cost of what one buys is the cost
of the other things one could have bought with the same money. Opportunity cost may also refer
to the cost of something in terms of alternatives foregone.
Why we Study Economics
• In the context of Least Developed Countries, the aim of teaching economics is to give
students a grasp of the main issues and problems that LDCs are faced with so that they
can be able to formulate appropriate economic policies designed to achieve rapid
economic development.
• We study economics in order to properly allocate the scarce resources so as to improve
the standard of living.
• The study of economics is also important because it makes us aware of what may happen
when a certain decision is made (deadweight loss).
• The study of economics is vital because it quickly transforms students into better decision
makers. Economics therefore teaches that we take only those actions with positive
economic surplus.
• Economics enables learners to realise that making wise choices reduces wastage of
resources which are naturally scarce.
• Economics deals with cost-benefit analysis which helps us to weigh. This can be realized
when it says that if the benefits of the action exceed its costs, then you should do it; but if
the benefits fall short of the costs, then you should not do it.

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• Whether scarcity, choice or opportunity cost or any other, an economics course equips the
learner with fluency in fundamental terms needed to understand how markets work. Even
when you do not use these terms in your current role, these economic terms will give you
a better understanding of market dynamics as a whole and how they apply to your
organization.
• Econ is not just learning of a fancy set of words, but using them to develop a viable
business strategy. E.g you can use theories and frameworks like SWOT analysis to assess
situations and make variety of economic decisions.

Benefits of Business Economics

Business Economics plays a key role in making sure the world’s economy continues to prosper
and businesses work at their best. Sometimes called managerial Economics, the field works in
collaboration with businesses to find solutions that can be used to meet the economic goals of
the business.
 Career opportunities
Business Economics students have plenty of options when looking for graduate jobs. Not only is
there generally a good availability of jobs in the financial sector, there are lots of different
career paths to be taken, E,g, they can become economists, portfolio managers, corporate
finance analysts, management consultants, financial advisors, etc

 International knowledge
- With knowledge of Business Economics, learners get insights into finance around the world,
including international events like the global financial crash, or how China’s economy is
growing. It may also put the learner in good stead for career opportunities abroad.

 Provides highly desirable skills

Knowledge of Business Economics will see you develop a range of desirable and useful skills for you
in your personal life such as;
 Research and analysis,
 Advanced mathematics and numeracy skills
 Knowledge of economic systems
 Problem solving and attention to to detail,
 Spoken and written English

 Combine Economics and business

Knowledge of Business economics allows learners have knowledge of two different subjects at once
which brings several benefits;
 You will be able to take learnings from an Economics module and use it in your business
module and vice versa. This will improve your academic work.
 Studying Business economics allows the learner to discover which field you prefer to
study and may help you to decide on your future career aims  Gives an edge in a
competitive job market too.

 Inspire Business success

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With knowledge of Business Economics, your future career is likely to have a high level of job
satisfaction. The learner will therefore have up-to-date knowledge of Economics and Business
theory, meaning you can put your ideas into practice right away.

 Knowledge of Important Terminologies

Business Economics helps you get equipped with how to leverage economic tools. Learning
economic theory is one thing, developing the tools to make business decisions is another,
economics teaches you the basics and gives you concrete tools for analysis.

 Understand you spending habits

Business Economics helps you understand your own spending habits. For example, willingness to
pay (WTP) is the maximum amount someone is willing to pay for a good or service.

 Successful Business strategy

A Business Economics course will equip the learner with tools to develop a successful business
strategy to benefit his organization or career.

More Concepts of economics

Economics as a science, has been categorized into two branches;

Microeconomics and Macroeconomics

Microeconomics
Microeconomics is a branch or a study of economic tendencies or what is likely to happen
when individuals make certain choices or when the factors of production change.
Microeconomics unlike macroeconomics is a science that focusses on the smaller factors that
affect choices made by individuals, communities and companies.
Microeconomics also explains what to expect if certain conditions change. Example, If a
manufacturer raises the price of cars, micro says consumers will tend to fewer cars than
before. Or if a major copper factory collapses in America, the price of copper will tend to
increase, because supply is restricted.
Microeconomics is a study of the economic actions of individuals and small groups of
individuals. It looks at the functions if the individual economic units. It is concerned with
the study of the small elements of the economic system. These may include consumers,
business firms and single prices.
In micro economics, the major concern is how a specific price is established. The major
importance of micro economics is that it helps us understand the functioning of individual
economic units.

Macroeconomics
Macroeconomics is a branch of economics that studies how the aggregate economy behaves.
It is a branch that deals with that deals with a variety of economy-wide phenomena such as
inflation, national income, unemployment, and economic growth or GDP.
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Macroeconomics refers to the study of the aggregate behavior of all individuals in the
economy. It is concerned with the behavior of large aggregate of the economy and national
income.
Macroeconomics looks at the economy as one functioning item because of two reasons;
• Different sectors of the economy are interrelated e.g. agriculture depends on industry and
vice versa.
• Certain institutions cover the entire economy e.g. money.

The many problems which are traditionally considered in macroeconomics are;

• Problem of economic growth; it is concerned with those factors that determine economic
growth. It is concerned with those factors which bring the economy to the path of stable
economic growth.
• Problem of unemployment; macroeconomics studies the causes of unemployment and the
various determinants of unemployment.
• Inflation; macro studies the effect of money on the economy.
• Problem of Balance of Payment; i.e. foreign exchange earnings and foreign exchange
expenditure.

The major importance of macroeconomics is that it helps us understand the functioning of the
economy.

Free good and economic good

A free good does exist in such a natural abundance that one’s desire can be satisfied at zero price.
At zero price, one can get as much commodity as one wishes. The cost is zero e.g. fresh air.

An economic good arises out of scarcity and choice. It must satisfy three conditions;
 Provide satisfaction i.e. utility.
• Relatively scarce.
• Marketable i.e. value.

Public and Private good

Public good is publicly owned; its consumption by an individual does not exclude the
consumption by another individual. Everybody can consume it. Ones consumption of such a
commodity does not reduce the consumption of another individual e.g. it does not pay a private
individual to provide a public good e.g. public road, public clock and streetlights.
Private good are the goods enjoyed exclusively by single individuals. The act of consuming the good
by one individual excludes others from consuming it.

Intermediate and Final good

Intermediate goods are used in the process of production e.g. wheat, steel and final goods are those
which are ready for consumption.

Market Concept
A market is an organization in which sellers and consumers come into a close contact. The
function of a market is to enable an exchange of goods and services to take place. The interaction
of buyers and sellers in a free competitive system results into a price which clears the market i.e.
price at which the quantity demanded is equal to the quantity supplied.
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Equilibrium Concept
This is when the economic forces as they exist at a particular time have no tendency to change. In
the economic analysis, equilibrium is said to exist when the set of variables under consideration
shows no tendency to change, if one of the variables is changed, there will be a state of
disequilibrium. If the original equilibrium position was a stable one, then all the variables will
return to their original position.
There are several types of equilibrium position;
 Market Equilibrium
 Consumers’ Equilibrium
 Producers’ Equilibrium

Fundamental Questions in Economics

The study of economics attempts to answer the following questions which economists are faced
with, given the limited resources.
• What to produce? This address the type of commodity; whether it is a consumer durable or
non durable.
• How to produce? This concerns about the production techniques and it tries to identify
those that minimize costs.
• When to produce? Society is always faced with a problem of choosing between producing
now for consumption or delaying production and have it later.
• For whom to produce? This question addresses the targeted markets; whether production is
for the low income or high income groups, for the young or the old. The aim is to produce
for those who need the good most since they are willing to demand more and hence pay
higher prices for the goods which in turn maximizes the producers’ profits.
• Where to produce? This question is concerned with the location of the firms; is it near to
the source of the raw-materials, energy, transport system or the market.
• How much to produce? This question attempts to determine how much of every commodity
shall be produced depending not only on the needs of society but also on the resources
available to producers and consumers. Depending on the type of economic system, this
question is answered by the price mechanism or by the state or a mixture.

Scarcity, Choice and Opportunity Cost

Scarce economic resources mean limited goods and service. Resources of decision makers no matter
how large they may be are always limited, thus less than people’s desires.

Scarcity restricts option and demands choices. Choice arises out of scarcity of resources and it
means making a right decision. Because of scarcity of resources, man must make a scale of
preference. A scale of preference is where items are arranged according to order of priority.
When you choose from the scale of preference, then you are said to be making choice.

Opportunity cost is the value of what is given up to obtain something else. When a consumer
uses his scale of preference to make choice because of limited resources, it implies that he is
making a decision to satisfy one set of wants. This means sacrificing some other set. It is this
sacrifice that is referred to as opportunity cost.
To get one of one thing, society forgoes the opportunity of getting something else. So the cost of
that obtained is the value of that sacrificed to get it.
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Production Possibility Frontier

Society uses its scarce resources to produce goods and services. The alternatives and choices it
faces can best be understood through a macroeconomic model of production possibilities. To
keep things simple, we assume:
• Full employment The economy is employing all its available resources.
• Fixed resources The quantity and quality of the factors of production are fixed.
• Fixed technology The state of technology (the methods used to produce output) is constant.
• Two commodities The economy is producing only two commodities: food products and
manufacturing equipment. Food products symbolize consumer goods, products that satisfy
our wants indirectly; manufacturing equipment symbolizes capital goods, products that
satisfy our wants indirectly by making possible more efficient production of consumer goods.

A production possibility frontier is a curve showing different combinations of two commodities that
can be produced when all resources are fully utilized.

The production possibility curve

Manufacturing
equipment Y

Y1 A C

Y2 B
D
PPF

O X1 X2 food products X

Each point on the production possibility curve represents some maximum combination of two
products that can be produced if resources are fully and efficiently employed. When an economy
is operating on the curve, more manufacturing means less food products, and vice versa. A point
outside the curve such as C is desired because it shows more units of food products and
manufacturing equipment produced in an economy. But such a point is unattainable because of
limited resources and a fixed technology.
A point inside the curve is attainable but undesired because it indicates that full employment is not
being utilized.

Shifting of the PPF

A movement from a point on a PPF to a point outside the PPF shows economic growth. This
involves shifting of the PPF outwards to the right.

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Shifting of the PPF

Manufacturing
equipment Y

Y1 A C

Y2 B
D
PPF1 PPF2

O X1 X2 food products X

The shifting of the PPF to the right (economic growth) can be brought about by:
• Increase in supply of resources.
• Improvement in resource quality.
• Technological advancement.  Improvement in skills of production
• Acquiring of grants from abroad.

Slope and Shape of the PPF

The shape of the PPF is referred to as the marginal rate of product transformation. It shoes the
quantity of the commodity X that must be given up in order to produce an additional unit of
commodity Y. The PPF has a negative slope. This implies that for an economy to increase on
the production of a commodity, it has to forego the production of some units of the other
commodity.

Review Questions
1. a) Distinguish between:
i) Microeconomics and macroeconomics.
ii) Positive economics and normative economics.
b) Discuss the fundamental problems that economics addresses and show how they relate.
c) Explain the questions that economics attempts to answer.

2. a) Explain the concept of production possibility frontier and discuss its underlying
assumptions.
b) What would production at a point outside the production possibility curve indicate?
What must occur before the economy can attain such a level of production?
c) Draw a PPF for an economy producing only food products and automobiles. Suppose
improvement occurs in the technology of producing food products but not in automobiles.
Draw the new PPF. Now suppose that a technological advancement occurs in producing
automobiles but not in producing food products. Draw the new PPF. Now draw a PPF that
reflects technological improvement in the production of both goods.

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CHAPTER TWO
Market Exchange – Demand, Supply and Market Equilibrium
A market is a place where buyers and sellers come together and exist in many forms. The corner
gas station, an e-commerce site, the local music store, a farmer’s roadside stand – all are familiar
markets. The Uganda Stock exchange is a market where buyers and sellers of stocks and bonds
and farm commodities communicate with one another to buy and sell.

Some markets are local, while others are national or international. Some markets are highly
personal, involving face-to-face contact between demanders and suppliers; in others are buyers
and sellers never meet or know each other.

Demand
Demand refers to the ability and willingness to buy at a given price (effective demand)

Law of Demand
The Law of demand states that the higher the price the lower the quantity demand and viceversa,
other factors being constant.

The Demand Curve

Other things equal, consumers will buy more of a product as its prices declines and less of the
product as its price rises. The demand curve is derived from a demand schedule which is the a
table showing different quantities of a commodity demanded at different prices.
Demand curve
Demand
Price Quantity schedule
1200
for per demand apples
1000
apple
Price 800
1000 10 600
700 20 400
500 30 200

0
10 20 30

Quantity demand

When the above information is plotted on a graph then we obtain a demand curve.
The other-factors-constant assumption is critical here. Many factors other than the price of the
product being considered affect the amount purchased.

The Demand Function

The demand function shows the relationship between quantity demand and the factors that determine
demand. It can be expressed simply as
Qd = f (Xi)
Where Xi is a vector of all factors that affect demand
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The quantity demanded of a commodity by a consumer will depend on many factors (determinants
of demand). These include:

Price of the commodity All else equal, equal, as price falls, the quantity demanded rises, and as
price rises, the quantity demanded falls. In short, there is an inverse relationship between price
and quantity demanded. Economists call this inverse relationship the law of demand.

Income of the consumer For most products, a rise in income increases demand. Consumers
collectively buy more TVs and cell phones as their incomes rise. Products whose demand
increases with increase in income are called superior goods or normal goods.
Although most products are normal goods, there are a few exceptions. As incomes increase
beyond some point, the demand for used clothing and cassava may decline. Higher incomes
enable consumers to buy new clothing, banana and higher-quality meats. Goods whose demand
decreases with increase in income are called inferior goods.

Price of related commodities, A change in the price of a related good may either increase or
decrease the demand for a product, depending on whether the related good is a substitute of
complement.

Beef and chicken are substitutes. When two products are substitutes, an increase in the price of
one will increase the demand for the other. For example when the price of beef rises, consumers
will buy less beef and increase their demand for chicken.

Complements are products that are used together and thus typically demanded jointly. For
example computers and software, cell phones and cellular services, etc. If the price of a
complement goes up (for example computer), the demand for the related (for example software)
will decline. Conversely, if the price of a complement falls (for example tuition), the demand for
a related good will increase (for example textbooks).

Tastes and preferences A favourable change in consumers tastes (preferences) for a product means
more of it will be demanded at each price.

Expected price of a commodity, when consumers expect a higher price in the future, they may
buy more now to beat the anticipated price rise. In contrast when consumers expect the price of
the commodity to fall, they may decrease the demand for the product.

Number of buyers An increase in the number of buyers in a market increases the demand for the
product. For example an increase in the number of people constructing houses will lead to an
increase in the demand for building materials. On the other hand, the migration of people away
from small rural communities will reduce the demand for houses and home appliances.

Other factors include the following:

• Geographical location of the consumer
• Religion and culture
• Government policy
• Level of education
• Age

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• Level of education
• Season of the year

Change in Quantity Demanded

A change in demand is a movement from one point to another on the same demand curve. This is
caused by an increase or decrease in price of the commodity under consideration.

Price
(P)
d

P1 A

P2 B

d
Q1 Q2 Quantity demanded Q

A movement from point A to B is referred to as a change in quantity demand. At a higher price

P1, the consumer demands less quantity Q 1. When price falls to P2, the consumer demands more
quantity Q2.

Change in Demand
Be sure not to confuse a change in quantity demand with a change in demand. A change in
demand is a shift of the demand curve to the right either to the right (increase in demand) or to the
left (a decrease in demand). A change in demand is caused by other factors affecting demand
leaving price of the commodity constant.

A shift of the demand curve to either d2 or d3 is a change in demand.

Shifting of the demand curve

showing a change in demand
P

Po

d3 d1 d2

Q3 Q1 Q2 Q

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Marked Demand
So far, we have concentrated on just one consumer. But competition requires that more than one
buyer be present in each market. The market demand is the summation of the individual demands
at each of the various prices in the market.
If there are only three consumers in the market, as represented by the table below, it is easy to
determine the total quantity demanded at each price. We simply sum the individual quantities
demanded to obtain the total quantity demanded at each price. The particular price and the total
quantity demanded are then plotted as one point on the market demand curve.

Price Quantity Quantity Quantity Total quantity

demanded by demanded by demanded by demanded
consumer A consumer B consumer B (market demand)
5 10 12 8 30
3 20 23 17 60
2 35 39 26 100

Individual and market demand curves

P P P P

3
dA dB dC dM

0 35 Q 39 Q 26 Q 100 Q

We obtain the market demand curve by adding horizontally the individual demand curves of all
the consumers in the market. Because the market demand curve is the horizontal summation of
all individual demand curves, it is flatter than any individual demand curve.

Supply
Supply is a schedule or curve showing the amounts of a product that producers will make available
for sale at any given price and time.

Law of supply
The law of supply states that as price rises, the quantity supplied rises and vice-versa. This is
basically common sense. Firms will offer for sale more of their products at a high price than at a
low price. This is common sense.
To a supplier, prices represent revenue, which is needed to cover costs and earn profit. Higher
prices therefore create a profit incentive to produce and sell more of a product. The higher the
price, the greater this incentive and the greater the quantity supplied.

Supply Curve
Because price and quantity supplied are directly related, the supply curve for an individual producer
has a positive slope.

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Supply schedule
price Quantity
supplied
1 5
2 20
3 35
4 50
5 60

Supply Curve

4
price
3

0
5 20 35 50 60
Quantity Supplied

Determinant of Supply
In constructing the supply curve, we assume that price is the most significant influence on the
quantity supplied of any product. But other factors do affect supply and these include the
following:

Price of the commodity This is in accordance to the law of supply. The higher the price the higher
the quantity supplied

Resource prices The prices of the resources used in the production process help determine the
costs of production incurred by firms. Higher resource prices raise production costs and,
assuming a particular product price, reduces profits. The reduction in profits reduces incentive
for firms to supply output at each product price. In contrast, lower resource prices reduce
production costs and increase profits. So when resources prices fall, firms supply greater output
at each product price.

Technology Improvement in technology enable firms to produce units of output with fewer
resources. Because resources are costly, using fewer of them lowers production costs and
increases supply.

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Taxes and subsidies Businesses treat sales and property taxes as costs. Increase in those taxes
will increase production costs and reduce supply. In contrast, subsidies are “taxes in reverse.” If
the government subsidizes the production of a good, it in effect lowers the producers’ costs and
increase supply.

Prices of other Goods Firms increase the supply of their products when the prices of the
substitute goods rise and vice-versa. Conversely, firms reduce their supply if the prices of the
complements increase.

Expected prices Changes in expectations about the future price of a product may affect the
producer’s current willingness to supply that product. If producers expect a higher price for their
product in future, they may withhold some of their current stock from the market, thereby causing
a decrease in the current supply of wheat. In contrast, if manufacturers expect price to reduce,
they will increase their current supply.

Number of Sellers Other things equal, the larger the number of suppliers, the greater the market
supply. As more firms enter an industry, the supply curve shifts to the right. Conversely, the
smaller the number of firms in the industry, the less the market supply.

Other factors include:

Gestation period
Natural hazards for agricultural produce
Government policy
Political climate
Availability of factors of production

Change in Quantity Supplied

Change in quantity supplied is caused by the change in price of the commodity leaving other factors
constant.

Change in quantity supplied

Price S
P2
B

P1 A

O Q1 Q2 Quantity supplied

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An increase in price from P1 to P2 leads to an increase in quantity supplied from Q 1 to Q2. This is
equivalent to movement from point A to B along the supply curve.

Change in Supply
A change in supply is brought about by change in other factors affecting supply apart from price
of the commodity. It is illustrated by a shift in the supply curve either to the right (increase in
supply) or to the left (decrease in supply).

Change in supply
S3 S1 S2
Price

Po

S3 S1 S2

O Q3 Q1 Q2 Quantity supplied

At the same price Po, quantity supplied increases from Q1 to Q2 or decreases from Q1 to Q2.

Market Equilibrium
Equilibrium refers to the state where selected inter-related variables have no tendency to change in
the model in which they constitute.
In the market, equilibrium is said to be attained where quantity demanded is equal to quantity
supplied.

Price D S

Pe

S D

O Qe Quantity (Q)

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The intersection of the demand curve and the supply curve determines the equilibrium price P e and
the equilibrium quantity Qe.

Determination of the Equilibrium Price and Quantity

Equilibrium is attained when quantity demanded is equal to quantity supplied.

Qd = Qs ……………………………………………………. (1)

We assume that Quantity demanded (Q d) is a decreasing linear function of price (as P increases,
Quantity demanded decrease)

Qd = a – bP ………….…………………………………….. (2)

Quantity supplied on the other hand is an increasing linear function of P

Qs = - c + dP ……………………………………………….. (3)

Let us now solve some numeric examples Example

1:
Given the following demand and supply equations, solve for the equilibrium price and quantity.
Qd = 36 – 4P
Qs = -12 + 12P

Solution

At equilibrium Qd =Qs
Implying that Substituting for P in either the demand or
36 – 4P = -12 + 12P supply equation we can get the
Collecting like terms together equilibrium quantity.
36 + 12 = 12p + 4P Q = 36 – 4P
48 = 16P Q = 36 – 4 x 3
Dividing both sides by 16 we get Q = 36 – 12
P=3 Q = 24
Therefore equilibrium price is Shs 3 and
equilibrium quantity is 24 units.

Exercise 1.
Given the following market models, find the equilibrium price and quantity.
a) Qd = 51 – 3P b) Qd = 24 – 2P c) Qd = a – bP Qs = 6P – 10 Qs
= -5 + 7P Qs = -c + dP

Consumer’s Surplus

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Consumer’s surplus refers to the difference between what a consumer is willing to pay and what
he actually pays. The concept of consumer’s surplus tends to suggest that consumers gain some
sort of free bonus, or surplus for every purchase. Graphically. The consumer’s surplus is
represented by the area below the demand but above the price level.

Consumer’s surplus

price S
A consumer’s surplus

Pe B

O Qe Quantity

At equilibrium, the consumer is willing to pay OABQ e. However, she pays only OP eBQe. The
difference becomes the consumer’s surplus given by the shaded area PeAB.
If the demand curve is linear, the consumer’s surplus is given by:
A = ½ bh

Example 2
Consider the demand and supply functions in example 1.
Qd = 36 – 4P
Qs = -12 + 12P
The solution P = 3 and Q = 24

price S
9 consumer’s surplus

3 B

O 24 Quantity

Producer’s Surplus
A producer sets a minimum price that he is willing to accept in exchange for his commodity.

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Producer surplus is the difference between the amount of money that a producer actually receives
upon the sale of a commodity and the minimum amount of money that he would be willing to
accept for the same quantity.

The producer’s surplus is shown by the area above the supply curve but below the equilibrium price.

Producer’s surplus
price S
A Producer’s surplus

Pe B

O Qe Quantity

Government Set Prices

In most markets, prices are free to rise or fall with changes in supply or demand, no matter how
high or low those prices might be. However, government occasionally concludes that changes in
supply and demand have created prices that are unfairly high to buyers or unfairly low to sellers.
Government may then place legal limits on how high or low a price or prices may go.

Price Ceiling
Government sets a maximum legal price a seller may charge for a product or service and any
price above it is illegal. The rationale for establishing price ceilings specific products is to enable
consumers to obtain some essential goods or services that they could not afford at the equilibrium
price.
Price Ceiling
Price S

Pe

Pc Ceiling

Shortage D

O Qs Qe Qd Quantity (Q)
The problem with the price ceiling is that it results in a persistent product shortage, here shown by
the distance between Qs and Qd.

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Price floors
A price floor is a minimum price set by the government and any price below it is illegal. Price
floors above the equilibrium are usuall set when society feels that the price determined by the
market system has not provided sufficient income for the suppliers or producers.

Price Ceiling
Price surplus S

Pf

Pe

O Qd Qe Qs Quantity (Q)

The problem with the price floor is that at any price above the equilibrium price, quantity
supplied will exceed quantity demanded – that is, there will be a persistent surplus or the product.
Farmers will be willing to produce and offer for sale more products than private buyers are
willing to buy at Pf.
The government may cope with the surplus resulting from a price floor in two ways:
• It can restrict supply
• Government can purchase the surplus output at Pf.

Revision Questions
1. Explain the law of demand. Why does a demand curve slope downwards? How is a market
demand determined from individual demand curves?
2. Distinguish between a change in quantity demanded and a change in demand. What are the
determinants of demand?
3. Why does the supply curve slope upwards? What are the determinants of supply?
4. Using clear illustrations where necessary, explain the following concepts:
a) Market equilibrium e) Shortage
b) Equilibrium price f) Price ceiling
c) Equilibrium quantity g) Price floor
d) Surplus

Elasticity of Demand

Elasticity refers to the responsiveness of quantity demand due to a given percentage in any of the
factors that affect demand.

Price Elasticity of Demand

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Price elasticity of demand is a measure of responsiveness of demand to changes in the

commodity’s own price. It is a percentage change in quantity demanded due to a one percentage
change in price of the commodity.
The coefficient of price elasticity of demand is given by the formula

Ed = percentage change in quantity demanded

Percentage change in price

The percentage changes in the equation are calculated by dividing the change in quantity
demanded by the original quantity demand and by dividing the change in price by the original
price. So we can restate the formula as

Ed = change in quantity demanded × original price

change in price original quantity

= ∆Qd × P1

∆P Q1

Because demand curves slope downwards, the price elasticity coefficient of demand will always be
a negative number.

Example 1
Given the following demand schedule, find the price elasticity of demand.
Pr Quan
ice tity
30 10
15 20
E
Solution =
10
×
Ed = ∆Qd 3
× P1 0
∆P Q1

E -15
d 10
=
2
0
- =
1 300
0 =-
× 2
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3 - 15
0 0
Ther
15 - 30 efor
10 e
price
elast
icity
of
dem
and
is
- 2.

The negative sign tells us that it is a normal demand curve.

Perfectly Inelastic Demand (Ed = 0) A change in price of a commodity does not affect the
quantity demanded.
Price D

P1

P2

O Qo Quantity

Inelastic Demand (Ed < 1) If a specific percentage change in price produces a smaller percentage
change in quantity demanded, demand is inelastic. Then Ed will be less than one.

price d
A big change in price brings
P1 about small change in quantity demanded and curve is very steep O Q 1 Q2
Quantity

P2
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Unitary Elastic Demand (Ed = 1) This occurs where a given percentage change in price results in
the same percentage change in quantity demanded.
price d

P1

P2
d

O Q1 Q2 Quantity
Elastic Demand (Ed > 1) Demand is elastic if a specific percentage change in price results in a
larger percentage change in quantity demanded. The Ed will be less than 1.

price

P1
P2
d

O Q1 Q2 Quantity

Perfectly Elastic Demand (Ed = ∞) This is where quantity demanded changes without changes in
price. That is, infinite quantities are demanded at the same price.
price

P1 d

O Q1 Q2 Quantity

Determinants of Price Elasticity of Demand

We determine the price elasticity of demand to be zero, one, less than one, or greater than one?
We cannot say what determine the price elasticity of demand in each individual situation, but the
following generalizations are often helpful.
Please be keen not to confuse them with determinants of demand.

Number of Substitutes, generally, the larger the number of substitutes that are available, the
greater is the price elasticity of demand. This is because any slight increase in the price of the

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commodity, the consumer will reduce the consumption of that commodity significantly and
increase the demand of the substitute goods which now appear cheaper.

Proportion of Income Spent on a Commodity, if a commodity takes a small percentage of a

consumer’s income (for example pencils, matchboxes, and chewing gum), a change in it price
may not affect much its quantity demanded. Thus, price elasticity of such low-priced items tends
to be low (inelastic). In contrast, if the price increase is a significant fraction of the incomes and
budgets of most families (for example a 10% increase in the price for automobiles), the number
of units demanded of the commodity will diminish significantly. Thus, price elasticity of such
highly priced items will be high (elastic).

Number of Uses of a Commodity, a commodity that have many uses tends to be more price
inelastic than one with few uses. This is because the consumer reduces the number of uses when
its price increases meaning that he reduces the quantity demanded. For example sugar can be
used to mage juice, tea, and cakes. When its price rises, the consumer may stop using it for
making cakes and juice and use it only for tea.

Consumers’ Habit, when a consumer is addicted to a commodity, changes in its price may not
affect the quantity demanded of that commodity.

Degree of Necessity, the higher the degree of necessity of the commodity the more inelastic it is
likely to be. Since the commodity is indispensable, increase in price may not affect much the
quantity demanded of that commodity. For example water, salt and food are price inelastic. In
contrast, the more that a good is considered to be a luxury the greater is the price elasticity of
demand.

Time, consumers often need time to adjust to changes in price. For example, consumers may not
immediately reduce their purchases very much when the price of beef rises, but in time they may
shift to chicken and fish. Therefore the shorter the time required to adjust to changes in price the
more inelastic the demand will be. In the long run, demand is more elastic.

Cross Elasticity of Demand

Cross elasticity of demand refers to responsiveness of quantity demanded of a commodity to a
given change in price of another commodity. It measures a percentage change in quantity
demanded of commodity Y due to a given percentage change in the price of another commodity
X.

Exy = percentage change in quantity demanded of Y

Percentage change in price of X

Exy = ∆Qy × Px
∆Px Qy

Example 2.
Given the following demand schedule, determine the cross elasticity of demand for commodity X
and Y.

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Price Quantity Quantity

demanded of X demanded of Y
100 20 15
200 10 25

Solution
Exy = ∆Qy × Px Exy = 10 × 100
∆Px Qy 100 15

Exy = 1000 = 0.67

Exy = 25 - 15 × 100 1500
200 -100 15

Interpretation of cross elasticity of demand

If:
Exy is negative, the products are complements
Exy is positive, the products are substitutes
Exy is zero, the products have nor relationship

Income Elasticity of Demand

This refers to the responsiveness of quantity demanded of a commodity to a change in the
consumers’ income. It measures a percentage change in quantity demanded due to a given
percentage change in the consumers’ income.

EY = percentage change in quantity demanded

Percentage change in Income

EY = ∆Q × Y
∆Y Q

Interpretation of income elasticity of demand

If:
EY is negative, the product is an inferior good.
EY is positive, the product is a normal good.
EY is zero, the product is a necessity.

Importance of the Concept of Price Elasticity of Demand

1. To Producers
• It is used in the pricing strategy. With price discrimination, the producer can charge
different prices from different consumers depending on the price elasticity of demand.
Higher prices will be charged on commodities with low elasticity, well as commodities
with elastic demand attract lower prices.
• To determine the degree of advertisement. The producer will intensively advertise
commodities with elastic demand because they assumed to have close substitutes. He may

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not have to advertise for commodities with inelastic demand as they may have no
substitutes.
• To determine the amount of commodities to be supplied in the markets. Producers will
supply of commodities with inelastic demand since profit maximization is possible with
limited supply. However, to maximize profits on commodities with elastic, the producers
have got to expand outputs.
• Use to determine wage rates of a particular type of labour. The unskilled has an elastic
demand and therefore, always paid lower wages. On the other hand, skilled labour
possesses elastic, thus is commonly highly paid.

2. To Consumers
• Use to determine consumer’s expenditure. When a consumer buys a commodity whose
demand is elastic, the expenditure will reduce with an increase in price. On the other
hand, when he consumes a good whose demand is inelastic, the expenditure increases
with an increase in price.
• Use to determine tax incidence. Taxes imposed by government had normally shares
between consumers and producers depending on price elasticity of demand. For elastic
demand, the incidence of tax on the producer and therefore, pays more tax. However, a
larger part of tax is paid by the consumers if the commodity has an inelastic demand.

3. To the government
• Use in the taxation policy. Government normally imposes higher taxes on commodities
which have got inelastic demand. This is because; the increase in price due to taxes will
not so much reduce quantity demand. But of commodities with elastic demand, lower
taxes are normally levied.
• Use in devaluation strategy. For devaluation to succeed, the price elasticity of demand for
the country’s exports and imports must be elastic. Changes in process must significantly
affect the amount of exports and imports.
• Use to explain paradox of poverty amidst plenty. During the bumper harvest, farmers earn
less income since agricultural products have an inelastic demand. Increase in supply
results into reduction in prices, but their reduction does not significantly increase quantity
demanded. Therefore, the incomes of farmers fall instead of increasing.
• Use for subsidization policy. While subsidizing particular producers, government
normally considers the price elasticity of demand for the commodities. Support is
normally given to the producers of commodities with elastic demand.

Importance of Income Elasticity of Demand

• Useful in determining the type of commodities; either necessities, normal good, superior
goods or luxury good. It thus help a consumer to knoiw what type of a commodity he or
she is consuming.
• Helps producers to determine what commodity to produce for different groups of
consumers with different income elasticity of demand e.g. luxury for the rich.
• Enables the producers to foretell the directions of demand for his commodities in case of
change in income of consumers. As income increases, the demand for normal, (luxury)
goods increase that of necessity remains constant and for inferior goods falls.

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• Helps governments determine the degree of income inequality from the value of
purchases of the different goods. High expenditure on luxuries suggests inequitable
income distribution.
• Helps a consumer in estimating his nature of expenditure. A consumer’s expenditure is
likely to increase following an increase in income if he is the type of a consumer who has
an appetite for luxury goods.
• A useful guide for the government in the distribution social utilities.
• Helps in price discrimination based on incomes. Goods with inelastic income demand
should be charged less compared to those with elastic income demand.
• A country will earn little foreign exchange from exports whose demand is income
inelastic and vice versa.
• Helps a producer determine how much to supply to the market. A producer dealing in a
commodity that is income inelastic will supply less of it to the market when consumer’s
income rises in order to earn more revenue.
• Helps entrepreneur determine the location of their enterprises. Firms that produce luxury
goods should be located in the region where rich dwell e.g. urban centres.
• Useful to government in policy making e.g. subsidizing and price legislation among
others.
• Useful to government in taxation. Essentials and necessities should be taxed less than
non-essentials like luxuries.

Importance of Cross Elasticity of Demand

• Useful to determine whether a good has a substitute or a compliment.
• It reveals the relationship between commodities that are consumer in practice.
• It helps producer in determining the degree of competition. Producers of substitutes
normally face stiff competition than producers of compliments.
• Provides a useful knowledge to knowledge to the consumers about the extent of their
bargaining or haggling power. A consumer has a strong bargaining power when a good
has a substitute.
• Help in a government taxation policy. Substitutes generate less tax revenues compared to
the compliments.
• Help in determining the degree of monopoly and monopolistic competition. The power of
monopoly and monopolistic competition if other commodities dealt with has several
substitutes.
• Help consumers make choice; substitutes make this possible.
• Helps in setting or fixing of commodity prices by producers. Producers of goods that have
substitutes do well by not hiking their commodity prices.
• Helps in arriving at the definition of an industry as a group of firms producing goods with
high Cross Elasticity of demand.

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Revision Questions
1. Distinguish between price elasticity of demand and cross elasticity of demand. What are
the determinants of price elasticity of demand?
2. Suppose when price for apples goes up from Shs500 to Shs600 the quantity demand of
apples changes form 1200 boxes to 1000 boxes and quantity demanded of mangos
changes from 1500 to 1600.
i) Determine the price elasticity of demand for apples. Is the demand for apples
elastic or inelastic?
ii) Determine the cross elasticity of demand for apples and mangos. What is the
nature of these commodities?
Production Theory

Theory of the Firm

A firm is the smallest technical unit in which commodities are produced. The traditional economic
theory assumes that profit maximization is the only objective of business firms.

Modern economics theories such as Boumal and Tobin have indicated that firms assume a
multiplicity of objectives such as sales maximization, growth maximization, lung-run survival,
cost minimization, and others.

Basic Concepts in Production Theory

Production Function The production function is a technical or mathematical relationship
between output and the inputs required to produce that level of output. It represents the ability of
the firm to convert inputs into outputs given the technology.

Assume a production process that requires two inputs, labour and capital.
Q = f(L,K)
It can take on a linear form, for example
Q = a + bL
Or a Cobb-Douglas of the form,
Q = ALαKβ

Shape of the production function

The Production Function

Output

Total Product (TP)

Input

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The shape of the production function is assumed to be affected by the law of diminishing
marginal return which states that “as more of a variable input X is employed on a fixed factor, the
total output increase first and later at a decreasing rate until a point is reached where additional
quantities of input X yield diminishing marginal returns, assuming other factors are kept
constant.”

Average Product (AP) This is defined as total output divided by total units of the variable factor.
AP = Q
L

Marginal Product (MP) This refers to the change in total output resulting from the use of one more
unit of the variable factor.
MPL = ∆TP
∆L Or
MPK = ∆TP
∆K

Relationship between Total Product, Average Product and Marginal Product

The relationship between these concepts can explained using the assumed table below.
Fixed Cost Variable Cost Total Product Average Marginal
(FC) (VC) (TP) Product (AP) Product (MP)
3 1 10 10/1 = 10 -
3 2 24 24/2 = 12 24-10 = 10

3 3 39 13 15
3 4 52 13 13
3 5 61 12.2 9
3 6 66 11 5
3 7 66 9.3 0
3 8 64 8 -2

A graphical representation of the three concepts is shown in the figure below.

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The relationship between TP, AP, and MP

Output

Total Product (TP)

O Labour

AP
MP

I II III

AP

O Labour

MP
A typical product function can be divided into three regions.
In the first region, total product, marginal product and average product are all positive. In this
region the variable factor for example capital is not fully utilized implying that average product is
still rising. So it benefits the producer when more units of a variable factor are employed since
increase in the variable factor leads to increase in the total product. Therefore it is irrational for a
producer to operate in this region.

In the second region is also referred to as the economic/optimal region. In this region TP, MP
and AP are still positive, although AP and MP are declining. In this region there is efficient
utilization of the fixed factor. Therefore production should take place in this region.

In the third region, the production function is characterized by declining AP, MP and TP and
indeed in this region MP is negative. This implies that employment of an extra unit of a variable
factor will lead to the decline in the total output. This is because of the over utilization of the
fixed factor input by the variable factor.

Production Decision of a Firm

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The production of any output usually involves use of more than one variable factor input. The
producer attempts to make decisions on how shall the inputs be divided among the various types
of the inputs so as to produce a given quantity of output. For simplicity, we limit ourselves on
only two factor inputs; capital and labour in our analysis.

An Isoquant
An isoquant is a curve that shows different combinations of factor inputs say capital and labour
required by the firm to produce a given level of output. A typical isoquant is convex to the origin
and its shape and slope depends on the rate at which one factor can be substituted for another to
produce the same level of output. This rate of substitution is called the marginal rate of technical
substitution (MRTS).

Illustration of an Isoquant
K

K1

K2

O L1 L2 L

Properties of an Isoquant
 Downward sloping
• The isoquant that lies above another shows a higher level of output.
• It is convex to the origin
• It does not touch any of the axes, otherwise it will lead to a corner solution where a particular
level of output can be produced using a single variable factor which might be unrealistic.
• Isoquants do not intersect.

Slope of an Isoquant
The slope of an isoquant is given by
Slope = ∆TP
∆L
= MPL = MRTSLK
MPK
From the above, we state that the slope of the isoquant is negative and is equal to the ratio of
marginal product labour to marginal product of capital and is referred to as the marginal technical
substitution of labour and capital.

Iso-cost Line

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This is the line showing the maximum level of expenditure by the producer given the fixed
amount of money available to a producer and factor input prices. We assume that the producer
has a fixed cost outlay equal to C and uses it to purchase tow factor inputs Capital (K) and Labour
(L) whose prices are PK and PL respectively.

C = PkK + PLL

The slope becomes (after making K the subject)

Slope = - PL
PK

Illustration of an iso-quant

Iso-cost line

L
Equilibrium in Production
Equilibrium in production is obtained where the highest isoquant is tangent to the isocost line

Illustration of the Equilibrium in Production

A
E

C q3
q2
q1
C
O L

Point defines the equilibrium point of production. Point A is desirable because it lies on the higher
isoquant but not attainable because the firm is constrained.
On the other hand point B is undesirable because it lies on the lower isoquant. Therefore point E
shows the optimal combination of labour and capital.
At equilibrium, since the isoquant is targent to the isocost line, the slope of the isoquant must be
equal to the slope of the isocost line.

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MPL = PL = MRTSLK
MPK PK
Cross multiplying
MPL =MPK
PL PK

Theory of Costs

Businesses need economic resources in order to produce its products. In obtaining and using
resources, a business makes monetary payments to resource owners (eg. Rent, interest, wages, etc
). And incurs opportunity costs when using resources that it already owns. Those payments and
opportunity cots constitute the firm’s costs of production.

Economic costs
Economic costs are the payments a firm must make to attract the resources it needs away from
alternative production opportunities. Those payments to resource suppliers are either explicit of
implicit.

• A firm’s explicit costs are the monetary payments (or cash expenditures) it makes to
those who supply labour, materials, fuel, transportation services, labour and the like.
These can be included in a firm’s books of account.
• A firm’s implicit costs are the opportunity costs of using its self-owned, self-employed
resources. Implicit costs are the money payments that self-employed resources could
have earned in their best alternative use. These costs cannot be included in the
computation of the firm’s costs because they cannot be monetised.

Short-Run Production Costs

We know that in the short run some resources, those associated with the firm’s plant are fixed. Other
resources, however, are variable. So short run costs are either fixed or variable.

Fixed Costs Fixed costs are costs that do not vary with changes in output. Fixed costs are
associated with the very existence of a firm’s plant and therefore must be paid even it its output is
zero. Such costs are rental payments, interest on a firm’ debts and builds.

Variable Costs Variable costs are costs that change with level of output. They include payments
for materials, fuel, power, transportation services, labour and so on.

Total Cost Total cost is the sum of fixed costs and variable costs at each level of output.

Average Costs
Producers are certainly interested in their total costs, but they are equally concerned with perunit,
or average costs. In particular, average cost data are more meaningful for making comparison
with product price, which is always stated on a per-unit basis.

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Average Fixed Costs (AFC) This is defined as the ratio of total fixed costs (TFC) to output. That
is,
AFC = TFC
Q
Because the total fixed costs is the same regardless of output, AFC must decline as output increases.

Average Variable Costs (AVC) Average variable cost for is the ratio of total variable cost to
output. That is,
AVC = TVC
Q
A graph of AVC is U-shaped

Average Total Costs (AC) Average total cost is the ratio of total cost to output.
AC = TC = TFC + TVC = AFC + AVC
Q Q Q
Marginal Costs The extra, or additional cost of producing one more unit output.
MC = change in TC
change in Q

marginal costs are costs the firm can control directly and immediately. MC designates all the cost
incurred in producing the last unit of output. Thus, it also designates the cost that can be saved by
not producing the last unit.

A firm’s decisions as to what output level to produce are typically marginal decisions, that is,
decision to produce a few more or a few less units. When coupled with marginal revenue,
marginal cost allows a firm to determine it is profitable to expand or contract its production.

Marginal cost is shown graphically in the figure below. At first it declines sharply, reaches a
minimum, and then rises rather abruptly. This reflects the fact that variable costs and therefore
total costs, increase first by decreasing amounts and then by increasing amounts.

Illustration of a firms cost curves

Q FC VC TC AFC AVC AC MC
1 10 9 19 10.0 9.0 19.0
2 10 17 27 5.0 8.5 13.5 8.0
3 10 24 34 3.3 8.0 11.3 7.0
4 10 30 40 2.5 7.5 10.0 6.0
5 10 37 47 2.0 7.4 9.4 7.0
6 10 45 55 1.7 7.5 9.2 8.0
7 10 54 64 1.4 7.7 9.1 9.0
8 10 65 75 1.3 8.1 9.4 11.0
9 10 78 88 1.1 8.7 9.8 13.0
10 10 93 103 1.0 9.3 10.3 15.0

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MC, AC, AVC and AFC

Costs

MC

AC
AVC

AFC

QUANTITY Q

AFC falls as 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. The marginal cost (MC) curve eventually rises because of diminishing returns
and cuts through the AC and AVC at their minimum points.

Long-Run Production Costs

In the long run an industry and individual firms it comprises can undertake all desired resource
adjustments. That is, they can change the amount of all inputs used. The firm can alter its plant
capacity; it can build a larger plant or revert to a smaller plant. The long run allows sufficient
time for new firms to enter and exit.

Long-run AC curve
The long-run AC curve is derived from short run AC curves. It is the tangent to all the short run
AC curves. The long run AC curve is made up of segments of the short-run cost curves (AC1,
AC2, etc) of the various size plants from which the firm might choose. If the number of possible
plant size is very large, the long run AC curve approximates a smooth curve.

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Long-run AC curve
AC
AC3

Long-run AC
AC1 SAC2

The long run AC curve is U-shaped because of economics of scale and diseconomies of scale.
Note that the law of diminishing returns does not apply in the long run because diminishing
returns presume one resource is fixed in supply while the long run means all resources are
variable. We can explain the U-shaped long run AC.

Long-run AC curve
AC
LAC

I II III

Q1 Q2 Q

Economies of scale explain the down sloping part of the long-run AC curve (section I). A number
of factors will for a time lead to lower average costs of production. These include;
• Labour specialization, Increased specialization in the use of labour becomes more
achievable as a plant size expands. Hiring more workers means jobs can be divided and
subdivided. Each worker may now have just one task to perform instead of five or six.
Workers can work full time on the tasks for which they have special skills.
• Managerial specialization Large-scale production also means better use of management.
Large firms can have departments. A supervisor can handle more workers without
increase in supervisory costs.
• Efficient capital, Small firms often cannot afford the most efficient equipments. In many
production lines such machinery is available only in very large and extremely expensive
units. Also effective use of the equipments require a high volume of production, and that
gain requires large scale producers.
• Start up costs which decline per unit as output increase  Advertisement costs decline per
unit
• etc.
All these factors contribute to lower AC for the firm that is able to expand its scale of operations.
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Diseconomies of scale explain the increase part of the AC curve (section III). In time the
expansion of a firm may lead to diseconomies and therefore higher average total cost. The
diseconomies of scale will be in form of management becoming difficult, workers working
inefficiently, and so on.

Constant returns to scale (section II) In some industries there may exist a wide range of output
between which economies of scale end and the output at which diseconomies of scale begin. That
is, there may be a range of constant returns to scale over which long-run AC does not change.

Revision Question
1. a) Distinguish between explicit and implicit costs giving examples of each.
b) Explain the concepts of average fixed costs, average variable costs, average total costs and
marginal cost. Show the relationship between these costs.
c) Distinguish between a short run AC curve and a long run AC curve. Explain why is the long
run AC curve U-shaped.

d) Given the following table, calculate the AFC, AVC, AC, and MC
TP (Q) 0 1 2 3 4 5 6 7 8
TFC 100 100 100 100 100 100 100 100 100
TVC 45 85 120 150 185 225 270 325 390
e) Discuss the economies and diseconomies of scale.

Market Structures
In this chapter several basic models of market structure that will help us understand how price,
output, and profit are determined in the many product markets in the economy.

Economists group industries into four distinct market structures; pure competition, pure
monopoly, monopolistic competition, and oligopoly. These markets differ is several aspects
these include:
• The number if firms in the industry
• Whether those firms produce a standardized product or try to distinguish their products from
those of other firms
• Ease of entry and exit.

Perfect Competition
Perfect competition is defined in terms of the following characteristics
• Very large number of sellers and buyers in the market each one of them having no notable
influence on the market price and quantities.
• Homogeneous products: Firms produce identical products. As long as the price will be the
same, consumers will be indifferent about which seller to buy the product from.
Buyers view the products as perfect substitutes for each other.
• Free entry and exit; new firms can freely enter and existing firms can freely leave purely
competitive industries. No significant legal, technological, financial, or other obstacles
prohibit new firms from selling their output in any competitive market.

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• Sellers and buyers are independent in decision making. There is no collusion of any type.
• Full and correct information about the market price, nature of the product, costs and demand.
Therefore there is complete absence of advertisement.
• There is no government intervention in the market of any form.
Although perfect competition is hypothetical, a less hypothetical one is the pure competition
based on the first four assumptions. A few industries more closely approximate pure competition
than any other market structure. Also perfect competition is a meaningful starting point for any
discussion of how prices and output are determined.

Short-Run Behaviour of a Firm under Perfect Competition

In the short run, the firm is constrained by the existence or certain fixed inputs. Further the
market power of the firm will be negligible. It will not be able to influence the price of the
product and its quantity significantly.

The price will be determined by the forces of demand and supply in the market. The individual
firms will accept this price and adjust the output to the maximum profit situation. The demand
curve faced by the individual firms will therefore be perfectly elastic at the market price.

The firms demand curve is also its average revenue schedule. Price per unit to the purchaser is also
revenue per unit, or average revenue to the seller.
The firms will get either positive or negative profits depending on the position of the average cost
curve.
Illustration of short-run behaviour of a firm under perfect competition for a firm
earning positive profits
Price S
Costs MC

AC
E
P1 X AR=DD P1

C
Y

O Qe
Q O Q

P1 is the equilibrium price determined by forces of demand and supply at point E. The individual
firm takes this price which implies a straight line demand curve parallel to the x-axis. The
optimum profit is determined at point X where price is equal to marginal cost (P = MC). At this
price the optimum profit earned by the firm will be given by the area P1XYC, the firm can not do
anything to increase the profit.

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Because the purely competitive firm is a price taker, it can maximize its economic profit (or
minimize its loss) only by adjusting its output.

If the AC curve is well above the demand curve then the firm will earn negative profits.

Illustration of short
-run behaviour of airm
f under perfect competition earning
negative profits
Price S
Costs MC

C Y AC
E
P1 X AR=DD P1

O Qe Q O Q

The losses are given by P1CYX

Long-Run Behaviour of a firm under Perfect Competition

The existence of the positive profits in the short run will attract new firms in the industry. The
number of suppliers will increase, market supply increases, the price of the products decline with
the fixed demand curve. Assuming a constant cost curve, the reduction in price means a
reduction in profits. The process continues until there is complete disappearance of the profit
margin

Illustration of short-run
behaviour of a firm under
perfect competition earning
negative profits

Price AC
MC
Costs
C

P1 X AR=DD

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O Qe Q

In the long run, profits are maximized where LAC = LMC. This point is at the lowest point of the
LAC.
There will be just normal profit in the business. From the above analysis, we note that the market
structure under perfect competition limits the firm’s conduct severally. It can not do anything
except to adjust its output level consistent with the market price in the light of its objective. The
short-run profits are temporally. The zero profits in the long-run imply that the firm can only
survive only on the basis of normal profits which cover the cost of production. If there is no
profit, the firm cannot exist in the market.

Advantages of Perfect Competition

• In the long-run, there is efficiency in production. All firms produce at the minimum point of
the AC curve.
• There is no wastage of resource through advertisement.
• Firms charge the lowest price possible.
• Consumers get the highest consumer surplus

Disadvantages of Perfect Competition

• There is lack of consumer choice because all commodities are similar.
• The assumptions of perfect competition are unrealistic (for example; perfect knowledge,
homogeneous products, etc). Therefore it does not exist in the real world.

Monopoly
Pure Monopoly exists when a single firm is the sole producer of a product for which there are no
close substitutes. The characteristics of pure monopoly are the following:-  Single seller of a
specific good or the sole supplier of a service.
• No close substitutes in that the firm produces a unique product.
• Not entry because of barriers, which may be economic, technological, legal, or of some
other type.
• Price maker in that the monopolist controls the total quantity supplied and thus has
considerable control over price. The monopolist confronts the usual downward sloping
demand curve. It can change the price by changing the quantity of the product it supplies.

Examples of pure monopoly are relatively rare, but there are examples of less pure forms.
Examples in Uganda include the National Water and Sewerage Cooperation, Uganda Electricity
Distribution Company Limited, UNEB, etc

Barriers to Entry (Sources of Monopoly Power)

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Barriers to entry are factors that prohibit firms form entering an industry and they include the
following:-
• Location or distribution, the certain commodity can be produced in only a single place.
• If it is only possible to produce a commodity in a complex factory or after installation of a
large amount of equipment such that it would be wasteful to have more than one.
• Legal barriers to entry. Government also creates legal barriers to entry by awarding patents
and licenses.
- A patent is the exclusive right of an inventor to use, or to allow another to use his
invention. Patents and patent laws aim to protect the inventor form rivals who would
use the invention without having shared in the effort and expense of developing it.
- Licenses; Government may also limit entry into an industry or occupation through
licensing.
• Ownership or Control of Essential Resources. A monopolist can use private property as an
obstacle to potential rivals. For example, a firm that owns or controls a resource essential to
the production process can prohibit the entry of rival firms. A local firm may own all the
nearby deposits of sand.
• Pricing; A monopolist may create an entry barrier by slashing its price, stepping up its
advertising, or taking other strategic actions to make it difficulty for the entrant to succeed.
• Exclusive methods of production for example professionals such as teachers and doctors.

The demand curve of a monopolist is down ward sloping because the monopolistic producer can
either determine the price or the quantity but not both.
The marginal revenue curve is also downward sloping, starts at the same point on a vertical axis
as the demand curve but steeper than the demand curve. The marginal revenue curve of a
monopolist slopes down wards because when more commodities are offered for sell prices fall
therefore the extra revenue received from additional output decreases.

Equilibrium of a Monopolist in the Short-run

Price
Revenue MC AC
A
P1

C1 B
E

D=AR

MR

O Q Q
Costs,

A profit maximizing monopoly will be at equilibrium when MC=MR. E is a point where

MR=MC. Q1 is the monopoly output and P1 is the optimum price and C1P1AB will be the
optimum profit.
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A monopolist produces at less optimal that is less than the minimum of the AC curve.

Equilibrium of a Monopolist in the Long-Run

In the long-run other firms wish to enter the market to share the super normal profits but
monopoly restrictions prevent them from doing so. So a monopolist can market super normal
profit even in the long-run.

Price Discrimination
We have so far assumed that the monopolist charges a single price to all buyers. But under
certain conditions the monopolist can increase its profit by charging different prices to different
buyers. In so doing the monopolist is engaging in price discrimination, the practice of selling a
specific product at more than one price when the differences are not justified by cost differences.

Conditions for price discrimination

Price discrimination is possible when the following conditions are realized:
• Monopoly power; the seller must be a monopolist or, at least, must possess some degree of
monopoly power, that is, some ability to control output and price.
• Market segregation; the seller must be able to segregate buyers into distinct classes at a
relatively low cost to itself each of which has a different willingness or ability to pay for the
product.
• No resale; the original purchaser cannot resell the product or service. If buyers in the low
price segment of the market could easily resell in the high price segment, will undermine the
monopolist’s price discrimination policy.

Forms of Price Discrimination

• Discrimination according to income where low prices are charged to the poor and high to the
rich for the same good or service.
• Discrimination according to sex where for example a low price is charge to females and a
high price to males for instance in theatres.
• Geographical discrimination where by commodities are sold at different prices specifically at
a low price to a foreign country than to a domestic country.
• Discrimination according to time for example when the students at evening programmes pay
more tuition than those on day for the same courses.
• Discrimination according to nature of the commodity for example publishers’ books with
hard cover are priced highly than ones with soft covers though with similar content

Advantages of Price Discrimination

• It enables the poor to get essential commodities and services at low prices
• It increases the revenue of the producer
• It redistributes income when the rich are charged highly and the poor are subsidized
• It helps the producers to dispose off the surplus products

Advantages of Monopoly
• There is no duplication of services
• Economies of scale can be enjoyed by the firm because it can expand using abnormal profits.
• There is no wastage of resources in advertisement

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• There is a possibility of price discrimination

• Monopoly restrictions protect and hence enable infant industries to grow.

Disadvantages of Monopoly
• The monopolist does not produce at the minimum of the AC curve. Therefore it leads to
under utilization of resources.
• It also reduces the consumer’s surplus.

Monopolistic Competition
Monopolistic competition is characterized by:-
• A relatively large number of sellers each with a comparatively small market share. The
presence of a relatively large number of firms ensures that collusion by a group of firms to
restrict output and set prices is unlikely. The firms also act independently among themselves
each of which determines its own pricing policy without considering the possible reaction of
the rival firms.
• Firms sell differentiated products often promoted by heavy advertisement. They produce
products with slightly different physical characteristics, offer varying degrees of customer
service, provide varying amounts of locational conveniences, or proclaim special qualities for
their products.
• Easy entry and exit: entry into competitive industries is relatively easy compared to
oligopoly or pure monopoly because of the small firms and few capital requirements. Also
exist is relatively easy because nothing prohibits a non-profit making monopolistic
competitor from to shut down.
• Advertisement: Monopolistic competitors advertise their products heavily in order to make
consumers aware of the product differences. If successful, the demand for the firm’s product
will increase.
The first and third characteristics provide the ‘competitive’ aspect of monopolistic competition;
the second characteristic provides the ‘monopolistic’ aspect. In general, however,
monopolistically competitive industries are much more competitive than they are monopolistic.

The demand curve of faced by a monopolistically competitive seller is highly elastic because of the
many competitors producing closely substitutable goods.

Short-run equilibrium of a firm under perfect competition

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C, P, R AC
MC
P1 Y

C X D=AR

MR

O Q1 Q

The monopolistic competitor maximizes profit by producing the output at which MR = MC. The
firm behaves this in the short run since it has quite different products from its rivals and the time
period is short enough so no rival can copy its actions.
The firm continues to get profits CXYP 1 charging price P1 and producing quantity Q1. The
economic profits will induce new firms to enter, eventually eliminating economic profits. Also
the other firms will soon or later revise their decisions in order to maintain the market share. This
will result in the competitive adjustment process.

Long-run Equilibrium under Monopolistic competition

C, P, R
MC AC

P1

D = AR

MR

O Q1 Q

The equilibrium is determined where MC = MR. P 1 is the price and equal to AC. In the long run the
firm earns normal profits. This is as the result of the competitive adjustments.

Oligopoly
Oligopoly is a market dominated by a few large producers of homogeneous or differentiated
product. Because of the small number, oligopolists have considerable control over their prices,

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but each must consider the possible reaction of rivals to its own pricing, output, and
advertisement.

Because firms are few in oligopolistic industries, each firm is a ‘price maker’, it can set its price
and output levels to maximize its profit. But unlike the monopolist who has no rivals, the
oligopolist must consider how its rivals will react to any change in its price, output, product
characteristics, or advertisement. Oligopoly is thus characterized by;
i) Strategic behavior – self interested behavior that takes into account the reactions of others.
ii) Mutual interdependence – a situation where each firm’s profit depends not entirely on
its own price and sales strategies but also on those of the other firms. So oligipolists firms base
their decisions on how they think rivals will react.

The Kinked demand Curve

Consider an oligopolistic industry made up of three firms, each having about the same share of
the total market for a differentiated product. We want to see how each firm’s demand curve looks
like.

Oligopoly is another market structure which is seen in reality, in fact it is the most dominant in many
countries.
An oligopolistic market is one containing a small number of sellers have influence upon his rivals.
The simplest form of oligopoly is called Duopoly when two firms operate in the market.

The firms under oligopoly are interdependent in the market in that if one firm say reduces the
price in order to increase its market share and earn more profits, the other firms will react to
protect their market share. Therefore, anyone taking a unitary decision regarding price or quantity
or anything else will take into account the possible reaction of its rivals.

The Kinked Demand Curve

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The kinked demand curve is based on the assumption that when that seller increases price of his
produce no one else will follow it but whenever a seller reduces the price, all other sellers will do
so.
DD1 represents the demand curve for the representative seller under oligopoly and it shows the price,
quantity relationship when all other firms keep their prices constant.

Revision Questions
1. Explain the short-run behaviour of a firm under perfect competition.
2. With illustrations contrast the long-run behaviors of firms under monopoly and monopolistic
competition.
3. Discuss the barriers to entry.
4. Explain the concept of price discriminations, and show the conditions for price
discrimination to succeed. What are the advantages of price discrimination?
5. Explain the concept of kinked demand curve under oligopoly.
6. Discuss the forms of non-pricing competition that are characteristic of oligopoly.

National Income and Measurement

Introduction
In common terms, national income refers to the total value of goods and services produced annually
in a year in an economy or a country.
National income has again been defined as the total income accruing to a country from economic
activities in a year’s time. It includes payment made to all resources in the form of wages, interests,
rent and profits.

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Definition of National Income

There are two classes of definitions of national income; the traditional definitions advanced by Marshall,
Pigou and Fisher, and the Modern definition.
The Marshallian definition. National income includes commodities produced, material and immaterial
and services of all kinds excluding depreciation and wearing out of machines plus income from abroad.
The Pigovian definition. In addition to the Marshallian definition, A. A. Pigou included in his definition
of national income that income which can be measured in terms of money (objective income of the
community) plus income derived from abroad, which can be measured in terms of money.
Fisher’s definition. Fisher adopted consumption as a criterion of national income instead of production
adopted by Marshall and Pigou. Fisher’s definition is considered to be better than those of Marshall and
Pigou because it provides an adequate concept of economic welfare, which is dependent on consumption,
and consumption represent standard of living.

The Modern definition. Simon Kuznets has defined national income as “The net output of
commodities and services flowing during the year from the country’s productive system in the hands of
ultimate consumers”.
The net value of all goods and services produced within a nation over a specified period of time.
This the layman’s definition of national income
Concepts of National Income
1. Gross Domestic Product (GDP)
This is the money value of goods and services produced within the country in a given period of
time usually one year. It is the total sum of all goods and services produced domestically by the
nationals of the country and the foreigners. It excludes incomes of nationals of a country who are
abroad. It is gross because allowance for depreciation has not been made.
2. Gross National Product (GNP)
This is the money value of all goods and services produced by the nationals of a country living
within the geographical boundaries of that country and abroad. It excludes the value of goods and
services produced by the foreigners living in that country, but include that of nationals of a
country living abroad i.e. GNP = C + I + G + (X – M). The element of depreciation is still
inclusive and that is why it is “Gross”.

GNP = GDP + Net property income from abroad (NPIA)

3. Net Domestic Product (NDP)

This refers to the money value of all goods and services produced within a country, excluding the
net incomes from abroad after allowance has been made for depreciation i.e. NDP = GDP –
Depreciation allowance.
4. Net National Product (NNP)

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This is the money value of all goods and services produced by the nationals within and without
the boundaries of the country less the amount necessary for depreciation (replacing worn out
machines). This is basically GNP – Depreciation i.e. NNP = GNP – Depreciation.
Thus, NNPFC = NNPMP – Indirect taxes + Subsidies.
5. GNP at Market Price
GNP at market price refers to GNP valued at the prevailing market price and is got by multiplying the
total output in a particular year by their market prices prevalent during that same year in a country. It
means the gross value of final goods and services produced in a year plus net income from abroad.
6. GNP at Factor Cost
GNP at factor cost is the sum of the money value of the income produced by and accruing to the various
factors of production in one year in a country.
GNP at factor cost = GNP at market price – Indirect taxes + subsidies
7. Personal Income
This is the amount of money received by an individual household over a given period of time.
Personal Income = National Income + transfer payments – individual corporate profits –
corporate income taxes – social security contributions.
Personal Income = Private Income – Undistributed corporate profits – Profit taxes
8. Disposable Income
This refers to the amount of income available for an individual or household to spend. It is given by;
yd = y – T + Tr
Where yd – Disposable Income
T – Taxes
Tr – Transfer payment
Y – Income
Disposable income = Personal income – Direct taxes

9. Domestic Income or Product

This is the income generated by the factors of production within the country from its own resources.
Domestic income = Nation Income – net income from abroad
Thus the difference between domestic income and national income is the net income earned from abroad.
Or if we add net income from abroad to domestic income, we get National income.
10. Private Income
Private income is any type of income (from any source, productive of otherwise) received by a private
individual or household, often derived from occupational activities. It can be arrived at by making certain
additions and deductions from NNP at factor cost.

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Private income = National income + transfer payments + interest on public debt

– social security – profits and surpluses of public undertaking.
11. Real Income
Real income is the income of individuals or nationals after adjusting for inflation. It is calculated by
subtracting inflation from the nominal income. Therefore, real income is a more useful indicator of
wellbeing, since it is based on the amount of goods and services that can be purchased with the income.
In order to find out the real income of a country, a particular year is taken as a base year when the general
price level is neither too high nor too low and the price level for that year is assumed to be 100.

Real NNP = NNP for the current year x Base year index (=100)
Current year index
Differntly stated, this is the purchasing power of money income. It is national income expressed
in terms of a general level of prices of a particular year taken as the base i.e.
Real Income = Money NNP x 100
Price Index for that year
12. Per Capita Income
This is the average income of the people of a country in a particular year. It is calculated by dividing
National income of a country by the population of the country in that year. Per capita income means how
much each individual receives, in monetary terms, of the yearly income that is generated in their country
through productive activities. That is what citizens would receive if the yearly income generated by a
country from its productive activities were divided equally among everyone. Per capita income is usually
reported in units of currency per year.
This concept enables us to know the average income and the standard of living of the people. But it is
not reliable, because of unequal distribution of national income.
Differently stated,
Income Per Capita (PY)
simply refers to average income per head. It is the average income earned per person in a given
country in a given year i.e.
Per Capita Income = Total National Income

Population
13. Cost of Living
This is the monetary value of goods and services required to maintain a given level of economic
welfare. Cost of living is said to have risen when it costs more to purchase the same quality of
goods and services. Cost of living and standards of living are inversely related.

14. Standard of Living (SOL)

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This is the of income, comforts, and services available, generally applied to a society or location
rather than individuals.
SOL refers to the level of wealth, comforts, material goods, and necessities available to a population
or society.
SOL refers to the quantity and quality of material goods and services available to a given population.

15. Consumption Per Capita (CC)

It is the average consumption per person. It represents the proportion of income consumed i.e.
Consumption Per Capita = Total National Income

Total Real Consumption

Determinants of the Level of National Income

• Technology: This is the know-how of the production process. It involves new techniques of
production, innovations and inventions in the production process. Technology increases factor
performance. It increases resource exploitation and raises the effectiveness of labour. Incomes
increase due to the production of high quality output.
• Trade position of a country: The share of a country in world trade determines the size of
National Income. The share in world trade is also determined by the Terms of Trade (TOT)
facing a country.
• Political factor: A favourable political atmosphere and good economic policies enhance
economic activities and raise the level of National income. Political instability discourages
investments and capital accumulation, hence making the level of National Income low.
• Quality and quantity of the labour force: This is the stock of knowledge and skills available.
People’s health and working attitudes affect productivity of labour and the degree of resource
exploitation.
• Quality and quantity of the natural resources: Natural resources like soils, forests, minerals,
water bodies, strategic location, climate, wildlife and their levels of exploitation determine the
size of a country’s National Income.
• Stock of Capital: It determines the level of stock exploitation and the productivity of labour,
enhances skills formation. These in turn determine the quality and quantity of output and hence
National Income.
• Institutional factor: The cultural, religious and political institutions of a country determine the
level of a country’s National Income positively or negatively.
Measuring National Income
To measure how much output, spending and income has been generated, we use national income accounts.
National income is a term used to measure the monetary value of the flow of goods and services produced
within the economy over a period of time. Measuring the level and rate of growth of national income (Y)
is important to economists when they are considering:

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 The rate of economic growth and whether the economy is in the business cycles
 Changes to overall living standards of the population
 Looking at the distribution of national income and wealth inequalities.

Estimates of National income (GNP) produced in a given year may theoretically be arrived at through
three different accounting approaches.

i) The income approach

Using the income approach, National income is estimated by estimates of the different kinds of earnings
people receive from producing the final goods and services. The earnings include:
• Total wages and salaries
• Profits of incorporated and unincorporated businesses
• Rental incomes
• Interest incomes
• Dividends – dividends earned by the shareholders form companies
• Direct taxes indirect business taxes depreciation
Thus according to income method GNP = total wages and salaries + profits of incorporated and
unincorporated business + rental incomes + interest incomes + dividends + direct taxes + indirect
business taxes + depreciation + net income from abroad
(Plus certain adjustments to account for wear and tear on productive assets like plant and machinery
depreciation and what are called indirect business taxes)

ii) Expenditure approach

Using the expenditure approach, National income is estimated by summing the amounts of money that are
spent on final goods and services by households (consumption), business firms (investment), government
(government purchases), and by the world outside the country (net export). Thus using the expenditure
approach;
GNP = C + I + G + (X – M)
Where C – Consumption expenditure
I – Investment expenditure by business firms
G – Government expenditure
X – Exports of goods and services
M – Imports of goods and services
iii) Product or Output approach (Value added)
Using the product or output approach, national income is estimated by summing up output of all the
various productive sectors in the country using the concept of value added; subtracting out costs of their
raw materials to avoid double counting and making suitable adjustments for depreciation and for the value
of imports and exports.
The productive sectors of the economy are the service industries, manufacturing and construction, and
extractive industries such as mining, oil together with agriculture.

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In theory, all the three approaches should give the same grand totals – but of course in actual practice
there will be discrepancies, and sometime sizable discrepancies between the three estimates.

Value Added Method

This is the value added by a firm at every stage to the raw materials or processed products that it
had bought from the preceding stage before passing on the product to the next stage in the
production process.
Item Shillings Value Added
Raw materials 70 -
Lint 100 30
Fabric 130 30
Shirt 160 30

Value added is therefore the value of the final goods/products (goods and services) and not
intermediate goods that are included. This therefore means that; 70 + 30 + 30 + 30 = 160 which is
the total value added by all production processes.
Why the Output Approach is used in Uganda for National Income Measurement
In Uganda like in many Least Developed Countries basically, it is this approach used due to the
following reasons;
• Unlike other approaches, it is a direct method and data is more readily available.
• It is only this approach that takes into consideration the subsistence output. Under this
approach, subsistence output can be estimated.
• The expenditure approach cannot be used because there are no records of private
expenditure and many transactions are carried out on barter basis. With the output or
product approach on the hand, these figures can be estimated.
• It is relatively cheaper to estimate product values using the product approach rather than
using the income approach as it is difficult to estimate incomes of self employed citizens
and they are the majority in our countries.
Difficulties/problems in the measuring of national income
• The difficulty of defining boundaries of the nation, because national income includes also income
earned by nationals of a country abroad.
• The use of money as a unit of measurement of national income, because a number of goods and
services are difficult to be assessed in money terms. For example, bringing up of children by a
mother. By excluding such services, the national income will be less than want it is actually is.
• Double counting which arises from the failure to distinguish properly between the finished goods
and the intermediate products. Sometimes certain goods and services are included more than once
and if this happens, national income would be higher than what it is actually is.

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• Incomes earned through illegal activities such as ‘magendo’, should not be included. But by
excluding them, the national income would be less than the actual.
• There is a problem of whether to include the transfer payments in the national income or not. Such
payments like pension, unemployment allowance and interest on loans. These payments fall under
individual incomes as well as government expenditures.
• Inventories changes are included in the GNP. The problem is that firms record these inventories at
their original costs rather than at replacement costs. When prices rise, the value of the inventories
rise and when prices fall, the value of inventories falls. Adjustments need to be done but the
procedure is very cumbersome.
• The problem of estimating current deprecation value of a piece of capital. The usual method is to
base on the original cost of the asset, but prices change.
• Another problem is that of price changes. Prices are never stable which affects the measuring of
national income. When prices rise, national income also rises even though the production might
have fallen and vice versa.
• There is a problem of use of money as a unit of measurement; it does not include leisure foregone
in the process of production of a commodity.
• Some public services, which are included in national income, cannot be estimate correctly. It is
difficult to estimate the contribution made to national income by profits earned on irrigation during
the wet and dry season.
• Non-availability of data. Data relating to crops, forestry, employment, fisheries, animal husbandry
and activities of petty shopkeepers, construction workers etc is not adequate in developing
countries. Also data on consumption and investment expenditure is not available.
• Non-monetanised sector. There is a large non-monetanised section in a developing country i.e. the
subsistence sector in which a large portion of production is carried out.
• Illiteracy. Majority of people in such countries are illiterate and therefore do not keep any
accounts about the production and sales of their products.
• Lack of occupational specialization. Crop farmers are also engaged in supplementary occupations
like dairy farming, poultry, cloth making, etc. but income from such activities is not included in
the national income estimates.
• Definition. Definitions try to exclude certain incomes. Certain groups of incomes such as gifts,
pocket money to students and unemployment benefits. This problem is practical where we are
using the income approach.
• Double counting. This may be caused by the lifespan of the commodity or it may be due to
difficulties in differentiating between intermediate goods and final goods.
• Errors of omissions. Due to insufficient statistical data, these errors are committed. Many activities
in Least Developed Countries go un-marketed especially in rural areas. These include; activities
like work done by housewives, children in home garden, leisure foregone and output for
subsistence among others.
• Errors of commission. Some activities are ignored due to their negative contribution to national
income figures such as pollution, resource exploitation and depletion are not catered for in national
income statistics.
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• Some transactions are not properly recorded because they are informal in nature.

Importance of National Income Statistics

• National policy analysis. Policies on employment for example can be based on the level of
output and investment. Policies on inflation and taxation can also be based on national
income statistics.
• For comparison. National Income figures are used for international comparisons to see the
status of the economy at that particular time.
• Determination of Per Capita Income (GDP). National Income figures are used in measuring
Per Capita Income which is a good indicator of either an improvement or a decline in the
Standards of Living.
• National Income estimation or statistics show the distribution of income among the various
sectors of the economy.
• Nation Income figures show us the contribution made by the different sectors of the economy
as seen from the output approach.
• National Income data is important in the area of economic planning and economic policy
formation. The data concerning country’s gross income output, savings and consumption is
necessary for planning.
• These national income figures also show the rate of resource utilization. The increase in
national income figures is a result of increased resource utilization.
• National Income statistics is important as it tends to attract foreign investment laid. These
figures are an indicator to the outsiders about the performance of the economy.
• Research scholars find national income statistics as very useful. They may make use of the
various data of the country’s input, outputs and income among others in research and
investigation of some facts.
Question 1
1. Distinguish between
i) GNP and GDP
ii) National income at market price and National income at factor cost iii)
Real income and Per capita income
2. Explain the various methods of measuring nation income
3. Examine the usefulness of national income statistics in your country
4. Discuss the main problems involved in the estimation nation income figures.
5. What is meant by the circular flow of income?

Circular flow of Income and Expenditure

The circular flow of income and expenditure refers to all transaction that is payments and receipts,
which take place between the different sectors of an economy through time. These transactions are
classified in various forms; consumption expenditure, factor income or payments, saving,
investment, government purchase, transfer payments, imports and exports. The discussion of the
circular flow of income and expenditure is based on the number of sectors assumed to constitute an
economy at any particular time. The most basic economic framework is a two sector model, with the
Household and Firms sectors only. Addition of the government sector transforms a two sector model
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into a three sector model. A three sector model is complete system but it remains closed to
international transactions. Introduction of export, imports and capital flows opens up the economy
and it forms a four sector model.
Two Sector Model
This model comprises of the household and business sectors. The business sector comprises of
producers who supply commodities to the households. So, in the first place, income flows in form
of payment of rent, wage and interest income from the business sector to the household sector for
the supply of factors of production used to produce goods and services by the firms. The
household sector in turn spends its income on purchase of commodities produced by the business
sector.
This implies that the entire income of the household sector is spent on purchase of goods and
services, all goods produced by the business sector are sold out to the household sector and no
inventories are held. And also, that the business sector spends its entire income by way of
payments to the factors of production. This situation supports the conclusion that economy is
always at full employment.

A A = Consumption Spending
B B = Goods and Services
C = Factors of Production
D = Household Income
E = Saving
F F = Investment
Firms Money Market E Household

C
D

It is important to note that the above model ignores the saving and investment transactions in the
economy. Households do not spend all their income on consumption, there is saving out of
income. Also firms use other source of resources rather than consumption and these include
investment and borrowing. Withdraw of income, in form of saving from the flow, reduces income
and it is known as a leakage. An introduction of income into the flow, in form of investment in
this case, is considered as an injection.

Importance of the circular flow of income

Broadly, the circular flow provides a clear view of an economy and from its study we can have
knowledge about the performance of an economy and its functioning. However, the Specific
importance of the circular flow of income includes;
Calculation of national income: The circular flow of income helps in calculating the economy’s
national income through the flow of funds accounts. The flow of funds accounts provides a
complete picture of all monetary transactions in the economy and depict the link between saving
and investment, and lending and borrowing by the different sectors of the economy.
Formulation of Monetary Policy: A study of the circular flow explains the importance of the
monetary policy in establishing equilibrium between saving and investment. Government controls
the capital market through the monetary policy. Excess saving over investments causes deflation,
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while excess investment over saving causes inflation. The government can control these situations
by regulating investment with use of the monetary policy tools.
Role of Fiscal Policy: The study of the circular flow of income highlights the importance of the
fiscal policy. In a three sector model a government sector is included with specification of how tax
revenues are mobilized from households and firms. The model also shows how government makes
its spending on subsidies, transfer payments, provision of public goods.
Formulation of Trade Policies: Due to participation in international trade of goods and services
and flow of capital, countries develop policies that are meant to influence these flows. Effective
interventions achieve the greater returns from dealing with countries are done with help of
circular flow of income based on a four sector model.
Level of Economic Activities: The circular of income helps us to understand the effect of certain
variables on the level of economic activities. An increase in saving is seen to cause a depression
and therefore a reduction in employment. However economic activities are augmented with
injections in form of investments. Therefore, depending on the prevailing conditions in an
economy, leakages or injections could be varied to achieve a desired state of the economy with
help of a circular flow of income models.

Unemployment
This is a situation where the acting labour force is idle, i.e. it is not working at the current wage rate.
Unemployment can be voluntary or involuntary unemployment.
Voluntary unemployment

It’s a situation where the jobs are available but the labour force is unwilling to offer work at the
ongoing wage rate. The causes of this include:
(i) Laziness of the labour force. Its common among the youth and women.
(i) The job available is socially unacceptable e.g. being a hangman working in a
mortuary.
(ii) The unemployed person may decide to live on past savings.
(iii) Low wages or poor wage remuneration.
(iv) Good economic background i.e. family wealth background and one expects to
survive on that.
(v) The present employment may be considered inferior to the worker (vi)
Expectation of another better job.
(vii) Being too qualified for the available job.
(viii) Unfavourable geographical location of job.
(ix) Desire for leisure than work especially women.
(x) Poor working jobs in the available job e.g. working for long hours, harrasement,
un present environment etc.
(xi) High risks involved e.g. mining, army etc.

Involuntary Unemployment.
It’s a situation where labour is actively and too willing to work but cannot find job. The causes
include:
(i) Rapid population growth against growth of employment opportunity.

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(ii) Defective education system which creates job seekers rather than job makers-
white collar jobs.
(iii) Discrimination in the labour market on the basis of religion, age, sex, race
political affliation etc.
(iv) Political instabilities and insecurity in areas that could offer jobs and also the fact
that they can destroy investment.
(v) Rural – Urban migration which cause open urban unemployment.
(vi) IMF conditionality of restructuring civil servant which has led to retrenchment
and demobilization of soldiers.
(vii) Technological advancement or adoption of automation systems in production.
This has created technological un employment..
(viii) Ignorance of the labour force about the available job opportunities.
(ix) Physical and mental disabilities which result into residual unemployment.
(x) Climatic or seasonal changes especially in agriculture which make labour
redundant e.g. in the dry seasons.
(xi) Shortage of co operant factors like capital to work with labour.
(xii) Decline in demand for the products which forces the employer to lay off some
workers.
(xiii) Depletion of raw materials e.g. minerals.

Types of Unemployment
Frictional unemployment
This is sometimes called normal or transitional unemployment. It occurs when labour is in the
process of looking for a job after retiring or abandoning the other – it is caused by:
(i) Ignorance of the existing jobs elsewhere.
(ii) Labour immobility geographically or occupationally.
(iii) Advancement in technology.
(iv) Structural break down in the economy e.g. Civil service restructuring, political
instability.
(v) Changes in demand and supply conditions in the market. E.g temporary decline in
the demand for a commodity.
(vi) Specialized training in a given job i.e. where one lacks the skills in the existing
jobs.

Solutions

(i) Advertising jobs by the employees.

(ii) Development and improvement in transport and communication network to
enable labour mobility.
(iii) Training labour in a variety of skills.
(iv) Renovation and repair of industrial structures.

Structural Uunemployment

It’ is the unemployment that arises from structural changes in the economy. It is experienced
when the economy is undergoing structural economic transformation or adjustment e.g.

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privatization. Introduction of automation systems in production process. It is sometimes called

circular unemployment.

Causes
(i) Change in demand, fashion, tastes and preferences for commodity changes
in demand from the natural fiber. This means that working in the natural
fiber production may not be unemployed.
(ii) Government policy of adopting structural adjustment programme.
(iii) Political instability where people move from political instable areas to
peaceful areas.
(iv) Technological advancement e.g. Computers.
(v) Exhaustion of the natural resources e.g. copper.
(vi) vii) Long training period which makes labour immobile due to lack of multiple
skills.
(vii) Existence of an economic depression where the economic activities are
very low hence unemployment.
(viii) Structural break down of industries due to lack of spare parts, war e.t.c.

Solutions.
(i) Financial accommodation to the declining industries to purchase spare parts
or renovate.
(ii) Encouraging labour mobility by training labour into numerous skills even
when structural break down occurs.
(iii) Diversification of the economy to create more avenues for labour.
(iv) Encouraging flexibility in the production process so that if there is a problem in one line
of production, the fume can switch on to other activities and still maintain the
labour force.

Seasonal Unemployment
It is the unemployment that occurs due to climatic changes which cause shortage of economic
activities. It should be noted that some workers remain idle during particular seasons e.g.
constructional workers. It is caused by;
(i) Climatic changes.
(ii) Limited diversification of economic activities.

Solutions
(i) Diversification of the economy especially in agriculture sector.
(ii) Training labour in various skills.
(iii) Modernization of the agricultural sector e.g. reduces depending on nature through
migration, use of fertilizers.

Casual unemployment
It occurs when labour is idle due to reduced demand for it is services or when the job is
accomplished or when the contract expires e.g. construction workers, lawyers.
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(i) Lack of skills to other jobs.

(ii) Low economic activities in an economy.

Solutions
(i) Adoption of intermediate technology.
(ii) Use of labour intensive technology.
(iii) Training labour in the required skills.

Residual Unemployment.
It arises out of mental and physical disabilities of labour which may be due to; natural disabilities,
wars, accidents, sickness, witchcraft.
Solutions
(i) Adoption of appropriate economic activities for them like craft making
especially in informal sector.
(ii) Provide necessary skills for them.
Disguised Unemployment
This is unemployment where people pretend to be working yet in actual sense they are not. In
such a situation, marginal productivity of labour is either zero or negative. Since labour cannot be
transferred from that occupation without affecting output. It occurs in a country with over
population and common in the service industry like in garages, taxi parks etc.

Solutions
(i) Expand industries to increase employment opportunities.
(ii) Introduce better production methods.
(iii) Transfer the access labour to other activities.
(iv) Diversification of the economic activities.
(v) Make use of the available land maximumly.

Hidden Unemployment
It is the position where the full potential of labour is not fully utilized. In the absence of jobs,
labour engages in second choice or last resort jobs. This is a form of disguised and under
employment e.g. a graduate becoming a shop keeper (retail) or getting involved in socially
unacceptable jobs.

Natural Unemployment
It is the unemployment experienced in conditions of full employment when the labour market is in
equilibrium. i.e when supply of labour is equal to demand for labour.

International Unemployment (Export Unemployment)

It occurs when there is loss of export market for a country’s commodities / goods and services.
E.g if here’s loss of market for export-oriented goods, workers in export promoting institutions or
industries will be laid off hence causing international unemployment.

Keynesian Unemployment.
This is sometimes called cyclic unemployment or deficiency demand unemployment. It is
unemployment resulting from deficiency of aggregate demand in the economy. The Keynesian
theory of employment tries to show the relationship between investment, income and
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employment. It was based on the level of consumption, saving, investment and output (National
income). These four variables are interrelated.

The level of employment at particular time depends on the level of output in the country and this
in turn depends on the amount of goods and services which individuals and institutions purchase
i.e. consumption and investment levels. The level of employment, therefore depends on the level
of investment which is the sum total of the investment expenditure of business units. Thus an
increase in investment expenditure by firms leads to an increase in output which creates more
incomes for individuals via the multiplier effect and generates consumption expenditure which in
turn increases the total level of employment in the economy.

The Keynesian theory of unemployment states that unemployment arises due to deficiency in
effective or aggregate demand for goods and services especially in times of economic recession
or depression. Due to low demand for final products, firms reduce output, income levels fall,
investment is discouraged and less labour and capital are employed. The theory based on the
following assumptions;

i. A developed industrial economy and closed economy with no foreign trade or influence. ii.
The existence of idle resources i.e. capital, entrepreneur etc. which only need to be reacted.
iii. Reducing tax rates i.e. reduced taxation levels
iv. Using expansionary monetary policies
v. Increased government expenditure / Subsidization of consumer
vi. Encouraging export and finding new markets
vii. Encouraging private domestic and foreign investment through incentives and relaxing the
opening of economy. Improving on the investment climate through incentives like land
allocations, tax holidays, low interest rates on loans etc. encourage investment thus
stimulating aggregate demand.

An illustration of Keynesian theory of unemployment

.
Expenditure AS
AS
AD dg = un employment
AD
.
Ye
0

Employment
In Keynes theory, employment (N) depends on effective demand. Effective demand (ED) results in
output (O). Output creates income and income provides employment. According to Keynes, ED
=O=Y=N

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N = f (Y)
ED is determined by two factors;
• The aggregate supply function (Z).
• The aggregate demand function (D).

The aggregate supply function depends on physical or technical conditions of production, which
do not change in the short run. It is the aggregate demand function, which fights depression &
unemployment. This employment depends on aggregate demand, which in turn is determined by
consumption demand and investment demand.

Causes
(i) Deficiency in effective aggregate demand.
(ii) A fall in investment expenditure which limits job opportunities.
(iii) A fall in the volume of exports in world market.
(iv) A fall in the prices of goods due to lower demand or excessive supply.
(v) Decrease in the level of income in the economy which limits aggregate demand.
(vi) A fall in level of savings which are used for investment.
(vii) A fall in the interest rates on deposits. This discourages people from saving funds
for investment.

Solutions to the Keynesian Unemployment

The major solution according to Keynes is to;
(i) Fiscal policy i.e. reducing direct taxes on incomes of people to their disposable
incomes so as to increase the aggregate income.
(ii) Subsidization or increasing government expenditures to increase income of the
people or boast investment.
(iii) Expansionary monetary policy i.e. increase money supply in the economy (iv)
Encourage exports to increase foreign exchange earning or incomes.
(v) Discourage imports to save the scarce foreign exchange and also to avoid more
supply of goods and services through the domestic economy.
(vi) Improvement in investment climate through political stability, improvement in
transport to increase the marketing of goods and thereby, increasing the income
of people and aggregate demand.

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(vii) Subsidization of consumers.

(viii)

Relevancy of the Keynesian Unemployment Theory to Low Developed Countries.

It is relevant to Least Developed Countries to a small extent. It’s due to the following factors;
(i) At times unemployment in Uganda results in a fall in demand for goods and
services either domestically or in foreign markets e.g. there has been
a fall in employment of coffee subsection due to a fall in market prices of coffee.
(ii) In Uganda there is an element of Industrialization and hence the theory may apply
in the industrial sector where as demand for industrial products fall employers
may be forced to lay off.
(iii) Investment climate affects employment level and therefore, promotion of
investment in Uganda will expand employment opportunities.
(iv) In the long run as the supply of co operant factors e.g. labour become available, the
theory becomes relevant.
(v) Measures to stabilize export earnings ensure increasing effective demand and
reduction in unemployment. This is a cause where there is deficiency in the
market.
(vi) The use of expansionary monetary policies to increase purchasing power in Uganda
has increased employment levels.
(vii) The use of expansion monitoring policies to increase purchasing power in Uganda
has increased employment levels

Irrelevancy of the Theory

To a greater extent, it is irrelevant due to;
(i) It is concerned with aggregate demand deficiency yet in low developed countries
unemployment arises from the supply side.
(ii) Unemployment according to Keynes mainly affects industrial economies
yet Uganda is largely Agricultural economy
(iii) The theory is applicable under conditions of full employment where the resources
are fully exploited but such conditions are not found in developing countries
Uganda inclusive.
(iv) The product, factor and money markets are not as functional in low developed
countries as it is in more developed countries.
(v) As a solution to unemployment, Keynesian prescribed policies which increase
levels of aggregate demand like the expansionary monetary policy. However, such
policies may be inflationary in the economy.
(vi) The theory is based on the assumption of a highly monetised industrial economy but
Ugandan’s economy is basically subsistence.
(vii) The Keynesian theory is based on the existence of a big and strong private sector yet
in Uganda, private sector is less and weak.
(viii) The theory emphasizes employment multipliers as a contributor to employment in
Uganda yet in Uganda emphasis is on export multipliers.
(ix) Keynes theory based on a closed economy yet Ugandan economy in an open one.
(x) The fumes in Uganda because of the structural difficulties tend not to respond
quickly and effectively to changes in demand.
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Open-Urban unemployment
It is the unemployment in urban areas or where the members of the labour force are idle in the
urban centers which can either be voluntary or involuntary. Open urban employment can best be
explained by the theory of rural urban migration. It’s the process by which people move to urban
centers due to either the pull or push factors. The push factors are those that operate in rural areas
and are forcing people to move to towns e.g. epidemics, political instability, oppressive cultures,
family conflicts. The pull factors are those that operate in urban centers and are attracting people
to move to towns. They include expected employment, good infrastructure and better standards of
living.

Causes of Rrural-Urban Unemployment

(i) Urban – Rural income differences. People in urban areas earn higher
incomes compared to those in rural areas especially those working in
industries.
(ii) Unequal distribution of infrastructure.
(iii) Inappropriate education system which prepares students for white collar jobs. So
school levers will always migrate to urban centers for jobs because they lack
practical skills for self employment.
(iv) Population pressure in rural areas due to high levels of population growth rates.
(v) High wages in urban centers either fixed by the government benefits urban workers
more than rural workers. For instance in UPE where primary teachers in urban
receive a higher wage than those in rural.
(vi) High possibility of getting jobs in urban areas because of many economic activities
taking place.
(vii) Political instabilities or insecurity in rural areas.
(viii) Poor land tenure system which results into land shortages and land disputes hence
forcing mostly the youth to migrate.
(ix) Weak government policy of rural transformation and development.
(x) Extended family system which encourages people to stay within their relatives or
friends.
(xi) Social problems like witchcrafts, forced marriages, quarrels, land disputes etc (xii)
Natural calamities or epidemics e.g. diseases.
(xiii) Rapid industrialization in urban centers which has attracted people to search for
jobs.
(xiv) Some people move because of crimes committed or fear for their lives e.g. theft,
murder, rape etc
(xv) Good standards of living in urban areas against the poor standards of living in rural
areas in terms of electricity supply, water supply, housing facilities etc or
recreations.

General Causes of Unemployment in Uganda

 Rural-urban migration due to social service gap and wage between the rural and urban
areas. This has caused open urban unemployment.
 High population growth rate, which has led to increased urbanization and consequent
growth of labour force with limited employment opportunities. The rapid population
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increase in Uganda relative to the growth in employment opportunities is a major cause of

unemployment.
 Changes in seasons have led to seasonality of jobs. Seasonal patterns of work mainly affect
the agricultural sector activities for example after harvesting of agricultural produce some
workers becomes unemployed.
 Political instabilities in some parts of the country have led to migration and insecurity
hence discouraging meaningful productive activity.
 Poor or defective education system causing lack of enough appropriate skills for jobs
available. Education in Uganda and other LDCs prepares students as white collar job
seekers rather than job makers yet white collar jobs are not available i.e. selectivity among
school leaver is a major cause of unemployment.
 Technological progress; technological advancement has caused use of inappropriate
technology applications (capital intensive techniques) especially in the industrial sector,
which results into replacement of labour by machines.
 IMF conditionality of restricting the civil services through the policy of retrenchment has
caused dislocation for labour and efforts aimed at reducing unemployment.
 Discrimination in the labour market based on sex, age, political parties, colour, family
connection and even preference of expatriates.
 Ignorance about job opportunities, immobility of labour and frequent changing of job
leading to frictional unemployment in the short run.
 The poor land tenure system in Uganda causing landlessness especially among the youth is
also a major cause of unemployment. As the youth lack of means to generate productive
economic activities.
 Physical and mental incapacitation has led to residual unemployment in the country.
 Changes in testes and fashions causing a change in the patterns of demand and consequent
poor attitudes towards work. Many people are unemployed because of having a negative
attitude towards work. This has resulted in structural unemployment.
 Poor attitudes towards work. Many people are unemployed because of having a negative
attitude towards work
 Deficiency of or limited co-operant factors especially capital causes industrial decline and
increased costs of production resulting in a few people being employed since the demand
for labour is a derived demand.

Measures to Tackle Unemployment Problem in Uganda.

• Rural development: The majority of people in developing countries live in rural areas
therefore; the transformation of rural areas through the modernization of agriculture and
facilitating access to land is being encouraged with the hope of creating new opportunities
for productive employment and higher incomes in the rural areas.
• Diversification of economy for example encouraging setting up of small scale industries to
check on seasonal unemployment. Diversification stimulates production and accelerates
economic growth to match with population growth.
• Education reform emphasis is being put on the acquisition of practical skills for self reliance
i.e. training of people to be makers and to take up a live hood in the rural areas.

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• Attempts to control political unrest and restore law and order have been undertaken to give
confidence to investors and ensure security if life and property
• Attempts forge economic co-operation (integration) to promote intra regional economic
contacts have been undertaken hence the possibility of intra regional resources movement,
widened markets for products, increasing investment and thus more job opportunities.
• Controlling population growth rate tight population control measure with a view of reducing
the growth rates, which create pressure on land and thus match the population growth rates
with the capacity to create jobs.
• Encouraging the use of appropriate technology i.e. encouraging foreign investors to establish
industries using labour intensive techniques of production which techniques maximizes
labour (is employment creating)
• Advertising of existing jobs intensive job publication through advertising in all mass media
and the creation of employment officers or job exchange centre at local and national levels
to act as points of coordination between job seekers and potential employers.
• Setting up and improve infrastructure to increase labour mobility
• Attracting more investment. Attracting foreign investors to establish industries and thus
creating more job opportunities.
• Provision of co operant factors e.g. capital or credit such as Entandiikwa”and prosperity for
all to local investors in the private sector so as to create jobs.
• Previtalization of public enterprises so as to create more job opportunities in long run.
• Setting up institutions to encourage investment e.g. Uganda investment authority (UIA)
• Liberalization of the economy involving the removal of unnecessary controls on trade hence
giving people the liberty to trade with undue government controls thus creating more jobs.
• Regional rehabilitation programmes like the Northern Uganda Reconstruction programme
(NURP), karamoja development Agency (KDA) NUSAF etc to  reduce regional
imbalances therefore activation job creation.

Inflation
It refers to the persistent increase in the general price of goods and services in an economy in a
given period of time. This means if there is inflation there is a continuous fall of money value. A
country is said to have inflation when prices for most commodities are rising since it’s possible to
have prices for a few commodities falling while for others stable.

State of inflation
This refers to the rate at which prices are increasing in an economy. It’s categorized into two;

Mild inflation. This is also called creeping inflation or gradual inflation. It’s where there is a slow
raise in the general price level of goods and services in an economy and usually such is single
digit inflation. It’s desirable in the economy and may be induced by the government to stimulate
investment and employment.

Hyper inflation.
This is also called galloping or runaway inflation. It’s where there is a rapidly increasing general
price level of goods and services in an economy in a given period of time. This type of inflation

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unlike milled can easily be noted by the public and it’s undesirable in the economy since it
discourages savings, investment and employment.

How is Inflation Measured

It’s measured by using price index which can be given by the formulae below;

Present price – previous price x 100

Previous price

Types of Inflations (theories)

Demand Pull theory/inflation
This is the type of inflation that occurs when there is excessive demand for goods and services
compared to supply i.e. aggregate demand is greater than aggregate supply. This excessive
demand pulls up prices thereby causing inflation.

Causes of Demand-Pull Inflation

(i) Excessive money in the economy. This could be as a result of the central bank
printing more money and circulating it against few goods.
(ii) High population grow rate that outcompetes the available goods and services.
(iii) Increases in wages or salaries and allowances of the workers which increase their
purchasing power and aggregate demand.
(iv) Static supply of goods and services in a country.
(v) Restrictions on output either by monopoly or oligopoly films.
(vi) Reduced taxation particularly on incomes of the people which leaves them with a
high disposable income that results into excessive demand for goods and services.
(vii) Increasing high government expenditures which results into increase in individual
disposable income.
(viii) Low savings by the people, which is accompanied by high MPC.

Solutions to Excessive Demand-Pull Inflation

Adoption of a restrictive monitory policy to reduce the amount of money in circulation of money in
circulation and reduce aggregate demand. It’s done by use of tools of monitory policy.
(i) Physical policy. This has two forms that is to say; (a) Increasing direct taxes on
people’s income to reduce their disposal income and control aggregate demand.
(b) Reducing government expenditure on less productive activities to reduce
money in hand of the people.
(ii) Income policy. The government should reduce income or wages and other
allowances of the workers so as to reduce aggregate demand.
(iii) Reduce foreign restrictions on imports so as to increase supply of goods and
services in the domestic economy.
(iv) Production policy i.e. increasing production of goods and services in the
economy.

Note: Also refer to the control measures on the inflationary gap.

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Cost Push Inflation / theory.

It is the type of inflation, which arises from the increases in cost of production of goods and
services in an economy. It therefore originates from the supply side where the raise in costs of
production limits the supply of goods and services as illustrated below.

Forms of Cost Push Inflation

Price wage push / inflation
This occurs when the initial increase in price level of goods and services forces workers to
demand for higher wages and salaries because of an increased cost of living. The high wage
demanded will increase in the overall production costs and in oder for the producers to gain some
profits will be forced to change higher prices hence inflation.

Wage price push / Inflation

This occurs when wages are increased by trade unions. The producers also increase their product
prices in order to be able to meet the increased costs of production from the increased wage bill.

Wage - Wage push / inflation

It occurs due to inter sectoral wage differentials and comparisons. When worker’s wages in one
industry are increased, and then other industries remain constant yet they are producing the same
commodities and facing the same economic conditions, workers in the industry whose wages
hasn’t increased will demand for a higher wage and this will cause an increase in the general
price level.

Causes of Cost Push inflation

(i) Increase or high taxation of the producers. This increases cost of production and
the prices.
(ii) High rate of interest charged on capital or loans borrowed by the producers. This
increases the costs of production and also price for goods and services.
(iii) Increased prices for inputs for example raw materials, transport, insurance charges
which increase costs of production and eventually the price.
(iv) Increasing wages and salaries of workers influenced by trade unions and
government.
(v) Increasing costs of imported machinery and petroleum products which increase
costs of production and prices.
(vi) Industrial wage differential and comparisons, which increase, demand for higher
wages and for low wage industries hence causing increases in prices.
Solutions
(i) Subsidization of producers to lower production costs.
(ii) Reduce or control level of interest rates on loans secured by producers so as to
reduce costs of production.
(iii) Price control by the government to prevent over charging by businessmen and
women.
(iv) Provision of non monetary rewards or benefits to labour to make them more
comfortable and to prevent them from demanding higher pay that is to say, free
transport, accommodation, medical care.

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(v) Wage control measures by the government.

(vi) Selective taxation and tax holidays to the producers to reduce production costs
and prices.

Bottleneck / Structural Inflation

It is the type of inflation that result from structural problems in a country, which leads to low
production of goods and services especially in the major sections of the economy.

Causes of Structural/ Bottleneck inflation

(i) Structural break down in the sectors for example break down of industries, lack of
spare parts which lead to low or no production at all.
(ii) Shortage of skilled manpower to organize production hence low production and
high prices.
(iii) Misallocation of foreign assistance to non-productive sectors.
(iv) Occurrence of natural calamities or hazards.
(v) Economic mismanagement through poor leadership, which results into resource
misallocation, corruption and embezzlement of funds.
(vi) Break down of infrastructures. For example road network storage facilities, which
limit supply of goods and services on the market.
(vii) Political instability and insecurity.
(viii) Scarcity of raw materials or inputs or exhaustion of raw materials.
(ix) Speculation by businessmen who create artificial shortages or scarcity of goods
and services through hoarding.
Solutions
(i) Improvement in major sectors of the economy to increase production that is
agricultural mechanism.
(ii) Rehabilitation, development and improvement of industries to produce more
goods and services and lower prices.
(iii) Improvement in infrastructures like power stations, roads etc in order to increase
and facilitate production.
(iv) Provision of inputs to producers at subsidized prices to lower prices for their final
products.
(v) Ensure political stability and security.
(vi) Price control by the government.
(vii) Ensure proper use of resources that is local and foreign aid.
Imported Inflation
It’s inflation resulting from importation of commodities from inflated countries or economies that
are already suffering from it.

Causes
(i) Importation of commodities from a country with it.
(ii) Raising prices for goods and services in the international market.

Solutions
(i) Protectionism that restricts imports into the country from economies experiencing
inflation.
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(ii) Adopt import substitution strategy to start producing commodities formerly being
imported.
(iii) Subsidise local producers to increase production or subside importers so as to sell
their imports at lower prices.
(iv) Avoid devaluation of the local currency.

Other Types of Inflation

Spiral inflation
It refers to persistent trend of inflation caused by alt raises in cost of living and purchasing power.

Suppressed inflation
This is sometimes called the controlled inflation. Its where the raise in price controlled or suppressed
by the government through price controls.

Foreign exchange rate inflation

It’s the type of inflation that results from the devaluation of a country’s currency. It makes the prices
of imports to increase and the prices of other non-exportable commodities to increase.

One digit inflation

It is where the inflation rate ranges from 1% to less than 10%.

Double digit
It is where the inflation rate ranges from 10% - 99%.

Triple digit inflation

It is where the rate of inflation ranges from 100% - 999%.

Spatial inflation
It ranges from 10% to more than 100%.
Effects of Inflation

Positive
(i) It increases the profit margins of the businessmen hence higher levels of
investment.
(ii) It stimulates people’s efforts to work harder. i.e encourages hard work so
as to maintain their standards of living hence more output will be
produced.
(iii) It increases government revenue through high taxation imposed as a way of
controlling inflation.
(iv) It encourages increased output by the producers in order to gain from
increased prices.
(v) It increases employment opportunities since it stimulates hard work and

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increased investment in the economy.

(vi) It promotes forced savings, which lead to capital accusation for
investments.
(vii) It increases exploitation of idle resources especially when prices are
increasing slowly which result into increase in profits. It then stimulates
economic activities such and hence growth of Gross Domestic Product.
(viii) It promotes labour mobility in the country in an effort to provide more
labour services and maintain a certain standards of living.
(ix) It discourages rural urban migration because of high costs of living in
urban centers.
(x) Debtors gain during inflation because they pay in an inflated value.

Negative

(i) It encourages dumping into country of cheap imported goods which

discourages the growth of infant industries
(ii) Fixed income earners and workers suffer industries during as their real
income is falling.
(iii) It reduces savings because during inflation, people cannot save since
most of the income is for consumption due to higher prices. This
concept limits the level of investment in the country.
(iv) Leads to balance of payment deficits. This is because inflation makes
exports expensive and therefore low foreign exchange earnings from
them while imports are very cheap and therefore more foreign exchange
outflow.
(v) The lenders or creditors suffer during inflation and this is likely to
discourage lending and therefore investment.
(vi) Widens the income gap. This is because it leads to uneven distribution of
income between civil servants and businessmen who earn abnormal
profits.
(vii) It causes strain among the people for example working for long hours,
doing many jobs etc.
(viii) It causes misery among the people especially the poor who cannot afford
high prices for goods and services and lowers the social standards of
living.
(ix) Encourages the consumption of inferior low quantity goods for example
second hand clothes which affect health.
(x) Leads to high cost of factors of production for example high wages for
labour, high depreciation rates etc.
(xi) Leads to continuous fall in the value of domestic currency. This greatly
discourages foreign investors and reduces output in the local market.
(xii) Encourages brain drain among the professionals for example teachers,
doctors etc to other countries.

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(xiii) Increases crime rates in the country. For example it distorts tax structures
by the government thus has to make tax re assessment to maintain its
structures by increasing taxes, impose tax of the exempted people theft
and corruption and embezzlement of funds.
(xiv) It is politically explosive. Causes the government to become unpopular
because the miserable condition will force the people to be dishonest and
un loyal to the government.
(xv) Encourages immorality in the society for example prostitution in order to
earn a living.
(xvi) It encourages misallocation of resources into the production of goods and
services, which are profit, oriented ignoring essentials and nonprofit
making activities.
(xvii) Makes it difficult to implement government plans because all the financial
targets to be met by the government keep changing time and again.
Note
1. Stagflation: It Is a situation where a higher rate of inflation co-exists with the high
levels of unemployment and stagnant output.
2. Deflation: It occurs when there is a persistent fall in the general price level of goods and
services.
3. Reflation: It’s a policy taken by the government to lift the economy out of deflation.

Distinguish between inflationary and deflationary gaps

General Causes of Inflation in low developed countries (uganda)

(i) Rapid population growth rate leading to shortage of goods and services hence inflation.
(ii) Excessive demand for goods and services compared to the amount of goods and services
available. High production costs for example transport and electricity.
(iii) Frequent wage and salary infrequent by the cost for civil servants which creates excessive
demand high prices.
(iv) Importation of goods from economies already suffering from inflation for example petroleum
products.
(v) Excessive printing of money by the central bank because of deficit finances by the
government, which has to continue to increase money supply, compared to the growth of
output levels.
(vi) Supply rigidities especially in the agricultural sector due to natural calamities. For example
draughts, pests and diseases.
(vii) Desire/ Greed for excessive profits by businessmen hence continuous increment in prices for
goods and services.
(viii) Depreciation of local currency against other currencies leading to rise in price of local goods
and services.
(ix) Political instabilities for example wars have disrupted production in some areas.
(x) Poor infrastructures like roads and railway lines which facilitate increase in prices of goods
and services.
(xi) Influence of trade unions which activities demand increased wages for their workers causing
cost-push inflation.
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Measures taken to control Inflation in Uganda

(i) Increased rates of tax imposed on people’s income and other activities to reduce disposable
income.
(ii) Reducing government expenditure for example through retrenchment reduced official trips
abroad. (Less productive activities).
(iii) Reduce government borrowing from central bank, which forces the central bank to print
more money.
(iv) Operation on monitory tools especially the open market operation that is to say; where the
central bank sells the treasury bills to the public to reduce money in circulation.
(v) Wage freeze for those in higher income bracket to reduce money supply.
(vi) Investment incentives should be given in order to encourage investors in increased
production.
(vii) Provision of subsidies to producers by the government. This lower production of goods and
services and hence reducing cost push inflation.
(viii) Encourage liberalization and privatization to increase output.
(ix) Improvement in infrastructures for example roads, hospitals, Hydro Electricity Board supply
in order to increase production levels and lower the prices.
(x) Controlled population growth rate through Family planning, education, reproductive health
etc. this will reduce aggregate demand for goods and services.
(xi) Provision of non-monitory rewards to labour that is to say; free benefits food in kind but not
in increasing wages.
(xii) Ensure political stability to encourage investment.

Why it is difficult to fight Inflation in low developed countries.

(i) Lack of appropriate method of controlling population growth rate hence rapid
increase in population, which leads to excessive demand for goods and services.
(ii) Dependency on importation of essential goods like fuel, whose prices are over increasing
hence the imported inflation.
(iii) Lack of control over nature for example harsh climatic conditions and other natural
calamities which leads to low agricultural production and hence inflation.
(iv) Production of goods and services is not under the government control but in the private
sector. These are profit motivated and change very high prices.
(v) Fear to impose high taxes by the government to reduce on the aggregate demand. It’s so
because the government fears to be unpopular due to high taxes.
(vi) Shortage of co operant factors for example capital has always limited government efforts to
increase production of goods and services to reduce inflation.
(vii) Scarcity of inputs like raw materials and therefore increasing costs for inputs leading to
cost push inflation.
(viii) Persistent political instabilities in some parts of the city, which has disrupted corruption
leading to high price of goods and services.
(ix) Poor performance of the major sector in the economy that is; agriculture. There is a
shortage of food, which has resulted into high prices.

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(x) Widespread corruption and embezzlement have led to the shortage of goods and services
hence high prices.
(xi) Difficult to control rural urban migration hence shortage of goods and services in the urban
centers leading to high prices.
(xii) Poorly developed infrastructures like banks and most of them are urban centered which
makes it hard for the monetary tools to operate.

Keynesian Theory of Employment

• The principle of Effective demand
• Analysis of the level of Effective Demand
• The concept of Unemployment, The Concept of Full –
Employment, Types, Causes and Policies of
Unemployment,
• Keynesian Unemployment and its relevance to Less
Developed Economies

Classical Theory of Employment

According to the classical economists, there is full employment in the economy, every job seeker
gets the job in accordance with his capabilities and there is never involuntary unemployment.
However, the resources of the economy are fully employed. The classical theory of output and
employment is based on the following assumptions;
• There is the existence of full employment without inflation.
• It assumes a closed laissez faire capitalist economy without foreign trade.
• Perfect competition in the labour and product markets.
• Labour is homogeneous.
• Total output of the economy is divided between consumption and investment expenditure.
• The quantity of money is given.
• Wages and prices are flexible.
• Money wages and real wages are directly related and proportional.
• Capital stock and technological knowledge are given in the short run.
In other words, the classicals believed in the free enterprise economy.
The classical model has two pillars; the say’s law of market and quantity theory of money.

Say’s Law
“Supply creates its own demand.” This is known as Say’s Law of markets named after Jean
Baptist Say (1767 – 1832). Say’s law argued that an economy is self-regulated provided that all
prices including wages are flexible enough to maintain it in equilibrium.
In a more simplistic and somewhat inaccurate form, Say’s law states that supply creates its own
demand and over production is impossible. This theory has major implications for how
government responds to periods of high employment or widespread unemployment.

Complete Classical Model

In its simplest form, the determination of output and employment in classical theory occurs in
labour, goods and money markets of the economy. In the labour market, the demand for labour

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and the supply of labour determines the level of employment in the economy. Both are functions
of the real wage rate (W/P).
The Pigouian equation N = qY/W explains the entire proposition.
N – is the number of workers employed.
Y – is the national income.
W – is money wage rate.
q – is the fraction of income earned as salaries and wages.
This means that N can be increased by a reduction in W. Thus the key to full employment is a
reduction in money wage. This is explained in the figure below;

S is the supply curve of labour and D is the demand curve for labour. The intersection of the two
curves as E shows the point of full employment N F and the real wage W/P at which full employment
is secured. If real wage is maintained at a higher level W/P 1, supply exceeds the demand for labour
by sd. N0 NF labour is unemployed.
Therefore, full employed is achieved at point E where there is no unemployed. MPL is the
marginal product of labour and it slopes downwards. Since every worker is paid wages equal to
his marginal product, the full employment level N F is reached when the wage rate falls from W/P 1
to W/P.
Total output in turn = depends upon the level of employment given other capital stock and
technological knowledge. It is shown by the production fn Q = f (K, T, N) which relaxes total
output to NF level of full employment as shown below;

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Given the stock of capital technological knowledge and resources, a precise relation exists
between total output and the amount of employment. Total output is an increasing function of the
number of workers Q = f (K, T, N).
In the figure, OQ corresponds to the full employment level of NF.

Further, it is the mechanism of the rate of interest which brings about the equality of savings
and investments so that the amount of commodities demanded should remain equal to the
amount supplied at the full employment level as shown in the figure below;

SS is the saving curve and II is the investment curve. The two curves intersect at E where the rate
of interest is Or and both S & I are equal to OA. If there is an increase in I, the I curve shifts to
the right as I1 I1. Consequently, both S & I are equal. Equilibrium in the money market is
represented by the equation MV≡PT. It explains the price level corresponding to the full
employment level of output.

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Keynes Criticism of Classical Theory

Keynes wrote in his General Theory attacking the Classical Theory on the following grounds;
• Full employment equilibrium in the economy is unrealistic. He said that the general situation
in a capitalist economy is that of underemployment.
• The Say’s Law that supply always created its own demand is unrealistic. All income earned
by the factor owners would not be spent in buying products which they helped to produce.
Apart of the income is saved and not automatically invested.
• Keynes did not agree with the classical view that laissez faire policy was essential for
adjusting process of full employment equilibrium.
• The assumption that I and S were equal at full employment level and in case of any
divergence in equilibrium is brought about by r is unrealistic. Keynes held that the level of
savings depends on the level of income and not on r.
• The classical economists believed that money was demanded for transactions and
precautionary purposes and did not recognize the speculative demand for money.
• Keynes did not agree with Pigou that friction maladjustments alone account for failure to
utilize fully our productive power.
• Keynes refuted the Pigouian theory that a cut in money wage could achieve full employment
in the economy and that the adoption of such a policy leads to a reduction in unemployment.
• The classists believed in the long-run full employment equilibrium through self adjusting
process. Yet Keynes’s philo
• sophy of life was a short-term philosophy.

Review Questions
1. Explain the classical theory of employment.
2. On what grounds did Keynes criticize the classical theory of employment?

The Principle of Effective Demand

In a capitalist economy, the level of employment depends on effective demand. This is the starting
point of Keynes theory of employment (the principle of effective demand).
Definition
1. Demand means desire.
2. Effective demand is when income is spent on buying consumption goods and investment
goods. Keynes used the term “effective demand” to mean the total demand for goods and
services at various levels of employment. Different levels of employment represent different
levels of aggregate demand.
Effective demand is when aggregate demand equals aggregate supply. This according to Keynes,
the level of employment is determined by effective demand, which in turn is determined by
aggregate demand price and aggregate supply price.
Aggregate Demand Price
Aggregate demand price is the amount of money, which the entrepreneur expects to get by selling
the output produced by the number of men employed. It refers to the expected revenue from the sale
of output produced at a particular level of employment. Different aggregate demand price relate to
different levels of employment in the economy.

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The different demand prices at different levels of employment can be presented in a statement called
the aggregate demand price schedule or aggregate demand function.

Aggregate Demand Schedule

Level of employment (N) Aggregate demand price (D)
0 0
30 420
35 450
40 460
50 470
50 480

The table shows that with the increase in the level of employment, aggregate demand price (D)
increases. The aggregate demand curve can be drawn on the basis of the above schedule as it
slopes upwards.

Aggregate Supply Price

When an entrepreneur employees a certain amount of labour, it requires certain quantities of
cooperant factors like land, capital & raw materials among others which will be paid
remuneration along with labour. Thus each level of employment requires certain money cost of
production. At any given level of employment of labour, aggregate supply price is the total
amount of money, which all the entrepreneurs in the economy, taken together must expect to
receive from the sale of the output produced by that given number of men, if it is to be just
employing them. In brief, the aggregate supply price refers to the proceeds necessary for the sale
of output at a particular level of employment. Therefore, each level of employment in different
aggregate supply prices leads to different levels of employment. Prof. Dillard “The aggregate
supply function is a schedule of the minimum amounts of proceeds required to induce varying
quantities of employment.
Level of Employment (N) Aggregate Demand Price (D)
0 0
30 240

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35 250
40 270
45 280
50 290
50 300

From the schedule, as the level of employment increases, aggregate supply also increases. The
aggregate supply curve can be drawn on the basis of the above schedule.

It slopes upwards from left to right because as the necessary proceeds increases, the level of
employment increases. Nevertheless, when the economy reaches the level of full employment, the
aggregate supply curve becomes vertical. At this point with increase in the proceeds, it is not
possible to provide the level of full employment.

Determination of Effective Demand

The level of employment is determined at the point where the aggregate demand equals the
aggregate supply price. It is the point where what the entrepreneurs expect to receive equals what
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they must receive and their profit is maximized. This point is called effective demand and here,
the entrepreneurs earn normal profits.
At ON1 level of employment the proceeds expected (revenue) exceeds the proceeds necessary (C)
i.e. RN1 > CN1. This indicates that it is possible for entrepreneurs to provide employment to
workers till ON level is reached where the proceeds expected and necessary are equal at point E.
It will not be profitable however for entrepreneurs to increase employment beyond N f because
now the proceeds necessary (costs) exceed the proceeds expected (revenue). Thus E determines
the level of employment in the economy which is of under employment.
Importance of Effective Demand
The principle of effective demand is the most important contribution of Keynes.
• Determinant of employment. Effective demand determines the level of employment in an
economy. When effective demand increases, Employment also increases and vice versa.
• It removes the Say\s law and full employment thesis. This principle points out that
underemployment equilibrium is a normal situation and full employment equilibrium is
accidental.
• Replication of wage cost. The Pigouvian view that full employment can be achieved by a
reduction in money wage cost is also repudiated by this principle.
• Role of investment. The principle highlights the significant role of investment in determining
the level of employment in the economy. The two determinants of effective demand are the
consumption expenditure and the investment expenditure.
• It explains the paradox of poverty in the midst of potential plenty in the modern capitalism.

Sample Questions
1. a) What is effective demand?
b) Explain the principle of effective demand.
c) Explain the role of effective demand in Keynes theory of employment.
2. a) Distinguish between aggregate demand price and aggregate supply price.
b) How is effective demand determined?
c) Explain the importance of effective demand.

The Consumption Function

The Consumption Function refers to the relationship between total consumption and gross
national income i.e. C – f (Y), Ceteris Paribas. Propensity to consume or consumption function is
a schedule of the various amounts of consumption expenditure corresponding to different levels
of income.
Consumption Schedule
Income (Y) Consumption (C)
0 30
80 90
110 110

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170 160
230 210
290 260
350 310

Consumption expenditure increases with the increase in income. When income is zero during the
depression, people spend on their past savings on consumption because they must eat in order to
live. When income is 80, it is not sufficient to meet the consumption expenditure of the
community so that consumption expenditure is 90. When both consumption and income is 110, it
is basic consumption. After this, income increases by 60 and consumption by 50. This shows a
stable consumption function during the short run as assumed by Keynes. Consumption function
can be illustrated below;

The consumption curve slopes upwards to the right indicating that

consumption is an increasing function of income. B is the breakdown
point where consumption is equals to income. Above this point,
income exceeds consumption. The proportion of income not
consumed is saved and is shown by the vertical distance between the
consumption curve and the 450 line. Therefore, the consumption
function measures not only the consumption but also the saving.
Properties of the Consumption Function
1. The Average Propensity to Consume: This is the ratio of consumption to any particular level
of income. APC = C/Y. APS = 1 – APC.
Graphically, the APC is anyone point on the consumption curve.

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2. The Marginal Propensity to Consume: This refers to the ratio of the change in consumption to
the change in income i.e. MPC = ΔC/ΔY. The MPC is constant at all levels of income as shown
in column 5.
MPS = 1 – MPC.

Y C APC = C/Y APS = S/Y MPC = ΔC/ΔY MPS = ΔS/ΔY

160
170 160 /170 = 0.94 = 94% 0.06 - -
210 50
230 210 /230 = 0.91 = 91% 0.09 /60 = 0.83 = 83% 0.17
260
290 260 /290 = 0.89 = 89% 0.11 ,, ,,
310
350 310 /350 = 0.885 = 88.5% 0.115 ,, ,,

Importance of MPC
In Keynes analysis, the MPC is given more prominence. Its values is assumed to be positive and
less than one which means that when income increases, the whole of it is not spent on
consumption (O<MPC<1). This tells us that;
• The consumption is an increasing function of income and it increases by less than the
increment in income.
• The theory explains the theoretical possibility of general over production or
underemployment equilibrium.
• The theory explains the relative stability of highly developed industrial economy. This is
because the gap between income and consumption at high levels of income is for wide to be
easily filled by investment. This may lead to underemployment.
Thus, the importance of MPC lies in filling the gap between income and consumption through
planned investment to maintain the desired level of income.

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Its importance further lies in the multiplier theory. The higher the MPC, the higher the multiplier
and vice versa. The MPC is low in rich people and higher in poor people. This accounts for
higher MPC in Least Developed Countries and low in advanced countries.
Determinants of the Consumption Functions
There are two principled factors that influence the consumption functions; the subjective factors
and the objective factors. The subjective factors are endogenous whereas the objective factors are
exogenous.
1. Subjective Factors
The subjective factors are the psychological characteristics of human, nature, social practices and
institutions.
i. Individual motive: These are motives, which lead individuals to refrain from spending out of
their incomes. They are; the desire to build reserves from unseen contingencies, the desire to
provide for anticipated future needs, the desire to enjoy an enlarged future income, the desire
to enjoy a gradually increasing expenditure in order to improve the standards of living, the
desire to enjoy a sense of independence and the desire to serve business projects among
others.
ii. Business motives: The subjective factors are also influenced by the behavior of business
corporations and governments. Keynes lists for motives of accumulation of income and they
are; the desire to do big things and to expand, the desire to meet emergencies, the desire to
serve large income and to show successful management, the desire to provide adequate
financial resources.
The factors remain constant in the short run and keep the consumption function stable.
2. Objective Factors
These cause shifts in the consumption function;
i. Change in the wage level: If the wage rises, the consumption function shifts upwards. The
workers having a high propensity to consume spend more out of their increased income
and this tends to shift the consumption curve upwards. A cut in the wage rate will reduce
the consumption function of the community due to a fall in income, employment and
output. This will shift the curve downward.
ii. Windfall gains or losses: Unexpected changes in the stock market leading to gains or
losses tend to shift the consumption function upward or downward.
iii. Changes in the fiscal policy: For example, heavy commodity taxation adversely affects
the consumption function by reducing the disposable income of the people. On the other
hand, progressive taxation along with that of public expenditure on welfare programmes
tends to shift the consumption function by altering the distribution of income.
iv. Expectations: For example, if a war is expected in the near future, people buy much in
excess of their current needs and the consumption function shifts upwards. On the other
hand, if people expect prices to fall, they would buy only those things that are essential
leading to a downward shift of the consumption function.
v. Change in the rate of interest: Changes in the interest rate may indirectly affect the
consumption function in many ways, for example; a rise in the rate of interest will lead to

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a fall in the prices of bonds, thereby tending to discourage the propensity to consume of
the bondholders.
vi. Financial policies of corporations: If corporations keep more money in the form of
reserves, dividend payments to shareholders will be less; this will have the effect of
reducing the income of the shareholders, as the consumption function will shift
downwards.
vii. Holding of liquid assets: If people hold larger liquid assets, they will have a tendency to
spend more out of their current income and the propensity to consume will have more
upward and vice versa.
viii. Income distribution: If there are large disparities in income distribution between the rich
and the poor, the consumption function is low because the rich have a low propensity to
consume and the poor with a key low income are unable to spend more on consumption.
Consumption function will shift upwards if measures are taken to reduce the income
inequality.
ix. Attitude towards savings: If people value future consumption more than present
consumption, they will tend to save more and the consumption function will shift
downwards. This tendency may be reinforced by the state through compulsory saving e.g.
NSSF and compulsory life insurance among others.
x. Duessenberry Hypothesis: James Duesenberry propounded relative income hypothesis
affecting the consumption function. The hypothesis first of all relates to the demonstration
effect and the tendency to emulate the consumption patterns of one’s rich neighbors and
even to surpass them.

Measures to raise the Propensity to Consume

Unless there is a change in the propensity to consume as pointed out by Keynes, employment and
investment will not increase. Therefore, there is a need to study the measures to raise the
propensity to consume;
i. Income redistribution: Propensity to consume can be raised by redistributing income from
the rich to the poor. This is because the Marginal Propensity to Consume is higher in low-
income people than the rich. This can be done through taxation and public spending.
ii. Increased wages: Increase in wages will lead to shifting of the consumption function
upwards. But the wage policy affects the level of employment in the economy. Therefore,
the long run wage policy should be such that wage increases are accompanied with
increase in labour productivity. iii. Social security measures: these tend to raise the
consumption function in the long run. Examples of social security measures are;
unemployment relief, medical facilities and old age pension etc.
iv. Credit facilities: When loans are easily and cheaply available to the people, they buy
more.
v. Advertisement: Advertisement through the various media to make the consumers familiar
with the use of products. The consumers are attracted towards them and they tend to buy
them which raises their propensity to consume.

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vi. Development of the means of transport: Prices may fall due to the reduced transport costs.
Also commodities are available to the people in their respective locations. All these raise
the propensity to consume.
vii. Urbanization: Deliberate urbanization by the state shifts the consumption function
upwards. When urbanization takes place, people move from the rural to urban areas. In
urban areas, they are influenced by the demonstration effect.
The Investment Function
Definition
i) Investment: Investment means an addition to the existing equipment. Investment
means an addition to the stock of goods in existence. (real investment)
ii) Capital: Capital refers to real assets like factories, plants, equipment, and inventories of
finished and unfinished goods.
It is any previously produced input that can be used in the production process to produce
other goods.

Investme
Therefore I assets during any period of time.
investments is the acquisition of real capital
nt I3 I is the investment curve which shows
Types of investment
induced investment at various levels of
1) InducedI investment. This is the type of investment influenced
income by factors like prices, wages,
2
demand and interest rate which affect a profits. For example, the increase in demand due to
increase in income, brings about an increase in investment.
Induced investment is a function of income. I = f(y) As income increases, investment also increases
and vice-versa.

O Y1 Y2 Y3 Income Y
Figure: Induced investment

From the above figure we can derive the following:

i) The Average propensity to invest (API), which is the ratio of investment to income.
APS = I/Y, at any point on the investment curve.
ii) The Marginal Propensity to Invest (MPI), which is the ratio of change in investment to the
change in income.
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MPI = ∆I
∆Y
2) Autonomous investment. This is the type of investment that is not influenced by the level of
income. Autonomous investment is influenced by exogenous factors like; innovations,
inventions, growth of population and labour force, research, social and legal institutions whether
changes, war, revolution etc. It is independent of the level of income and is not influenced by
changes in demand.
Investment in economic and social overheads by either the government of private enterprises is
autonomous. For example, building of dams, roads, hospitals, etc. since investment on these
projects is generally associated with public policy, autonomous investment is regarded as public
investment.
Diagrammatically, autonomous investment is represented as follows.
Autonomous investment
I
Iii I1

Ii I

0 Y

Factors affecting the inducement to invest other than the interest rate

1) Uncertainty. The business expectations are very uncertain. They may change quickly
and drastically in response to the general mood of the business community, rumours, news of
technical developments, political events, etc. these factors tend to bring instability in the
investment function and make it difficult to calculate the expected annual returns on life of capital
assets.
2) Existing stock of capital goods. If the existing stock of capital goods is large, it would
discourage potential investors from entering into the making of goods.
3) Level of income. Increase in the income in the economy due to rise in money wage
rates and other factors prices, will lead to increase in the demand for goods which will in turn
raise the inducement to invest. On the other hand, the inducement to invest falls with the fall in
income. 4) Consumer Demand: If the current demand for consumer goods is increasing rapidly,
more investment will be made. Also the future demand for the products influences the level of
investment.
5) Liquid assets. If the investors possess large assets, the inducement to invest is high.
This is more so with firms which keep large reserve funds. On the other hand the inducement to
invest is low for investors having little liquid asset.
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6) Inventions and Innovations. If inventions and technological improvements lead to more

efficient methods of production which reduces costs, the MEC of new capital assets will rise.
Higher MEC will induce firms to make larger investments in the new capital assets.
7) Growth of Population. A rapidly growing population means a growing market for all
types of goods in the economy. To meet the demand of an increasing population, investment has
to increase.
8) Government Policy. If the government levies taxes on goods, their prices will be high
and their demand will be too low, which lowers the inducement to invest. On the other hand if
the sate encourages private enterprises by providing credit, and other facilities, inducement to
invest will by high.
9) Political Climate. If there is political instability in the country, the inducement to invest
is affected. On the other hand, a stable government creates confidence in the business community
whereby the inducement to invest is raised
10) New Products. The nature of new products affects the inducement to invest. If the sale
prospects of a new product is higher and the expected revenues are more than the costs, the
inducement to invest will be high.
Question
1. a) Distinguish between
i) Capital and Investment ii) Induced and
Autonomous Investment iii) MEC and
MEI
b) Explain how the rate of interest in an economy affects the level of investment.
c) Discuss the determinants of investment in an economy apart from the rate of interest

Savings and Investment Equality

All economists believe in the equality of savings and investment, but they differ in what brings about
this equality. We study the Classical and Keynesian view.
The Classical View
The Classicals believes in the existence of full employment when savings and investment are
always equal. According to the Classicals, savings and investment are a function of interest rate
i.e. S = f (r) and I = f (r). Therefore, the mechanism of interest rates brings about the equality in
the periods of less than full employment. The mechanism of equality between savings and

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investment is shown in figure below;

If there is an increase in I, the I curve shifts to the right to I 1I1 as at the interest rate R. OC
Investments is greater than OA savings. According to the Classicals, the S curve remains constant
when there is an increase in I. To maintain the equality between S & I, r will rise to Or 1 and
consequently, S and I curves intersect at E 1 at OB investment. Criticisms of the Classical View
(Keynes)
• Keynes does not agree with the classicals that brings about the equality between investment
and savings but changes in income that brings the two to equality.
• The view that the S Curve is constant. Keynes is that when the investment changes, savings
also changes.
• The view that investment and savings are equal at the equality below full employment level.

The Keynes View

There are two Keynes views about the equality of savings and investment;

1. The Accounting or Definitional Equality

That savings and investment are always equal times and at any level of income. That both savings
and investment in the current period are defined as the excess of current income over current
consumption (Yt - Ct), so that they are necessarily equal.
S t = Y t – Ct
It = Y t – C t
St = It
In other words, Keynes defines income in the current period as consumption plus current investment.
Yt = Ct + It

Yt is the savings plus consumption.

Yt = Ct + It

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Yt = St + Ct
Ct + It = St + Ct
It = S t

However, the equality is not without criticisms for example; it is difficult to understand how the
equality can take place when different groups of people take savings and investment decisions.
2. The Functional Equality
Savings and investment are equal only at the equilibrium level of income. In other words, savings
and investment are equal at the equilibrium level of income. When savings is more than
investment, income falls and when investment is more than savings, income rises. This dynamic
process of changes in income, savings and investments continues till savings and investment are
not only equal but are also in equilibrium.

When income is YI, I is greater than S. Higher investment will lead to rise in income and savings
via the multiplier process till savings and investment are equal at E (equilibrium income level).
When savings is greater than investment, it will bring about a fall in income via the reverse
operation of the multiplier till savings and investment are equal ay OY level of income.

Sample Question
1. Explain the following statements;
i. Savings and investment are always equal.
ii. Savings and investment are always equal in equilibrium.

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The Multiplier Theory

To Lord Keynes, an increase in expenditure (an increase in demand) increases income more
than the original increase in expenditure
Keynes Investment Multiplier
The Keynes investment multiplier establishes a precise relationship between aggregate
employment and income and the rate of investment. It tells us that when investment increases,
income increases by K time. ΔY = KΔI K = ΔY/ΔI

Where K is the multiplier coefficient and it is the power, which multiply initial investment
expenditure to obtain the formal increase in income. The value of the multiplier is determined by
the MPC; the higher the MPC, the higher the value of the multiplier and vice versa.
Y=C+I
ΔY = ΔC + ΔI

But ΔC = CΔY
ΔY = CΔY + ΔI
ΔY – CΔY = ΔI
ΔY (1 – C) = ΔI
ΔY/ΔI = I/I – C

But ΔY/ΔI =K
K = I/I – C
I = I/C

Where C is the MPC

O≤K≤∂
O ≤ MPC ≤ I

The formula shows that the size of the multiplier varies directly with the MPC. Also K = I/MPS
How the Multiplier Works
The multiplier works both forward and backward;
1. Forward Working
In forward working, an increase in investment leads to increased production which creates
income and generates consumption expenditure. Suppose that the MPC of the economy is ½, an
increase in investment will lead to a rise in production and income. ½ of this income will be spent
on consumption goods which will lead to increase in production and income by the same amount
and so on.
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C + I is the investment curve. The original equilibrium is at E I where C + I intersect to the 45 0

line. An increase in I by ΔI leads to a new curve C + I + ΔI which intersect the 45 0 at EII and
income. The distance between C + I and C + I + ΔI since MPC is half.
2. The Backward Working
The backward operation of the multiplier occurs when a reduction in investment leads to
contraction of income and consumption, which in turn lead to cumulative decline in income, and
consumption till the contraction in aggregate income is the multiple of the initial decreased in
investment. The higher the MPC, the greater the value of the multiplier and the greater the
cumulative decline in income and vice versa.
Leakage of Multiplier
Leakages are the potential diversions from the income stream, which tend to weaken the
multiplier. Therefore, the increase in income in each round declines due to leakages in the income
stream. They include;
1. Saving: Since the MPC is less than one, the whole increment in income is not spent on
consumption. A part of it is saved which goes out of the income stream and increase in
income in the next round declines. Therefore, the higher the MPS, the smaller the size of the
multiplier and the greater the amount of leakages and vice versa.
2. Strong liquidity preference: If peoples\ desire to hoard the income inform of money is high,
it will act as a leakage out of the income stream.
3. Purchase of Old Stock and Securities: If a part of the increase in income is used in buying
old stocks and securities instead of consumer goods, the consumption expenditure will fall
and its effect on income will be less than before. That is the size of the multiplier falls with
the fall in consumption expenditure.
4. Debt Cancelation: If a part of increased income is used to repay debts to banks instead of
spending it for further consumption; that part of income goes out of the income stream and the
multiplier is weakened.

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5. Inflation: When increased income leads to price inflation, the multiplier effect of increased
income will be affected at higher prices. This is because the increased income will be
absorbed by higher prices and real consumption and income falls.
6. Imports: If increased income is spent on the purchase of imported goods, it acts as a leakage
out of the domestic income stream because such expenditure fails to affect the consumption of
domestic goods.
7. Undistributed profits: If profits accruing to joint stock companies are not distributed to the
shareholders but are kept in the reserve fund, it acts as a leakage from the income stream. This
is because the income will be reduced and hence consumption of goods will be reduced which
weakens the multiplier.
8. Taxation: Progressive taxes have the effect of lowering the disposable income and reducing
the consumption expenditure. In addition, consumption taxes tend to rise the prices of goods,
all of which reduce the income stream and lower the size of the multiplier.
9. Excess stock of consumer goods: If the increased demand of consumption goods is met from
the existing excess stock of consumption goods, there will be no further increase in output.
The income stream will lower to the half till the old stocks are exhausted.
10. Public Investment Programmes: If the increase in income is because of increased
investment due to public expenditure, the increased income may not be used for further
investment.
Criticisms of Multiplier
The theory of multiplier has been severely criticized by the post Keynesian economists. Prof.
Hart considers it “useless fifth wheel”, which Hott calls it as a “rubbish apparatus.” The criticism is
in the following grounds;
1. That K = I/I – C is a mere arithmetic multiplier and not a true behavior multiplier that shows
relationship between consumption and income.
2. It is a timeless analysis. The multiplier does not involve the true lag between the receipt of
income and its expenditure on consumption goods and also in producing consumption goods.
3. A worthless theoretical Toy. According to Hazlitt, it can never be a mechanical relationship
between investment and income.
4. Acceleration effect ignored. The theory studies the effect of investment and income through
changes in consumption expenditure, but it ignores the effect of consumption and investment,
which is known as the acceleration principle.
5. MPC does not remain constant. According to Gordon, in a dynamic economy, it is not likely
for MPC to remain constant. Because of increase in private investment or public spending
leads to a rise in MPC.
6. Relationship between consumption and income. Keynes establishes a linear relation between
consumption and income and that MPC is less than one and greater than zero. But empirical
studies of the behavior of consumption in relation to income show that the relation is
nonlinear and is complicated.
Importance of Multiplier
The importance of Keynes multiplier lies in the following;
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1. Investment. The multiplier shows the importance of investment in income and employment
theory. A fall in investment leads to cumulative decline in income and employment by the
multiplier process and vice versa.
2. Trade cycle. The multiplier highlights the different phases of the trade cycle. When there is a
fall in investment, income and employment decline in a cumulative manner leading to
recession and ultimately to depression. On the other hand, an increase in investment leads to
revival and if this process continues to a boom.
3. Saving – Investment Equality. It also helps in bringing the equality between savings and
investment. When there is a divergence between savings and investment, an increase in
investment leads to a rise in income via the multiplier process by more than the increase in
initial investment. Because of the increase in income, savings also increases and equals
investment.
4. Formulation of economic policies. The multiplier is an important tool in formulating
economic policies. Thus the principle presupposes state intervention in economic policies.
5. It helps to achieve full employment. if investment is insufficient to bring employment, the
state can inject regular investment for this purpose until the level of full employment is
reached.
6. Deficit financing. In situation of depression, increased public expenditure through public
investment programmes by creating a budget deficit helps in increasing income and
employment by multiplier.
7. Public investment. The multiplier highlights the importance of public investment in creating
or controlling income & employment for example by increasing investment during a
depression or decrease investment in periods of over full employment.
Other types of Multipliers
I. Balanced budget Multiplier
II. Foreign Trade Multiplier
Sample Questions
a) The higher the MPC, the higher the multiplier. Discuss the statement.
b) Discuss the concept of investment multiplier.
c) Explain the relationship between MPC and multiplier.

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