Kmartin martin kaonga

K>MARTEEN
THE UNIVERSITY OF
ZAMBIA

EC=115
MICRO-
ECONOMICS
2009
CHAPTER 1

INTRODUCTION TO ECONOMICS
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After studying this chapter, the students should be able to:

Appreciate the subject matter of Economics XE "Economics"

Explain how Economists derive their theories
Identify the nature of factors of production XE "factors of production"
Explain the law of diminishing Returns
Explain the relationship that exists between Scarcity XE "Scarcity" , Opportunity Cost and
Choice
Understand the basic Economic tables, graphs and models
Explain the Economic systems, their merits and demerits
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_

1.0 INTRODUCTION – THE SUBJECT MATTER OF ECONOMICS

Economics XE "Economics" comes from the verb ‘to economise’, and this means making
ends meet. This is a study of how society makes decisions, regarding the allocation of scarce
resources. Economics as a subject is divided into two parts;

Microeconomics XE "Microeconomics" , which deals with individual economic decision

makers or
agents, namely households, firms etc. Households as resource owners supply XE
"supply" factors of
production XE "factors of production" to firms, and earn an income. In return
households demand goods and
services produced by firms, and spend their income.

Firm in general demand and pay for factors of production XE "factors of production"
from households and in
return, supply XE "supply" goods and services at a price, to households.

The interaction between the individual decision makers is known as the circular flow
of income, it is dealt with in detail at a later chapter.

Economics XE "Economics" assumes that these individual economic units behave

rationally:
Firms or producers always try to maximise their profits.
Households or consumers always try to maximise the satisfaction or utility they
derive from their income.
Governments always attempt to maximise the welfare XE "welfare" of society

Macroeconomics looks at the total (aggregate) picture, the practical effects of

decisions of the Economic units.

Economics XE "Economics" as a subject makes use of normative statements of

Economic and social
value judgments of what society thinks ought to happen in an ideal scenario, such as
Zambia winning the world cup!

Economics XE "Economics" is also concerned with positive statements and objective

explanations of what
has happened in the past, and based on that, what is likely to happen in the future.
Economics XE "Economics" is a social science subject; it deals with human behaviour, which
is diverse. Therefore, it is difficult to come up with blanket conclusions. The assumption,
ceteris paribus “all things remain equal”, usually applies.

The subject matter of Economics XE "Economics" is concerned with human beings “trying to
make ends meet with what they have”, the basic Economic problem is that:-

Human wants are unlimited or insatiable. Maybe because goods wear out and have to be
replaced, or, new and improved products become available on the market, or people are just
tired of what they own and want a change.

Economic resources, which are required for the production of goods and services to satisfy
human wants, are limited.

The above are the two pillars on which the whole subject matter of Economics XE
"Economics" rests is the scarcity of resources and the choices that have to be made to try to
make ends meet, since not all of our unlimited wants can be satisfied!

The scarce economic resources are commonly known, as factors of production XE "factors
of production" and these have to be examined in relation to how they limit production.

Factors of production

The factors of production XE "factors of production" are the resources that are necessary for
production, and if these were in plentiful supply XE "supply" , there would be no need to
economise, and society would have free goods! What affect the rate of Economic growth XE
"growth" that an economy can manage is the quantity and the quality of the factors of production
they have.
The following are the four different groups into which factors of production XE "factors of
production" are usually classified:

Land
This refers to all natural resources XE "natural resources" such as farmlands, mineral wealth
XE "wealth" , fishing grounds provision of site where production can take place, and so on.

Land differs from other factors of production XE "factors of production" in three main ways
as follows:

It is a “gift of nature”, man has done nothing to bring it about.

It is limited in supply XE "supply" but man through schemes such as fertilizers, irrigation,
better quality seeds etc can improve it.
Since land XE "land" is in limited supply XE "supply" , Diminishing returns tend to set in
early.

The Law of Diminishing Returns.

Diminishing returns refers to a situation where a firm is trying to expand by using more of
its
variable factors, but finds that the extra output they get each time they add one more variable
factor to a fixed factor of production such as land XE "land" , gets progressively less and less.
This usually
arises because the capacity of land for example, is limited in the short-run and the
combination
of the fixed and variable factors becomes less than optimal.

The law, with reference to land XE "land" , states, “after a certain point, successive
application of
equal amounts of resources to a given area of land produces less than proportionate
return”.

If, for example, a farmer has one hectare of land XE "land" (fixed factor) and produces the
following bags of maize by employing more workers (variable factor).

Number of workers Output per year Addition to Output

1 100 100
2 210 110
3 300 90
4 250 -50
 Fig: 1 The law of Diminishing Returns

Output 300

per

year 250

200

150

100

50

0 1 2 3 4

Number of workers

Note that diminishing returns start after the second worker is employed, when the
additions
to output start to decline from 110 to 90, and eventually being negative. It is no longer
worthwhile to employ more workers on only one hectare of land XE "land" , it costs
more to employ than the additional revenue XE "revenue" from an additional worker.
Additional workers can only be employed when more land is acquired, but this can
only be achieved in the long run XE "long run" .

Labour
This is a human resource, it is human effort employed in production.
Labour is considered as the most important economic resource, it is indispensable to all forms
of production. It is the end user of everything that is produced. It differs from other factors in
that ethical and moral consideration has to be taken into account when dealing with labour XE
"labour" .
The quantity and quality of labour XE "labour" has to be considered as they both relate to
production and productivity. The supply XE "supply" of labour depends on:-
Total population XE "population" of a country
Proportion of the population XE "population" available for employment
Number of hours worked per year

Quality, efficiency or productivity of labour XE "labour" varies, depending on a number of

issues, such as

The climate
Nutrition and health of the worker
Peace of mind
Working conditions
Education and training

Capital

This is composed of man-made aids to production, for example, factory, bridges, machinery,
raw materials, means of transportation etc.

Quantity of capital XE "capital" depends on the wealth XE "wealth" accumulated from

previous production by firms and governments. ‘Wealthy’ or rich firms and governments have
a lot of the latest sophisticated equipment, while poor countries have very little, depending on
obsolete equipment and few ‘handouts’. The quality of capital is influenced by a nations
Economic development and technological progress.

Enterprise XE "Enterprise"

This is another human resource, but entrepreneurial ability requires organising land XE "land" ,
labour XE "labour" and capital XE "capital" for production. It is concerned with decision-
making. Therefore, there are two distinct functions of the entrepreneur, uncertainty bearing by
supplying risk XE "risk" capital and organizing for production by making decisions on what
to produce, how to produce and for whom to produce etc.

Such decisions or choices are necessary because factors of production XE "factors of

production" are not only scarce but they also have alternative, competing uses. Choices are
made, to satisfy some wants and to forgo other wants.

When a choice is made, an alternative has to be given up, this sacrifice is termed as the
opportunity cost XE "opportunity cost" . Opportunity cost explains the fact that ‘the cost of
something is what you have to give up in order to get what you want’ a ‘trade off’. It is the real
cost of an action, which is considered as the next best alternative forgone. It usually has a
monetary value, but it can also be a choice over the use of time, for example, choosing to watch
a movie or to study Economics XE "Economics" !

1.2 PRODUCTION POSSIBILITY CURVE

The relationship between scarcity, choice and the forgone alternative is exhibited by a
production possibilities curve or frontier, also known as the transformation curve, opportunity
cost XE "opportunity cost" curve. It helps to explain the important Economic concept of
opportunity cost.

To simplify, assume that they are only two commodities, and if the society chooses more of
one thing it must necessarily choose less or sacrifice something else, such as more of good X
means less of good Y. The production possibility curve for any country is a graph showing the
combination of two goods that can be produced using all of its scarce Economic resources in
the most efficient manner, given a country’s Economic development and technological
progress.

Fig: 2 Production Possibility Curve

Good Y B

Good X

Any point along the PPF is the maximum of all possible combinations of the two products X
and Y. Society can choose a specific combination of output, a single point along the PPF such
as point A, B, C, and D.

At point A the existing resources are all being used to produce commodity Y and no X is being
produced. Alternatively, at point D the economy chooses to produce X without Y, or decide on
large quantities of Y and small quantities of X (at point B), or vice versa, at point C.

Any point inside the PPF (e.g. point E) or an inward shift to the left, is an indication that the
economy is producing beneath its full potential, and therefore operating inefficiently or some
resources are lying idle. An inward shift normally occurs when a country is at war and or the
economy is contracting. There is no Economic growth XE "growth" .

An outward shift to the right, as shown by the dotted lines, shows an increase in the productive
capacity of the economy, Economic growth XE "growth" . Economic growth can occur from
either better use of existing resources, increased productivity, or effective use of newly
acquired inputs or resources, that is increased production. Increased output may also be due to
division of labour XE "labour" and specialization.

It is important to note that the curve is normally drawn as being concave to the origin, a sign
that some resources are well suited to the production of one good rather than another good and
vice versa. Otherwise, the PPF would be a straight line slanting downwards from left to right,
implying that if production of X reduces by one unit, then the production of Y would increase
by one unit, if it reduces by two units, then the production of the other good would increase by
two units, and so on. However, that is not the case.

The existence of scarcity and choosing between competing ends creates decisions that must be
made regarding resource allocation.

What to produce
How to produce
For whom to produce
Where to produce
How to distribute etc.

Note that factors of production XE "factors of production" are not only scarce with competing
uses, but they can also be specific, if they are of a specialized kind, and therefore cannot be
easily used for any other purpose other than that for which they are originally intended.
Examples of specific factors are bridges, factories, accountants, and economists, combine
harvesters blast furnaces, etc.
Alternatively, factors can be non-specific, that is, if a factor can easily be transferred from one
use to another. For example, land XE "land" used for animal grazing, growing maize,
unskilled labour XE "labour" , raw materials like cotton is used to make blankets, carpets
clothes or small tools like a knife used to cut meat, rope and so on.

1.3 ECONOMIC GROWTH AND ECONOMIC WELFARE

When a country’s PPF shifts outwards, to the right, then Economic growth XE "growth" is
judged to have taken place. It is measured by a ‘real’ increase in the national income XE
"national income" figure. The national income is the total value of goods and services
produced in a country in a year. When production is increasing then the economy is growing.
Factors determining increases in output are both internal and external. Internal factors include
the quantity and quality of a country’s factors of production XE "factors of production" , the
amount of scarce Economic resources available and their productivity. The external factors
result from a country’s relationships with the rest of the world, including the terms of trade..

Economic growth XE "growth" is an important subject in that it affects the measurement of

Economic welfare XE "welfare" , an improvement in the overall standard of living XE
"standard of living" of the people in any country, more goods and services are available. The
quality of life in terms of, for example, the life expectancy in Zambia improving to an average
of eighty years or above instead of forty years or less!

The other advantages of economic growth XE "growth" are an improvement in the social
sector, better infrastructure, a lower doctor: patient, teacher: pupil ratio etc.

Economic growth XE "growth" maybe balanced or unbalanced, that is some sectors and
some areas grow faster than others. In Zambia, the mining, agriculture and tourism sectors as
well as the some urban areas are expanding faster than others.

Unfortunately, there are a number of disadvantages associated with economic growth XE

"growth" . It is associated with a cost, the opportunity cost XE "opportunity cost" of
diverting resources from present consumption XE "consumption" . It also implies that there is
faster use of natural resources XE "natural resources" , it gets depleted quickly. There is need
to continuously discover new natural resources to sustain Economic growth. Unfortunately, the
wealth XE "wealth" is not equally distributed; there is a marked difference between the rich
and the poor people in the society.

Economic growth XE "growth" also leads to less desirable attitudes, people leading carefree
and selfish lifestyles, moving away from extended families to nuclear families in this era of
H.I.V/A.I.D.S orphans prevalent in poor countries like Zambia, extended families are needed to
assist in looking after orphans.

Another problem is social costs XE "social costs" , the undesirable effects of modernisation
and industrialization as the economy grows. There is increased noise, traffic congestion, and
loss of natural beauty, crime, pollution etc. Social benefits may also arise. The social costs and
benefits are jointly known as externalities. Externalities are spillover effects, there are external
to the transaction. An externality occurs when a cost or benefit of an Economic action is borne
or received by society as a whole, and not just the cost to a firm or a benefit to the consumer, it
is regarded as the difference between private and social costs, as well as private and social
benefits.

An example of the private cost and the private benefit to a person drinking a bottle of beer or
smoking cigarettes is the actual cost of the items and the enjoyment by the customer. However,
this transaction affects society in general through the social cost of drinking and drunkenness,
fumes and generally the increased health care provision by the government. The loud music
played in bars and enjoyed by the patrons is a private benefit, but, even passersby may enjoy
the music. This is a social benefit.

1.4 ECONOMIC SYSTEMS

The decisions to the central Economic problems of what to produce, how to produce and for
whom to produce depend on the Economic system prevailing in any particular country. To a
large extent, the Economic system depends on the political system and the manifesto of the
political party that has formed the government.
Society gives its mandate as to which political/Economic system they prefer by voting for a
particular political party during the general elections.

There are three (3) main Economic systems:

a) MARKET ECONOMY

Also known as the ‘capitalist system’. This is the kind of Economic system generally
characterized by advanced Western countries such as Germany, France, the United Kingdom in
th th th
the 19 and 20 centuries. During the 20 century there has been rapid technological
progress in many countries, many of them becoming capitalists.
The features of this system is emphasis on the freedom of the individual or firm, both as a
consumer and as the owner of productive resources, to make their own Economic choices on
what, how and for whom to produce.

In its pure form, there is no government interference in Economic activity, resources are
allocated on the basis of price. Price signals facilitate change and show shifts in consumer
wants, the concept of consumer sovereignty. A consumer expresses his choice of goods
through the price he is willing to pay for the product. The system responds to consumer
preferences. There is no or very little wastage of resources.

The system is efficient and self-adjusting, there is an ‘invisible’ hand in the market which helps
in the resource allocation. There is technical and Economic efficiency, and most importantly, it
is more practical than the socialist system since there is a clear incentive by producers, this is
self-interest!

DISADVANTAGES

Marked inequalities in income and wealth XE "wealth" distribution.

It ‘suffers’ from market failure, that is failure to produce a satisfactory allocation of resources
using the market forces of demand and supply XE "supply" for some commodities such as
defence, street lights etc, known as public goods XE "public goods" .
Lack of adequate provision of goods considered worth providing in great volumes,
such as education providing in great volumes, such as education and health knowns merit
goods.
There are monopolies instead of competition
There is no guarantee that demand will match supply XE "supply" , there is usually a time lag.
b) PLANNED (COMMAND) ECONOMY

This is a ‘socialist’ political system advocated by ‘idealists’, or anyone uncomfortable with the
marked inequalities in income, which is a common characteristic of capitalism. In the planned
Economic
system, the government makes production decisions on what how and for whom to produce on
behalf of the community, for the benefit of everyone. An attempt is made to create a new social
order, where everyone is happy, and ‘utopianism’.

The disadvantages of the market economy correspond closely to the merits of the centrally
planned economy.

The central planning authority can ensure that

Adequate resources are devoted to community goods and merit goods XE "merit goods" .
An attempt is made to distribute resources equally.
There is full utilization of resource, no unemployment of resources. Sometimes, workers are
employed simply to keep them occupied.
Monopoly powers are used in the interest of the community, no self-interest.
There is certainty into production and improving mobility by directing resources, including
labour XE "labour" .
Inefficiencies, which result from competition, are eliminated
Weaker members of the society are well taken care of; their basic needs such as food, clothing
and shelter are met by the government.
Adequate resources are devoted to community

DISADVANTAGES
Lack of sensitivity and initiative, and even if the resources are fully employed, they are used
inefficiently.
There is too much bureaucracy.
Errors are easy to make so there are either surpluses (wastage) or shortages, resulting in black
markets.

c) MIXED ECONOMIC SYSTEM

There are few countries that follow entirely the market or the planned Economic system.
Examples of socialist countries are Cuba and North Korea. In practice, most economies in the
world make decisions and choices regarding resource allocation by adopting both free market
and planned Economic policies. They do not make a complete choice between the two
extremes, in order to enjoy the best of both ‘worlds’, thus following the ‘middle of the road’.

Economic wealth XE "wealth" is divided between the private and the public sectors. The major
difference is the extent to which an economy is ‘leaning’ towards a market or a planned
Economic system. A good example is Zambia, just after independence from Britain, the country
was following a mixed system although the proportion of centrally planned decision making
was more than that of the free market. Under the Movement for Multi party Democracy
(MMD), the country is more towards capitalism than socialism. Yet it is still maintains a mixed
Economic system.

A government can have three-quarters of production carried out by private enterprises through
the market, while the government is directly responsible for the other quarter. Government
involvement is necessary because there is need for public provision of merit goods XE "merit
goods" such as education and health, which are deemed to be worthwhile for everyone. The
market forces cannot provide for public goods XE "public goods" , such as defence, police,
justice and national parks. Government involvement may also be in the form of public
deterrence of commodities considered being harmful to society like beer and cigarettes.

1.5 CHAPTER SUMMARY

The subject matter of Economics XE "Economics" is on allocation of scarce resources, how to

make ends meet by:-

Explaining the number of theories, models that make up the principles of Economics XE
"Economics" ;
Emphasizing that human wants are unlimited, while resources required to satisfy these wants
are limited;
Looking at the problem of scarcity of resources (factors of production XE "factors of
production" ) which have competing uses and the related problem of making choices that
involve sacrificing alternatives, called opportunity costs;
Identifying the relationship between resources and Economic growth XE "growth" and
Economic welfare XE "welfare" ;
Allocating resources using the market system or the planned Economic system, the advantages
and the disadvantages of each system;
Looking at the real world, most economies have a the mixed Economic system;

REVIEW QUESTIONS

What is the basic Economic problem facing all economies?

How would you describe positive and normative Economics XE "Economics" ?
What are the main production decisions that have to be made?
What are the four factors of production XE "factors of production" ?
What is opportunity cost XE "opportunity cost" ?
What does a production possibilities curve show?
How are the decisions and choices on the allocation of resources made in a planned Economic
system?
What is an externality?
How is actual Economic growth XE "growth" measured?
What is unbalanced Economic growth XE "growth" ?

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EXAM TYPE QUESTION 1.1

(a)
Explain the term “opportunity cost XE "opportunity cost" ”. (4 Marks)
Illustrate with examples the practical importance of this concept with reference to the individual,
the firm and the state (6 Marks)

(b)
What is the opportunity cost XE "opportunity cost" of a non Economic (free) good? ( 2
Marks)
Which of the following are non-Economic goods and why?
beer

hedge trimmings
a worn out suit case
a second hand car
a NATech Certificate
sand in the Sahara
sand in a builders’ yard (8 Marks)
(Total: 20 Marks)

EXAM TYPE QUESTION 1.2

What is meant by the law of diminishing returns (6 Marks)

How might the concept of Diminishing Returns be applied in the following cases:

Motor car production (2 Marks)

Wheat production (2 Marks)
Listening to lectures? (2 Marks)

How does the market system answer the key Economic questions relating
to the problem of the allocation of resources?
(8 Marks)

(Total: 20 Marks)

CHAPTER TWO

SUPPLY AND DEMAND

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After studying this chapter, the students should be able to:

Explain how decisions are made on what to produce, how to produce and for whom to
produce, how prices act to allocate resources within an economy
Explain Consumer behaviour and demand
Draw standard demand and supply XE "supply" curves
Explain Price determination
Explain why prices change from time to time, the main influences of demand and supply XE
"supply"
Distinguish between a change in demand or supply XE "supply" , and a change in the quantity
demanded and supplied
Explain why and how the government intervenes
Explain the effects of government intervention
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1.0 INTRODUCTION

This chapter deals with how the free market Economic systems deals with the allocation of
scarce resources, making choices on what, how and for whom to produce. This emphasis is on
the market for goods and services. However, the factor market, which is the market for
factors of production XE "factors of production" , land XE "land" , labour XE
"labour" , capital XE "capital" and enterprise, with the corresponding rewards, rent, wages,
interest and profit respectively, works in almost a similar way.

A market is where buyers and sellers meet, it does not necessarily mean a geographical
location. What determines what and how much of anything to produce is the price, and price
results from the operation of demand by buyers and supply XE "supply" from sellers.

In a free market, prices, which are basically determined by demand and supply XE "supply" ,
combine to solve the problem of resource allocation. Prices act as a signal of what people want
to buy, indicating to producers where their scarce factors will most profitably be utilized.

1.1 DEMAND

Individual demand must be differentiated from wants or desires. Demand refers to the
willingness by consumers to own goods, and it must be backed by money XE "money" , it is
therefore, qualified as effective demand. This is the quantity of a product or service that
consumers are willing and able to buy at a given price. Emphasis is not only willingness, but
this must be supported by the ability to pay. Market demand is the total quantity, which all
customers are willing and able to buy at a particular price.

1.2 THE DEMAND SCHEDULE

There is an inverse relationship between the quantity demanded and price, the amounts that a
consumer is willing and able to purchase at various prices at any given time tends to be high at
low prices, and low at high prices.

Below is Mr Banda’s demand schedule for mangoes in the month of November.

Price (K) Quantity demanded (units)

1 000 0
 800 3
500 4
300 6
200 10

1.3 DEMAND CURVE

When the data above is plotted into a line graph, a demand curve is produced.

FIG 3: DEMAND CURVE

Price
D

Quantity

A ‘normal’ demand curve slopes downwards from left to right, due to changes in price. A
change in price never shifts the demand curve for any good, it results in a movement along a
demand curve. This is a change in the quantity demanded.

An increase in price from OP to OP1 causes a contraction in demand from OQ to OQ1.

Alternatively, a reduction in price from OP1 to OP results in an extension in the quantity
demanded from OQ1 to OQ.

Contraction in demand Extension in demand

1.4 UTILITY THEORY

The standard shape of a demand curve, downward sloping, explains consumer behaviour with
reference to utility theory. Utility is the satisfaction or the benefit derived from consuming a
good or a service, and total utility is the total satisfaction. The utility theory assumes that
consumers want to maximize the total utility they gain when they buy goods and services, a
sign that they are behaving rationally.

In general, when a consumer buys more of a product, the total utility rises, but the marginal
utility, which is the satisfaction gained from consuming one additional unit of a product,
reduces. For example, if a very thirsty person drinks a glass of water, she will derive a lot of
satisfaction from that, but the second glass of water will be less satisfying, by the time she
drinks the third and fourth glasses of water, there is very little satisfaction derived from
drinking water. This signifies that successive increases in consumption XE "consumption"
raise total utility but at a diminishing rate, known as diminishing marginal utility. A person is
only prepared to pay less for an extra unit bought, more demand is at a lower price! This
explains the shape of the demand curve, it slants downwards from left to right, signifying that
the lower the price, the higher the quantity demanded and the higher the price the lower the
quantity demanded.

The normal demand curve is also partly explained by the substitution effect XE "substitution
effect" , which occurs due to relative price changes. Changes in the price of goods and services
cause consumers to adjust their demand schedules. If the price of a good falls, there is a
substitution effect, consumers buy more of that good and less of the other goods because of
relative price changes. However, there is also an income effect XE "income effect" , as the fall
in price increases a consumer’s real income. The consumer is better off, and can buy more of a
product, hence increasing demand as price falls.

A consumer’s spending of a good is in equilibrium where the marginal utility is equal to price.
Therefore the equilibrium for a combination of goods is

Marginal utility of good A = MUB = MUC

Price of good A PB PC

Note that the utility theory has a number of limitations, the important one being that it is
subjective, an individual who does not smoke cannot derive any satisfaction from cigarette
smoking. For some products such as beer, there is no diminishing marginal utility for some
people! In addition, a poor person who is starving can pay dearly for basic foodstuffs, while a
rich person will find this negligible in terms of price and utility.
1.5 A CHANGE IN DEMAND

Demand curves shift only if there is a change in the conditions of demand other than price.

The following are the main influences on demand:

Household income
An increase in income leads to an increase in the demand for goods and services,
known as ‘normal’ goods. These are expensive, luxurious products. Demand falls
when there is a reduction in income, indicating a positive relationship between
household income and most goods and services.

For some products, there is an inverse relationship between household income and demand.
Demand is high only when household income is low. Goods, whose demand decreases when
income is high, are known as ‘inferior’ goods. Examples are black and white television sets,
cheap wine, some vegetables etc.

The price of other goods

`This can either be substitute or competitive goods, those goods that are
interchangeable, are competing with each other. Examples are margarine is a substitute
for butter, and tea is a substitute for coffee. Different brands of tea, coffee and different
cellular phone service
providers like Celtel, Telecel and Zamtel are very close substitutes of each other!

For substitute goods XE "substitute goods" , a change in the price of one good causes a change
in the demand for the other good. Suppose there is an increase in the price of butter, the
demand for margarine is likely to increase as consumers will switch to margarine, which will
appear relatively cheaper.

The other goods can also be complementary goods or those goods that are jointly demanded
such as cars and fuel, or cell phones and sim cards.

For complementary goods, a change in the price of one good also causes a change in the
demand for the other good, however, an increase in the price of motor vehicles causes a
reduction in the demand for fuel.

There is an increase in demand for herbal medicines because of the complexities of the H.I.V
A.I.D.S. scourge.

Population
An increase in population XE "population" creates a larger market for goods and
services, demand increases
and vice versa.

Price expectations XE "expectations"

 Expectations of future price increases in a commodity results in an increase in demand,
the
idea is to purchase a lot of goods at the current ‘low’ price and ‘beat’ future price
increases.

A change in demand is a shift in the whole demand curve either to the right or to the left,
indicating an increase or a decrease in demand respectively.

Price D2
D1 D

Quantity

In the diagram above, a decrease in demand shifts the demand curve to the left from DD to
D1D1 and an increase in demand would shift the demand curve to the right from DD to D2D2

2.0 SUPPLY

Supply must be differentiated from production, which is the total value of goods in stock.
Supply is the amounts of a good producer are willing and able to sell at a given price.

2.1 THE SUPPLY SCHEDULE

There is a positive relationship between the quantity supplied and price. The amounts that
producers or sellers are willing and able to sell at various prices at any given time tend to be
high at high prices, and low at low prices.

Below is Ms Chanda’s supply XE "supply" schedule in the month of November.

Price (K) Quantity supplied (units)

1 000 0
800 3
500 4
300 6
200 10
2.2 SUPPLY CURVE
When the data above is plotted into a line graph, a supply XE "supply" curve is produced.

Price S

Quantity

A ‘normal’ supply XE "supply" curve slopes upwards from left to right, an indication that at
high prices, supply is high, while at low prices, supply is also low. A change in price never
shifts the supply curve for any good, it results in a movement along a supply curve. This is a
change in the quantity supplied.

An increase in price from OP to OP1 results in an extension in supply XE "supply" from OQ to

OQ1. Alternatively, a reduction in price from OP1 to OP results in a contraction in the quantity
supplied from OQ1 to OQ.

Price

1
P
P
1
P P

0
Q Q1 Quantity Q1 Q

2.3 A CHANGE IN SUPPLY

The supply XE "supply" curve shifts only if there is a change in the conditions of supply
either than price. If supply conditions change, a different supply curve must be drawn, unlike a
change in the quantity supplied due to price changes,

The following are the main influences on supply XE "supply" :

Cost of production
A rise in costs generally decreases the amount of a commodity being supplied to the
market, since firms cannot continue in business for long if they are failing to cover the
costs of production. Low costs encourage production and therefore increases the supply
XE "supply" of goods and services.

Technological changes
Improvements in technology lead to more efficient production a method that reduce
production cost per unit and therefore increases supply XE "supply" . Obsolete
technological has the opposite effect.

Weather conditions
For agricultural goods, natural disasters like floods, droughts or favorable weather
conditions can reduce or increase the supply XE "supply" respectively.

Prices of other goods

The goods can be either substitute goods XE "substitute goods" or those that are
jointly supplied.

Suppose it is easy to shift resources into the production of other goods, then an increase in the
producer price of one maize would lead to an increase in the production and supply XE
"supply" of maize, and a decrease in the production and supply of groundnuts.

An increase in the price of a good such as beef, would lead to an increase in its supply XE
"supply" . In addition, the supply of leather would also increase.

Government policy, such as taxes and subsidies XE "subsidies"

Taxes are treated as costs, subsidies XE "subsidies" are benefits to a firm. An increase
in taxes reduces supply XE "supply" , while a reduction in taxes tends to increase the
supply.

A subsidy is when the government pays part of the costs in order to encourage the
production of goods. Increased production increases supply XE "supply" .

Other factors
Industrial and political unrest in the form of work stoppage, strikes, fire, wars, riots etc,
can lead to a reduction in supply XE "supply" .

A change in supply XE "supply" is a shift in the whole supply curve either to the right or to
the left, an
indication of an increase or a decrease in supply respectively.
In the diagram below, a decrease in supply XE "supply" shifts the supply curve to the left
from SS to S1S1 and an increase in supply shifts the supply curve to the right from SS to
S2S2.
 Price S1
S
S2

S1
S
S2

Quantity

4.0 PRICE DETERMINATION

The equilibrium market price is the price at which consumers want to buy equals the price at
which producers want to sell.

Consumers and producers both act rationally. Consumers want to maximize their utility and
therefore want to purchase goods as cheaply as possible, while producers also act rationally
and aim at profit maximization, they charge high prices. The equilibrium market price therefore
is determined by the interaction of the market forces of demand and supply XE "supply" . The
point where the demand and supply curves intersect is the compromise price, both consumers
and producers are satisfied at this point.

Consumers are willing and able to purchase OQ quantities at price OP, while Producers are
also willing and able to supply XE "supply" OQ quantities at price OP, as shown in the
diagram below.

Price D S

S D

O
Q Quantity

At the equilibrium price, there are neither surpluses nor shortages. The price is stable unless
there are changes in either supply XE "supply" or demand conditions listed above under
there are changes in either supply XE "supply" or demand conditions listed above under
changes in demand and supply.

Note that the marginal utility of consumers varies, with some consumers willing and able to
pay for a product than the prevailing market price, since they are paying less, there is a
consumer surplus.
A producer surplus also arises when some suppliers are willing to sale at less than the
prevailing market price, since they are selling at a higher price there is a producer surplus.

Price

Consumer
surplus

Producer
surplus

Quantity

4.1 PRICE CHANGES

Shifts in the supply XE "supply" or demand curves will change the equilibrium price and
quantity traded.

If for example, there is a large increase in consumer’s income, the demand curve will shift to
the right from DD to D1D1 signifying an increase in the demand for goods and services. The
new equilibrium price is OP1 and the quantity traded also increases to OQ1.

Price D1
S
D

P1

D1
S
D
O Q Q1 Quantity
 D
O Q Q1 Quantity
4.2 DISEQUILIBRIUM IN THE MARKET

The market system is considered to be the best way of allocating scarce Economic resources,
because prices act as signals to producers. An increase in the price of product X, is a signal to
producers to transfer resources to the production of product X and vice versa.

The objective of maximizing profits provides the incentive for firms to respond to changes in
price.

The system is self-adjusting. If the price is above the equilibrium at OP1, there is excess supply
XE "supply" , surpluses. At this high price, producers are encouraged to supply more, but the
quantity demanded at this high price is less. This causes a downward pressure of cutting down
production to eliminate the surplus and reducing the price to encourage demand.

At prices below the equilibrium at OP2, there is excess demand, shortages. Producers supply
XE "supply" few quantities at low prices while more consumers are willing and able to
purchase products at low prices. Excess demand causes an upward pressure on price resulting
in a rise in price and output.

Price D S
Excess supply XE "supply"
P1

P
P2
Excess demand
S D

O
Q Quantity

4.3 GOVERNMENT INTERVENTION

Price regulation and government policy of taxation XE "taxation" and subsidy interfere with
the working of the free market system.

MAXIMUM PRICE (PRICE CEILING)

If the government thinks that the price determined by the market forces of supply XE "supply"
and demand for a product or service is high, the government might decide to set a maximum
price, that is the price should not go beyond the amount stipulated by the government.

Maximum prices are normally set to encourage the consumption XE "consumption" of goods
and services, considered to be essential, and therefore should be affordable to everyone.

This has the same effect as the price being below the equilibrium, at OP2 in the diagram above.
The result is excess demand, shortages. There is no self-adjustment as this is government
policy; queues, black markets and tie in sales become common whenever there are shortages.

The government may attempt to ration the few commodities, or subsidize consumers.

Price D S

S D

O
Q1 Q Q2
Quantity

Maximum price OM, at this price OQ, quantities are supplied while OQ2 quantities are
demanded, the result is a shortage.

MINIMUM PRICE (PRICE FLOOR)

This is set in order to protect producers. If the government feels that the price set by the market
forces of supply XE "supply" and demand is too low for producers to earn a decent standard
of living XE "standard of living" them a minimum price is set. This meaning that the goods
should not be sold below the amount stipulated by the government.

This has the same effect as the price being above the equilibrium at OP.

Price D S

D
O
Q1 Q Q2 Quantity

Minimum price is OM, quantity supplied is OQ2 while the quantity demanded at this high
price is only OQ1. The result is excess supply XE "supply" , surplus amounts that have to be
sold at low prices “dumped” in poor countries.
The surplus can also be stored away, but this is at a cost.

Government intervention in relation to taxation XE "taxation" and subsidy is explained in

detail in the next chapter.

5.0 CHAPTER SUMMARY

In a free market economy prices act as a means for consumers to signal to the market what they
wish to buy, and for producers where their scarce Economic would most profitably be utilized.
The price for any good or service is determined by the demand for and the supply XE "supply"
of that good or service.

Changes in demand or supply XE "supply" cause changes in the equilibrium price and
quantity
Government intervention, such as the setting of maximum and minimum prices, as well as
taxation XE "taxation" and subsidy also disturbs the equilibrium price and quantity.

If maximum prices are imposed, there are shortages or excess demand, and if minimum prices
are imposed, there are surpluses or excess supply XE "supply" .

Indirect taxes lead to an increase in price, while subsidies XE "subsidies" cause prices to
reduce.

REVIEW QUESTIONS

Describe the shape of a typical demand curve

What is the difference between a shift in demand and an expansion of demand?
If a cabinet minister urged people in Zambia to cut down on the high cost of living
by buying only ‘cheap’ products, is that Economically sound?
How does a consumer surplus arise?
List some factors which can cause a change in supply XE "supply"
What are substitute and complementary goods? Give two examples of each.
What is the shape of a typical supply XE "supply" curve?
When the price of a good is set above the equilibrium price, what is the result?

Illustrating graphically and specifying the assumptions upon which your reasoning is based,
describe briefly
The effect on the price and output of fresh maize of adverse weather conditions.
The effects on the price and output of oranges of an increase in consumer’s income.

---------------------------------------------------------------------------------------

EXAM TYPE QUESTION 2.1

Explain the difference between ‘a change in supply XE "supply" ’ and a ‘change in the quantity
supplied’
(12marks)

Zim Police warns dubious traders.

HARARE–“The Zimbabwean police warned last Monday unscrupulous traders selling

commodities at above the government stipulated prices that they risked being arrested if
caught doing the unlawful act.

Police spokesperson Inspector, Cecilia Churu, said that police would not hesitate to arrest
 any retailer caught flouting the gazetted price.

The warning comes in the wake of unjustified price increases of Mealie Meal in the past
two weeks by millers without the approval of the government.”
th
Zambia Daily Mail, 24 July,
2003.

You are required to:

Explain, with the aid of a diagram, the effect of this form of government intervention on the
price mechanism.
( 8
Marks)

(Total: 20 marks)

CHAPTER 3

ELASTICITY
__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Explain why demand or supply XE "supply" may not change in spite of price changes
Explain and measure the price elasticity of demand and supply XE "supply" .
Explain the determinants of price elasticity of demand and supply XE "supply" .
Assess the relationship between price elasticity of demand and total revenue XE "revenue"
Explain why demand may change when income changes.
Explain why demand for one product changes when there is a change in the price of
another product
Appreciate the use of elasticity in pricing of goods, taxation XE "taxation" and subsidy of
certain goods
___________________________________________________________________________
____

1.0 INTRODUCTION

The law of demand states that an increase in price causes a decrease in the quantity demanded,
while a decrease in price causes an increase in the quantity demanded.
Elasticity XE "Elasticity" measures the degree of responsiveness or sensitivity of demand to a
change in price.

If a small change in price causes a big change in the quantity demanded then demand is elastic.
However, if a big change in price causes only a small change in the quantity demanded, then it
is inelastic.

2.0 PRICE ELASTICITY OF DEMAND (PED)

It is measured by the formula: % change in quantity demanded

% change in price

There is an inverse relationship between price and quantity, as such the sign is negative.
Note that the sign is always ignored when interpreting the elasticity value.

2.1 CATEGORIES OF PRICE ELASTICITY OF DEMAND

There are five categories of PED, namely:-

Perfectly or completely inelastic demand

When a change in price has no effect at all on the quantity demanded, PED when measured is
equal to zero. This is an extreme situation, the closest it can be liked to is medicines.
Consumers purchase exactly the same quantities whatever the price is, whether it is high at OP
or low at OP1, the quantity remains OQ.

Price D

P1

O
Q Quantity

Inelastic demand

This is when elastic is relatively or fairly inelastic, a big change in price results in only a small
change in the quantity demanded and the conclusion is that demand is inelastic. Price changes
by a big margin, from OP to OP1, but the demand reduces by a very small amount, from OQ
to OQ1. PED when measured is greater than zero, but less than one.

Inelastic demand applies to necessities such as mealie meal, sugar, salt, and addictive products
such as cigarettes, beer, drugs.
Price
D
 P1

D
O Q1 Q Quantity

Unitary elasticity XE "Unitary elasticity" of demand

This is a hypothetical scenario, based on the assumption that if price changes by a certain
percentage, then the quantity demanded should also change by exactly the same percentage.
When measured, elasticity is equal to one exactly.

Price D

P1

D
O Q1 Q Quantity

Perfectly or completely elastic demand

This is another theoretical structure, it is important because a perfectly competitive market

structure model is based on it.

At the compromise price of OP, demand is infinite, but a small change in price would cause
demand to reduce to zero.

PRICE

P D
 QUANTITY
Elastic demand

Demand is relatively or fairly elastic when a small change in price results in a big change in the
quantity demanded, a sign that consumers are able to respond to changes in prices.

Therefore goods and services that can easily be substituted, those that are mere luxuries and are
expensive (normal) goods are the ones which have an elastic demand.

When measured, the value would be greater than one but less than infinity.

Price
D

P1
P
D

O Q1 Q Quantity

2.2 CALCULATING PRICE ELASTICITY OF DEMAND

The calculation is done in two ways

(a) Point Elasticity XE "Elasticity" of Demand

Under point elasticity, the elasticity is calculated at a certain point on the demand curve.

Example1
The price of a product was K4000 and the annual demand was 2000 units when the price was
reduced to k3000, the annual demand increased to 4000 units.

Calculate the price elasticity of demand for the price changes given.

PED Formula = % change in quantity demanded = Q2 - Q1 ÷ P2 –P1

% change in price Q1 P1

= Q 2 - Q1 × P1
 Q1 P2 –P1

where Q2 = 4000
Q1 = 2000
P2 = 3000

P1 = 4000
= 4000 – 2000 x 100
2000
___________________
3000 – 4000 x 100
4000

= 2000 x 4000 = -4_

2000 -1000 Demand is elastic

Example 2

The price of a commodity was initially K10, 000 and 150 units were bought per day. When the
price fell to K5, 000 the units being bought increased to 200 per day. What is the price elasticity
of demand for the price changes given?

PED Formula = % change in quantity demanded = Q2 - Q1 ÷ P2 –P1

% change in price Q P1
1

= Q 2 - Q 1 × P1
Q1 P2 –P1

where Q2 = 200
Q1 = 150
P2 = 5000
P1 = 10000

200 - 150 x 100 50

150 150
= _____ = 50 x 10 000 = 10
150 -5 000
-15

5 000 – 10 000 x 100 -5000

 10,000 10000

= -2 = - 0.67
3
Demand is inelastic

Example 3

From the following data

Price quantity bought

(K’000) ( units)
1.75 125
2.0 100

Calculate PED

At price K1.75
% Change in quantity 25 x 100 = 20%
125

% Change in Price -0.25 x 100 = -14.2857%

1.75

PED Formula = % change in quantity demanded

% change in price

= 20% = -1.4 Demand is elastic

-14.2857%

(b) Arc elasticity of demand XE "Arc elasticity of demand"

The elasticity is calculated over a range of values or an arc.

Example 1
The annual demand for a product is 1,800,000 at K2, 600 per unit and demand reduces to
1,500,000 when the price increases to K3, 000 per unit. What is the elasticity of demand over
this price range?

PED Formula = Percentage change in quantity demanded

Percentage change in price

Q2 - Q1 x 100 Where Q2 = 1 800 00

Q 1 + Q2 Q1 = 150 0000

___ 2______________ P2 = 2600

___ _______________________ P1 = 3000

P2 - P1 x 100
P 1 + P2
2

18 00000 – 15 00 000 x100

1500000 + 18 00 000

2 600 – 3 000

3 000 +2 600 x 100

2

300,000
1650 000

= 300,000 x 2800 = -1.27

-400 1650 000 -400 demand is elastic
2800

Example 2
From the following data

Price Quantity bought

K’000 000 units
10 15
5 20

Calculate PED

Change in quantity -5 x 100 = -28.57%

17.5

Change in price -5 x 100 = 66.67%

7.5

PED = -28.57% = - 0.43

66.67% demand is inelastic

2.3 PRICE ELASTICITY ALONG THE DEMAND CURVE

The five categories of price elasticity of demand can be shown on one demand curve. Demand
curves generally slope downwards from left to right, and elasticity varies along the length of a
demand curve. The ranges of price elasticity of demand at different points along a demand
curve are illustrated below.

Price PED = ∞

PED>1

PED = 1 (mid-point of the line)

PED<1

PED = 0
Quantity
0

Along the top half of the line, PED is greater than 1. We say that demand is elastic. Along the
bottom half of the line, PED is less than 1 and we say that demand is inelastic. Exactly halfway
along the line, PED = 1; demand is of ‘unitary elasticity’.

The arithmetic accuracy can be examined by studying the demand schedule for beans shown
below:

Price Quantity
(K’000) (kilograms)

10 0
9 10
8 20
7 30
6 40
5 50
4 60
3 70
2 80
1 90
0 100
If the price is lowered from 8 to 7, PED is 10/20 ÷ 1/8 = 10/20 x 8/1 = 4.
Demand is therefore, elastic.

If price is lowered from 4 to 3, PED is 10/60 ÷ ¼ = 10/60 x 4/1 = 2/3 = 0.66.

Demand is therefore, inelastic

At higher price ranges, demand is elastic. At lower price ranges, demand is inelastic.

At the point where demand is changing from elastic to inelastic demand, demand is unitary. If
price is lowered from 5 to 4, PED is 10/50 ÷ 1/5 = 10/50 x 5/1 = 1.

Note that it is wrongly assumed that when calculating elasticity values, either an increase or a
decrease in price calculations, given the same values, have the same elasticity coefficient. It is
also wrongly assumed that two demand curves with the same shape will have the same
elasticity coefficient, and yet the slope and position of the demand curve determine the
numerical value of elasticity. In general, a big change in price causes only a small change in
the quantity demanded, resulting in an inelastic demand curve if the demand curve is steep,
further from the origin, and vice versa.

2. 4 POSITIVE PRICE ELASTICITIES OF DEMAND OR EXCEPTIONAL

DEMANDCURVES

If the quantity demanded of certain goods falls as an individual’s income reduces, then the
goods are said to be inferior goods XE "inferior goods" . It is assumed that a person
substitutes better quality alternatives, for example substituting a black and white television for a
colour, flat plasma television set, from buying mixed cut beef to a high quality expensive steak.

The quantity demanded for a good may also increase when the price increases if the product is
a status maxi miser! Ostentatious goods such as gold and diamond jewels, private jets, etc.,
are more desirable to some consumers when the price is high, when the price falls, the products
become common and are no longer desirable to those people.

If consumers anticipate future price increases whenever the price of a product increases, they
are likely to buy more to ‘beat’ inflation in the short term.

2.5 FACTORS DETERMINING PRICE ELASTICITY OF DEMAND

Elasticity XE "Elasticity" of demand depends on the consumer’s ability to increase or reduce

the quantities being purchased when there is a change in price. This depends on the following:

Availability of substitutes
Substitutes have a very big impact on elasticity, if there are close substitutes available,
then an increase in the price of a good, will enable consumers to react, and demand will
be elastic. However, the demand for a unique product is likely to have an inelastic
demand.

Income
This is when a commodity constitutes a small proportion of an individual’s income, a
cheap product such as a razor blade, a rubber and pencil or a box of matches, items
costing K100 or so would still be affordable even if there is a 100% percent increase in
price. In contrast, the demand for luxurious expensive products is likely to be elastic. A
10% increase in the price of a product costing K2 million would make consumers
responsive to changes in demand.

Necessities
The demand for commodities such as mealie meal, salt, sugar, milk etc is likely to be
stable and inelastic.

Additive or habit forming products

Consumers who are addicted to products such as beer, cigarettes, drugs etc feel that
they cannot function properly without them. To them, the products are ‘necessities’, and
therefore their demand is stable and inelastic.

Time period
It takes time to adapt to changes in price. Consumers are likely to cling to a certain
lifestyle until reality sets in and they are forced to adjust their spending habits. As such
demand is more likely to be elastic in the long run XE "long run" rather than in the
short run XE "short run" .

3.0 PRICE ELASTICITY OF SUPPLY XE "PRICE ELASTICITY OF

SUPPLY" (PES)

Price elasticity of supply XE "supply" is analogous to price elasticity of demand, it measures

the responsiveness of supply to changes in price. That is the extent to which producers increase
production and therefore the quantity which they take to the market as a result of a rise in price.
PES is measured by the formula: % change in quantity supplied
% Change in price

There is a direct relationship between price and quantity supplied.

3.1 CATEGORIES OF PRICE ELASTICITY OF SUPPLY XE "PRICE ELASTICITY

OF SUPPLY"

As with elasticity of demand, there are five categories of elasticity of supply XE "supply" .

Perfectly or completely inelastic supply XE "supply"

A change in price has no effect at all on the quantity supplied to the market. The same quantity
is supplied regardless of a price change, from 0P to 0P1 or vice versa.

Elasticity XE "Elasticity" is equal to zero.

Price S

P1

O Q Quantity

Inelastic supply XE "supply"

This is when elastic is relatively or fairly inelastic, a big change in price results in only a small
change in the quantity supplied. A large increase in price results in only a small increase in the
quantity produced and therefore supplied to the market. The conclusion is that supply XE
"supply" is inelastic. Price changes by a big margin, from OP to OP1, but supply increases by
a very small amount, from OQ to OQ1. PES when measured is greater than zero, but less than
one.
 Price S

P1

O Q Q1 Quantity

Unitary elasticity XE "Unitary elasticity" of supply XE "supply"

This is a hypothetical; it is based on the assumption that if price changes by a certain

percentage, then the quantity supplied should also change by exactly the same percentage.
When measured, elasticity is equal to one exactly.
Price S

P1

O Q Q1 Quantity

Perfectly or completely elastic supply

This is another theoretical structure. At price OP, supply XE "supply" is infinite, producer will
supply any amount, but a small change (reduction) in price would cause supply to reduce to
zero. Absolutely nothing is supplied to the market even at the smallest decrease in price
Price

P S

O Quantity

Elastic supply XE "supply"

Supply is relatively or fairly elastic when a small change in price results in a big change in the
quantity supplied, a sign that producers are able to respond to changes in prices. A small
increase in price is able to induce a large increase in the quantity produced and supplied to the
market and vice versa.

When measured, the value would be greater than one but less than infinity.

Price

S
P1
P
S

O Q1 Q1 Quantity

3.2 FACTORS INFLUENCING PRICE ELASTICITY OF SUPPLY XE "PRICE

ELASTICITY OF SUPPLY"

Elasticity XE "Elasticity" of supply XE "supply" depends on the producer’s ability to increase

or reduce the quantities being supplied to the market when there is a change in price. This
depends on the following:

Time period
This is one of the major factors affecting PES. Supply is likely to be more inelastic in
the short run XE "short run" than in the long run XE "long run" generally because
existing stock levels may be low, or it may take some time for producers to purchase
more capital XE "capital" equipment in order to increase production, if they are already
operating at full capacity.

Availability of factors of production XE "factors of production"

In order to respond to an increase in price, a firm should consider the existing stock
 levels, do they have enough to increase supply XE "supply" ? What is the shelf life of
what is in stock, etc? Are the necessary raw materials and labour XE "labour" easily
available in order to increase production? What about the existence of other factors of
production XE "factors of production" like fixed capital XE "capital" equipment if the
firm is already operating at full capacity?

Number of firms and entry barriers can also affect the price elasticity of supply XE "supply" .

4.0.0 THE SIGNIFICANCE OF PRICE ELASTICITY

4.0.1. WHEN DEMAND OR SUPPLY CHANGES

In the previous chapter, the explanation on why prices change is given as due to a change in
either supply XE "supply" or demand conditions. In practice, while any change in demand or
supply alters the equilibrium price and output, the effects will vary due to the differences in the
elasticities involved!
If demand is inelastic, a shift in supply XE "supply" will cause a large change in the price but
only a small change in the quantity traded, and vice versa.

a) INELASTIC DEMAND

S
Price
S1

P D

P1 D1

0 Q Q1 Quantity

b) ELASTIC DEMAND
S
Price
S1

P D
P1 D1
 0 Q Q1 Quantity

In the same general way, the effects of a shift in demand depend on the elasticities of the supply
XE "supply" involved. Where supply is inelastic, a shift in demand causes a large change in
the equilibrium price but only a small change in the equilibrium output, and vice versa.

a) INELASTIC SUPPLY b) ELASTIC SUPPLY

Price D1 Price D1

D D
P1 P1
P
P

0 Q Q1 Quantity 0 Q Q1 Quantity

In extreme cases, where demand or supply XE "supply" is perfectly inelastic or elastic, a

change in supply or demand does not change the equilibrium position at all.

a) PERFECTLY INELASTIC DEMAND b) PERFECTLY ELASTIC SUPPLY

Price
S1 Price
D1
D
P1 S

0 Q Quantity 0 Q Q 1 Quantity

Under a), a change in supply XE "supply" causes the equilibrium price to change but the
equilibrium output does not change. Under b) a change in demand causes the equilibrium
output to change but the price does not change.

Note that an understanding of this first section is very crucial as sections 2, 3 and 4
below are more or less a repetition and an extension of this concept.

4.0.2. WHEN THERE IS A CHANGE IN TOTAL REVENUE

The calculation of PED is very useful to the business community, as well as the amount being
spent by consumers. If the demand for a good is elastic, then a reduction in price increases
total revenue XE "revenue" , and the total amount being spent by consumers. A business
selling products that are very competitive on the market, those with close substitutes, luxuries
etc., can advertise small reductions in prices and discounts in order to woo customers and
increase the company’s total revenue XE "revenue" .

Price

P D
P1 D1

0 Q Q1 Quantity

Total revenue XE "revenue" is price x quantity, the price reduction results in a more than
proportionate increase in the quantity demanded, this offsets the price reduction. Area 0PDQ is
‘given up’, while area 0P1D1Q1 is what is ‘gained’ when the price is reduced, total revenue
increases.

Alternatively, if total revenue XE "revenue" falls after a price rise then demand is elastic.

If the demand for a good is inelastic, then an increase in price increases total revenue XE
"revenue" . A business selling products that are necessities and addictive products like beer and
cigarettes, can afford to increase prices, and the reduction in the quantity demanded is
negligible, as shown below.
Area 0P1D1Q1 is ‘given up’, while area 0PDQ is what is ‘gained’ when the price is increased,
therefore, total revenue XE "revenue" increases.

Price

D
P

P1 D1
 0 Q Q1 Quantity

Alternatively, if total revenue XE "revenue" falls after a price cut then demand is inelastic.

If total revenue XE "revenue" or total expenditure by households remains unchanged whether

there is an increase or reduction in price, then the elasticity of demand is unitary. The areas
are equal!

Price

D
P

P1 D1

0 Q Q1 Quantity

4.0..3 WHEN AN INDIRECT TAX IS IMPOSED ON A PRODUCT

Imposing an indirect tax on a product is a form of government intervention, like the setting of
maximum and minimum prices. An indirect tax is a tax on expenditure. Such taxes reduce
output, maybe harmful to the domestic industry if it is in a competitive environment and some
foreign firms are not subject to the same tax. Taxes however, can assist in the allocation of
resources when there is a lot of pollution and only polluters are pay through heavy taxes.

The significance of elasticity is in determining how the burden of the tax is to be shared
between the producer and the consumer.

Suppose, a product has unitary elasticities of demand and supply XE "supply" , the market
forces determine the equilibrium price and output. Following the imposition of a tax, some
producers transfer their resources to another product, as this one would be deemed unattractive.
Supply reduces, and the supply curve shifts to the left, to S1. The price paid by consumer’s
increases to P1, but the net amount received by the producer is lower than previously, since he
must pay to the government part of the earning and there is a reduction in output to Q1, due to
the tax.

Price D S1
 S
P1

P2

0 Q1 Q Quantity
In the diagram above, the burden of the tax is shared equally between the producer and the
consumer.

In practice, such an equal distribution of the tax burden is unlikely. The burden of the tax
depends on the elasticities of demand and supply XE "supply" involved! If the demand for a
good is inelastic, a firm producing necessities and addictive products like beer and cigarettes
can afford to pass the major burden of the tax on to consumers, price increases to P1 from P.
Producers bear a small portion of the burden, return falls toP2.

a) INELASTIC DEMAND

S
Price
S1

P1

P2

0 Q Q1 Quantity

b) ELASTIC DEMAND
S
Price
S1

P1
P

P2
 0 Q Q1 Quantity

If the demand for a good is elastic, then a firm dealing in products that are competitive on the
market by having close substitutes, luxuries etc., the burden of the tax is borne mainly by
producers. The price paid by consumers rises slightly to P1, the return received by suppliers
falls by a big margin, to P2.

INELASTIC SUPPLY

S1
Price S

P1
P

P2

0 Q Q1 Quantity

The conclusion as to how the burden is shared is self explanatory from the diagram, the price
paid by consumers rises slightly to P1, the return received by suppliers falls by a big margin, to
P2.

4.0.4 WHEN A SUBSIDY IS GIVEN

A subsidy is the exact opposite of an indirect tax. It is another form of government

intervention, it is when the government makes a payment to producers, and it can bring about
artificially low prices.

Suppose, a product has unitary elasticities of demand and supply XE "supply" , the market
forces determine the equilibrium price and output. When a subsidy is given, production is
encouraged. Supply increases, and the supply curve shifts to the right, to S1. The price paid by
consumers reduces to P2, and this is a benefit to them. There is an increase in output to Q1, and
the amount received by the producer increases.

Price D S
 S1
P1

P2

0 Q Q1 Quantity

The significance of elasticity is in determining how the benefit of the subsidy is to shared
between the producer and the consumer, the benefit will fall more on the consumers if the
product has an inelastic demand and vice versa.

5.0 OTHER ELASTICITY MEASURES

5.1 INCOME ELASTICITY OF DEMAND XE "INCOME ELASTICITY OF

DEMAND" (YED)

The elasticity measures are alike, the definition of income elasticity of demand is similar to that
of price elasticity of demand, but price is replaced by income.

Income elasticity of demand measures the degree of responsiveness or sensitivity of demand to

changes in income.

The formula = percentage change in quantity demanded

percentage change in income

5.2 Categories of income elasticity of demand

Positive Income Elasticity XE "Elasticity"

This is when an increase in income leads to an increase in demand, YED > 0. It applies to
‘normal’ goods such as colour television sets, motor vehicles etc. Most goods have a positive
income elasticity of demand.

Quantity

Income

Negative Income Elasticity XE "Elasticity"

For some goods, an increase in income causes a reduction in demand, YED < 0. Inferior
goods, such as black and white television set, have a negative income elasticity of demand.
 Quantity

Income

Zero income Elasticity XE "Elasticity"

A change in income may have no effect on the quantity demanded, demand remains the same,
YED = 0. Consumers purchase only what they require, this applies to Giffen goods XE
"Giffen goods" , ‘necessities’ like mealie meal, potatoes etc. Note that with Giffen goods, less
is demanded when price falls because the negative income effect XE "income effect"
overcomes the positive substitution effect XE "substitution effect" .

Quantity

Income

5.3 Factors affecting income elasticity of demand

The size of income elasticity of demand depends on the current standard of living XE "standard
of living" . For example, the developed countries have a high standard of living, so that when
income expands, sales of consumer durables such as washing machines and cars will rise; sales
of basic commodities (Food, etc) are unlikely to respond significantly to the rise in income
(zero income elasticity). In contrast, developing economies such as Zambia, when income rises,
the income elasticity of demand for basic goods will be higher as a large percentage of the
population XE "population" is unable to afford basic commodities at its current level of
income.

5.4 Practical uses of income elasticity of demand

Producers may wish to know the income elasticity of demand for their product, it has an effect
on their businesses. The planned future production may depend on whether incomes are rising
or falling. Income increases during Economic prosperity (Economic boom), businesses sell
normal goods XE "normal goods" . While during a recession, basic inferior goods XE "inferior
goods" are more profitable.
6.0 CROSS ELASTICITY OF DEMAND XE "CROSS ELASTICITY OF
DEMAND"
Cross elasticity of demand measures the sensitivity of demand for one good to changes in the
price of another good. The formula for cross elasticity of demand (XED) is given below.

The formula for cross elasticity of demand

XED =percentage change in quantity demanded of Good A

percentage change in price of Good B

6.1 Categories of cross elasticity of demand

Positive cross elasticity of demand

The XED between butter and margarine is positive, this is because butter and margarine are
substitutes. When the price of butter goes up, demand for margarine rises and demand for
butter falls. In other words, the price of margarine and demand for butter move in the same
direction, therefore XED is positive.

Negative cross elasticity of demand

The XED between complements XE "complements" (goods that are jointly demanded) is
negative. Consider cars and fuel, if the price of cars increases, demand for fuel would fall. Cars
and fuel are complementary goods, so demand for cars is also likely to fall. The price of cars
and demand for fuel move in opposite directions, so the XED of complements is negative.
Zero cross elasticity of demand

This applies to unrelated goods. A change in the price of one good has no effect on the quantity
demanded of the other good.

7.0 CHAPTER SUMMARY

Price elasticity of demand and supply XE "supply" measure how much the quantity demanded
and supplied responds to changes in price.

PED/PES are calculated as the percentage change in quantity demanded/supplied divided by the
percentage change in price.

PED/PES are very important in determining the effects of changes in demand and supply XE
"supply" , increases and reductions in total revenue XE "revenue" given changes in the prices
of goods and services. In addition, PED/PES are important in determining the effects of
changes in government policy such as taxation XE "taxation" and subsidies XE "subsidies" .

If total revenue XE "revenue" increases following a price cut, then demand is elastic. If total
revenue falls after a price cut, then demand is inelastic, and vice versa. If total revenue remains
unchanged, then demand is unitary.

There are a number of factors, which determine the ability of consumers and producers to
respond to changes in price, such as the availability of substitutes, whether a product is a
necessity or it is addictive, as well as the income of consumers.

In most markets, supply XE "supply" is more elastic in the long run XE "long run" than in the
short run XE "short run" , it takes time to transfer resources following a price rise, it also
depends on the availability of factors of production XE "factors of production" especially raw
materials and labour XE "labour" , as well as the ease of entry of new firms into the market.

Income elasticity of demand measures how much the quantity demanded responds to changes
in income.

Cross-elasticity of demand measures how the quantity demanded of one good responds to
changes in the price of another good.
REVIEW QUESTIONS

What is the price elasticity of demand?

The price of a good falls by K10, 000, but the quantity demanded increases from 100 to 120
units. Calculate the price elasticity of demand?
List any four factors, which influence price elasticity of demand.
What is an inferior good?
Demand is said to be……, when the price of a good rises, the quantity demanded falls and the
total expenditure on the good decreases.
How would you classify a good with a positive income elasticity of demand?
How would you classify goods with a negative cross-elasticity of demand?
List the commodities that has a positive price elasticity of demand
Draw a perfectly or completely elastic supply XE "supply" curve.
Show how the burden of a tax will be shared between the producer and the consumer when
demand for a product is perfectly elastic.

EXAMINATION TYPE QUESTIONS 3.1

The following table is a demand schedule for a particular commodity, between which price
range is demand elastic? Explain your answer. Hint: At least three calculations, a reduction
from K8, 000 to K7, 000, K5, 000 to K4, 000 and from K4, 000 to K3, 000.

Price (K’000s) Quantity Demanded

10 0
9 10
8 20
7 30
6 40
5 50
4 60
3 70
2 80
1 90
0 100

(10 Marks)

What do you understand by the term “income elasticity of demand” (6 Marks)

Why should a firm pursuing long term growth XE "growth" be interested in the income
elasticity of demand of its products? (4 Marks)

(Total: 20 Marks)
CHAPTER 4

PRODUCTION AND COSTS

__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Differentiate legal forms of business units, the advantages and disadvantages of each
Name the three classes of production
Explain how production costs are determined
Discuss Division of labour XE "labour" , its merits and demerits
Explain the differences between fixed, variable and marginal costs XE "marginal costs"
Explain on the rewards of factors of production XE "factors of production"
___________________________________________________________________________
____

1.0 Introduction

Production takes place in firms. A firm is an independently administered business unit. In

practice, there are different types of firms, known as sole traders XE "sole traders" ,
partnerships XE "partnerships" etc.

1.1 Sole traders

Individuals who set up businesses of their own are sole traders XE "sole traders" . It can be
someone with a good business idea, an own invention or finding something to do after
restructuring or simply being his or her own boss after several years as someone else’s
employee.
An example of a sole trader is a corner shop, a fish trader, a marketeer etc.

Advantages

It requires little capital XE "capital" to set up.

Self-interest acts as an incentive to work.
Regular customers and suppliers are known.
Owner can make quick business decisions.

Disadvantages

It does not have a separate legal personality, if a person mortgages the house to raise capital XE
"capital" . If the business fails, then the house is lost.
Thus, there is unlimited liability.
Difficult to raise capital XE "capital" .
Holidays or illnesses cause problems.
Lack of continuity after the death of the owner.

1.2 Partnership

Business company owned by partners: a company set up by two or more people who put
money XE "money" into the business and share the financial risks and profits. An example of
a partnership is a firm of doctors, lawyers etc. The activities of partnerships XE "partnerships"
are regulated by a legal document, a partnership deed.

Most of the advantages and disadvantages of sole traders XE "sole traders" are transferred to
partnerships XE "partnerships" , as it is only slightly better than a sole trader. Partners
contribute the capital XE "capital" , and as owners, share the profits, they can specialize and
they have regular known customers.

However, partnerships XE "partnerships" also have unlimited liability, and one partner’s
mistake affects all partners. Lack of continuity if partners disagree, or if one partner dies.

1.3 Private limited Company

This is a company with limited stockholder liability, a registered company in which the
stockholders' liability for any debts or losses is restricted, regulated by the Companies Act.
Two or more shareholders own the company. An example is a small family firm. Shareholders
contribute capital XE "capital" of the company. Shares are not sold to the general public. Like
sole traders XE "sole traders" and partnerships XE "partnerships" , there is limited capital for
expansion, and therefore limited economies of scale.

The advantage of private limited companies XE "companies" is that if the company goes
bankrupt, owners have limited liability for the company’s debt. They only lose the capital XE
"capital" they have invested in the company, nothing more.

1.4 Public limited Company

Public limited companies XE "companies" identify themselves by putting the word ‘PLC’ after
their name. These are companies whose share can be bought and sold on the stock market,
unlike private limited companies, they are allowed to sell shares to the general public.
Shareholders are subject to restricted liability for any debts or losses. An example is Chilanga
Cement PLC Large amounts of capital XE "capital" can be raised, as such they are usually
very large, enjoying economies of scale.

Professional managers normally run the companies XE "companies" , and the company can be
remote from customers and there are potential diseconomies of scale.

1.5 Co-operatives

These are formed when people join together to carry on an Economic activity for mutual
benefit. It is owned or managed jointly by those who use its facilities. An example is a
consumer cooperative, which is for the wholesale or retail distribution usually of agricultural
goods. Membership is open, and goods are sold to the general public as well as to its members.

The major disadvantage of cooperatives is lack of business or management experience by

members to carry out an Economic activity.

2.0 Industry- the three classes of production

Production is divided into three categories

Primary production XE "Primary production"

The producers of natural goods such as farmers, oil drillers, copper miners etc, are all
engaged in primary production.

Secondary production XE "Secondary production"

The producers of sophisticated goods, manufactured goods such as carpenters, tailors, car
manufacturers, are in secondary production.

Tertiary
These are providers of services like bankers, retailers, stockbrokers, accountants, teachers,
doctors and entertainers.

3.0 Specialisation

Specialization happens when one individual, region or country concentrates in making one
good.
Division of Labour

The division of labour XE "labour" is a particular type of specialization where the production
of a good is broken up into many separate tasks each performed by one person. An early
economist, Adam Smith, suggested that without any division of labour XE "division of labour"
and specialization, one worker could produce only ten pins in one day. However, in a pin
factory where each worker performs only one task, ten workers using the division of labour
principle, could produce a daily total of 48 000 pins. Output per person (productivity) can rise
from 10 to 4800 when the division of labour principle was used.

3.1 Advantages of the division of labour XE "labour"

The division of labour XE "labour" raises output, thereby reducing costs per unit, for the
following reasons:

Workers become more practiced at the task

Workers can be trained more precisely for the task
Specialization enables more efficient organization of production with a series of distinct
tasks

3.2 Disadvantages of the Division of Labour

Eventually the division of labour XE "labour" may reduce productivity and increase unit costs
of the following reasons:

Continually repeating a task may become monotonous and boring

Workers begin to take less pride in their work
If one machine breaks down then the entire factory stops.
Some workers receive a very narrow training and may not be able to find alternative
jobs.
Mass produced goods lack variety.

3.3 Limits to the Division of labour XE "labour"

Mass production requires mass demand.

The transport system must be good enough to reach a large number of consumers
(mass market)
Barter is the direct exchange of goods for other goods. Each worker creates only part of the
finished goods; -therefore the division of labour XE "labour" cannot be used in a barter
society.

4.0 COSTS OF PRODUCTION

It is important to first divide the costs of production into time period of short run XE "short
run" and long run XE "long run" costs, depending on variable or fixed factors of production
XE "factors of production" .

The short run XE "short run" is defined as a period when at least one factor of production is
in fixed supply XE "supply" , a combination of both variable and fixed factors. The short run
is the time period that is too brief for a firm to alter its plant capacity. The plant size is fixed in
the short run. Short run costs, then, are the wages, raw materials, etc., used for production in a
fixed plant.

A firm will undertake production in the short run XE "short run" , if the price at which their
product is sold is at least equal to the average variable cost of production. Therefore, a firm will
continue in business in the short run as long as it is able to cover the variable costs XE
"variable costs" of production.

The long run XE "long run" is a period when all factors of production XE "factors of
production" can be varied. All the factors of production are considered to be variable. The long
run is a time period long enough for a firm to change the quantities of all resources employed,
including the plant size. Long run costs XE "Long run costs" are all costs, including the cost
of varying the size of the production plant.

4.1 Total Costs

The amount spent of producing a given amount of a good by a firm is called total cost, TC, and
is found by adding together variable and fixed costs.

4.2 Variable Costs

Variable costs, VC, depend on how many (the output) goods are being made. If just one more
unit is made then total variable costs XE "variable costs" rise. Variables costs are costs that
vary with output. Examples include the following:-

Wages paid to casual workers

The cost of buying raw materials and components.
The cost of electricity and charcoal.

4.3 Fixed Costs

Fixed costs XE "Fixed costs" , FC, are independent of output. Fixed costs have to be paid out
even if the factory stops production. Fixed costs are costs that do not vary with output.
Examples include the following:

Monthly salaries paid to managers

Rent paid for the use of premises
Rates paid to the council
Any interest paid on loans
Depreciation, that is money XE "money" put aside to replace worn-out machines and vehicles
sometime in the future

The short run XE "short run" cost schedule of an individual firm shows the behaviour of costs
when output is varied. Table 1 below presents the cost structure of a hypothetical firm, to
illustrate the general principles covered under 4.1, 4.2 and 4.3, total costs remain the same at
different levels of output. The total costs are made up of fixed and variable costs XE "variable
costs" . The output and the costs are in thousand units and thousands of kwacha respectively.

Output Total fixed Total variable Total Costs

units costs costs

0 50 0 50
1 50 50 100
2 50 90 140
3 50 120 170
4 50 160 210
5 50 210 260
6 50 270 320
7 50 340 390
8 50 420 470
9 50 510 560
10 50 610 660

After plotting the above information, the following diagrams are obtained:

Costs TC
660

TVC

50 TFC

0 10 Output

4.4 Average cost, AC or average total cost (ATC) is the cost of producing one item, it is
 sometimes called per unit cost. It is calculated by dividing total costs by total output
(ATC = TC/Q).
Note: ATC also equals AFC + AVC.

4.5 Marginal cost, MC is the cost of producing one extra unit of output, and is calculated by
dividing the change in total costs by the change in output. Marginal decisions are very
important in determining profit levels. Marginal revenue XE "revenue" and marginal cost
are compared.

4.6 Average fixed cost is the total fixed cost divided by the level of output (TFC/Q). It will
decline as output rises.

Average variable cost is the total variable cost divided by the level of output
(AVC = TVC/Q).

Note that in Economics XE "Economics" , for practical purposes, the average cost data is used
more than the total aggregate figures. The table 2 below presents the cost structure of a
hypothetical firm, a continuation of table 1 above. It illustrates the general principles covered
under 4.4,4.5, 4.6 and 4.7

Output Average variable Average fixed Average total Marginal

units costs costs costs costs
0 - - - -
1 50 50 100 50
2 45 25 70 40
3 40 16.6 56.6 30
4 40 12.5 52.5 40
5 42 10 52 50
6 45 8.3 53.3 60
7 48.6 7.1 55.7 70
8 52.5 6.3 58.8 80
9 56.6 5.5 62.1 90
10 61 5 66 100

After plotting the above information, the following diagrams are obtained, where 1 is the
marginal cost curve, 2 is the average total cost curve, 3 is the average variable cost curve and 4
is the average fixed cost curve respectively.

4.8 Explicit costs are those costs that are clearly stated and recorded.

4.9 Implicit costs are those costs that are implied, unstated but understood as a necessary
component in the economist’s view. These are opportunity costs, benefits forgone by
 not using the factor of production in the next most profitable way.
This is important because it explains the difference in the calculation of profit
between the Accountant and the Economist.

Accounting profits are sales revenue XE "revenue" minus explicit costs of a business.

Economic profits consist of sales revenue XE "revenue" minus explicit and implicit costs!

For example, assuming that Mabvuto runs a business and sells goods worth K10 million, the
cost of sales is K4.5 million. If the premises used for the business could be put to alternative
use, it can earn a rent of K1million. The capital XE "capital" invested in the business could
have earned K1.5 million in interest if deposited in a bank. Suppose Mabvuto was employed
elsewhere, he would have been earning an income of K2.5 million. The accounting gross profit
and the Economic profit or loss earned is as follows:

Accounting profit K’M K’M

Sales 10
Less cost of sales 4.5
___
Gross Profit 5.5

Economic profit

Sales 10
Less cost of sales 4.5
___
Gross Profit 5.5

Less opportunity costs

Rent 1
Interest 1.5
Salary 2.5
Opportunity costs total 5.0

Economic profit 0.5

4.10 SHAPE OF THE SHORT RUN COST CURVES

Short run production reflects the law of diminishing returns that states, “as successive units of
a variable resource are added to a fixed resource, beyond some point the product attributable to
each additional resource unit will decline”.
The law of diminishing returns is explained as an essential concept for understanding average
and marginal cost curves. The general shape of each cost curve is a “U”.

The AFC and the AVC both influence the AC. As output increases, both the AVC and the
ATC curves will first slope downward and then slope upward due to diminishing returns. The
same volume of fixed costs are divided by increasing levels of output, therefore the AFC is
constantly decreasing.

Marginal cost is a reflection of marginal product and diminishing returns. When diminishing
returns begin, the marginal cost will begin its rise. The marginal cost is related to AVC and
ATC. It is the variable cost component in the total cost that changes as output levels increase.

These average costs XE "average costs" will fall as long as the marginal cost is less than either
average cost. As soon as the marginal cost rises above the average, the average will begin to
rise. The relationship between AC and MC is summarised as

At low levels of output, the MC curve lies below the AVC and the ATC curves
These curves will slope downward
At higher levels of output, the MC curve will rise above the AVC and the ATC curves
These curves will slope upward
As output increases, the average curves will first slope downward and then slope upward
Will have a “U” shape
The MC curve will intersect the minimum points of the AVC and the ATC curves.

5.0 FACTOR MARKETS

The four factors of production XE "factors of production" explained in chapter one, land XE
"land" , labour XE "labour" , capital XE "capital" and enterprise are used by firms in any
productive service that people perform. Each factor receives a reward.

Labour performs work and is paid by wages and salaries.

Capital is a man made resource, and the owners of capital XE "capital" receive interest.

Land consists of natural resources XE "natural resources" for which rent is paid.

Entrepreneurs establish business firms and receive profit.

The important question is ‘what determines the rate at which each factor is paid?’ In other
words, what determines the level of wages and salaries, rent, interest and profit? Factor
rewards are prices paid for each factor of production, and just like any price, it is determined
by the market forces of demand and supply XE "supply" .
The demand for factors of production XE "factors of production" differs from the demand for
consumer goods and services. The demand for factors is said to be a derived demand, the
demand is derived from the demand for the final product, which they help to produce. Factors
of production are not demanded for their own sake, but they are demanded because firms want
to produce consumer goods and services.
The market demand curve for a factor resembles that of a consumer good, a typical demand
curve slopes downwards from left to right. The higher the ‘price’ of a factor, the lower the
demand for it, and vice versa.

The demand for factors of production XE "factors of production" also introduces the
diminishing marginal productivity theory that is each additional unit of any factor employed
tends to add progressively less to total output (other factors being held constant).
An individual firm will increase its employment of any factor as long as the value of the extra
output achieved exceeds the additional cost involved.

The supply XE "supply" of a factor represents the different quantities that are offered at
various possible ‘prices’. For example the higher the wage rate, the higher the supply of labour
XE "labour" , and vice versa. Therefore, a typical supply curve for a factor resembles that of a
consumer good, it slopes upward from left to right.

A change in factor ‘prices’, such as wage rates, maybe due to changes in the demand and
supply XE "supply" conditions of labour XE "labour" , just like in the product market.

Note that the above is generalized, in practice, there are other factors that should be considered
in the factor market, including elasticity.

6.0 CHAPTER SUMMARY

There are various types of organizations in mixed Economic systems. Business organizations
are categorized as sole traders XE "sole traders" , partnerships XE "partnerships" , limited
companies XE "companies" and cooperatives.

The economy can be divided into primary, secondary and tertiary sectors.

A firm’s output decisions can be examined both in the short run XE "short run" , when at least
one factor of production is in fixed supply XE "supply" , or in the long run XE "long run" ,
when all factors of production XE "factors of production" are considered to be variable.

A firm’s total cost of production is made up of fixed and variable costs XE "variable costs" .

Average fixed cost declines as output increases, average variable costs XE "variable costs"
initially falls as output increases, then after a certain point, when diminishing returns set, the
average variable costs begin to rise.
When average fixed cost and average variable cost are added, the resulting average total costs
fall, and then rises as output increases.

The marginal costs XE "marginal costs" also falls briefly, then rises, cutting the average costs
XE "average costs" at their minimum points.

Economic costs are different from accounting costs. Economic costs include the opportunity
costs of factors of production XE "factors of production" that are used.

The factor market is similar to the market for goods and services. The demand for factors of
production XE "factors of production" is derived from the demand for the final goods and
services, which that factor helps to produce.

REVIEW QUESTIONS

1. What is the distinction between long run XE "long run" and short run XE "short run"
in Economics XE "Economics" ?
2. Distinguish between fixed costs and variable costs XE "variable costs" .
3. What costs should be covered in the long run XE "long run" ?
4. What is meant by the term marginal costs XE "marginal costs" ?
5. What is derived demand?
6. From the following cost schedule of a hypothetical firm:

Output Fixed costs XE "Fixed costs" Variable costs

(units) K’000 K’000

100 100 700

101 100 706
102 100 709
103 100 710

You are required to calculate

The total cost of production

The average total cost
The marginal cost

7. From the following cost schedule of a hypothetical firm:

Output Total costs

(units) K’000

20 270
 30 330
40 400
50 500
60 630
70 840

You are required to calculate

The average total cost

The marginal cost and to construct
The average total cost curve

-----------------------------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 4.1

(a) The table below is given as follows:-

Variable factor (in units) 1 2 3 4

Marginal physical product 6 10 15 12

You are required to calculate the:

(i) Total physical product (4 Marks)

(ii) Average physical product (4 Marks)

(b) Distinguish between fixed and variable costs XE "variable costs" , and give two
examples of each. (4 Marks)

c) Construct the following curves on one graph:

The marginal cost curve (2 Marks)

The average total cost curve (2 Marks)
The average variable cost curve (2 Marks)
The average fixed cost curve (2 Marks)

(TOTAL: 20 MARKS)
CHAPTER 5

LONG RUN COSTS

__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Explain how the shapes of the long run XE "long run" cost curves are determined
Draw long run XE "long run" and short run XE "short run" cost curves
Discuss internal and the external economies and diseconomies of scale
Appreciate small firms and their survival despite the advantages of large-scale production
Explain how the location of industries is determined
Explain the integration XE "integration" of firms to form large undertakings
Describe the revenue XE "revenue" structure of firms and the profit maximizing position
___________________________________________________________________________
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1.0 Introduction

The long run XE "long run" is when all factors of production XE "factors of production" are
variable, and as such all the costs must be covered. The firm is assumed to be a profit
maximiser. It can plan ahead on long run improvements, which involve changing factors of
production that are currently fixed. Therefore if a firm is to continue in business in the long
run, the price must at least equal average total cost of production.
In the long run XE "long run" , firms have combinations of factors of production XE "factors
of production" that result in low average costs XE "average costs" . The factors that cause
average costs to decline in the long run as output increases are known as economies of large-
scale production, commonly known as economies of scale.

The shape of the long run XE "long run" average cost (LRAC) curve however, depends on
whether

Output increases more in proportion to inputs, when there are economies of scale and
the LRAC decline to show increasing returns to scale.

Output increase in the same proportion as inputs indicating constant returns to scale.

Costs

Output

- The arrow is pointing to the minimum efficiency scale (MES), which is that level
of output on the LRAC curve at which average costs XE "average costs" first reach
their minimum
point. At output levels below this point, the firm will experience higher average
costs, otherwise, the LRAC remain unchanged at whatever the level of output, and
the curve is flat.

- Output increases less than in proportion to inputs, due to diseconomies of scale, LRAC
increases as output increases. As output continues to increase, most firms reach a point
where bigness begins to cause problems. When LRAC rise more than in proportion to
 output, there are diseconomies of scale, and the curve slopes upward.

The behaviour of LRAC can be summarised as:

Economies of scale (decreasing LRAC) at low levels of output

Constant returns to scale (constant LRAC) at intermediate levels of output
Diseconomies of scale XE "Diseconomies of scale" (increasing LRAC) at high levels of
output

Therefore, the LRAC curves are typically “U” shaped as shown below

Cost

Output

Economies Constant Diseconomies

of scale returns of scale
to scale

2.0 ECONOMIES OF SCALE

These indicate that as the output or plant size increases, the average costs XE "average costs"
per unit decreases or falls, they are reductions in long run XE "long run" average total costs
achieved when the whole scale of production is expanded.

Not all the factors are expanded proportionately with output. Average costs fall as output is
expanded, but not all fixed factors of production XE "factors of production" need to be
increased in line with output. This reduction in the long run XE "long run" average costs XE
"average costs" is due to economies of scale.

Economies of scale only occur in the long run XE "long run" , as they are associated with the
alteration of some or all of the firm’s fixed factors. The economies of scale are either internal
(within the firm) or external (originating outside the firm).

2.1 INTERNAL ECONOMIES

These are advantage that accrue within an organization because of large-scale production which
a firm a can plan to achieve directly by increasing the size of its output. The benefits accrue to
the individual firm, some of them include the following:

Financial Economies
When raising finance large firms, since they are household names, can easily borrow money
XE "money" from commercial banks and negotiate for lower interest rates XE "interest rates" .
In addition, they have more advantages because they offer better security to bankers than a
briefcase businessperson. Large firms can also raise new capital XE "capital" at a lower cost
through the issue of shares, company bonds or commercial paper.

Therefore, it is generally accepted that larger firms can raise funds more easily and cheaply than
small firms.

Technical Economies

The advantages of division of labour XE "labour" and specialization can be achieved, as the
plant grows in size and output increases, it becomes more possible for labour to undertake
more specialized activities. This increases efficiency and reduces costs per unit.

The firm can also buy specialized sophisticated machinery, this is utilized more efficiently if
operation is on a large scale. There is greater use of advanced machinery. Some machines are
worth using beyond a minimum level of output, which maybe beyond the capacity of a small
firm. For example the use of combine harvesters by commercial farmers, compared to its use
by small subsistence farmers with less than an acre of land XE "land" .

More resources are devoted to research and development XE "research and development"
because resources are borne over more units of output in large firms, this leads to further
technical improvements, more cost reductions.

Managerial Economies

The division of labour XE "labour" can be introduced into the task of management. The
function of management is divided into production, sales, finance etc. A large firm can afford to
hire specialists in different fields, which is an efficient use of labour resources.

Commercial or Trading Economies

The large firm achieves economies both in buying raw materials and other inputs, as well as in
selling finished products.

Favourable terms are granted to a large firm since it buys in bulk and may get discounts. It can
afford to employ specialist buyers.

The cost per unit of advertising XE "advertising" on television may be expensive for a small
firm, but far lower for a firm with a high output. Therefore, there are reduced costs per unit in
advertising, sales promotion and distribution.
Welfare

Large firms are in a position to increase production by improving the condition of service of
their employees through the provision of facilities such as transport, clinics, sport and other
recreation facilities.

2.2 EXTERNAL ECONOMIES

External economies are advantages of an increased scale possible to all firms in an industry.
They are influenced by the growth XE "growth" of the industry as a whole.

External economies occur when an industry is concentrated in one area, and the local economy
evolves around the industry. The industry is supplied with skilled labour XE "labour" force,
specialist suppliers etc. It is also associated with knowledge, new inventions and the discovery
of new markets.

External economies are made outside the firm as a result of its location and occur when:

A local skilled labour XE "labour" force is available

Specialist local back up firms can supply XE "supply" raw materials, component parts or
services. They supply to a large market and achieve their own economies of scale, which are
passed on through lower input prices.
An area has a good transport network
An area has an excellent reputation for producing a particular good
Firms in the industry may find a joint enterprise and share their research and development XE
"research and development" facilities, to lower the overhead costs.
As the industry grows in size, different firms within it specialize in different processes. A good
example of external economies of scale in Zambian is copper mining in the copper belt
province. A number of firms provide information, labour XE "labour" , machinery or
component parts that are required by the copper mining companies XE "companies" .

2.3 DISECONOMIES OF SCALE

These are problems of growth XE "growth" , unlimited expansion of scale of output may not
necessarily result in ever-decreasing costs per unit. There may be a point beyond which average
costs XE "average costs" begin to rise again.

Cost
 Output

Diseconomies of scale XE "Diseconomies of scale" can be categorized in the same way as

economies of scale.

2.4 INTERNAL DISECONOMIES XE "INTERNAL DISECONOMIES"

OF SCALE

Managerial diseconomies occur, as large firms are difficult to manage in relation to effective
control and coordination. The disadvantages of the division of labour XE "labour" , increasing
bureaucracy as the firm becomes too large and loss of control as management becomes
distanced from the shop floor.
Labour relations affected, workers cease to feel that they belong: moral and motivation fall.
As the firm increases in size management may become complacent since it is less vulnerable to
competition from other firms. These complacency leads to inefficiency termed “X” inefficiency.
Decisions are not taken quickly
Technical diseconomies occur, as the technical size of the plant may create large administrative
overheads.
Trading diseconomies, which is mass standardized production verses individualism.

2.5 EXTERNAL DISECONOMIES OF SCALE

As the firm and industry grows it may be hampered by shortage of various types, for example,

Local labour XE "labour" and raw materials become scarce and firms have to offer higher
wages to attract new workers or buy raw materials at high costs.

Land, factories become scarce, and rents begin to rise. Roads become congested and so
transport costs begin to rise.

Lack of markets for the firms’ out put.

3.0 SMALL FIRMS

It is difficult to classify firms as small or large. This generally depends on whether one is
residing in a developed or in a developing country. Generally, small firms are classified by size
relative to other firms, for example

25 employees or less is a small firm

A turnover of K1 000 000 or less
Assets like 3 vehicles or less
A relatively small market share, and so on.

Small firms are largely found in retailing, financial and services like consultancies.

The number of small firms is high because the number of people being self-employed is
growing due to retrenchments. In addition, there is no formal sector growth XE "growth" to
absorb the unemployed.

As the result, most governments have come up with a policy of advising and training people to
start small businesses.

Governments, mostly in developed countries, provide loans, loan guarantee schemes and
working capital XE "capital" as well as tax rebates.

Small firms compete with large firms and they owe their survival to the following:-

They can adapt to customer needs quickly.

They offer individualized service as opposed to mass production and standardized products.
There is personal involvement in the business by the owner.
Flexible approach and personal relationship with customers and employees in addition,
In addition, some products cannot be mass-produced, like spectacles, others have only a limited
demand for example custom made items, and some require little capital XE "capital" , like
window cleaning.

4.0 THE LOCATION OF INDUSTRY XE "LOCATION OF INDUSTRY"

A company will locate its factory and offices where it can achieve minimum costs and
maximum
profits.

Principle influences on the location of industries are:-

Nearness to raw materials especially where the raw materials are heavy and
bulky.
Accessibility to the markets
Nearness to the power supply XE "supply"
Government policy

5.0 INTEGRATION OR AMALGAMATION OF FIRMS

This may be horizontal, vertical or lateral.

5.1 Horizontal Integration

Horizontal integration XE "integration" occurs when firms that are producing the same type of
product, and are at the same stage of the production process, join together. An example is if
Kafue Textiles acquires or combines with Mulungushi Textiles.

The reasons for horizontal integration XE "integration" would be for firms to:

Obtain economies of scale

Increase market share
Fight off imports
Pool technology

5.2 Vertical Integration

This is the amalgamation of firms engaged in different stages of production, it may be towards
a source of raw materials, known as backward vertical integration XE "integration" , an
example is if Zambeef acquires a cattle ranch. Alternatively, it may be near to the market known
as forward vertical integration. An example is when an oil exploration company takes over an
oil marketing company like Total or British Petroleum.

Reasons for vertical integration XE "integration" :

- To eliminate transaction cost of middlemen

- To increase entry barriers for new competitors
- To secure raw material supplies
- To improve distribution network

5.3 Lateral Integration XE "Lateral Integration"

This occurs when firms increase the size of their products. Concentration on one product may
make a firm vulnerable, hence the need to diversify. A firm may be vulnerable to a change in
fashion, a ‘recession’ or a change in government policy.

Reasons for diversification XE "diversification" :

- To minimize risks
- To make use of expertise by seeking challenging situation
- To achieve economies of scale

6.0 DISTRIBUTION OF GOODS

An individual firm in most cases is only a single link in a larger supply XE "supply" chain and
distribution channel. A firm’s success depends on how well it performs as well as how well
its entire distribution channel competes with competitors’ channels.

Distribution of goods refer to the methods by which producers transfer goods and services
to consumers. A variety of functions are involved in distribution, including stock management
to ensure continuous production, transporting of goods to consumers, proximity to the local
market and knowledge of that market in order to pursuer economies of scale, as well as major
promotional campaigns and the display of goods for sale.

In setting up a channel of distribution, a producer has to take into account the following:-

The number of potential customers, their buying habits and their geographical location.
Product characteristics such as whether the product is perishable, and therefore speed of
delivery is essential, or whether the product is customized and has to be distributed directly etc.
The location, performance promotion, pricing policies and other characteristics of the
distributor.
The channel choice of competitors, which maybe exclusive.
The supplier’s own characteristics, for example, is the supplier a market leader, more
importantly, does the supplier have a strong financial base to operate own distribution channel?

6.1 WHOLESALING AND RETAILING

This consists of many organizations bringing goods and services from point of production to
point of use.

Wholesaling includes all the activities involved in selling goods or services to those who are
buying for the purpose of resale or for business use.

Wholesalers stock in a range of products from competing producers to sell to retailers. Many
wholesalers specialize in particular products and perform many functions such as selling,
promoting, warehousing, transporting, financing, supplying market information, providing
management services etc.

Retailing includes all the activities involved in selling goods or services directly to households
or final consumers for their personal non-business use. Retailers are traders operating outlets.
In practice, there are different types of retailers, the majority are classified as store retailers,
while others are non-store retailers, and this number is growing at a fast rate. A good example
in Zambia is street vending.
Store retailers are further classified as:-

- Self-service, limited service or full service, depending on the amount of service

they provide.
- Speciality stores, department stores, supermarket stores, convenience stores etc,
depending on the product line sold.
- Discount stores or price retailers, this depends on the relative prices.
- Corporate chains, retail cooperatives, merchandising conglomerates etc.,
depending on whether retailers have banded together in corporate and
contractual retail organizations.

6.2 DISTRIBUTION CHANNELS

Producers sometimes distribute goods directly to consumers, but in most cases, the
distribution is done indirectly through a wide range of intermediaries between the original
producer and the ultimate consumer. Each layer of intermediary that performs some work in
bringing the product and its ownership closer to the final consumer is a channel level. Both
the producer and the consumer perform some work and therefore, they are part of every
channel as shown below.

NUMBER OF INTERMEDIARIES/CHANNEL LEVELS

Zero One Two Three

Producers Producer Producers Producers

Agent

Wholesaler

Wholesaler
Retailer

Retailer Retailer
Consumer Consumer Consumer Consumer

Direct distribution
channel Indirect distribution channels

Note that in practice, there are other intermediaries, such as-

Distributors and dealers who contract to buy a producer’s goods and sell them to customers.
Distributors often promote the products and offer after sales service.
Agents sell goods on behalf of suppliers and earn a commission on their sales.
Franchisees are independent organizations, who trade under the name of a parent organization
in exchange for an initial fee and a share of the sales revenue XE "revenue" .

However, the two major channels of distribution are the retailers and the wholesalers.

7.0 TOTAL REVENUE (TR)

This is the money XE "money" the firm gets back from selling goods and is found by
multiplying the number sold, Q, by the selling price, P.

TR = (Q x P)

Average revenue XE "Average revenue" AR, is the amount received from selling one item
and equals the selling price of the good, the price per unit.

AR = TR
Q

Marginal Revenue MR is the change in total revenue XE "revenue" from the sale of one
more unit of output.

MR = ∆TR
∆Q

Profit
Firms are profit maximisers. Profit is calculated as the difference between total revenue XE
"revenue" and total costs.

P = TR - TC

It is private costs not social costs XE "social costs" that are taken into account. The private cost
to a motorist of driving from Chipata to Lusaka is the cost of petrol and oil and the wear and
tear on the car. However, other people have to put up with the externalities of the journey, for
instance the noise, smell, pollution and traffic congestion the motorist helps to cause along the
way.
Total revenue XE "revenue" and total cost both vary with output. Total revenue starts from
zero and increases gradually, then flattens out as output and sales increase.

Total costs do not start from zero due to the element of fixed costs, they accelerate and become
steep as output increases.

Profits are at a maximum where the vertical distance is greatest, as shown in the diagram
below.

Revenue TC
and
Costs
TR

Quantity

7.1 Profit maximising position

If MC is lower than MR, then profit increases by making and selling one more unit of output.

However, if MC is higher than MR, profits fall if one more unit is made or sold.
If MC is equal to MR, then the profit maximizing position has been reached, as shown below.

Profits are maximized where MC = MR.

AN IMPERFECT MARKET A PERFECT MARKET

MC Revenue MC
Revenue MR and
and Costs
Costs

MR

Quantity

Quantity
8.0 CHAPTER SUMMARY

As some firms expand, whether by mergers, diversification XE "diversification" or take-overs,

the firms enjoy economies of scale, whereby there is a reduction in average total costs as output
expands.

Economies of scale are of two types, internal and external.

Unfortunately, the growth XE "growth" is sometimes accompanied by problems of

diseconomies of scale, which are also of two types, internal and external diseconomies of scale.
This causes the average total cost to rise as output increases.

Small-scale production is equally important and continues to grow partly due to some
limitations on large-scale production.

Producers have to deliver goods and services to customers, this maybe done directly or
indirectly using a wide range of intermediaries such as agents, franchisees, dealers etc.
However, the two major channels of distribution are the wholesalers and the retailers.

Firms expand because of the desire to make more profits, enjoy the economies of scale etc. One
form of expansion is through amalgamation of firms, and this maybe vertical, horizontal or
lateral integration XE "integration" .

In Economics XE "Economics" , the stated objective of firms is profit maximization, and it is

attained where MR = MC.
8.1 Summary of equations

TC = VC + FC

VC = TC – FC

FC = TC – VC

AC = TC/Q

TR = P x Q

AR = TR/Q

MC = ∆TC/∆Q

MR = ∆TR/∆Q
Social Cost = Private costs + Externalities = Social Cost
(Cost to individual) + (Cost to other people) = (Cost to everyone)

REVIEW QUESTIONS

What is the difference between internal and external economies of scale?

Give a brief description of four categories of internal economies XE "internal economies" of
scale
Why might there be internal diseconomies of scale?
Give a brief description of two external economies of scale
What is the importance of the minimum efficiency scale?
Suggest three reasons for vertical integration XE "integration" .
How do small firms benefit an economy?
At what point is a firms’ profit maximized?
Why should the long run XE "long run" average cost curve for a business eventually rise?

------------------------------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 5.1

From the following data of a firm:

Output Total cost Price

0 40 9
10 70 8
20 100 7
30 140 6
40 180 5
50 200 4

i) You are required to calculate at each level of output

The firm’s total revenue XE "revenue" (3 marks)
The firm’s marginal revenue XE "marginal revenue" and average revenue XE "revenue" ( 3
marks)
The firm’s fixed costs (1 mark)
The firm’s marginal cost (3 marks)
The firm’s average cost (3 marks)
The firm’s profit levels (3 marks)

ii) State the type of market the firm is operating in

(1 mark)
iii) At what level of output will the firm aim to produce, state the reason.
(2 marks)
iv) State the relationship between average revenue XE "revenue" and price (1 mark)

(Total: 20 marks)

CHAPTER 6

MARKET STUCTURES: PERFECT COMPETITION XE "PERFECT

COMPETITION" AND MONOPOLY

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____

After studying this chapter, the students should be able to:

Explain what economists consider as perfectly competitive markets

Draw and explain a perfectly competitive market
Discuss the existence of one firm industries, a monopoly XE "monopoly" , the merits and
demerits
Draw a monopoly XE "monopoly" market structure
Explain how pricing and output policies are determined under perfect competition and
monopoly XE "monopoly"
Discuss the Economic assessment of normal and supernormal profits earned by firms
Describe price discrimination XE "price discrimination"
__________________________________________________________________________________________
_____

1.0 Markets

A “market” is not necessarily a geographical or physical location where people buy and sell like
at the city center market in Lusaka.

The modern usage of the word “market” is an exchange mechanism, an interpersonal institution
that brings together buyers and seller (both actual and potential) of particular products or
services.

Markets are classified according to number and size of buyers and sellers, the type of product
bought and sold, the degree of mobility of resources, and the extent to which information is
accessible.

1.1 Market Structures

Markets are categorized into either perfect or imperfect based primarily on the degree of
competition, the number of firms supplying or selling the product, whether the product bought
is homogeneous (identical) or differentiated and whether firms can easily enter or exit the
market.

The perfect market structure is composed of perfect competition, while the imperfect market
structure is made up of monopoly XE "monopoly" , monopolistic competition XE
"monopolistic competition" and oligopoly.

The continuum of market structures can be summarized as follows:

Very Perfect Very many firms in the

High competition market and a lot of product
is identical with no barriers
to entry.

Monopolistic Many firms in the market but

the product is not homogenous
However, there are no barriers
Degree of to entry.
competition

Oligopoly XE "Oligopoly" A few large firms, the capital XE

"capital"
required acts as a natural barrier to entry. The product
may or may not be homogenous

Very Monopoly A single firm makes up the

Low industry. There are entry barriers.

2.0 Perfect Competition

Perfect competition has the following characteristics:

There are many sellers and buyers in the market, both buyers and sellers are “small”, they lack
market power to influence the price of product. The price is determined by the market forces of
demand and supply XE "supply" . Individual producers and consumers are “price takers”.

The product being traded is homogenous each firm’s product is the same as what the
competitor is selling on the market.

There are no barriers to entry, firms are free to enter and exit the market.

There is perfect knowledge of market conditions. This perfect information is available to every
one, buyers and sellers at no extra cost.

Only the stock exchange and the foreign exchange markets are often cited as the closest
examples of this market structure.

2.1 Demand curve of a firm under perfect competition

No individual firm has market power, the market forces of demand and supply XE "supply"
for the product determine the price. Note that the price = average revenue XE "revenue" =
demand curve (P = AR = D)

D S Price

P P = AR = D

Quantity Quantity
The demand curve for the individual firm operating under a perfect market is a horizontal line.
At a given price of OP, the firm can sell as much as it can, whatever is taken to the market is
bought, and demand is infinite.

However, if an individual firm increases in price, even by a very small margin, demand reduces
to zero, since there is perfect market information, the product is homogenous and there are
many sellers.

2.2 Short run equilibrium position

The short run XE "short run" is defined as a period when at least one of the factors of
production XE "factors of production" is fixed, therefore it is possible in the short run for
individual firms to make supernormal profits or losses.

Suppose the price determined by the market forces of demand and supply XE "supply" is
high due to high demand relative to supply.

Price Costs
D S and MC
Revenue
P MR

AC

0 Quantity 0 Q
Quantity

The firm maximizes its profits when the price and output combination is such that the marginal
revenue XE "marginal revenue" of an additional unit of output is equal to the marginal cost of
producing it. This is at output OQ were MC = MR. At this level of output, the AR
(representing TR) is much higher than AC (representing TC). In short, the price charged is
greater than the long run XE "long run" average costs XE "average costs" incurred, the
difference are the supernormal profits made by the firm (represented by the shaded area).

Alternatively, the firm can make losses if the price determined by the market forces of demand
and supply XE "supply" is low. This can happen when market demand is low while market
supply is high.

Costs

Price and
Revenue MC
 AC
D
S

0 Quantity 0 Q Quantity

The firm maximizes profits at output OQ where MC = MR, at this level of output, AC is much
higher than AR and the firm makes losses.

2.3 Long run equilibrium position

There are no barriers to entry, firms are free to enter and to exit. Profits and losses can only
occur in the short run XE "short run" . Where profits are made, they are competed away
through the entry of new firms and where losses are made, firms will leave.

REVENUE AND
COSTS

The firm maximizes its profits at OQ where MC = MR. At this output level, AR is also equal
to AC. Individual firms earn normal profits only, in the long run XE "long run" .

In addition, at this level of output, AC is also equal to MC, the firm is operating at its most cost
effective point, where costs are at their lowest level, an indication that the firm is technically
efficient.

The firm is also allocatively (or economically) efficient since the price charged to the consumer
equals the marginal cost of its supply XE "supply" . The price is equal to the demand curve
and the marginal cost curve is in effect the individual firm’s supply curve. Economic efficiency
occurs where demand equals supply.
The unique feature of the long run XE "long run" equilibrium position is that all firms in the
industry have MR = MC = AC = AR = P = D.

Perfect competition is a theoretical model, but it sets a benchmark for efficiency and firms
should strive to attain the desired benchmarks.

3.0 MONOPOLY

In this market structure, one firm is the sole supplier of a product or service that has no close
substitutes. The firm makes up the industry.

3.1 Characteristics
The following characteristics features must be met for a monopoly XE "monopoly" to
exist.

There is only one supplier of the product or services

The product or service has no close substitutes
There are barriers to entry

3.2 Demand curve

A monopolist being the sole supplier has market power and therefore the firm is a “price
maker”.

However, the firm can only determine either the price or the quantity, but not both
at the same time. At high prices, few quantities are bought, while at low prices,
demand is high.

Therefore, the monopolist is faced with a downward sloping “normal” demand

curve.

Price
 P = D = AR
Output

3.3 Equilibrium position XE "Equilibrium position"

The firm maximizes its profit at OQ where MC = MR. The price charged, the average revenue
XE "revenue" is greater than the average cost. This difference is the supernormal or Economic
profits earned by the monopolist, represented by the shaded area of the rectangle.

The monopolist is likely to earn supernormal profits in both the short run XE "short run" and
the long run XE "long run" because of the barriers to entry, the supernormal profits are not
‘competed away’ by other firms.

The equilibrium position is illustrated in the diagram below.

AC

AR

3.4 Barriers to entry

Barriers limit competition in the market. Firms are prevented from increasing the supply XE
"supply" , pushing the supply curve to the right or pushing the demand curve to the left, which
reduces the price, and eliminates the supernormal profits.

Barriers to entry explain why monopolies continue to exist. Some of the entry barriers are as
follows:-

Government legislation.
Governments may play a major role in the creation of monopolies. A good example is
the Zambia Electricity Supply Corporation (ZESCO), which is the sole supplier of
electricity. The government may also be more comfortable when one organization is
marketing an essential product like maize. Such as the former grain marketing boards
(NAMBOARD) or the Food Reserve Agency (FRA).
Control of the source of supply XE "supply" for raw materials.
This gives the firm an advantage, as the other firms do not have access to the necessary
raw
materials to produce a product.
Legal barriers in terms of patent and copyrights
These grant a creative and innovative person or firm that has invented a product, written
a book, composed a song, the exclusive right to enjoy the benefits or profits from that
work, preventing others from exploiting that work.
Immobility of factors of production XE "factors of production" .
Resources are not mobile, including labour XE "labour" . This is worsened by the
formation of trade unions and professional associations. In addition, a single firm may
control a natural resource such as copper, which is found in the copper belt, no close
substitute, and no other firm can set up a competing firm.
Indivisibilities, the amount of fixed costs that a new firm would have to sustain would act as a
natural barrier to entry.
The minimum efficiency scale, which is the level of output at which the average costs XE
"average costs" first reach their minimum point, may be at a very high level. A new entrant
might need to spend a lot on advertising XE "advertising" , and sales promotion in order to
compete effectively with existing companies XE "companies" and to increase the market share.
The cost involved might again, act as a natural barrier to entry.

3.5.0 Price discrimination

Price discrimination means charging different prices to different groups of consumers for the
same product or service. Price discrimination is the same product or service being sold at
different prices in different markets. A firm may increase its revenue XE "revenue" by
charging high prices in some markets while lowering the price in other markets but the sales
volume increases, given the fact that TR = Quantity X Price. Either an increase in the quantity
sold or an increase in the price leads to an increase in the total revenue. A monopolist cannot
control both the price and quantity even if the firm is in an advantageous position and has
market power.

3.5.1 Examples of price discrimination XE "price discrimination"

A car manufacturer who sells cars cheaply in export markets than on the local
market.
Telephone charges during public holidays, weekends and at night are lower.
Electricity and water charges are lower for domestic use than for commercial
use.
The same electricity and water charges are lower in the high-density areas than
in the low-density areas.
Rail fares and airfares practice price discrimination XE "price discrimination" .
A doctor or lawyer who varies fees depending on the wealth XE "wealth" of the customer.

Generally, discrimination is by income, time, place or customer.

3.5.2 Basic conditions to practice price discrimination XE "price discrimination"
For price discrimination XE "price discrimination" to be possible, practicable and profitable,
certain conditions must be fulfilled.

Control supply XE "supply" of product, which means imperfections in the market.

Discrimination is not possible under conditions of perfect competition.
Consumers should be members of separate markets to prevent resale of the
product.
Elasticities of demand must be different so that different prices may be charged.
High prices are charged for inelastic markets and low prices for elastic markets,
and profits are maximized.

3.6 Regulations of monopolies

The barriers to entry explain the existence of monopolies, the question is whether monopolies
are harmful or beneficial. Monopolies operate against consumer interest and public policy. To
this end, governments regulate monopolies by forming monopoly XE "monopoly" regulation
commissions to correct the many inefficiencies resulting from lack of competition.

3.7 Arguments for monopolies

To achieve economies of scale as a single firm supplies to the whole market. Large scale
production results in a reduction in average costs XE "average costs" . The consumer is likely
to benefit from efficiencies through lower prices.
The supernormal profits that monopolists make, enable the firm to be innovative and spend on
research and development XE "research and development" . Society gains by having new
products on the market.
It is easier for a large firm to raise capital XE "capital" , again this enables the firm to be
innovative and spend on research and development XE "research and development" .
Through practicing price discrimination XE "price discrimination" , monopolists ensure that the
rich as well as the poor benefit by enjoying the same or a similar product.
Some monopolies are natural due to high ratio of fixed costs to variable costs XE "variable
costs" there is less contribution, which is less attractive, and as such, there are few
competitors.
Some governments feel that in some cases, production or distribution of, for example, gas,
electricity and water can be carried out more efficiently if it is in the hands of a monopolist.
Where there is competition, it would be wasteful and result in higher prices to
consumers.

3.8 Arguments against monopolies

At the profit maximizing level of output, prices are likely to be higher while output is less than
in a more competitive firm.
The supernormal profits, which monopolies make, are naturally at the expense of customers.
Monopolies are not technically efficient. At the profit maximizing level, the costs
are not at their lowest level since the marginal cost is not equal to the average cost. This
also implies that monopolies are not allocatively or Economically efficient.
Price discrimination is a restrictive practice carried out by monopolists.
Monopolies are not threatened by competition, they tend to adopt a complacent Attitude known
as ‘x’ inefficiency, and they may not be inclined to be innovative.
The lower prices that monopolies charge once in a while because of lower costs are just used
to stifle competition.
There may be diseconomies of large-scale production due to the size of the Monopoly firm.
The firm might become difficult to coordinate and control. Communication also becomes
difficult, the morale of workers is low etc.

4.0 CHAPTER SUMMARY

The market is an interpersonal institution that brings buyers and sellers together. A perfect
market consists of perfect competition, while the rest are considered to be imperfect. Many
sellers and buyers characterize a perfect market, the product is homogeneous, the information is
perfect, and there are no entry barriers in the market.
Firms operating in a perfect environment are price takers, in such an industry, market demand
and supply XE "supply" determine the price. Individual firms earn normal profits in the long
run XE "long run" .

Monopoly is where there is only one firm in the market selling a product, which has no close
substitute. A monopolist creates barriers to entry, which maybe legal barriers to entry, or
otherwise, in order to enjoy supernormal profits.
Monopolists generally charge higher prices and produce lower output than firms operating
under a perfect market. Monopolies have a number of merits and demerits, one of which is
price discrimination XE "price discrimination" .

Price discrimination is the charging of different prices to different customers for the same
product or service.

REVIEW QUESTIONS
What is a market?
What are the main assumptions of perfect competition?
What are the unique features of the long run XE "long run" equilibrium of a perfectly
competitive firm?
What is allocative or Economic efficiency?
Explain the reasons for the existence of monopoly XE "monopoly"
In a monopoly XE "monopoly" , the firm fixes the price. What determines the quantity
supplied?
Give two reasons to justify monopolies
What is price discrimination XE "price discrimination" ?
Mention the conditions necessary to practice price discrimination XE "price discrimination"
What is the aim of price discrimination XE "price discrimination" ?
From the figures below

OUTPUT Total
(units) Revenue

50 500
60 600
70 700
80 800
90 900
100 1000
110 1100
120 1200

You are required to:

Calculate the average revenue XE "revenue"

Calculate the marginal revenue XE "marginal revenue"
Draw the average revenue XE "revenue" curve
Determine the market structure

From the figures below

OUTPUT Total
(units) Revenue
50 750
60 840
70 910
80 960
90 990
100 1000

You are required to:

Calculate the average revenue XE "revenue"
Calculate the marginal revenue XE "marginal revenue"
Draw the average revenue XE "revenue" (demand) curve
Determine the market structure

13. Mention some differences between perfect competition and monopoly XE "monopoly"

EXAMINATION TYPE QUESTION 6.1

What are the main features of the perfectly competitive market? (6 marks)

With the help of well-labeled diagrams, compare the long run XE "long run" equilibrium of a
firm under a perfectly competitive market structure and a monopoly XE "monopoly" market
structure. (14 marks)

(Total: 20 marks)

CHAPTER 7
MONOPOLISTIC COMPETITION AND OLIGOPOLY
__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Explain imperfect market structures – monopolistic competition XE "monopolistic competition"

and oligopoly
Describe the main characteristics, pricing and output policies of monopolistic competition XE
"monopolistic competition"
Explain the significance of product differentiation
Draw and understand the standard graph relating to monopolistic competition XE
"monopolistic competition"
Explain the implications of monopolistic competition XE "monopolistic competition"
Describe the main characteristics, pricing and output policies of oligopoly
Draw and understand the standard graph relating to oligopoly markets
Explain why some firms sometimes enter into agreements not to compete against each
other
___________________________________________________________________________
____

1.0 MONOPOLISTIC COMPETITION

Monopolistic Competition combines features of perfect competition and monopoly XE

"monopoly" .

1.1 Characteristics of monopolistic competition XE "monopolistic competition"

A large number of sellers or firms in the market

A large number of buyers
There are no barriers to entry, firms are free to enter and leave the market.
The products are not homogeneous but are differentiated through product differentiation and
non-price competition, such as the use of brand names, attractive packaging, extensive
advertising XE "advertising" , offering guarantees, good after sales services etc.

1.2 Demand curve

Firms under monopolistic competition XE "monopolistic competition" attempt to monopolise

the industry through product differentiation, this gives firms some influence on price charged,
as a sign that they are ‘price makers’. An individual firm is faced with a normal downward
sloping demand curve, even if the demand curve is more elastic due to competition from close
substitutes.

Price
 P = D = AR

Output

1.3 Short run equilibrium position

The pricing and output determination in the short run XE "short run" is similar to that of a
monopolist since firms have some market power because of product differentiation.

Individual firms under monopolistic competition XE "monopolistic competition" maximise

profits where MC = MR. At this level of output, the AR is greater than the AC, therefore the
firm makes supernormal profits just like monopolies.
AC

REVENUE

AND
COSTS

AR

The supernormal profits attract new entrants into the market, since there are no entry barriers.
Rival firms produce products that are similar, but somewhat differentiated. This causes the
short run XE "short run" demand curve for an individual firm to be pushed to the left, as the
supernormal profits are competed away.

1.4 Long run equilibrium position

Individual firms as usual, maximize profits where MC = MR, in the long run XE "long run"
the AR is also equal to the AC and therefore the firm only makes normal profits, as shown
below.
 Revenue
and costs MC

AC

AR
MR

0 Q Quantity

IMPLICATIONS OF MONOPOLISTIC COMPETITION

The long run XE "long run" equilibrium position is not at a point where AC is
minimized, therefore, there is no technical efficiency XE "technical efficiency" .
A waste of resources like in a monopoly XE "monopoly" because prices are high
while output is low compared to a firm under perfect competition. Firms unable to
expand output to the level where AC is at a minimum, an indication that there is excess
capacity.
There is no allocative or Economic efficiency.
It is considered wasteful to produce a wide variety of differentiated versions of the
same product.
The extensive advertising XE "advertising" is also considered wasteful.

It is also argued that monopolistic competition XE "monopolistic competition" is not wasteful

as it provides consumers with choices, the differentiated versions of the same product is for the
benefit of consumers, besides, rational buyers should opt for the least cost good.
2.0 OLIGOPOLY

This is a market structure with a few large firms. The number of firms is few, but the capital
XE "capital" involved is large. The huge amounts of capital act as natural barriers to entry.

2.1 Introduction

The oligopoly market structure is based on a number of assumptions, which makes it rather
different from the market structures studied earlier. It maybe a perfect oligopoly, which means
the product is homogeneous, such as the oil marketing companies XE "companies" in Zambia,
British Petroleum, Caltex, Mobil, Agip, Total, Engen, etc. Alternatively, the product maybe
differentiated, this is known as imperfect oligopoly. An example is the Japanese motor vehicle
manufacturers like Nissan, Toyota, Honda, Mitsubishi, Isuzu.

2.2 Characteristics

Interdependence between firms, this is because an individual firm is uncertain of the

behaviour of rival firms.
Price stability
Non-price competition between firms

2.3 Demand curve

The shape of the demand curve depends on the assumption of the pricing policy of an
individual firm. A firm operating under conditions of oligopoly might adopt a number of
pricing strategies such as

Firms collude on pricing and or output policies, they may form cartels XE "cartels" or
price rings, known as collusive oligopoly.
A firm may become a price leader, initiating a price change, then the rival firms follow
suit.
A firm may decide simply to be a price follower, awaiting the pricing decisions of other
firms.
The firm’s demand curve is based on the assumption that an oligopoly firm, which is
competing, with rival oligopoly firms decide on its own price and output levels. Even
then, the firm’s decisions are influenced by what the rival firms can do, hence the
kinked demand curve XE "kinked demand curve" model.

Firms are few, and each firm has some market power, therefore the action of one firm affects
the market share of the rival firms. Suppose the firm increases the price above OP, and then if
the rival firms do not increase their prices, the result would be a reduction in sales and a fall in
the market share. This means that demand is elastic above OP, the price of the rival firms will
be relatively lower.
Price

D
Elastic demand curve
P
D

O
Quantity
Note that there is no explanation as to how the price is actually determined to be at OP.

If the firm lowers the price in an attempt to increase the sales and the market share, then the
rival firms are likely to follow suit, as they would not like to lose their market share. This
implies that the whole industry would suffer, the same quantities would be sold, but at reduced
prices!

Demand is therefore inelastic below OP

Price

Inelastic demand curve

P

0 Q Quantity

An oligopolist’s demand curve is a combination of the elastic and the inelastic demand curves,
where the two curves intersect, a kink is formed, hence the name kinked demand curve XE
"kinked demand curve" .

Price
D
Kink

D = AR = P
 Quantity

A more detailed diagram

Revenue and
Costs

MC1

MC2

0 Q
MR AR Q uantity

In the detailed diagram, the MR curve has a vertical discontinuity where the elastic demand
curve changes to inelastic demand curve (where there is a kink) on the AR/demand curve. The
discontinuity is explained by the fact that at prices higher than OP the MR curve corresponds to
the inelastic demand curve while at prices below OP the MR curve corresponds with an elastic
demand or AR curve.

The kinked demand curve XE "kinked demand curve" reemphasizes why an oligopolist might
have to accept price stability in the market. An individual firm cannot afford either to reduce or
to increase the price, as this leads to a change in the market share.

3.0 CHAPTER SUMMARY

Monopolistic competition combines the features of perfect competition and monopoly XE

"monopoly" . Like perfect competition, there are a number of buyers and sellers with no
barriers to entry. However, the products are differentiated. Differentiated products are similar
but not identical; the products are close substitutes to each other.

Product differentiation gives firms operating under monopolistic competition XE "monopolistic

competition" some form of market power, just like under monopoly XE "monopoly" .
Therefore, the firms are able to earn supernormal profits.
Lack of entry barriers causes the supernormal profits to be competed away in the long-run, and
the firms operating under monopoly XE "monopoly" can only earn normal profits in the long
run XE "long run" , just like firms under perfect competition.

However, there are some implications of firms operating under monopolistic competition XE
"monopolistic competition" compared to firms under perfect competition, in the long-run,
where there are normal profits for both firms. Prices are high, output is lower, and resources
are wasted under monopolistic competition.

Oligopoly XE "Oligopoly" is defined as where there are a few large firms in the market.
Oligopolistic markets do not have a standard analysis. The main characteristic feature is that an
individual firm’s production decisions in such markets are interdependent, as they affect rival
firms. This major feature of oligopoly markets is what leads to the kinked demand curve XE
"kinked demand curve" model.

When groups of oligopoly firms agree on the price, and or output policies, then a cartel has
been formed.

REVIEW QUESTIONS

Write two ways in which a firm operating under monopolistic competition XE "monopolistic
competition" can practice product differentiation
What is the importance of product differentiation in monopolistic competition XE
"monopolistic competition" ?
What is a cartel?
How is the oligopoly market structure different from other market structures?
What is meant by non-price competition?
Mention the implication of the kinked demand curve XE "kinked demand curve" model for
price and output by an oligopoly firm?
Draw a kinked demand curve XE "kinked demand curve"

---------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 7.1

In what ways does monopolistic competition XE "monopolistic competition" differ from

perfect competition? (12 Marks)

Is it correct to describe monopolistic competition XE "monopolistic competition" as wasteful?

(4 Marks)

What is product differentiation? (4 Marks)

(TOTAL: 20 MARKS)

EC-125
MACRO-
ECONOMICS
KAONGA
 MARTIN-R
2009
CHAPTER 8

NATIONAL INCOME
__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Describe the national income XE "national income" of a country

Explain the relationship between output, income and expenditure using the circular flow of
income
Explain the measurement of the national income XE "national income"
Discuss the problems associated with the measurement of national income XE "national
income"
Appreciate the uses of national income XE "national income" figures
Explain the factors that determine a country’s national income XE "national income"
___________________________________________________________________________
____

1.0 Introduction

Measures of national income XE "national income" and output are used in Economics XE
"Economics" to estimate the value of goods and services produced in an economy. They use a
system of national accounts or national accounting first developed during the 1940s. Some
of the more common measures are Gross National Product (GNP), Gross Domestic Product
XE "Gross Domestic Product" (GDP), Gross National Income (GNI), Net National Product
(NNP), and Net National Income (NNI).

There are at least three different ways of calculating these numbers. The expenditure
approach determines aggregate demand, or Gross National Expenditure, by summing
consumption XE "consumption" , investment XE "investment" , government expenditure and
net exports. On the other hand, the income approach and the closely related output
approach can be seen as the summation of consumption, savings XE "savings" and taxation
XE "taxation" . The three methods must yield the same results because the total expenditures on
goods and services (GNE) must by definition be equal to the value of the goods and services
produced (GNP) which must be equal to the total income paid to the factors that produced these
goods and services (GNI).

In practice, there are minor differences in the results obtained from the various methods due to
changes in inventory levels. This is because goods in inventory have been produced (and
therefore included in GDP), but not yet sold (and therefore not yet included in GNE). Similar
timing issues can also cause a slight discrepancy between the value of goods produced (GDP)
and the payments to the factors that produced the goods, particularly if inputs are purchased on
credit.

Gross National Product

Gross National Product (GNP) is the total value of final goods and services produced in a
year by a country's nationals (including profits from capital XE "capital" held abroad).

Gross Domestic Product XE "Gross Domestic Product"

Gross Domestic Product XE "Gross Domestic Product" (GDP) is the total value of final
goods and services produced within a country's borders in a year.

To convert from GNP to GDP you must subtract factor income receipts from foreigners that
correspond to goods and services produced abroad using factor inputs supplied by domestic
sources. To convert from GDP to GNP you must add factor input payments to foreigners that
correspond to goods and services produced in the domestic country using the factor inputs
supplied by foreigners.

GDP is a better measure of the state of production in the short term. GNP is better when
analysing sources and uses of income

Real and nominal values

Nominal GNP measures the value of output during a given year using the prices prevailing
during that year. Over time, the general level of prices rises due to inflation, leading to an
increase in nominal GNP even if the volume of goods and services produced is unchanged.

The national income XE "national income" of any country is important because it helps to
assess the performance of a country over a period of time, usually in a year.

National income accounting is much like the accounting carried out by the individual firms to
detect growth XE "growth" or decline in the profitability of a company. The national income
XE "national income" figure that is calculated is used to compare the performance of the
country in the previous years as well as the performance of that country with other countries.

In theory, the three methods of measuring the national income XE "national income" should
provide the same figure as illustrated by the circular flow of income.

1.1 The circular flow of income

The circular flow of income describes how money XE "money" moves between the different
sectors in the economy. The expenditure of one sector is the income of another sector.

For a closed simple economy where there are only two sectors, firms and households, firms
employ labour XE "labour" to produce goods and services. Firms spend on labour since
households receive income for providing labour. Household income is spent on goods and
services from firms.

1.2 THE NATIONAL OUTPUT OR THE VALUE ADDED METHOD

This is the total of consumer goods and services investment XE "investment" goods
(including additions to stocks) produced by the country during the year. The production of
goods and services in different sectors of the economy is added together. For example what is
produced in the agriculture and fisheries, forestry, manufacturing, hotels, banking, national
defence, education, health sectors etc, is all added together to arrive at the national income XE
"national income" using the output method.
It can be measured by

Totaling the value of the final goods and services and produced or
Totaling the value added to the goods and services by each firm, including the government.
This is done to avoid double counting and in order to use this method, a detailed knowledge of
pricing is required. This explains why the output method is also known as the value added
method.

The usefulness of this method is that it shows the changing shares of the industrial sectors in
an economy, that is a sector which is expanding or falling it its contributions to the national
income XE "national income" .

1.3 NATIONAL INCOME

Using this approach, the total factor incomes received by persons and firms for the provision of
factors of production XE "factors of production" , is added. Income from employment, trading
profits, rent and interest are all added together to arrive at the national income XE "national
income" using the income method.

When using this method:

Transfer payments or transfer incomes are excluded because the people receiving them do not
produce anything. It includes private money XE "money" gifts, sale of second hand goods
such as a house, a car etc.
Stock appreciation is deducted from the total because when inflation makes existing unsold
stocks more valuable, production has not increased.
Residual error (statistical discrepancy) is added to make statistics from each method balance.

1.4 NATIONAL EXPENDITURE

This involves adding together all total amounts spent on final goods and services by
households, central and local government, including what is spent by firms on the net additions
to capital XE "capital" goods and stocks in the course of the year.

The calculation of the national income XE "national income" using the expenditure method is
what is known as the aggregate demand. This total spending is made up of consumption XE
"consumption" expenditure, plus investment XE "investment" expenditure, plus government
expenditure, plus net exports (that is exports minus imports).

Adjustments have to be made for taxes and subsidies XE "subsidies" as they

distort market prices, the idea is to measure the national expenditure, which
corresponds to the cost of the factors of production XE "factors of production"
used in producing the national product, which is known as national expenditure
at factor cost.

The usefulness of this method is in detecting changing trends in consumption XE

"consumption" and investment XE "investment" , although this is the most widely used
method, it trends to over estimate national output.

GROSS DOMESTIC PRODUCT XE "GROSS DOMESTIC PRODUCT" (GDP)

The GDP is the first value arrived at in the national income XE "national income" calculations,
before any adjustments are made. This is often referred to as the value of the output produced
in the country during one year and if it increases in real terms, then it is a sign that the economy
has grown. The GDP is calculated at market prices, but after taxes are deducted and subsidies
XE "subsidies" are added, the GDP is at factor cost.

GROSS NATIONAL PRODUCT (GNP)

This refers to the value of the output produced by residents of a country in a year. It is arrived
at after including the output produced by companies XE "companies" and individuals of a
country but they are based abroad. In addition, output produced by foreigners and overseas
companies in that country is deducted. This is summarized as net property income from abroad,
which maybe positive or negative.

CAPITAL CONSUMPTION

Capital assets suffer wear and tear as such depreciation, termed capital XE "capital"
consumption XE "consumption" is deducted from GNP to arrive at the Net National Product
or the National Income is short.

In summary

GDP at market Prices

- indirect taxes
+ Subsidies

= GDP at Factor cost

+ Net property income from abroad

= GNP
- Depreciation

=NI

1.5 ZAMBIA’S GROSS DOMESTIC PRODUCT XE "GROSS DOMESTIC

PRODUCT" BY KIND OF ECONOMIC ACTIVITY AT CURRENT PRICES
(K'BILLION), 2003 – 2005 USING THE VALUE ADDED (OUTPUT) METHOD

KIND OF
E C O N O M I C
ACTIVITY 2003 2004 2005*
Agriculture, Forestry and
Fishing 4,244.6 5,568.2 6,856.6
Agriculture 1,008.2 1,249.5 1,526.0
Forestry 2,960.3 3,998.5 4,953.6
Fishing 276.1 320.2 377.0
Mining and Quarrying 564.8 809.6 980.5
Metal Mining 558.2 798.3 960.4
Ot h er M i n i n g an d
E C O N O M I C
ACTIVITY 2003 2004 2005*
Agriculture, Forestry and
Fishing 4,244.6 5,568.2 6,856.6
Agriculture 1,008.2 1,249.5 1,526.0
Forestry 2,960.3 3,998.5 4,953.6
Fishing 276.1 320.2 377.0
Mining and Quarrying 564.8 809.6 980.5
Metal Mining 558.2 798.3 960.4
Ot h er M i n i n g an d
Quarrying 6.6 11.3 20.0
PRIMARY SECTOR 4,809.4 6,377.7 7,837.0
Manufacturing 2,241.0 2,827.7 3,458.1
Food, Beverages and
Tobacco 1,397.2 1,726.6 2,145.5
Textile, and Leather
Industries 352.9 450.7 491.2
Wood and Wood
Products 164.7 222.2 283.7
Paper and Paper products 93.1 123.6 161.0
Chemicals, rubber and
plastic products 178.9 231.7 286.3
Non-metallic mineral
products 30.0 41.0 51.6
Basic metal products 3.1 4.0 4.6
F abri cat ed m et al
products 21.0 27.7 34.2
Electricity, Gas and
Water 595.1 694.7 922.7
Construction 1,590.0 2,402.1 3,689.8
SECONDARY SECTOR 4,426.1 5,924.5 8,070.6
Wholesale and Retail
trade 3,873.8 4,843.7 6,079.7
Restaurants, Bars and
Hotels 527.7 670.9 895.9
Transport, Storage and
Communications 1,058.2 1,252.3 1,408.3
Rail Transport 89.5 100.8 99.9
Road Transport 393.9 464.0 546.7
Air Transport 152.7 203.0 246.7
Communications 422.1 484.6 515.0
Financial Intermediaries
and Insurance 1,847.7 2,282.7 2,776.9
Real Estate and Business
services 1,341.2 1,691.8 2,105.8
Community, Social and
Personal Services 1,757.0 2,046.5 2,529.1
Public Administration
and Defence 683.0 723.9 869.4
Education 688.6 867.7 1,127.1
Health 252.4 292.8 329.1
Recreation, Religious,
Culture 26.4 28.8 36.1
Personal services 106.6 133.3 167.3
 services 1,341.2 1,691.8 2,105.8
Community, Social and
Personal Services 1,757.0 2,046.5 2,529.1
Public Administration
and Defence 683.0 723.9 869.4
Education 688.6 867.7 1,127.1
Health 252.4 292.8 329.1
Recreation, Religious,
Culture 26.4 28.8 36.1
Personal services 106.6 133.3 167.3
TERTIARY SECTOR 10,405.6 12,787.9 15,795.8
Less: FISIM (1,061.8) (1,311.8) (1,595.8)
TOTAL GROSS
VALUE ADDED 18,579.3 23,778.3 30,107.6
Taxes on Products 1,899.9 2,219.1 2,541.1
TOTAL GDP . AT
MARKET PRICES 20,479.2 25,997.4 32,648.6
Growth Rates in GDP 25.97 29.95 25.58
Cur r e nt G D P pe r Ca pita
(Current Prices) 1,852,017.00 2,317,860.00 2,909,857.00
Source: Central Statistical Office

1.6 Zambia’s GDP by expenditure method, in Kwacha (bn) at current

prices

19901991199219931994199519961997Total consumption XE "consumption"

9520057413161980277936084752Government consumption XE "consumption"
1735102192313489714857Private consumption XE "consumption" 7816547211241667229028943895Total
investment XE "investment" 202468223284394582701Gross fixed capital XE "capital"
formation192565217276385566681Public fixed capital XE "capital"
formation8132350235198239278Private fixed capital XE "capital"
formation11124216741187327403Changes in stock1-136991623Net
exports-1-6-72-57-23-175-246-284Exports of goods and services4176210498785110913441715Exports of
goods3870195454714102712001565Imports of goods and
services-41-81-282-555-809-1284-1590-2000Imports of goods-33-62-233-465-671-1034-1275-1601Total
GDP11321857014822241299839455169 Source: Internet

2.0 USES OF NATIONAL INCOME FIGURES

The main use is to assess the performance of an economy over a year. It is used as an
indicator of a growing or a contracting economy, Economic growth XE "growth" or
lack of it is assessed using the national income XE "national income" figures.
The figures are used to indicate the overall standard of living XE "standard of living" ,
especially after dividing by the total population XE "population" in a country to
calculate the per capital XE "capital" income.
This enables comparisons to be made between different countries. To ascertain which
are rich and which ones are poor countries.
To assist the government in managing the economy, using Keynesian demand
management.
The trade or Economic cycles depend on the national income XE "national income"
 figures. The figures are also used to estimate future movements.

2.1 LIMITATIONS IN NATIONAL INCOME CALCULATIONS

There are differences in the accuracy of the figures. Different countries collect and
invest in data collection differently.

Economic welfare XE "welfare" affected by medical and educational facilities per head.
There is need to know what proportion of the national income XE "national income" is
spent on the provision of better social sector facilities and not on defence! As with all
mathematical averages, per capita income data does not take into account how the GDP
is distributed amongst the population XE "population" . If the income is unevenly
distributed, then increases in the GDP per capita may disproportionately benefit a small
group of high income earners and have little impact on reducing poverty. If GDP per
capita data is to be used then its distribution must also be taken into account.

Arbitrary definitions, for example when calculating the national income XE "national
income" , only those goods and services that are paid for, are normally included. Do it
yourself jobs, such as gardening, repairing one’s own car, housework etc, are excluded,
and their exclusion distort the national income XE "national income" figure. These
unpaid services, which are normally provided by housewives, are included in the
calculation of the national income XE "national income" when done by someone else.
If an individual lives a in a house for which he pays rent to the landlord, this will be
treated differently from owning a house for which he no longer pays rent

Incomplete information, which can be attributed to, the high levels of subsistence
sector, barter and black economies that are more pronounced in developing countries.

Danger of double counting, for example, the cost of raw materials and that of finished
goods should not both be counted, this difficult to avoid when using the output method
of calculating the national income XE "national income" .

Using any monetary data, such as GDP per capita over time, must recognise that output
and incomes measures can increase for many reasons other than the country producing
more goods.

It is an increase in goods and services that is necessary if poverty is to be alleviated or

peoples’ livings standards rose. Output and incomes measures may increase because the
rate of inflation has simply increased the money XE "money" value of goods and service
produced rather than their real value. Real GDP per capital XE "capital" would be a better
indicator, as this is a measure of the physical value of goods and services produced. Real
GDP is equal to the nominal GDP adjusted for price changes, (minus inflation).

The different rates of inflation and the constant variations in the exchange rate within and
in
different countries make comparisons difficult.
 The national income XE "national income" measures the standard of living XE
"standard of living" . This has to relate to the size of the population XE "population" .
Some countries have a high-income figure and a correspondingly high population XE
"population" .

Some countries have high national income XE "national income" figure but are paying
a high penalty for living beyond their means and borrowing heavily.

It should be remembered that GDP only includes output that involves a financial
transaction i.e. is marketable. A considerable amount of Zambia's agricultural output is
produced on small-scale communal farms for subsistence purposes. It is currently
estimated that only 25% of production on communally owned land XE "land" involves
monetary transactions. The rest is not included in any national income XE "national
income" calculations. Likewise the output of the informal sector will not be included.

Increasing national income XE "national income" and growth XE "growth" may occur
at the expense of the environment rapidly growing economies may result in negative
externalities. An agricultural sector that increases productivity by intensive use of
pesticides and fertilisers or deforestation. may reduce future land XE "land" fertility
and worsen the level of poverty for future generations

2.2 FACTORS DETERMINING A COUNTRY’S NATIONAL INCOME

Income is not evenly distributed, and the factors determining a country’s national income XE
"national income" can be classified as internal and external, the latter resulting from a
country’s relationships with the rest of the world.

The most important internal factors are

Original Natural Resources

Natural resources are nature-given, such as mineral deposits, sources of fuel and power,
climate soil fertility, fisheries, navigable rivers, lakes that help communications etc. New
techniques allow national resources to be exploited while the exhaustion of minerals resources
reduces national income. Some countries are well endowed by nature, and if the resources
were well managed, then the national income XE "national income" would be high.

Where a country’s economy is predominantly agricultural, variations in weather may cause

national income XE "national income" or output to fluctuate from year to year, this happens to
be the problem with most developing countries.

The nature of the people, particularly of the labour XE "labour" force

This includes the quantity of the labour XE "labour" force, the higher the proportion of
workers to the total population XE "population" and the longer their working hours, the
greater s the national income XE "national income" figure.

Another factor is the quality of the labour XE "labour" force, their health, nutrition, energy,
inventiveness, judgment and ability to organize them to cooperate in production, the climate,
working conditions, peace of mind as well as education and training.

Capital Equipment

Productivity or labour XE "labour" will be increased if the quality of the other factors is high,
for example, the more fertile the land XE "land" , the greater is the output per man.

In addition, the quality of the capital XE "capital" equipment employed is the most important
factor, the output of workers varies almost in direct proportion to the capital equipment, and the
single most important material progress is investment XE "investment" in capital.

Consider the output per man where the majority of the farmers are using a hoe and an axe,
while in advanced countries, farmers use tractors and combine harvesters!

Knowledge of techniques

This is acquired through the development of Research and inventions. The government can
encourage this by financing research schemes. Alternatively the government can go into
partnership with the private sector or offer incentives such as tax rebates to companies XE
"companies" that are spending a lot on research and development XE "research and
development" . New inventions can bring in more income into the economy.

The organization of resources

One of the known factors that can improve production and therefore national income XE
"national income" in most of the developing countries is the organization and the management
of resources.

The leaders of any economy should have a vision for their countries. They have to be focused,
set goals and objectives, have the right people and the right resources in order to achieve those
objectives.

Political stability

A country has to be politically stable in order to produce. If the resources are being used on
warfare, very little production of goods and services takes place. This again is a common
problem in developing countries. Even if some are well endowed, they are not politically stable
and the organization of resources is poor.

The external factors are

Foreign loans and investments

These are an injection of funds that lead to an addition of stock, adding to the national income
XE "national income" .

Related to the above, gifts or handouts from abroad for the purposes of Economic
development and defence improve the national income XE "national income" of the receiving
countries.

Terms of trade XE "Terms of trade"

This is the rate at which one country’s exports exchange with another country’s imports. The
terms of trade is not constant, it changes as export and import prices change.

Developing countries generally deal in the primary sectors and not in the secondary sectors in
production. They export goods at low prices in their raw form, but import goods at relatively
high prices as these are finished goods.

3.0 CHAPTER SUMMARY

The national income XE "national income" of any country is simply the total value of goods
and services its people produce during the year. The national income can be measured in three
different ways, the value added (output) method, the income method and the expenditure
method. In theory, all the three methods should provide the same national income figure, based
on the circular flow of income. A simple model of the circular flow of income assumes a two-
sector economy of firms and households.

Factors of production move from households to firms, for the production of goods and
services. Firms pay factor incomes, such as wages and salaries to households in exchange for
the factors. The income earned by households is spent on goods and services produced by
firms.

Calculation of the national income XE "national income" is very important in every economy
as the figure has a number of uses. It is used to assess the performance of the economy over
the years, to indicate the overall standard of living XE "standard of living" , and to enable
comparisons to be made, from one year to the next, as well as comparisons between countries.

Unfortunately, there are a number of difficulties that are encountered in measuring national
income XE "national income" , which provides unreliable testimony as to how the real welfare
XE "welfare" of the people has changed, and when making comparisons.

The national income XE "national income" , and therefore Economic growth XE "growth"
depends on the natural resources XE "natural resources" of a country, the quality of the labour
XE "labour" force and its participation rate, the capital XE "capital" equipment being used etc.
REVIEW QUESTIONS

Outline the three approaches used in calculating national income XE "national income"
Distinguish between GDP and GNP
What is the difference between nominal and real GDP?
What are transfer payments XE "transfer payments" ? Give examples.
Explain why the transfer payments XE "transfer payments" must not be included in the
national income XE "national income" figure
What is net national income XE "national income" at factor cost + capital XE "capital"
consumption XE "consumption" + indirect taxes on
expenditure – subsidies XE "subsidies" equal to?
From the hypothetical data below relating to the economy of a country over a one year period

K’m
Subsidies 2 000
Exports 25 000
Government expenditure 40 000
Net property income from abroad 1 000
Imports 53 000
Capital consumption XE "consumption" 8 000
Capital formation 38 000
Taxes on expenditure 30 000
Consumers’ expenditure 97 000
Value of physical increase in stocks 5 000

You are required to calculate:

The GDP at market prices

The GDP at factor cost
The GNP at factor cost

Why are the figures above considered as “gross”

------------------------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 8.1

Explain the three ways of measuring the national income XE "national income" figure. ( 9
Marks)
Give a brief explanation why theoretically the national income XE "national income" figure
should be the same whichever method is used in its measurement. ( 2
Marks)
Give three reasons why national income XE "national income" accounts are not very useful in
making comparisons of living standards between countries. ( 9
Marks)

(TOTAL: 20 MARKS)

EXAMINATION TYPE QUESTION 8.2

The following data relates to the economy of a country over a one-year period.

K’B
Subsidies 1 000
Gross domestic fixed capital XE "capital" formation 2 400
Exports of goods and services 2 000
Government final consumption XE "consumption" 3
000
Property income from abroad 300
Imports of goods and services 2 500
Value of physical decrease in stocks 10
Consumer’s expenditure 8 000
Capital consumption XE "consumption" /Depreciation
1 500
Taxes on expenditure 1 750
Property income paid abroad 500

Required

Calculate the following from the above data:

Gross domestic product at market prices (5 marks)

Gross domestic product at factor cost (5 marks)
Gross national product at factor cost (5 marks)
Net national product at factor cost (5 marks)

(TOTAL: 20 MARKS)
CHAPTER 9

NATIONAL INCOME DETERMINATION

__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Explain the relationship between national income XE "national income" , consumption XE

"consumption" expenditure, savings XE "savings" and investment XE "investment"
Discuss the factors that determine consumption XE "consumption" , savings XE "savings"
and investment XE "investment"
Explain how the multiplier XE "multiplier" and the accelerator XE "accelerator" XE
"Accelerator" works
Explain what the circular flow of income for an open (complex) economy is
Discuss Economic or business cycles and their characteristic features
___________________________________________________________________________
____

1.0 Introduction
In macroeconomics, there are mainly theories of two schools of thought. The monetarists, the
famous one being Milton Friedman, their arguments are mostly on the money XE "money"
supply XE "supply" and the effects of changes in the money supply XE "money supply" .

The Keynesians, advocates of Sir John Maynard Keynes. Keynes wrote a book entitled
General Theory of Employment, Interest and Money, published in 1936. His work was at the
time of the great depression.
1.1 CONSUMPTION EXPENDITURE

From the circular flow of income, spending by households is termed consumption XE

"consumption" expenditure. It is an endogenous part of the circular flow of income.

Consumption expenditure depends on an individual’s income, it is therefore a function of

income.
C = F (Y).

As Y increases the level of consumption XE "consumption" also increases but Lord Keynes
maintained that each successive increment to real income is marched by a smaller increment to
consumption XE "consumption" expenditure, the rest is saved.

Consumption
and
Savings
AS (Y)

Savings
S
Dissavings

0
a 45
Disposable income

The extent to which consumption XE "consumption" changes with income is termed the
marginal propensity to consume XE "marginal propensity to consume" (MPC). The marginal
propensity to consume is the proportion of each extra kwacha of disposable income spent by
households. That proportion of each extra kwacha of disposable income not spent by
households is known as the marginal propensity to save (MPS).

If out of the extra kwacha increase, eighty ngwee is consumed, then the marginal propensity to
consume XE "marginal propensity to consume" is 80% or 0.8, and the marginal propensity to
save is 20% or 0.2.

Therefore the MPC is the ratio at which the extra income earned is consumed, and it is denoted
by the formula:

MPC = ΔC, and it depends on the slope of C.

ΔY the steeper the slope, the larger is MPC

MPC depends on the slope of the consumption XE "consumption" function, the steeper the
slope, and the larger the MPC, which implies a small MPS.

The nature of the relationship between consumption XE "consumption" and income is given
by the straight-line equation:

C = a + by

Where
C = consumption XE "consumption"
a = C when an individual is not working and income from employment is zero, it is also known
as autonomous consumption XE "consumption" .

b = MPC
y = income,

For example, assume K650 000 is required for a family of three people to survive, whether the
head of the family is working or not. The K650 000 has to be found for the family to stay alive;
it can come from social security, dissavings, begging, borrowing etc.

When in employment, for every extra kwacha earned, 80 ngwee is consumed. The equation
becomes
C = 650,000 + 0.8Y.

Factors influencing consumption XE "consumption" are income, interest rates XE "interest

rates" , government policy such as taxation XE "taxation" , which reduces the disposable
income, hire purchase and other credit facilities, and invention of new consumer goods, which
are later, introduced on the market.

Note that in any economy households, firms and government undertake consumption XE
"consumption" of goods and services

2.0 SAVINGS

Savings is defined as the part of income not spent, it is a withdrawal or a leakage from the
circulation flow of income.
Y=C+S

∴S=Y–C

Therefore consumption XE "consumption" and savings XE "savings" are two sides of the
same coin and the consumption function XE "consumption function" tells us not only how
much households consume, but also how they save. The factors that influence consumption
naturally affect savings.

MPS is denoted by the formula = ΔS

ΔY where Δ is change.

Since any increment in income must be either spent or saved, MPC + MPS = 1

3.0 INVESTMENT EXPENDITURE

Investment is spent on the production of capital XE "capital" goods (houses, factories,

machinery, etc) or on net additions to stocks such as raw materials, consumer goods in shops,
etc.

In national income XE "national income" analysis, investment XE "investment" takes place

only when there is an actual net addition to capital XE "capital" goods or stocks.

Investment is a major injection into the circular flow of income and affects national income XE
"national income" and aggregate demand. Investment through the multiplier XE "multiplier" is
needed to achieve Economic recovery. Investment is very dynamic, it determines future shape
and pattern of Economic recovery.

Economic growth XE "growth" determined by technological progress, increase in size and

quality of labour XE "labour" and the rate at which capital XE "capital" stock is increased
replaced. Addition to stock should be greater than stock depreciation.

Investment therefore determines long-term growth XE "growth" , and both the private and the
public sector can carry it out. If it is undertaken by the private sector, the government is
expected to provide an enabling environment by stimulating business confidence by providing
a stable Economic climate. Setting and achieving macroeconomic targets like low levels of
inflation, controlling the money XE "money" supply XE "supply" and therefore controlling
the interest rates XE "interest rates" and consumption XE "consumption" . The government
can offer tax concessions or finance research schemes, sometimes in conjunction with the
private sector.

Keynesian demand management XE "demand management" emphasizes the importance of the

role, which the government plays to influence investment XE "investment" .
4.0 KEYNESIAN DEMAND MANAGEMENT

National income determination is a Keynesian concept. Keynes emphasized the importance of

aggregate demand in the economy. The national economy could be managed by taking
appropriate measures to influence aggregate demand up or down depending on whether there
was a deflationary or an inflationary gap XE "inflationary gap" in the economy.

The aggregate demand (AD) is the total demand for goods and services in the economy.
Aggregate demand is made up of consumption XE "consumption" expenditure (C),
government expenditure (G), investment XE "investment" expenditure (I) and exports (X)
minus imports (M), that is AD = C + G + I + (X – M).
The aggregate supply XE "supply" curve (AS) is the total supply of goods and services in the
economy, and a typical Keynesian aggregate supply XE "supply" curve is an inverse “L”. The
explanation is that the AS curve becomes vertical when all the resources are fully
employed.Keynes concentrated on shifting the AD, hence the name Keynesian demand
management XE "demand management" , and it involves manipulating national income XE
"national income" by influencing C, I, G, or (X – M). According to Keynes, the
equilibrium is where the AD is equal to AS at the full employment level. This is the ‘ideal’
position where all the resources are fully employed.

Prices
AS
AD

0 (Real national income XE "national income" )

Output, employment and Income

Suppose the economy is in a recessionary stage, and there is underemployment of resources, it

means there is a deflationary gap XE "deflationary gap" .

Prices AD AS

P
D

P1
 O Y YFE (Real national income XE "national
income" )
Output, employment and Income

Where D is the deflationary gap XE "deflationary gap" , this is the extent to which the
government needs to increase AD to shift it to the right or upward to reach the ‘ideal’ full
employment level in the economy.

Alternatively, the economy maybe experiencing inflationary pressures if AD is above the

‘ideal’ full employment position. The resources cannot be increased any further and this puts
pressure on the prices of goods and services.

Prices
AD AS

1
AD
P
I

P1

(Real national income XE "national income" )

Output, employment and Income

Where I is the inflationary gap XE "inflationary gap" , the extent to which the government
needs to reduce AD to shift the curve from AD to AD1, back to the equilibrium level.

4.1 THE MULTIPLIER PRINCIPLE

Keynesian demand management XE "demand management" involves manipulating national

income XE "national income" by influencing C, I, G, or X – M, while C is an endogenous
part of circular flow of income, the others are injections into the circular flow. Any injection
into the circular flow of income of a country starts a snowball effect.

If the government decides to build a big hospital in Zambezi district costing K10 billion, the
increase in government expenditure through the construction of the hospital provides incomes
to the factors of production XE "factors of production" employed in the construction of the
hospital. Part of the K10 billion goes to the contractor as profits, part of it goes to the workers
as wages and part of it is used for the purchase of building materials. The three groups who
will earn the income will spend it.

Any expenditure becomes someone else’s income, which is then in turn spent, generating a
whole series of rounds of additional spending and income generation, the snowball effect.
However, not all the income earned is consumed, some of it is saved. Savings is a leakage from
the circular flow, other leakages from the circular flow of income are imports and taxes. The
total amount leaked out is known as the marginal rate of leakages.

The effect on total national income XE "national income" of a unit change any of the injections
into the circular flow income can be measured, it is called the multiplier XE "multiplier" .

The investment XE "investment" , government or export multiplier XE "multiplier" =

Eventual change in NI
Initial change in I, G spending or X

The multiplier XE "multiplier" is denoted by the symbol K, and can be re-written as

K = Total increase in NI
Initial increase in NI

The shortcut method is to take into account the leakages, therefore

K = 1
Marginal rate of leakages

Numerical example in a simple closed economy XE "closed economy" starts with the
assumption that income is either consumed or saved. Suppose the MPC in the example above
where there is an injection of K10 billion is 80% (0.8). & income increases by £200

Increase in Increase in
Expenditure Savings
(K’billion) (K’billion)
Stage

1 Income increase 10 -
 2 80% consumed 8 2

3 A further 80% is
consumed 6.4 1.6

4 A further 80% is
consumed, etc 5.12 1.28

It works out to be K = 1= 1 = 1 = 5 times

1 – MPC MPS 0.2

This translates to 5 times the initial investment XE "investment" of K10 billion, meaning that
the eventual change in national income XE "national income" is K50 billion! If the marginal
propensity to consume XE "marginal propensity to consume" were much higher than 80%,
then the multiplier XE "multiplier" effects would be much higher and vice versa.

Multiplier in a complex, open economy would be lower because all the leakages or withdrawals
from the circular flow of income would be taken into account.

THE CIRCULAR FLOW OF INCOME FOR AN OPEN (COMPLEX) ECONOMY

WITHDRAWALS/
LEAKAGES

INJECTIONS

4.2 Accelerator theory

The accelerator XE "accelerator" relates to a small change in the output of consumer goods,
which is said to result in a greater change in the output of capital XE "capital" equipment. This
change in the production of capital equipment depends on the capital-output ratio.
The accelerator XE "accelerator" theory suggests that the level of net investment XE
"investment" will be determined by the rate of change of national income XE "national
income" . If national income is growing at an increasing rate then net investment will also
grow, but when the rate of growth XE "growth" slows net investment will fall. There will then
be an interaction between the multiplier XE "multiplier" and the accelerator that may cause
larger fluctuations in the trade cycle.

In the multiplier XE "multiplier" principle, an increase in investment XE "investment" affects

income and consumption XE "consumption" , while under the accelerator XE "accelerator" ,
consumption affects investment. When the economy is expanding, and income as well as
consumption is high, then the business sector is encouraged to produce more goods. Thus
investment increases. The increase in investment leads to an increase in income and
consumption, and so on.

The combined effect of both the multiplier XE "multiplier" and the accelerator XE "accelerator"
results in the sequence of rapid growth XE "growth" in the national income XE "national
income" followed by a slow growth, the business or trade cycles. These are made up of four
phases namely, the recession, depression, recovery and boom.

When aggregate demand falls, businesses are discouraged, and both employment and
production fall this is the recession stage. If this continues, then a full depression sets in.While
a recession is quicker, recovery is slower because of lack of business confidence. Once
recovery starts it is likely to quicken as business confidence returns. As output, employment
and income increase, there is even more investment XE "investment" because of business
expectations XE "expectations" until a ‘business boom’ is reached.

4.3 THE PARADOX OF THRIFT XE "PARADOX OF THRIFT"

In theory, investment XE "investment" depends on savings XE "savings" . In order to increase

savings, consumption XE "consumption" must reduce because income is either consumed or
saved.

Unfortunately, a reduction in consumption XE "consumption" reduces business expectations

XE "expectations" , and the business sector reduces investment XE "investment" . A reduction
in investment causes greater reductions in income. When income reduces, savings XE
"savings" also reduces.

The paradox of thrift explains the working of the ‘demultiplier’.

5.0 CHAPTER SUMMARY

The level of national income XE "national income" of any country is determined by the
relationship between decisions by households to spend and save and decisions by the business
community to invest.

The consumption XE "consumption" function is C = a + bY. Where b is the marginal

propensity to consume XE "marginal propensity to consume" , this is the proportion of an
increase in income, which is spent (consumed).

Therefore, the most important determinant of the level of consumption XE "consumption" is

income.

Savings is that amount of income not spent, and therefore, it also depends on income.
However, there are other factors that influence consumption XE "consumption" and savings
XE "savings" , such as interest rates XE "interest rates" , inflation, levels of taxation XE
"taxation" , existence of financial institutions etc.

In theory, the national income XE "national income" remains the same from one period to the
next if people decide to save an equal amount as the one, which business houses decide to
invest.

Investment is the actual increase in stocks, the creating or buying capital XE "capital"
equipment, not goods which are for immediate consumption XE "consumption" . Investment
depends mostly on the expected returns.
When national income XE "national income" is at its full employment level, and the total
spending, commonly known as aggregate demand, is less than this figure, the deficiency is
known as a deflationary gap XE "deflationary gap" .

If, on the other hand, at full employment, aggregate demand is in excess of the full employment
national income XE "national income" , then an inflationary gap XE "inflationary gap" occurs.

An increase in aggregate demand gives rise to additional income due to the workings of the
‘multiplier XE "multiplier" ’, but a reduction in aggregate demand gives rise to multiple
reductions in income, called the de-multiplier.

The ‘accelerator XE "accelerator" ’ theory links consumption XE "consumption" expenditure

to investment XE "investment" decisions. An increase in consumption expenditure results in
more investments in capital XE "capital" goods in order to increase output to satisfy
customers.

The combined effect of both the multiplier XE "multiplier" and the accelerator XE "accelerator"
results in the business or trade cycles. A business cycle consists of simultaneous expansion in
many fields of business activity, followed by widespread contraction.
The ‘paradox of thrift’ reflects the fact that a decision to increase the rate of savings XE
"savings" may result in a decline in income.

Note the fact that the theory of income determination is developed on simplified models whose
application in practice may be limited. However, Keynesian demand management XE "demand
management" is important because governments intervene in order to stabilize their national
economies, and even if their interventions may not be fully successful, they do influence the
level of Economic activity.

REVIEW QUESTIONS

What does the equation ‘C = a + bY’ mean?

When, in theory, is an economy in equilibrium?
Mention why in practice, the above is not possible
Name two injections into the circular flow of income
How does the aggregate demand ‘differ’ with the injections into the circular flow of income
According to Keynes, why does investment XE "investment" grow faster than consumption
XE "consumption" ?
Explain the ‘multiplier XE "multiplier" ’ principle, and indicate the formula for both a closed
and an open economy.
What is a trade or a business cycle? Indicate its correct sequence.
Why does the ‘paradox of thrift’ arise?
When can a ‘deflationary gap XE "deflationary gap" ’ occur?

-------------------------------------------------------------------------------------------------

EXAMINATION TYPE

QUESTION 9.1

Explain why the level of investment XE "investment" is considered to be important in any

economy? (4 marks)
How might governments encourage a high level of business investment XE "investment" ? ( 6
marks)
Explain what is meant by the multiplier XE "multiplier" in the context of national income. (5
marks)
Explain the paradox of thrift. (5 marks)

(TOTAL: 20 MARKS)
CHAPTER 10

MONEY AND INTEREST RATES

__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Define and differentiate forms of money XE "money"

Describe the basic characteristics of money XE "money"
Appreciate the functions of money XE "money" in the economy
Explain the demand for money XE "demand for money"
Explain how the money XE "money" supply XE "supply" is defined
Explain how Interest rate is determined
Discuss the Economic effects of interest rate changes
___________________________________________________________________________
___

1.0 INTRODUCTION

Money is defined as anything that is generally acceptable in repayment of a debt. It is a medium

of exchange, a legal tender.

The early forms of money XE "money" where items that were in common use and generally
acceptable, such as cattle, hides, furs, tea, salt, shells, cigarettes, etc.

These early forms of money XE "money" had a lot of limitations, some items like cigarettes
are not generally acceptable to be used by all to settle debts. Other early forms of money like
cattle were not easy to carry around, and therefore not convenient. Some were perishable
products like hides and as they were deteriorating with frequent handling.
In addition, there was no homogeneity in terms of size, colour and weight. The money XE
"money" that is used now such as the one, ten or fifty kwacha bank notes are similar and they
are easily recognizable.,

Therefore, a good monetary medium must be:-

Generally acceptable
Fairly durable
Capable of being divided into small units
Easy to carry (portable)
Should be relatively scarce
Should be uniform in quality

1.1 The Origin of Money

Money came into use due to the abundance of some things, after producing in greater quantities
than what is required for immediate consumption XE "consumption" . There was need to
exchange the surplus with another person for some other commodity. Initially, it was mostly
the exchange of goods for goods, the barter system.

This method had a lot of limitations and inconveniences such as the ‘double coincidence of
wants’. Finding a person who had an item or service you wanted and in return you also have
an item, which is wanted by that person, before any, exchange can take place.

There was also the problem of the rate of exchange. That is, how much of item X has to be
given for item Y. Related to this was issue of one party to a transaction having only a large
commodity to offer, but requires a small item in exchange.

The barter system is still being practiced among some people but to a very small extent.

Given the shortcomings of the barter system it is easy to appreciate and understand the
functions that money XE "money" performs in modern economies.

1.2 Functions of money XE "Functions of money"

Money performs four main functions:

A Medium of Exchange

This is its earliest function and the most important one. Money facilitates the exchange of
goods, buyers and sellers meet and trade easily without the inconveniences of the barter
system. This in turn promotes specialization, productivity, efficiency and wealth XE "wealth"
creation. Money is considered to be the ‘oil, which allows the machinery of modern buying and
selling to run smoothly’.

A Unit of Account and a Measure of Value

Another drawback of the barter system is the difficulty of determining a rate of exchange
between different kinds of goods especially large indivisible articles. Money acts as a common
measure or standard value of the unit account of goods and services.

The value of goods and services is reduced to a single unit of account, and therefore the
process of exchange is greatly simplified.

Money makes possible the operation of a price system and automatically providing the basis of
keeping accounting records, calculating the profit and loss accounts the balance sheet etc.

A Store of Value

Money is the most convenient way of keeping any income, which is surplus to immediate
requirement. It makes possible a build up of stores of many things for future use, a store of
wealth XE "wealth" .
Money can also be stored in the form of other assets such as houses, but money XE "money"
is a preferred because it is a liquid store of wealth XE "wealth" . This means that money can be
converted almost immediately into a medium of exchange without ‘loss of face value’.
Assuming that money is stable in value!

A standard for Deferred Payments

Use of money XE "money" makes it possible for payments to be deferred from the present to
some future date. Borrowing and lending are greatly simplified; loans are taken and repaid in
the form of money. Credit transactions cannot easily be carried out unless money is used.
Given the assumed stability in its value, future contracts are fixed.

Credit transactions cannot easily be carried out unless money XE "money" is used.

1.3 The Demand For Money

Demand for money XE "money" means the desire to hold money, as distinct from investing it.
This desire to hold liquid reserves is known as liquidity preference. According to Lord
Keynes there are three motives for holding money XE "money" .

The transactions motive

Both consumers and businessmen hold money XE "money" to facilitate current transactions.
A certain amount of money is needed for every day requirements, the purchase of food,
clothing, to pay casual workers etc.
The Precautionary Motive

Most people like to keep money XE "money" in reserve, in case an unexpected payment has to
be made, e.g. illness, funeral, accident, car defects, household appliance defects, etc.

nd rd
‘Active’ balances, depends any, fairly inelastic, less inelastic in the 2 and elastic in the 3
known as ‘idle’ balances.

The Speculative Motive XE "Speculative Motive"

This is for the purpose of accumulating more, since holding money XE "money" in active
balances does not yield any interest.

Speculation depends on the expectation of the future tend in securities e.g. attractive shares and
govt. stock, this generally moves in the opposite direction with interest rates XE "interest rates"
if interest rates go up i.e. people think the price of stocks will go down in the future they will
hold money XE "money" …

2.0 THE SUPPLY OF MONEY

Money supply XE "supply" in any economy is a very important part of government policy.
Money supply has to be monitored as a guide to Economic policy.

The argument of the monetarists is based mostly on the money XE "money" supply XE
"supply" . However both the Keynesians and monetarists accept the importance of money
supply XE "money supply" .

The money XE "money" supply XE "supply" is the stock of money XE "stock of money"
existing at any particular point in time. It is basically made up of coins and notes in circulation
as well as bank deposits. Coins and notes make up approximately only one fifth of the total
money supply XE "money supply" while bank deposits make up four fifth. This is because
commercial banks ‘create’ money through the creation of credit and the creation of deposits.

2.1 MONETARY AGGREGATES

The definition of the money XE "money" supply XE "supply" is carried out in order to
measure monetary aggregates. In practice, money is measured either narrowly or broadly, with
a very thin dividing line between the two.

Narrow Money XE "Narrow Money"

This is money XE "money" that is available to finance current spending, money that is held for
transaction purposes, it highlights the function of money as a medium of exchange. Narrow
money is designed in different ways, the narrow measure of money starts from MO
(Pronounced as ‘m nought’), is the narrowest definition of narrow money. It comprises mostly
notes and coins in circulation, plus commercial banks operational deposits held by the bank of
Zambia XE "bank of Zambia" .

Broad Money

This is narrow money XE "money" plus balances held as savings XE "savings" , that is the
function of money as a medium of exchange and as a store of value. Therefore, broad money
is money held for transactions purposes and money held as a form of saving.

Broad money XE "money" includes assets, which are liquid but not as liquid as assets under
narrow money XE "money" . Broad money is also defined in different ways. The first broad
definition of money XE "money" is M4, and when foreign currency deposits are included, the
definition is M3.

3.0 INTEREST RATE DETERMINATION

Interest is the price of money XE "money" , and in the credit market, it is determined by the
market conditions of demand for and supply XE "supply" of money. According to the
Keynesians, the demand for money XE "demand for money" , liquidity preference is partly
depend on the rate of interest XE "rate of interest" . The supply of money is perfectly inelastic,
the supply might increase or decrease depending on the government policy.

The equilibrium market rate of interest XE "rate of interest" is determined at the point where
the supply XE "supply" of money XE "money" equals the demand for money XE "demand
for money"

Interest
Rate MS

LP = d

O m Quantity of money XE "money"

As in other markets, changes in either demand or supply XE "supply" conditions lead to a
change in interest rates XE "interest rates" . In the Keynesian model, an increase in the money
XE "money" supply is associated with a fall in interest rates and vice versa.

Interest
Rate MS MS 1

r1
LP = d

O m m1 Quantity of money XE "money"

If the money XE "money" supply XE "supply" increases from MS to MS1, the equilibrium
rate of interest XE "rate of interest" reduces from or to Or1.

3.1 THE MONETARISTS VIEW

Monetarists XE "Monetarists" ensure that there are no three motives for holding money XE
"money" . Monetarists hold the view that money is held mostly for transactions purposes and
enjoyment, and that demand for money XE "demand for money" is interest rate inelastic. As a
result, any slight change in money supply XE "money supply" leads to a big change in the rate
of interest XE "rate of interest" . This explains the need to maintain stability in the money
supply XE "supply" in order to maintain stable interest rates XE "interest rates" .

Interest D MS Interest MS MS1

Rate rates D

r
r

D r1

O m Quantity of money XE "money" O m m1

Quantity
 of money XE
"money"

Another argument by the monetarist is the microEconomic view known as the loanable funds
theory (explained under factor markets).

3.2 EFFECTS OF INTEREST RATE CHANGES

Stable interest rates XE "interest rates" are important in any economy, if there is a large
increase in the rate of interest XE "rate of interest" , then the economy is affected in a number
of ways.

The cost of credit increases borrowing reduces and investment XE "investment" expenditure
reduces.

Spending by households also reduces savings XE "savings" is encouraged, since income is

either consumed or saved, an increase in savings reduces consumption XE "consumption"
expenditure.

Investment and consumption XE "consumption" expenditure are components of aggregate

demand, if spending by both households and firms reduces, then inflation is likely to be
lowered. Low prices and less borrowing is a sign of less Economic activity.

The foreign flow of funds increase financial speculators with ‘hot money XE "money" ’ are
likely to be attracted to the high rates of interest.

An increased flow of foreign funds puts pressure on the exchange rate. The high demand for
the kwacha causes the kwacha to appreciate in value.

A strong kwacha makes exports less attractive on the international market, reducing the demand
for exports. Some workers are likely to be laid off, this reduces the level of Economic activity
furthers.
The business sector is also affected by the likely impact on profitability and investment XE
"investment" projects that are appraised. High costs of borrowing compared to reduced cash
flows due to a reduction in consumption XE "consumption" expenditure.

3.3 VARIATIONS IN THE INTEREST RATES

Interest rates are determined by the market forces supply XE "supply" of and demand for
money XE "demand for money" . In practice, there are several variations of interest rates XE
"interest rates" that financial intermediaries apply, financial institutions do not give or charge
exactly the same interest rates.

Finance bank, Indo-Zambia bank, Zambia National Commercial Bank etc all have their own
rates that they offer to customers.

‘Lending rates’ given to surplus units (the depositors/savers who supply XE "supply" funds)
and ‘borrowing rates’ charged to deficit units are different.

An individual bank can give or charge different rates to customers depending on estimated
compensation for trying up the money XE "money" , perceived ‘risk XE "risk" ’ of the
customer, amount and period of the loan etc.

In addition, there is the real rate of interest XE "rate of interest" , which is the nominal rate of
interest adjusted for inflation. The nominal rates of interest are the expressed rates, in
monetary terms, hence they are also known as the money XE "money" rate of interest.

The relationship between the inflation rates, the real rate of interest XE "rate of interest" and
the money XE "money" rate of interest are:

(1 + real rate of interest XE "rate of interest" ) x (1 + inflation rate) = 1 + money XE "money"

rate of interest. This is usually approximated as real rate of interest + inflation rate = money rate
of interest (nominal interest rate).

5.0 CHAPTER SUMMARY

Money is a medium of exchange, anything that is generally acceptable in the settlement of a

debt. Early forms of money XE "money" were items in common use, but had a number of
limitations, hence a good monetary medium has a number of characteristics.

Money performs a number of functions in the economy, it is a medium of exchange, unit of

account and measure of value, and it is a store of value and a standard for deferred payments.

The demand for money XE "demand for money" , according to Keynes, is the desire to hold
money XE "money" , and it is held as active balances, for the transactions and precautions
motive, this depends on an individual’s income and it is interest rate inelastic. Money is also
held as idle balances for speculative reasons, and this depend on the rate of interest XE "rate of
interest" .
The money XE "money" supply XE "supply" in any economy is simply made up of notes
coins and bank deposits; however, money supply XE "money supply" is a very important part
of government policy, and it can be measured both narrowly and broadly.

Generally, the market forces of supply XE "supply" and demand determine interest rates XE
"interest rates" . Interest rates should
have some degree of stability, as they are very important in Economics XE "Economics" and
in the business environment.

In practice, there are variations in the rate of interest XE "rate of interest" , which affect savings
XE "savings" and loan repayments.
REVIEW QUESTIONS

What is money XE "money" ?

Give a brief explanation of the characteristics of money XE "money"
What are the four functions of money XE "money" in an economy?
Distinguish between narrow money XE "money" and broad money
What do broad measures of money XE "money" include?
Why do people demand money XE "money" ?
If interest rates XE "interest rates" rise, will bond prices rise or fall?
What is the real rate of interest XE "rate of interest" ?
What effect has an increase in the rates of interest have on the exchange rate?
Sketch a liquidity preference schedule XE "liquidity preference schedule"

---------------------------------------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 10.1

In what ways might a business be affected by a large change in interest rates XE "interest
rates" ? (8 Marks)
Sketch and explain a liquidity preference schedule XE "liquidity preference schedule" .
(6 Marks)
Explain the loan able funds theory of interest rate determination. (6 Marks)
(Total: 20
Marks)

CHAPTER 11

FINANCIAL SYSTEMS AND MONETARY POLICY

__________________________________________________________________________________________
___
After studying this chapter, the students should be able to:

Appreciate the flow of funds and financial intermediation

Identify the main elements of the monetary and financial system
Explain the importance of the monetary environment to the business sector
Explain the functions performed by commercial banks and the central bank.
Understand how commercial banks ‘create’ money XE "money"
Explain the Economic role of government through monetary policy and its basic
instruments
Understand commercial bank’s conflicting objectives of liquidity, profitability and security
___________________________________________________________________________
____

1.0 INTRODUCTION

A financial system is made up of financial markets and financial institutions, it may also include
formal and unregulated systems of finance, such as moneylenders, trade credit, micro finance
and co-operative credit.

Financial markets are the capital XE "capital" market, the money XE "money" market and the
foreign exchange market XE "foreign exchange market" . Financial institutions are commercial
banks, building societies, insurance companies XE "companies" , national savings XE
"savings" and credit bank etc.

A financial system brings in many benefits in the economy, it facilitates payments, raise the
level of savings XE "savings" and investment XE "investment" . Capital is accumulated and
allocated to uses where there are highest returns. The system helps to provide a means of
transferring and distributing risk XE "risk" across the economy. Risk is diversified or pooled
among a large number of savers and investors, by offering assets with different degrees of risk,
financial institutions assess and manage risks and assign to individuals having different
attitudes and perceptions towards flow of funds.

1.1 THE FLOW OF FUNDS

Funds flow between three sectors in the economy. Individuals give and lend money XE
"money" to each other. Organizations lend money and purchase goods from each other. The
central government provides funds to the local government and loss making nationalized
industries.

In addition, there is also a flow of funds between the different sectors of the economy.
A go-between, known as a financial intermediary, such as a commercial bank or building
society, facilitates the flow of funds. Banks provide a means by which funds can be transferred
from surplus units in the economy to deficit units.
Linking lenders to borrowers.

An individual deposits saving with a bank, the bank provides a loan to a company, as explained
under credit creation.

If no financial intermediation takes place, lending and borrowing is direct.

Lends

To

Direct lending is also known as financial disintermediation. Savers wishing to lend have to
find a trust worthy borrower. The lender bears the risk XE "risk" of default.
The borrower has to locate savers with money XE "money" to lend. This results in high
information cost and high default risk XE "risk" .

In practice, financial intermediaries also lend abroad, as well as borrow from abroad. Therefore,
a detailed diagram of the flow of funds showing the role of financial intermediation in an open
economy is as shown below:
1.2 BENEFITS OF FINANCIAL INTERMEDIATION

A convenient way in which lenders save money XE "money"

They can package the amounts lent by savers and lend on to borrowers in bigger amounts
(aggregation)
They provide a ready source of funds for borrowers.
The lenders, capital XE "capital" is secure, bad debts are borne by the financial intermediary.
They bridge the gap between the wish of most lenders for liquidity and the desire of most
borrowers for loans over longer periods. This is known as maturity transformation.
They provide tangible returns to savings XE "savings" i.e. Interest rates.
They act as an important medium for the implementation of financial (monetary) policies.

1.3 FINANCIAL INTERMEDIARIES

The banking system is made up of commercial banks and the central bank, and the non-banking
financial intermediaries e.g.

Building societies
National credit and savings XE "savings" bank
Insurance companies XE "companies" invest premiums paid on insurance policies by
policyholders.
Pension funds are mobilized through forced contributions from employees, and these are
invested in financial markets and real estate.
Investment trust companies XE "companies" invest in the stocks and shares of other
companies and the government. Investment trusts simply trade in investment XE "investment" .
Unit trusts are similar to investment XE "investment" trusts in that they invest in stocks and
shares of other companies XE "companies" , but they enable small investors to invest with
minimum risk XE "risk" . Unit trusts comprise of portfolios (stocks or shares in a range of
companies or for example shares in mining companies), the trust creates a large number of
small units, which are then sold to individual investors.
Development banks are specialized financial institutions that provide long term and medium
term funds.
Venture capital XE "capital" is investment XE "investment" in long-term, risky equity
finance, where the reward is an eventual capital gain, a takeover, a trade sale or a stock market
flotation, rather than dividend income or interest. The main providers are investors in industry.
Hire-purchase companies XE "companies" , facilitate the acquisition of physical assets
through extension of credit.

2.0 FINANCIAL MARKET

The market for finance is basically divided into the following

- Money markets
- Discount market Short term and commonly known as the money XE "money"
market.

- Capital market
- Stock market Long term capital XE "capital" market

Money markets deal with short-term finance i.e. lending and borrowing for less than one year.
Active participants in the market are commercial banks, the central bank, big organization and
brokers. Financial instruments traded are:

Certificate of deposits
Commercial paper, I Owe You ( I O U )
The discount market, which performs the following functions:

Help finance short-term trade debts by purchasing commercial bills at a discount.

Create a market in bills of exchange

The money XE "money" markets also includes

Inter-bank markets for unsecured loans between banks; this facilitates smoothing out
fluctuations in receipts and payments of banks, and determines likely future trends in interest.
Eurocurrency markets, which are short-term deposits and borrowing mainly for the purposes
of working capital XE "capital" . It is in other currencies either than that of the denomination of
a particular country. With the growth XE "growth" in mergers largely involving multinational
companies XE "companies" , there is need to shop around for favourable terms and avoid
domestic government credit restraints.

2.1.0 Capital Markets

This market is divided into primary market for the new issue of shares, and the secondary
market, which deals with reselling of existing securities. Instruments traded on the capital XE
"capital" market are equity shares, mortgages, corporate and government bonds etc.

Note that the international capital XE "capital" market for medium term and long term are
known as the eurocredit (for working capital and investment XE "investment" purposes) and
the Eurobonds respectively.
The Eurodollar or the Eurobond market deals with long-term finance. Bonds are issued by very
large companies XE "companies" , banks, governments and institutions such as the European
Union. The bonds are denominated in a currency other than that of the borrower.

The bonds are bought and traded by investment XE "investment" institutions, banks etc.

2.1.1 The Stock Exchange

The Lusaka stock exchange is an organized capital XE "capital" market, which plays an
important role in the functioning of the economy.

It makes it easy for large firms and the government to raise long term capital XE "capital" , by
providing a market for borrowers and investors to come together
It publishes the prices of quoted (or listed) securities, which are then reported in the media.
It tries to enforce certain rules of conduct for its listed firms and for operators in the market to
provide investor confidence, and make them more willing to put their money XE "money" into
stocks and shares.
It is a primary market for newly issued shares. Note that a firm’s new shares are issued by an
issuing house with the help and advice of a stockbroker.
A secondary market exists for the buying and selling of existing shares, the buyers of new
issues know that they can sell them in future.

The capital XE "capital" instruments traded are equities/securities such as ordinary shares,
preference shares and debentures, as well as government bonds/gilds.

It also acts as an Alternative Investment Market (AIM), where small companies XE

"companies" gain access to capital XE "capital" , under less stringent, less costly procedures.

A stock market is usually given as an example of a perfectly competitive market, even if it is

affected by political factors such as wars, elections or any other form of uncertainty, including
the general mood of the business.

3.0 COMMERCIAL BANKS AND CREATION OF MONEY XE "CREATION OF

MONEY"

Commercial banks are financial intermediaries, with the same roles and benefits as other
financial institutions.

A Commercial bank’s activities can be one or more of the following:

Clearing – settling payments

Retail – traditional banking, offers small deposits and small loans to customers.
Wholesale – bank dealing with large quantities
Investment-also known as merchant banks, are specialized and deal with corporate customers.

3.1 Functions of commercial banks

Banks provide a payment mechanism and a place to store surplus money XE "money" ; they
also provide means of obtaining and selling foreign exchange.

Commercial banks advise and assist companies XE "companies" in the issue of shares, and
give investment XE "investment" unit trust advice and business.

They also engage in financial leasing, debt factoring or collection management, including
executorships (trustee) services.

Banks finance import and export operations and investments.

The most profitable business of commercial banks is lending money XE "money" in the form
of overdrafts, discounting bills of exchange and loan facilities. This particular function is
always expanding because banks create credit, create deposit and therefore create money.

3.2 Credit creation

Commercial banks are financial intermediaries, who accept deposits and extend loans. They
operate on the assumption that they know from experience that customers only withdraw a
fraction of what they have deposited and that not all depositors withdraw all their cash at the
same time. Therefore, banks only keep a small fraction of their assets as actual cash, known as
fractional reserve system XE "fractional reserve system" .

To simplify the explanation on credit creation, assume that there is only one commercial bank,
which is already in business with lenders and borrowers. Assume also that the bank knows
from experience that the reserve ratio, that is, funds that a commercial bank must keep, as actual
cash is 10% of a customer’s deposit.

If a customer deposits K100 million in the bank, then the bank’s balance sheet on day one with
appear as follows:-

DAY ONE

Liabilities Assets

Km Km
Share Capital 10 Fixed assets 10
Customer deposit 100 Cash 100
110 110

Note that the share capital XE "capital" is used to finance fixed assets, and therefore, can be
ignored; it is not part of the credit creation process.

If the bank loans 90% of the deposit, then the bank’s balance sheet will appear as follows:
DAY TWO

Liabilities Assets

Km Km
Share Capital 10 Fixed Assets 10
Customer deposit 100 Cash 10
Loan 90
110 110

An individual, firm or a government borrows money XE "money" for a purpose. Suppose the
loan of K90m is used to purchase a motor vehicle, the person receiving the money deposits it in
the bank, and the bank’s balance sheet will appear as follows:

DAY THREE

Liabilities Assets
Km Km
Share Capital 10 Fixed Assets 10
Deposit - original 100 Cash 10
New deposit 90 Cash from new deposit 90
Loan 90
200 200

The bank will again maintain only 10% of the new deposit as actual cash and lend the rest to
customers. This process continues, however, the credits and deposits being created reduce
until it becomes too small to generate a fresh loan.

It is possible to calculate the total deposits created from any initial deposit and to come up with
the final balance sheet by using the formula.

D =C where D = final deposits created

R C = initial cash deposit
R = cash reserve ratio

D = 100 = 100 x 100 = 1 000

10% 10

From the initial deposit of K100m, the bank’s final balance sheet appears as:

Liabilities Assets

Km Km
Share Capital 10 Fixed Assets 10
Total deposit 1000 Cash 100
 Loans 900

1010 1010

Note that the bank has created credit worth K900m from the initial deposit of K100m, this has
resulted in additional deposits of K900 which is in circulation as part of the money XE
"money" supply XE "supply" .

In practice there are several banks in any economy and billions of money XE "money" is
‘created’, but the process remains basically the same. This process is very important to know
because it is closely linked with the money supply XE "money supply" in the economy and as
such the level of Economic activity.

3.3 LIMITS TO CREDIT CREATION

A deposit of K100m with a cash credit multiplier XE "multiplier" of 10% may not result in K1
billion total deposits. Some of the restrictions on credit creation may be summarized as:

Since there are several banks, an individual bank cannot adopt an expansionist policy, unless
other banks are willing to do the same. The clearing bank may have an overcautious credit
policy, and restrict lending.
A bank’s ability to lend depends on its ability to acquire deposits, this may sometimes be
limited by the lack of public confidence in the banking sector, and their inability to make
abnormal demands for cash.
Lack of collateral security may also hinder the process of lending and borrowing.
The government, through the central bank, may decide to restrict lending and borrowing, in
order to control the money XE "money" supply XE "supply" in the economy.
There is an inverse relationship between the cash reserve ratio and the money XE "money" that
is ‘created’ by banks. In developing countries, the cash ratios are relatively high, this means
less Economic activity
If the loans are spent on imported goods, then the foreign banking system benefits instead of
domestic banks.

4.0 CONFLICTING OBJECTIVES OF PROFITABILITY, LIQUIDITY AND

SECURITY

A commercial bank’s assets and liabilities XE "bank’s assets and liabilities" reflect a balance
between conflicting demands of liquidity, profitability and security. A commercial bank has to
serve the interests of its shareholders, which is maximising profits, and to attain this, the bank
has to lend as much as possible. However, the bank has to ensure that it has adequate liquidity
to meet the cash demand from depositors. As far as depositors are concerned, their money XE
"money" is secure at the bank.

- Liquidity
Used to settle daily cash withdrawals from customers and to settle accounts with other
commercial banks in the clearing system, but balances for these purposes earn no interest and
are unprofitable. Banks have to make sound investment XE "investment" policy, by investing
in assets that can be easily converted into cash.

- Profitability
A commercial bank’s profit is normally obtained from interest charged on assets minus interest
paid on liabilities.

Commercial banks have an objective of trading profitably like other commercial organizations.
To pursue this objective they need to earn high interest rates XE "interest rates" . Therefore,
they have to lend for a long term and to high-risk XE "risk" customers. This reduces the
choice of liquidity and security.

- Security
Commercial banks are expected to act prudently to safeguard the interests of depositors and
shareholders; this however reduces opportunities for profitable lending.

5.0 THE CENTRAL BANK

This is the principal financial institution in a country, and it acts as a regulator of the banking
system. Zambia’s central bank is known as the Bank of Zambia (BOZ), it was established to
take over from the Bank of Northern Rhodesia on the 7th of August 1964 although its Act was
only passed in June 1965.

The central bank does not deal directly with the general public, but provides services to the
commercial banks and the government and manages the money XE "money" supply XE
"supply" on behalf of the government and the people of Zambia for the good of the economy
and not for profit maximization.

The Bank of Zambia’s stated functions are:

To ensure appropriate monetary policy formulation and implementation

To act as the fiscal agent of the Government
To license, regulate and supervise banks and financial service institutions registered under the
Act to ensure a safe and sound financial system
To manage the banking and currency operations of the Bank of Zambia ensuring the provision
of an effective service to commercial banks, Government and other users.

5.1 Other functions of a central bank

Issuing notes and coins. Bank of Zambia has the sole right to issue coins and notes in the
economy.
It acts as banker to the government. The government is the most important customer of the
central bank. In addition, the central bank performs many tasks for and on behalf of the
 government such as:

Keeping the central government accounts and the accounts of the many other government
departments.
Giving assistance by means of “ways and means” advances if the account is in “red” or
overdrawn
Conducting government borrowing through the issue of Treasury Bills and government
stock.
Advising the government on financial matters

It acts as banker to the commercial banks, use the central banks use the central bank in the
same way as private customers use the commercial banks. Commercial banks:

Draw coins and notes from their balances at the central bank as required.
Set off the net payments which has to be made to other banks as a result of the days clearing by
drawing on the balance held at the central bank
Take advice on financial matters from the central bank

- Acting as lender of the last resort

Holding the gold and foreign currency reserves in the exchange equalization account,
which the central bank uses to stabilize or manage the kwacha.
The central bank maintains close contact with other central banks and monetary authorities
of other countries with the aim of achieving greater international monetary stability.
It works in conjunction with international monetary organization like the international
monetary fund XE "international monetary fund" and the world bank XE "world bank"
The central bank manages the national debt. It is responsible for floating new loans and the
repayment of maturing loans plus interest as well as payment of interest to holders of
government securities.

5.2 BANKING SUPERVISION

- Capital Adequacy XE "Capital Adequacy" Rules

Commercial banks make profits by charging interest on amounts borrowed, some amounts are
not repaid, bad debts arise; hence the need to set capital XE "capital" adequacy ratios. The
central bank imposes certain rules and requirements.

- Liquidity
Commercials banks need to hold money XE "money" to meet customer demand, the central
bank discusses with each individual commercial bank the adequacy of its stock of liquidity and
can advise on changes.

- Provision.
The central bank encourages commercial banks to make adequate provision for bad and
doubtful debts. In addition a bank is not allowed to lend more than 10% of its capital XE
"capital" base to one single borrower.
- Systems
Each commercial bank reports periodically on its procedures and controls. The central
Bank examines methods for monitoring credits risks, its systems for recoverability, its
arrears patterns etc.

- Personnel
The directors, managers and large shareholders of banks have to satisfy the central bank that
they are “fit and proper” people for such positions that is in terms of honesty, competency,
diligence and are of sound judgment.

5.3 MONETARY POLICY

Monetary policy XE "Monetary policy" is becoming increasingly important in Economic

management. Fiscal (budgetary) policy is once a year, in between, the government has to rely
on monetary policy. The central bank controls the money XE "money" supply XE "supply" in
order to help the government achieve its macroeconomic objectives.

Monetary policy XE "Monetary policy" is decisions and actions of the government regarding
the supply XE "supply" of money XE "money" and its price (the rate of interest XE "rate of
interest" ). An increase in the money supply XE "money supply" , which is loose monetary
policy leads to a lot of borrowing and spending. With too much money in circulation, inflation
as well as an external trade deficit is the likely result.

To reduce the money XE "money" supply XE "supply" , the central bank has to curtail the
borrowing and spending by limiting the commercial bank’s capacity to create credit, create
deposits and therefore ‘create money’. The instruments that the central bank uses to control the
money supply XE "money supply" are:

Open Marketing Operations

By intervening in the open market to buy or sell securities, the central bank can directly
influence the size of bankers’ deposits. If the central bank wants to reduce the rate of inflation,
it has to control (reduce) the money XE "money" supply XE "supply" , and if it sold
securities, e.g. treasury bills XE "treasury bills" if it is a short term measure or government
bonds if it is a long-term measure, the central bank receives payment by cheques drawn on
commercial banks. This brings about a reduction in commercial banks deposits as well as the
amount of money circulating in the economy.

Bank Rate (interest rate changes)

The importance of central bank rate is that other rates of interest used, depend on it, the rate
charged to discount houses, the rates charged on advances to customers and the rate offered on
deposit accounts.

These rates move up or down with central bank rate. To check inflation, i.e. to reduce the
money XE "money" supply XE "supply" , the interest rate is raised to make credit
expensive and as such discourage people from borrowing.
Special Deposits
To reduce the cash basis for credit creation and to contract credit, the central bank can request
commercial banks to place specified amount or to increase the percentage of these specified
amounts, which are supposed to be kept in frozen accounts with the central bank. The
government pays interest on the ‘special deposits’. When following an expansionary policy, to
encourage lending, the special deposits are returned.

Assets Ratios
The central bank dictates or compels commercial banks to keep certain proportions of specified
assets. To control inflation the ratio is raised.

Directives (moral suasion)

This is a direct instruction from the central bank to the commercial banks to restrict their
lending.

The directive can be in two forms:

- Qualitative, this is when commercial banks are requested to restrict lending only to purposes
regarded as being in the national interest. Commercial banks would be encouraged to lend
only
to important sectors in the economy such as agriculture, mining and manufacturing.

- Quantitative, this is when banks are instructed to reduce their lending by a required amount.

Note that directives are easy to enforce in a command, planned Economic system. In a
liberalized market Economic system, firms including banks have the freedom to meet new
market demands without much government intervention.

5.4 Limits to Monetary Policy

In practice, monetary policy is not easy to achieve, not only because of a liberalized market
Economic system, but because it also depends on commercial banks curtailing credit, given the
fact that lending is the most profitable business of commercial banks, the banks find ways of
circumventing the policies.

In addition, central banks face problems in applying monetary policy, for example
A central bank may lack adequate, detailed, up to date information on the economy and the
money XE "money" supply XE "supply" .
The central bank has to closely supervise the commercial banks to ensure that they have
reduced their lending to customers, in order to reduce the money XE "money" supply XE
"supply" in the economy.
Conflicting objectives of reducing the money XE "money" supply XE "supply" , which results
in an increase in the rate of interest XE "rate of interest" , lower investments, less Economic
activity and increased unemployment. The government has to trade inflation for unemployment
or vice versa.
The reluctance of the central bank to undermine initiative and commercial banks’ ability to make
profits, as mentioned earlier, lending is the most profitable business of commercial banks.

6.0 CHAPTER SUMMARY

Financial systems are made up of financial institutions and financial markets. Financial
institutions enable the three sectors of the economy, the households, firms and government to
borrow and lend to each other as financial intermediaries.

Some of the functions of financial intermediaries are to provide savings XE "savings" facilities
and tangible returns to savers, maturity transformation, ready source of funds for borrowers,
and as a medium for the implementation of monetary policy.

The financial market is composed of the money XE "money" and the capital XE "capital"
market, dealing in short and long-term finance respectively. Both markets are divided into
primary and secondary markets, meaning issuance of new securities and trading in second hand
securities respectively.

One of the significant groups of financial intermediaries is the banking sector. Commercial
banks perform a number of functions, such as providing a payment mechanism, offering
financial advice, financing import and export operations etc.

More importantly, the operation of the banking system increases the money XE "money"
supply XE "supply" , as commercial banks ‘create’ money. This depends on the cash deposited
in the banking system and the cash reserve ratio.

When pursuing the most profitable business of commercial banks, which is lending to
customers, a bank has to try and balance liquidity, profitability and security.

The central bank is the primary financial institution in any country, and it performs a number of
functions. The most important of which is banking supervision and controlling the money XE
"money" supply XE "supply" in the economy, known as monetary policy.
REVIEW QUESTIONS

State the role of financial intermediaries in the economy

Give everyday examples of disintermediation
What is a cash ratio?
Which assets are most profitable to commercial banks?
What are capital XE "capital" adequacy rules?
What are open market operations XE "open market operations" (OMOS)?
Suggest limitations/problems with monetary policy
What do capital XE "capital" markets provide?
Distinguish between primary and secondary capital XE "capital" markets
What is a money XE "money" market?
Which instruments are traded on the money XE "money" market?

------------------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 11.1

Define the term financial intermediaries and give four examples of major financial
intermediaries (6 marks)

Explain any four functions of financial intermediaries. (8 marks)

Describe the role of financial intermediaries to government, and business organizations

(6 marks)

(Total: 20 marks)

EXAMINATION TYPE QUESTION 11.2

a) Explain briefly, the importance of each of the following for the structure of bank assets:
Profitability (4 marks)
Liquidity (4 marks)
Security (4 marks)

b) State briefly four important functions of the Bank of Zambia. (8 marks)

(Total: 20 marks)

CHAPTER 12

INFLATION AND UNEMPLOYMENT

__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Define and explain causes of inflation

Understand how to measure changes in the value of money XE "money"
Identify the negative effects of inflation
Explain the measures used to control inflation
Define and explain types of unemployment
Understand how to measure changes in unemployment levels
Identify the negative effects of unemployment
Explain the relationship between inflation and unemployment
Appreciate the supply XE "supply" -side policies
___________________________________________________________________________
____

1.0 INTRODUCTION

In any economy, the government can follow expansionary or contractionary monetary or fiscal
policies by either increasing the money XE "money" supply XE "supply" and increasing
aggregate demand or reducing the money supply XE "money supply" and reducing the
aggregate demand respectively. Unless the ‘supply side policies’ are put into effect, a
government cannot easily control both inflation and unemployment at the same time. One
Economic ‘evil’ has to be ‘traded off’ for the other.

2.0 INFLATION

Inflation is a sustained rise in the general price level of goods and services. It is
measured using price indices.

Inflation can be classified between two extremes depending on the speed at which prices are
changing. Creeping inflation is when there are small price increases while hyperinflation is
the worst case of inflation. The prices of goods and services change very rapidly.

2.1 CAUSES OF INFLATION

There are three main causes of inflation, one view from the Monetarists XE "Monetarists" , and
two views from the Keynesians. Demand-pull and cost-push are essentially Keynesian
explanations of inflation. Monetarists reject these and believe that inflation is caused by an
increase in the money XE "money" supply XE "supply" .
Keynesians on their part do not accept that an increase in the money XE "money"
Supply actually causes inflation.

They believe that an increase in the money XE "money" supply XE "supply" is an

indication that there is inflation in an Economy. It is not a cause of inflation.
2.2 MONETARISTS VIEW AND THE QUANTITY THEORY OF MONEY

Monetarists XE "Monetarists" consider the increase in the money XE "money" supply XE

"supply" as the only cause of inflation. The argument of the monetarists is based on the
quantity theory of money XE "quantity theory of money" . The theory is summarized as the
fisher equation, Irving Fisher developed the Fisher equation of exchange. It appears in various
guises, the most common is:

MV = PT
where:

M is the amount of money XE "money" in circulation

V is the velocity of circulation XE "velocity of circulation" of that money
P is the average price level and
T is the number of transactions taking place

MV = PT states that money XE "money" supply XE "supply" multiplied by the velocity of

circulation XE "velocity of circulation" equals the price level multiplied by total transactions.
This equation is true by definition since receipts are equal to expenditure. PT can therefore be
thought of as equivalent to National Expenditure.

Assuming that V is constant in the short run XE "short run" as it is determined by the money
XE "money" supply XE "supply" , and T is also fixed in the short run. Then, an increase in
the money supply XE "money supply" would lead to an increase in the general price level.

2.3 COST-PUSH INFLATION

This inflation is caused by an autonomous increase in the costs of production, considered as

cost-push factors. These may then cause cost-push inflation. Cost-push factors may be
changes in wages, changes in the exchange rate, which change the price of, imported raw
materials or perhaps changes in indirect taxation XE "taxation" . Cost-push inflation occurs
when a company's costs rise and to compensate, a firm has to put prices up. Cost increases may
happen because wages have gone up or because raw material prices have increased. The
increase in the costs, with aggregated demand remaining uncharged, causes the aggregate
supply XE "supply" curve to shift to the left from AS to AS1, and price increases from OP to
OP1.

Prices
AS

AD

P1
AS
1

P AS

0 Y National output, employment and income

Cost-push factors that can contribute to the increase in the cost of production include:

Strong, powerful trade viewers who force employers to concede high wage increases, costs
then rise and these are later passed on to consumers in the form of price increases. This
situation is worse during periods of low unemployment.
Import cost inflation, especially for a country which depends on one or more of the
Imported raw materials or other imported inputs
Imported finished products, capital XE "capital" equipment and more especially the ever
Increasing price of imported fuel.
High indirect taxes such as when there is an increase in value added tax XE "value added tax"
or excise duties, consumers simply notice an increase in prices.

2.4 DEMAND-PULL INFLATION

If there is an excess level of demand in the economy, this will tend to cause prices to rise. This
type of inflation is called demand-pull inflation and is argued by Keynesians to be one of the
main causes of inflation. Inflation occurs when increases in aggregate demand pull up prices,
with aggregate supply XE "supply" remaining constant.

The aggregate demand is the total demand in an economy, made up of government expenditure,
consumption XE "consumption" expenditure, investment XE "investment" expenditure and
exports minus imports. Any increase in one or more of these components of aggregate demand
can put pressure on prices. As demand increases from AD to AD1 there is increasing
inflationary pressure on prices. This is demand-pull inflation - "too much money XE "money"
chasing too few goods."
 Price
level AS
AD1

AD

P1

O Y YFE (Real national income XE "national

income" )
Output, employment and Income

Increase in demand can be caused by either expansionary monetary or fiscal policies. If there is
a high public sector net cash requirement, then total demand in the economy is stimulated.

The Keynesian original aggregate supply XE "supply" curve is an inverse “L”. According to
them, the pressure on prices is when aggregate demand expands after the full employment of
resources, before that point, an increase in aggregate demand acts as an incentive for firms to
increase output.

When the resources are fully employed, the aggregate supply XE "supply" curve becomes
vertical, and if aggregate demand increases beyond this point, an inflationary gap XE
"inflationary gap" is created.

Price AD AS

Inflationary
gap

Output/employment/income

2.5 ANTI INFLATIONARY MEASURES

To control inflation, first, it is necessary to know the cause. Unfortunately, this is difficult to
do because inflation tends to feed on itself and there is the price wage spiral.

Suppose the prevailing inflation is demand driven, then, measures to reduce aggregate demand
should be put in place; such as tight fiscal and monetary policies like increasing direct taxes and
interest rates XE "interest rates" to reduce consumption XE "consumption" expenditure and
investment XE "investment" expenditure respectively. Government expenditure should also
be reduced. This means that the government must aim for a budget surplus, by increasing its
income through increased taxes, but reduce government spending, the excess money XE
"money" should be kept frozen at the central bank.

If the inflation is due to an increase in the money XE "money" supply XE "supply" then the
government should attempt to reduce the money supply XE "money supply" by reducing
commercial bank lending using the instruments mentioned under the control of the money
supply. These are open market operations XE "open market operations" , increasing interest
rates XE "interest rates" and asset ratios to discourage lending. Directing commercial banks to
reduce their lending and requesting them to make special deposits at the central bank.

If the source of inflation is an autonomous increase in the cost of production, then measures
should be taken to stop the wage-price spiral, reducing the power of trade unions or match the
increased costs with increased productivity.

A country’s currency can be allowed to depreciate in order to discourage imports, while

encouraging exports, this means increased production. An increase in supply XE "supply"
lowers the price.

Prices and incomes policy that is wage and price controls can also be instituted to control
inflation. This means freezing prices and incomes. This may not work well in a liberalized
market economy. It also means controlling the consequence and not the cause of inflation!

2.6 ECONOMIC CONSEQUENCES OF INFLATION

A little inflation is considered to be good for any economy as it provides an impetus for firms
to increase output. High prices are a sign that there is a high demand for goods and services
and there is a prospect of higher profits.

Generally, the negative effects of inflation are as follows:

Inflation redistributes income

Retired people who are on fixed incomes suffer a lot from inflation. Some people earn K20,
000 per month as pension. At the time of retirement, they were able to purchase a lot of goods
and services from that amount, but due to inflation their purchasing power and standards of
living falls.
Inflation distorts consumer bahaviour. Consumers purchase a lot of goods because of expected
future price increases. They hoard goods hoping to ‘beat’ inflation and in the process create
shortages.
Inflation undermines business confidence. Businesses are unable to make concrete future plans
because of uncertainty in price fluctuation in addition, they have to change the price tags on
products on a regular basis and this can be so costly and time consuming.
Inflation and interest rate and savings XE "savings" . The real rate of interest XE "rate of
interest" , which is the money XE "money" rate of interest after making an allowance for
inflation, is reduced. Lenders demand for high money rates to compensate for lower real
values.
Lower real interest rates XE "interest rates" discourage savings XE "savings" and encourage
spending. This may have a long-term effect on long-term finance for investment XE
"investment" .
Inflation reduces a country’s international competitiveness.
High prices make products (exports) unattractive on the international market,
consumers are likely to prefer cheaper imports to locally produced products. This
affects the balance of payments. A country has an adverse balance of payments when
exports are lower than imports.
Inflation causes the currency to depreciate when there is a low demand for exports, therefore,
the demand for the currency is low compared to its supply XE "supply" , and the currency
depreciates in value.
Inflation redistributes wealth XE "wealth" , it causes borrowers to gain at the expense of
lenders as it reduces the value of the debt. The lenders receive less relative to what they had
lent. This is related to the time value of money XE "money" .
Inflation leads to uncertainty in price forecasting, both at central government level and at
corporate business level.
Money is unable to perform its functions properly.
Inflation has little impact on money XE "money" ’s function as a medium of exchange. Money
is still used to purchase goods and services.
The use of money XE "money" as a means of deferred payment is rendered less effective by
inflation. Credit is granted but payment is deferred. This leads to redistribution of wealth XE
"wealth" where borrowers or those who purchase goods on credit gain but lenders lose.
The greatest effect of inflation on the functions of money XE "money" is the function of
money as a store of value. The value of money is measured indirectly through prices when
prices rise, it is a sign that the value of money has fallen since few items can be brought from
the same amount of money. Money becomes an ineffective store of value. Interest rates paid
are supposed to compensate, and this is one of the explanations why interest rates XE "interest
rates" rise during periods of inflation.
Money is used as a unit of account and as a measure of value. This function is also hampered
by inflation as the relative values of things being compared keep on changing in monetary
terms.

3.0 UNEMPLOYMENT

Unemployment simply means people do not have jobs. It occurs when people capable of and
willing to work are unable to find suitable paid employment.

Unemployment is measured as # of unemployed x 100

Total workforce

Full employment is when there are more jobs than people. The number of unfilled vacancies is
equal to the number of people out of work. It is the level of national income XE "national
income" at which everyone who wants to work is able to do so, in other words, there is
sufficient demand to employ everyone.
Classical economists argued that the economy would automatically tend to this equilibrium, due
to the market forces of supply XE "supply" and demand. Keynesians maintain that it is the role
of government, using policy instruments at their disposal, to ensure that there s full
employment in an economy.

3.1 CAUSES OF UNEMPLOYMENT

In some books the words ‘causes’ and ‘types’ are used interchangeably. However there is a
distinction.

Type is the label given to describe the main common characteristic of some unemployment,
while Cause is more analytical, an attempt is made to explain how some unemployment has
arisen.

Causes of unemployment can be broadly divided into demand and supply XE "supply"
factors:

Demand deficiency unemployment is caused by lack of demand for goods and services, and as
a result, firms lay off workers. This is usually when the economy is in the recession stage of
the economic or trade cycle and there is little economic activity.

Keynesians argue that a shortage of aggregate demand is one of the key causes of
unemployment.

Monetarists XE "Monetarists" view Supply side factors such as strong trade unions
demanding for high wages as causes of unemployment as firms employ less labour XE
"labour" while the supply XE "supply" of labour XE "labour" increases, as shown below:

Price
D S

W1

S D

O Q1 Q Q2 Number of workers
At a high wage rate of OW1, the demands for labour XE "labour" by firms reduces to OQ1,
supply XE "supply" naturally increases to OQ2, because individuals who were unwilling to
work at wage rate OW are now encouraged by the high wage rate. The difference between
OQ1 and OQ2 is unemployment caused by the activities of trade unions.

Firms lay off workers if import prices are too high, like the high price of oil, which reduces a
firms’ competitiveness, and loss of customers.

State benefits tend to encourage ‘voluntary unemployment’. When the benefits are higher than
the market wage, as in the diagram above, a person feels ‘better off’ being unemployed earning
OW1 than earning a low wage (OW) while in employment.

3.2 TYPES OF UNEMPLOYMENT

Seasonal unemployment is considered to be temporal and occurs in certain industries where

Economic activity is in specific periods or seasons, examples are tourism, agriculture and
construction industries. There is a high demand for labour XE "demand for labour" during
certain periods of the year, and then most of the workers are laid off during off peak periods.

Frictional unemployment is of a short-term duration. It refers to secondary school or college

graduates who are searching for jobs, as well as individuals who are in between jobs, the
transitional period between workers leaving one job and starting another. Frictional
unemployment is also an indication of imperfections in the market such as lack of knowledge,
the geographical immobility of labour XE "labour" or a mismatch between the requirements of
the employers and the available skills of the unemployed.

The more efficiently the job market is matching people to jobs, the lower this form of
unemployment will be. However, as long as there is imperfect information and people
don't get to hear of jobs available that may suit them then frictional unemployment is likely
to be high.

Structural unemployment refers to long-term changes in the pattern of demand and supply XE
"supply" in an economy. On the demand side, a firm may fail to compete with rival firms,
demand for the company’s product declines and the firm is likely to lay off workers and close
the business.

Changes in the supply XE "supply" of a product, for an example if the product like
copper ore is getting depleted, there is no need to employ miners and this can also lead to
unemployment in the Copperbelt. It may also result from changes in the production
methods labour XE "labour" is replaced by machines or capital XE "capital" equipment,
termed technological unemployment. Structural unemployment also includes regional
unemployment; some regions in a country may have higher unemployment levels
 compared to other regions because of different regional economic performances.

Unemployment results because individuals do not respond quickly to the new job
opportunities; they find themselves with no readily marketable talents. Their skills and
experiences are unwanted, as they have become obsolete.

Cyclical unemployment is the same as deficiency in demand unemployment. It is characterized

by fluctuations in economic growth XE "growth" , characterized by booms and recessions, the
trade cycles. During the recession phase, there are high levels of unemployment.

Voluntary unemployment is a relatively new concept, defined by the monetarists as being due
mostly to high state benefits, either unemployment benefits or being on welfare XE "welfare" .
This causes people to be unwilling to work at existing low wage rates. They realize that they
are “better off” not working and receiving state benefits.

Voluntary unemployment also includes individuals who simply do not want to work!

3.3 NEGATIVE EFFECTS OF UNEMPLOYMENT

The Economic consequences of unemployment are classified as Economic, financial, social or

political costs:

Labour is a factor of production, and due to unemployment, the Economic resource is not being
utilized, this is at a cost, the opportunity cost XE "opportunity cost" of goods and services not
produced, quality of workforce diminishes as idleness causes labour XE "labour" to be less
efficient, this in turn increases the cost of retraining it.

Government revenue XE "revenue" is mostly from taxes, unemployment results in a loss of

government revenue, as the unemployed do not pay any tax, in some rich countries they receive
state benefits, which means that unemployment is a financial cost to the government.

Unemployment may lead to social undesirable behaviour like theft, vandalism, riots or general
discontent. The mental and physical health of the unemployed tends to deteriorate, the
unemployed are more prone to commit suicide. This is considered to be a social cost.

Whenever there are high levels of unemployment in the country, the political party that forms
the government, is likely to lose popularity, this is a political cost to the government.

4.0 THE PHILLIPS CURVE

It shows the relationship between inflation and unemployment. In 1958, Professor A. W.

Phillips found a statistical relationship between unemployment and money XE "money" wage
inflation. Inflation and unemployment are two sides of the same coin. If the rate of inflation
falls, unemployment rises and vice versa.

Zambia under the United National Independence party (UNIP), was experiencing high levels of
inflation, up to three digit figures, but the levels of unemployment were relatively low. Under
the Movement for Multiparty Democracy (MMD), the country has experienced low levels of
inflation but very high levels of unemployment.

The Phillips Curve explains the “trade off” between inflation and unemployment; it is a
graphical illustration of the inverse relationship between inflation and unemployment. It shows
that the lower the rate of inflation the higher the rate of unemployment.

Inflation rate

0
Unemployment rate

High inflation is associated with low unemployment. Note that the curve crosses the horizontal
axis at a positive value for the unemployment. It is not possible to have both zero inflation and
zero unemployment; zero inflation is associated with some unemployment.

The above means that the government cannot achieve two of its macroeconomic objectives of
low rates of inflation or stableness and low rates of unemployment at the same time. The two
are mutually exclusive. The government can only achieve one objective at the expense of the
other.

4.1 STAGFLATION

Once in a while, in any country the “trade off” does not apply, as both inflation and

unemployment move in the same direction. This situation is known as stagflation.

Stagflation is a term coined by economists in the 1970s to describe the unprecedented
combination of slow Economic growth XE "growth" and rising prices. The Phillips curve
does not apply, there is no “trade off”, and instead, there are unacceptably high levels of both
inflation and unemployment. This means a country can be experiencing stagnation, the
recession phase of the trade cycle and very high levels of price increases.
The a above maybe as a result of high costs of production, especially the price of crude oil,
which may cause the supply XE "supply" curve to shift to the left. This causes the price to
increase from 0P to 0P1 and output, employment and income reduces from 0Q to 0Q1

Price D S1

P1 S

S1 D

0 Y1 Y Output, Employment, Income

5.0 SUPPLY-SIDE POLICIES

Monetarists XE "Monetarists" believe that stagflation is as a result of ignoring the aggregate
supply XE "supply" side of the equation on supply and demand analysis. Keynesians believe
in manipulating aggregate demand in order to manage the national economy, and monetarists
argue that Keynesian demand management XE "demand management" is inflationary, the
solution is to put in place measures to improve the supply of goods and services, known as
supply side policies.
Supply-side policies can be used to reduce market imperfections. This should have the effect of
increasing the capacity of the economy to produce, that is increase output, employment and
income and reducing prices at the same time. It is without doubt the only non-inflationary way
to get increases in output.

Price D S

P S1
 P1 S

0 Y Y1 Output, Employment, Income

The idea is to increase aggregate supply XE "supply" from SS to S1S1 in order to increase
output to Y1 and at the same time reduce prices from 0P to 0P1.

The above is an indication of the need to shift both Economic and government policy towards
supply XE "supply" side policies. The long run XE "long run" Economic growth XE
"growth" and standard of living XE "standard of living" are both functions of both production
and supply. The low prices from increased supply imply that a country can compete with the
low cost producing countries of South East Asia.
In general, supply XE "supply" side policies aim to remove market imperfections and
encourage individualism in order to increase efficiency and raise competitiveness. They are
micro orientation, unlike Keynesian policies that are macro.

Some of the best-known supply XE "supply" side policies are:

Lower income taxes. High direct taxes are a disincentive to enterprise and hard work, more
especially overtime. There is need to encourage individuals and firms to be more enterprising,
and to increase production.
Privatization and deregulation, since government intervention and regulation weakens a
country’s ability to make the economy dynamic and self regulating, Adam Smith’s ‘invisible
hand’ in the market. Public provision of services, government grants and subsidies XE
"subsidies" encourage inefficiencies, and state owned industries are not competitive.
Strong trade unions and employment legislation lead to unemployment and encourage over
manning. There is need to have weak trade unions and workers who will accept ‘flexible’
wages.

D S

W1

0
Q1 Q2 Q3 Number of workers
Strong trade unions can successfully bargain for high wage rates (0W1), which results in few
workers (0Q1) being employed, while the supply XE "supply" is high at 0Q3. By accepting
lower wages (0W), more workers would be in employment (0Q2). The inflexibility in the
labour XE "labour" market creates unemployment.

Related to the above, are wage controls, wage regulations and employment legislation which all
contribute to inflexibility, workers ‘pricing themselves’ out of the market and ultimately
unemployment. According to the supply XE "supply" side policies, these should be abolished.
Better information on job opportunities and adequate training is what is required for the
aggregate supply XE "supply" curve to shift to the right.

6.0 CHAPTER SUMMARY

Inflation to a layman is simply a sustained increase in the price of goods and services. Inflation
is measured as a percentage change, and the two extremes are creeping inflation to
hyperinflation.
Inflation can be caused by demand factors, supply XE "supply" factors, or according to the
monetarists, any change in the money XE "money" supply is inflationary.

There are several reasons why inflation is considered to be economically undesirable, it affects
planning both at central government and at corporate business level and it also undermines
business confidence. Inflation reduces a country’s international competitiveness and causes the
currency to depreciate given a low demand for exports. Inflation discourages savings XE
"savings" , and ultimately, investment XE "investment" . It also distorts consumer behaviour,
consumers purchase a lot of goods in the hope of ‘beating’ inflation. More importantly,
inflation has a big impact on people who are on fixed incomes, their purchasing power and
standard of living XE "standard of living" falls, and money XE "money" is unable to perform
its functions properly.

Unemployment simply means people do not have jobs. The words ‘types’ and ‘causes’ of
unemployment are usually interchanged, but generally, unemployment is categorized as
cyclical, structural, seasonal, frictional and voluntary. Unemployment also has a number of
negative consequences, classified as Economic, financial, social or political.

A government can control both inflation and unemployment using either fiscal or monetary
policies, or both. Unfortunately, there is a negative relationship between inflation and
unemployment, which is illustrated by the Phillip’s curve. The government has to ‘trade off’
inflation for unemployment or vice versa. Sometimes, there is an increase in inflation and
unemployment, a situation known as stagflation.

An effort to ‘cure’ both inflation and unemployment is explained by the monetarists using the
supply XE "supply" -side policies. These policy measures are intended to free up the supply of
goods and services in all markets, eliminating market distortions, increasing production, the
‘supply’ side of the equation, through deregulation. The government has to reduce taxes,
privatize, allow the labour XE "labour" supply to move freely, weaken trade unions, etc.
REVIEW QUESTIONS

What is the quantity theory of money XE "money" ?

Define inflation, and state how it is measured
What are the two main types of inflation?
What could be the underlying causes of demand-pull inflation?
What are the economic consequences of inflation?
List three important types of inflation
Specify three costs of unemployment
How do Keynesians explain unemployment?
What does the Phillips curve show?
What is ‘supply XE "supply" side’ economics concerned with?

--------------------------------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 12.1

(a) Describe five economic effects of a continuous, moderate inflation.

(15 marks)
(b) How might governments use monetary policy to reduce the rate of inflation?
(5 marks)
(Total: 20 marks)

EXAMINATION TYPE QUESTION 12.2

(a) Distinguish between “Structural unemployment” and “cyclical (demand deficiency)

unemployment” (8 Marks)

(b) Explain any four “supply XE "supply" -side” policies, which might be used to reduce
the level of
unemployment. (12 Marks)

(Total: 20 marks)
CHAPTER 13

PUBLIC SECTOR ECONOMICS

__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Appreciate the role of government in the economy.

Identify the main items of government expenditure
Explain of the different sources of government revenue XE "revenue" and
Understand the advantages and disadvantages of the main sources of government
revenue XE "revenue"
Understand fiscal policy XE "fiscal policy"
Identify the fiscal stance through the public sector net cash requirements
Explain of the nature and composition of national debt
___________________________________________________________________________
____

1.0 Introduction

There are many aims to public finance, but the priority on how the government deals with its
finances in the course of performing its functions varies with political complexities. However,
generally, the bulk of government revenue XE "revenue" is spent on socially desirable
expenditures such as education, health and social services. Therefore, public finance is
concerned with government expenditure and government revenue, and the difference between
them, which is the public sector net cash requirements.

2.0 Government expenditure

Government capital XE "capital" expenditure refers to government spending on investment XE

"investment" goods. This means spending on things that last for a period of time. This may
include investment in hospitals, schools, equipment and roads.

Government current expenditure refers to government day to day spending. This means
spending on recurring items. This includes salaries and wages that keep recurring, spending on
consumables and everyday items that get used up as the good or service is provided

In general, the main items of government expenditure in most countries can be can be classified
under the following headings;

Defence
Internal security that is, the police, fire brigade etc.
The merit goods XE "merit goods" under the social sector like education, health and housing.
Economic policy covering subsidies XE "subsidies" to agriculture and industry, the provision
of capital XE "capital" to the nationalised industries XE "nationalised industries" (government
investments).
Social security and other transfers make up a big chunk of government expenditure in
developed countries
Debt interest payments on the national debt are a big burden for the poor countries.
Miscellaneous expenditure such as diplomatic services.

2.1 Government revenue XE "revenue"

This is mostly from taxation XE "taxation" . However, taxation has other functions besides
covering central and local government expenditure.

The other reasons for taxation XE "taxation" are:

To check the consumption XE "consumption" of demerit goods like beer and cigarettes and to
cause the pricing of the products to reflect the social costs XE "social costs" to society of
smoke related illnesses.
To reduce inequality of incomes and wealth XE "wealth" through a progressive system of
taxation XE "taxation" .
To put into effect the ‘automatic stabilisers’, that is increase the levels of direct taxes to dampen
the upswings and reduce on the inflationary pressures when the economy is at the ‘boom’
phase of the trade cycle.
To protect infant, strategic and declining industries by introducing indirect taxes like import
duties to discourage imports by making them more expensive and therefore less competitive.

2.2 Principles of taxation XE "taxation"

Adam Smith outlined the basic characteristics of a good tax system as the four canons of
taxation XE "taxation" , namely:
Equity, which means that taxes should be fair and therefore should depend on
an individual’s ability to pay. Taxes must be proportional to one’s income.
Certainty, with regard to the amount to be paid, how, where and when it should be paid.
Convenience of payment and collection by the taxpayer.
Economy, that is, the cost of collection should not be excessive especially in relation to yield.

The additional principles of taxes considered by governments are summarised as efficiency and
flexibility. Taxes must as far as possible achieve its objective efficiently and not undermine
other aims and taxes. It should also be adjustable to changes in policy.

2.3 Classification of taxes

Taxes can be classified in several ways depending on:

Who is levying the tax? This can either be the Central or the Local government.
What proportion of a person’s income is taxed? There are three categories:

a) A progressive tax

A progressive tax is a tax that takes an increasing proportion of income as income rises. The
rate of tax keeps on increasing with every subsequent increase in income. Most direct taxes are
progressive, a good example is income tax XE "income tax" , and the rate increases as a person
earns more.

b) A regressive tax

This takes a higher proportion of a poorer person’s income. Most indirect taxes are regressive.
A regressive tax is a tax that takes a smaller proportion of income as income rises, this means it
takes a higher proportion of a poorer person’s income. In other words it is a tax that hits less
well-off people harder than the better off. Most indirect taxes are regressive. An example of a
regressive tax is the television licence. It is exactly the same amount for everyone, which makes
it a much smaller proportion of a large income than a small one.

c) A proportional tax

This is when the tax is the same proportion on all incomes, whether large or small. It simply
taxes a given proportion of one’s income for example 10% of K500,000.00, 10% of
K5,000,000.00 and 10% of K50,000,000.00.

Tax burdens that are proportion to income are considered to be fair, however, they do not
contribute towards equal distribution of wealth XE "wealth" .

Who is paying the tax? Is it a direct or an indirect tax?

A direct tax is a tax on income, profit or wealth XE "wealth" . It is paid directly to the
revenue XE "revenue" authorities by the taxpayer. Examples of direct taxes are

Income Tax
Corporation Tax XE "Corporation Tax"
Capital Tax
Inheritance tax XE "Inheritance tax"
Other taxes to the local government like personal levy, motor vehicle duties

Advantages of direct taxes:

Are equitable, that is they conform to the principle of ‘ability to pay’, through the progressive
system of taxation XE "taxation" .
Have an elastic and high yield; the rate of taxation XE "taxation" can be increased and
therefore increasing government revenue XE "revenue" .
Are certain, both the taxpayer and the government know the amount to be paid, how, where
and when it should be paid.
Lead to equal distribution of income and wealth XE "wealth" , this again is through the
progressive system of taxation XE "taxation" .
Are automatic stabilizers through their progressive nature, taking more money XE "money"
out of the economy (withdrawals) when the economy is in its ‘boom’ phase, while taking less
money XE "money" and increasing welfare XE "welfare" payments when the economy is
faced with a depression.
Are not inflationary like indirect taxes.

Disadvantages of direct taxes

High rates acts as a disincentive to efficiency, effort and enterprise. Tax reduces the return on
the investment XE "investment" and reduces a firm’s ability to invest and expand as this
depends on the retained profits. Workers are less inclined to put in extra hours. Individuals and
firms want to make money XE "money" for themselves and not to contribute to government
revenue XE "revenue" .
High rate might also encourage migration of skilled manpower to ‘tax havens’
High rates encourage tax avoidance. People find loopholes so as to avoid paying tax. It also
encourages tax evasion, which is illegal non-payment of tax especially in the informal sector.

An indirect tax is a tax on expenditure. Tax is paid indirectly to the revenue XE "revenue"
authorities as part of the payment for a commodity or service, whenever particular purchases
are made. Examples of Indirect taxes are:

Customs or import duties

Excise duties, this is a tax on some locally produced commodities
Value added tax.

The advantages of indirect taxes:

Revenue yield from indirect taxes help to avoid high direct taxes.
Payment is certain since they are difficult to avoid and to evade.
Convenient to the taxpayer since they are paid in small amounts and at intervals instead of one
big lump sum of money XE "money" which is deducted and paid every month like pay as you
earn. In addition, they are convenient in that they are paid when an individual is in a position to
buy the commodity and therefore can afford to pay the tax.
Economical in collection as companies XE "companies" and traders collect on behalf of the
government and reduce the administrative burden that should fall on the revenue XE "revenue"
authorities.
It is not harmful to effort and initiative like direct taxes. Instead, it is less painful since it is
hidden in the price of a commodity or service.
Most importantly, indirect taxes are flexible instruments of policy as they can be adjusted to
specific objectives of Economic policy such as:-
Protecting infant industry or vital (strategic) defence industries
Strengthening political links e.g. Southern African Development Cooperation (SADC) and
Common Market for East and Southern Africa (COMESA).
Citizen’s health may be safeguarded as indirect taxes can be used to encourage or discourage
the production and consumption XE "consumption" of particular goods and services.
The balance of payments may be strengthened or improved by taxing certain imports.

The disadvantages of indirect taxes:

There are regressive, a flat rate like a poll tax, a specific tax charged as a fixed sum per unit
sold or an ad valorem tax which is charged as a fixed percentage of the price of the good with
no concessions for people in the low income bracket, take a higher proportion of the income of
low income earners than high income earners.
They do not depend on a person’s ability to pay both the rich and the poor pay the same
amount as tax as long as they both buy the same product or service. Therefore they are not
equitable.
Some people who use unauthorized border entry points, the ‘black economy’, may evade
indirect taxes like customs duties.
May encourage inflation, whenever value added tax XE "value added tax" , customs duties or
excise duties increase, the prices of taxed goods and services also increase.
Possibly harmful to industry especially for goods with elastic demand

3.0 LAFFER CURVE

Government revenue XE "revenue" is mostly from taxes. A Laffer curve shows how tax
revenue and tax rate are related.

The Laffer curve is named after Professor Art Laffer who suggested that if the tax rate is 0%,
then government revenue XE "revenue" would be zero. If the tax rate is 100%, again there
would not be any government revenue as individuals and firms would not be willing to
contribute 100% of their income to the government. No one would be willing to work.

The Laffer curve also shows the rate at which the government can achieve a maximum revenue
XE "revenue" Tr, the tax rate should be Tx. In addition, it also shows that the government can
achieve very high tax revenue at two rates, 25% and 75%.

Given the fact that a high tax rate discourages hard work and enterprise, the best option is a tax
rate of 25%. According to the advocates of supply XE "supply" side policies, lowering tax
rates increases production and supply. This in turn increases the national income XE "national
income" .
Tx represents the optimum tax rate where the maximum amount of tax revenue XE "revenue"
can be collected.

4.0 PRIVATISATION VS NATIONALISATION

Privatisation implies
The transfer of the nationalized industries to private ownership.
Selling state assets, either completely or partially
Opening up state monopolies to outside competition
‘Contracting out’ to the private sector services paid for out of public funds, such as, refuse
collection, which was previously done by the local government.
Charging beneficiaries ‘Economic fees’ for publicly provided goods and services like hospitals
and schools.

Therefore, privatization implies more than the movement of assets from the public to the private
sector. It embraces all the different means by which the disciplines of the free market in the
provision of goods and services can be applied to the public sector.

The case for privatisation is the argument that is put forward for deregulation of industries,
which is, the removal or weakening of any form of state interference with the operation of free
market activity

The main aim of deregulation/privatisation is to improve competition and efficiency.

Once the statutory barriers are removed, the economy is said to have liberalized industries or it
is following a liberalized market economic system, compared to the command economic
system.

4.1 Arguments for privatisation

Reduced burden on the public purse as the government no longer supports loss- making
nationalized companies XE "companies" . Privatisation allows a reduction in the public sector
borrowing requirement and tax cutting, as it provides funds for the treasury when
companies XE "companies" are sold.

There is greater economic freedom from detailed economic control as privatized companies
XE "companies" are not subject to state control.
Improved efficiency through competition in the market, this encourages producers to cut their
costs in order to be more competitive, and firms have to be innovative in the search for profits.

In addition to the above, there is also improved quality since firms have to compete to survive
and have to be responsive to customer complaints.
If companies XE "companies" are not in state control, there is greater resistance to the power
of trade unions, industries are more fragmented and difficult to organise.

Privatisation leads to a creation of a property-owning class, more people are able to buy shares,
this gives buyers market power, they work harder and strike less, a better understanding of
private profit motive and business problems.

Costs and inefficiency decrease as bureaucracy from nationalized companies XE "companies"

is reduced.

4.2 Arguments against privatisation

Privatisation does not mean that competition is automatically enhanced. Instead, private
monopolies have been created. An example is if the Zambia Electricity Corporation (ZESCO),
became privatized, it means a previously government controlled monopoly XE "monopoly"
becomes an uncontrolled one in private hands, with no public responsibility. Consumers
may suffer. However, this is what leads to most governments to regulate or attempt to regulate
the newly privatized companies XE "companies" in much the same way as the nationalized
industries.

Just as privatization does not mean competition, it also does not guarantee efficiency.
Customers have ended up with fewer services, and at higher prices. A good example is rural
transport. The government owned United Bus Company of Zambia (UBZ), used to go to all the
rural areas, everything was timetabled (date and time).

The quality of service has reduced, with costs being saved by reducing the number of workers
‘right sizing’, paying lower wages and reducing the services that were being provided, as
mentioned above, some routes were termed ‘unprofitable’ or the roads ‘impassable’.

Privatisation may allow people in rural areas without Economic power to suffer, since loss-
making services are not provided by the private sector, most of which are important to the
poorest members of the society.

In theory, it is the loss-making companies XE "companies" that are supposed to be

privatized, but in practice, the privatization exercise is rarely properly done in most countries
in the world, for example asset sales are under priced to attract buyers and in the process,
create big capital XE "capital" gains for private investors.

Companies that are in private hands often pay their top executives very large salaries and offer
them very good conditions of service, while reducing the powers of trade unions and paying
union members low wages. This lowers the morale of the workers and lowers productivity
while encouraging pilfering, strikes etc.

If competition is enhanced through privatisation, it sometimes leads to waste of resources and

the duplication of goods and services, an example is monopolistically competitive market
structures.
4.3 Nationalised industries

The public sector includes some businesses run by the government, such as Zambia Electricity
Company (ZESCO), Zambia Telecommunications Company (ZAMTEL), Lusaka Water and
Sewerage Company etc. Managers of such companies XE "companies" are accountable to the
elected politicians (ministers) in charge of that sector, and government-sponsored boards such
as the Zambia Energy Regulation Board, which regulates ZESCO, regulate them.

The case for nationalization can be considered alternatively as the disadvantages of

liberalisation.

Nationalisation can lead to reduced costs through economies of scale, since with increased
competition, each firm produces less output on a small scale, and unit costs increase.
There is provision of un economic services for consumers. Nationalisation, just like the
socialism or planned economic system, social benefits are placed above private profits. It
considers the net gain to society, to the point of keeping industries that are clearly
technologically inefficient, as in the case of Maamba coalmines. Another argument in favour of
providing uneconomic services is that it helps to protect employment.
It is sometimes in the national interest that some basic industries are brought under public
control, especially, strategic industries which would be dangerous under private ownership
such as atomic or nuclear energy.
It may also be necessary to carry out government policy, like controlling the money XE
"money" supply XE "supply" , as in the case of the Bank of Zambia.
Nationalised industries have sufficient capital XE "capital" available for investment XE
"investment" , because of government support. Where competition is wasteful, it maybe better
to create a large state-owned monopoly XE "monopoly" , to avoid waste and duplication.
A fairer distribution of wealth XE "wealth" , the huge profits do not go to the capitalist owners,
surpluses are used for the benefit of society. A case in point is ZESCO, the supernormal
profits are used for rural electrification. The supernormal profit XE "supernormal profit" also
justifies the high salaries enjoyed by ZESCO employees.

5.0 FISCAL POLICY

Fiscal policy is the use of government expenditure and taxation XE "taxation" to try to
influence the level of
economic activity. It is the decisions and actions of the government regarding its expenditure
and its revenue XE "revenue" taxes, that is, since government revenue is mostly from taxation
XE "taxation" . The government as an instrument of economic policy uses fiscal policy XE
"fiscal policy" , also known as budgetary policy, through the balance between government
expenditure and revenue XE "revenue" . In order to reduce high levels of unemployment, or to
stimulate recovery from a recession, the government aims for a budget deficit or an
expansionary fiscal policy XE "fiscal policy" .

An expansionary (or reflationary) fiscal policy XE "fiscal policy" could mean:

Cutting levels of direct or indirect tax
Increasing government expenditure

Reducing taxes causes government revenue XE "revenue" to be lower than government

expenditure, which results in a budget deficit, government borrowing covers the difference.
The government needs to borrow money XE "money" to finance its activities. This borrowing
is referred to as the public sector net cash requirement (PSNCR). It used to be called the
public sector borrowing requirements (PSBR). The PSBR is the amount of money the
government needs to borrow to meet their spending plans. In other words it is the amount that
their spending exceeds their tax revenue. Therefore, an increase in the PSNCR or PSBR is a
sign that the government is following an expansionary fiscal policy XE "fiscal policy" . The
effect of expansionary policies would be to encourage more spending and boost the economy.

Budgetary policy can also be used to check inflation or an adverse balance of payment by
aiming for a budget surplus, or a contractionary fiscal policy XE "fiscal policy" . This is the
exact opposite of an expansionary policy.

A contractionary (or deflationary) fiscal policy XE "fiscal policy" could mean:

Increasing taxation XE "taxation" , either direct or indirect
Cutting government expenditure.

Reducing government expenditure while increasing taxes is what leads to a government

surplus. The difference is the public sector net cash surplus. This used to be called the public
sector debt repayment (PSDR) the government is in a position to service the debts plus
interest. It is a sign that the PSNCR are low. A reduction in both government and consumption
XE "consumption" expenditure reduces the level of demand in the economy and help to reduce
inflation.

5.1 The Public Sector Net Cash Requirements (PSNCR)

The balance between government expenditure and government revenue XE "revenue" shows
the fiscal stance being followed by the government. Government expenditure is an injection
into the circular flow of income, a component part of aggregate demand, therefore an increase
in government expenditure is an indication of the expansionary stance being followed by the
government. Whereas taxation XE "taxation" is a withdrawal or leakage from the circular flow
of income, and as such, increasing taxes is an indication of a contractionary stance.

In practice it maybe difficult to reduce the growth XE "growth" rate of public expenditure due
to for example political factors such as by-elections and defence if a country is at war. Existing
capital XE "capital" projects, which can only be, completed over a period of years, as well an
economic depression, which results in high welfare XE "welfare" and unemployment benefits
to act as automatic stabilisers. If the size of the PSNCR increases from one year to the next,
then it is a sign that the government wants to boost the economy.

In general, for most rich nations, the increase in the PSNCR can stem from the increased life
expectancy and an ageing population XE "population" , which implies more spending on social
security. High unemployment levels which may lead to more unemployment benefits being
paid. For most poor countries, an increase in the PSNCR can stem from debt interest, political
commitments like the numerous by-elections in Zambia or high inflation levels which raises the
cost of public provision of goods and services.

Both the developed and the developing countries can be affected by tax rate changes, tax
reductions for example, reduce government revenue XE "revenue" , so the government has to
depend on borrowing.

5.2 Parliament control procedures

The legal framework that governs the management and control of the public finances in Zambia
is made up in the constitution. Parliament is supposed to provide the necessary checks and
balances in the budget process. During the fiscal year the scrutiny of the spending reports, if
any, is done by the Committee of Supplies, while hearings on expenditures is conducted by
the sessional committees of Parliament. The Minister of Finance and Economic Planning must
prepare supplementary estimates for expenditure, for approval by the National Assembly
within a period of four months and if the National Assembly is in recess at the first sitting
of the Assembly. The Minister of Finance is required to prepare a Supplementary
Appropriation Bill confirming the approval by Parliament of such expenditure or the excess of
expenditure within 15 months after the end of the financial year. If the National Assembly is
not sitting then, the bill must be tabled within a month of the first sitting, a Bill to be known as
the Excess Expenditure Appropriation Bill.

Thus, the roles and responsibilities of the legislature is moderately well assigned in principle
but the budget disbursement of resources to spending units is appropriated on the basis of ad-
hoc criteria which can later be legitimised by both supplementary and excess expenditure acts,
and there is inadequate time for parliamentarians to scrutinise budget documents.

5.3 GOVERNMENT REFORM PROCESS (from Public Expenditure Management

and
Financial Accountability, PEMFA Evaluation Report)

5.3.1 General description of recent and on-going reforms

In the early 1990s, Government began a political and socio-Economic reform process, which
entailed democratising the political system and liberalizing the economy. The political reforms
gave special impetus to public demand for good governance, transparency and accountability in
the conduct and management of public affairs. The Economic reforms focused on privatization
of parastatal entities and the redefinition of the role of the Public Service from that of
controlling the overall economy to that of providing a conducive environment for market based
and private sector driven economy.
5.3.2 Public Service Reform Programme (PSRP)

In 1993, Government initiated the PSRP to restructure the Public Service in order to improve
the quality of service delivery. Therefore, Government designed the Public Service Capacity
Building Project (PSCAP) as a comprehensive strategy to build institutional and human
capacity for quality public service delivery, it became operational in October 2000 and was
designed to be implemented over a thirteen-year period (2000-2013). The focus of the first
phase was on the following five major outputs:

right-sizing and pay reform of the Public Service,

improved policy and Public Service management,
improved financial management, accountability and transparency,
improved capacity of the judicial and legal systems and
decentralisation and participatory governance.

5.3.3 Poverty Reduction Strategy Paper (PRSP)

The PRSP was developed as the Nations’ medium term overall policy framework for national
planning and interventions for development and poverty reduction for the period 2002-2004.
The strategy for poverty reduction was rapid economic growth XE "growth" and employment
creation. This would result in improvements in national resources management, a conducive
macroeconomic framework, sectoral performance improvements especially in key sectors such
as agriculture and social sectors, infrastructure developments, overall improvements in
governance and public service delivery capacity.

6.0 AUTOMATIC STABILISERS

During a recession ‘phase’, income does not fall to zero because the benefit (welfare XE
"welfare" and unemployment benefits) system provides some income. The effect of automatic
stabilizers when an economy is recovering from a recession is known as ‘fiscal drag’.

Fiscal drag refers to the effect inflation has on average tax rates. If tax allowances are not
increased in line with inflation, and people's incomes increase with inflation then they will be
moved up into higher tax bands and so their tax bill will go up. However, they are actually
worse off because inflation has cancelled out their pay rise and their tax bill is higher, this is to
the benefit of the revenue XE "revenue" authorities. It is getting more tax without increasing
tax rates, a subtle means of raising more tax revenue. To maintain average tax rates, allowances
should be increased by the amount of inflation each year.

7.0 THE PUBLIC DEBT

This is the total amount of accumulated borrowing by the local and central governments
including public corporations, to its various creditors both local and foreign, the International
Monetary Fund (IMF), the World Bank etc. Note that debt increases, interest rate payments
form a large portion of government expenditure.

The debt instruments are of two types:

Debt management in terms of contracting, servicing and repayment is a major element of the
overall fiscal policy XE "fiscal policy" . The financial report of the Minister of Finance and
Economic Development must include a statement showing the particulars of debt charges paid
in that financial year in respect of loans raised under the Act. A loan may be raised as a debt
instrument of two types, marketable debt, this is either short-term debt that consists of
treasury bills XE "treasury bills" or long-term debt that consists of Government bonds or by
agreement in writing. Non-marketable debt consists of any other debt raised by the
Government either internally or externally. In addition, the debt can be reproductive, that is,
used to purchase a real asset or it can be a deadweight debt, meaning that no assets are
covering the debt.

The Act empowers the minister to raise any loan in accordance with such conditions and upon
such terms, as s/he shall direct. If the loan is raised through the issue of a bond, stock or
Treasury bill, the Bank of Zambia is the Minister’s agent.

The Zambian National Debt problem is being addressed with the implementation of the HIPC
Initiative (from multilateral and Paris Club bilateral creditors), voluntary additional relief on part
of some of the Paris Club bilateral creditors and the G8 debt cancellation initiative.

Prudent fiscal policy XE "fiscal policy" /discipline needed to reduce the budget deficit to
manageable levels.

8.0.0 FIFTH NATIONAL DEVELOPMENT PLAN (FNDP)

Governments accept the Keynesian Theory that active Government involvement in the
economy is necessary for macroEconomic stabilisation. In a mixed Economic system, the
party in power can change the shape of the economy. The Government, it may decide to trim
down the public sector and fatten the private sector, or vice versa.

The Zambian government has a major Economic role and responsibility, it has articulated its
long -term development objectives in the National Vision 2030, and the FNDP is an important
step towards the realisation of this vision. The development goals are:

(a) Reaching middle-income status

(b) Significantly reducing hunger and poverty
(c) Fostering a competitive and outward oriented economy.

The theme of the FNDP is ‘broad based wealth XE "wealth" and job creation through citizenry
participation and technological advancement’. The broad MacroEconomic objectives for the
FNDP are as follows:

To accelerate pro-poor Economic growth XE "growth" , this is the main goal of the FNDP, to
realise this goal, the aim is to have an annual growth rate of at least seven percent, and ensure
that growth is broad based and rapid in the sectors where the poor are mostly engaged.
To achieve and sustain single digit inflation
To achieve financial and exchange rate stability
To sustain a viable current account XE "current account" position, and
To reduce the domestic debt to sustainable levels.

The above are the overall characteristics of the economy, which any government discern as
desirable. An additional objective, which is included in the FNDP theme of job creation, is
attainment of full employment.

The MacroEconomic objectives of Governments are interdependent, at the same time,

simultaneous success is impossible (Phillips curve!). The FNDP contains the policy
instruments that the Government intends to use to achieve the MacroEconomic objectives listed
above, are outlined as follows:

8.0.1 FISCAL POLICIES

To focus on avoiding excessive fiscal deficits and debt by reducing government borrowing
which in turn, contributes to a decline in interest rates XE "interest rates" , besides the reduced
external debt servicing through the highly indebted poor countries (HIPC) initiative. This will
also allow for an expansion of credit to the private sector, no crowding out effect!

However, budget execution need to be improved, financial accountability and expenditure

monitoring systems need strengthening, as well as strengthening the revenue XE "revenue" base,
whose weak systems have created potential avenues for fraud.

8.0.2 MONETARY AND FINANCIAL POLICIES

To focus on achieving and maintaining single-digit inflation as a pre-requisite for reducing high
interest rates XE "interest rates" which have contributed to poor access to financial services
within the economy. The Zambian financial sector is characterised by high cost of borrowing,
thin capital XE "capital" markets and absence of financial services in rural and peri-urban areas.
The focus in the FNDP is to develop the capital markets, developing and implementing a rural
financing policy and strategy and the strengthening of banking and non-banking financial
institutions.

8.0.3 SUPPLY-SIDE POLICIES

To reduce inflation, there is need to address supply XE "supply" side factors such as the poor
infrastructure and marketing systems, the vulnerability of the agricultural sector to weather
fluctuations, and weak policy implementation.

8.0.4 EXTERNAL SECTOR POLICIES

The objectives of the external sector are to achieve the following:

Sustain a viable Current Account balance by promoting export growth XE "growth" and
maintaining a competitive exchange rate. The mining sector will continue to play an important
role, however, the development strategy focus is diversification XE "diversification" away from
copper.
Improve the external competitiveness of the economy.
Maintain a sustainable external debt position.

8.1 POLICY CONSTRAINTS

In practice, Governments have limitations in their ability to achieve MacroEconomic objectives

generally, because of various reasons. Some of the constraints are:

Previous policy decisions taken by the previous government, especially the fiscal and regional
policies.
The Government may lack perfect knowledge/information of the economy. The statistics
may be outdated or based on estimates.
Policy changes take time to implement and time to be effective, a time lag.
There is no ceteris paribus, this means that there is no technique that to hold other variables
constant. Zambia has extremely free trading with borders very wide open compared to
countries like Zimbabwe and South Africa.
Political factors often supersede prudent policy Economic judgement, especially in a
developing country like Zambia with not enough checks and balances and unplanned by-
elections!
In addition to the constraints of information and time, the methods may be inefficient in that
they do not achieve their targets, or the pursuit of one policy instrument may limit the
effectiveness of the other.
The fluctuating patterns of booms and recessions, the trade cycle, can affect the
achievement of macroEconomic objectives. For example, when there is international recession,
there is no Economic growth XE "growth" .

9.0 CHAPTER SUMMARY

Public finance deals with finances of the Government, which is reflected in terms of
expenditure and revenue XE "revenue" . Governments spend their income on the provision of a
variety of services that the private sector does not provide. Examples are defence, internal
security, education, health etc.

The large sums of money XE "money" , which governments require, are obtained primarily
through taxation XE "taxation" levied on incomes (direct, progressive taxes), and on goods
and services sold (indirect, regressive taxes). Taxes may be apportioned among people on the
basis of ability to pay or on the basis of benefits received. Each type of tax has its advantages
and drawbacks.

Another source of government revenue XE "revenue" is through privatization. This is the

transfer of assets from public to private ownership. However, it has some advantages and
disadvantages, hence there are some arguments in favour of nationalized industries.

When it is inexpedient or impossible to raise needed funds, governments may borrow money
XE "money" , either on a long or a short-term basis. In addition, governments manipulate their
tax impositions, their expenditures and their borrowing so as not to merely to finance desirable
projects and services but also to maintain the national economy in a stable condition, known as
fiscal policy XE "fiscal policy" .
The objective of fiscal policy XE "fiscal policy" can be either a deflationary gap XE
"deflationary gap" , operate a budget deficit (reduce taxes and increase government
expenditure) in order to reduce the high levels of unemployment. Alternatively, a government
can aim for an inflationary gap XE "inflationary gap" , that is, operating a budget surplus
(increase taxes and reduce government expenditure) in order to check inflation.

The total amount of government borrowing is known as the national debt.

The FNDP is an important step towards the realisation of national vision 2030, and the
development goals are:

reaching middle-income status

significantly reducing hunger and poverty
fostering a competitive and outward oriented economy.

The government came up with five discernable macroeconomic objectives, these will achieved
using various instruments such as fiscal and monetary policies. In practice, governments face a
number of policy constraints which hinder them from achieving the macroeconomic objectives.
REVIEW QUESTIONS

What is the difference between fiscal policy XE "fiscal policy" and monetary policy?
What are the objectives of fiscal policy XE "fiscal policy" ?
Distinguish between direct taxes and indirect taxes.
What is:
A regressive tax?
A progressive tax?
A proportional tax?
What are Adam Smith’s four canons of taxation XE "taxation" ?
If the government decides to introduce a poll tax, which would
involve a flat levy of K20, 000 on every adult member of the population XE "population" ,
how would you describe this tax? Would it be a progressive, proportional, regressive or an ad
valorem tax?
What is the public sector net cash requirement (PSNCR)?
What is the fiscal stance?
State four arguments in favour of privatisation

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EXAMINATION TYPE QUESTION 13.1

Explain briefly what is meant by the term ‘public sector net cash requirements’ and describe
how it might be financed? (10
marks)

Describe the problems governments face when attempting to reduce the public sector net cash
requirement and explain briefly how the business sector might be affected by these attempts.
(10 marks)

TOTAL: 20 MARKS

EXAMINATION TYPE QUESTION 13.2

The revenue XE "revenue" of the Zambian Government is mostly from taxation XE

"taxation" . Distinguish between direct and indirect taxes giving two examples of each.
(8 marks)
Explain what is meant by fiscal policy XE "fiscal policy" . (4 marks)

Outline the principles of a good tax system (8 marks)

TOTAL: 20 MARKS

CHAPTER FOURTEEN

INTERNATIONAL TRADE
__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Appreciate the growing impact of globalisation and the multinational companies XE

"companies"
Explain why countries undertake international trade and the benefits they get from
international trade
Understand the law of absolute and the law of comparative advantages
Distinguish free trade from protectionism
Identify the reasons for trade restrictions, and the different forms of trade restrictions
Understand terms of trade and its importance
Appreciate of international organizations that facilitate free trade
___________________________________________________________________________
____

1.0 INTRODUCTION
International trade involves the exchange of goods and services between countries. It involves
trades among nations. A nation trades because it lacks the raw materials, climate, specialist
labour XE "labour" , capital XE "capital" , or technology needed to manufacture a particular
good. Thus, international trade arises because countries have different production capacities and
different demands for goods and services.

1.1 GLOBALISATION

Economic activity has been internationalized. This is reflected in the growth XE "growth" of
trade and other capital XE "capital" flows, currency bought and sold in the foreign exchange
market XE "foreign exchange market" , has lead to the term global economy. The global
economy refers to an open economy where the ratio of exports to output forms a significant
proportion of economic activity.

World trade has been expanding to the extent that neighbouring countries that have always
traded with each other are making such arrangements more formal. Trade agreements like the
free trade areas where countries agree to reduce or abolish trade restrictions between member
countries, while allowing members to impose their own separate trade restrictions against non-
member states.

Alternatively, it may be extended into a customs union, where free trade is encouraged among
members but erect a common external tariff on imports from non-member states. In addition,
there are common markets, which are similar to customs unions but include the free
movement of factors of production XE "factors of production" as well as trade.

1.2 MULTINATIONAL COMPANIES (MNCs)

The growth XE "growth" of multinational companies XE "companies" has taken place in an

environment of increasing globalisation of markets.

A multinational company is one, which owns or controls production or service facilities in

more than one country. Note that a company does not become a multinational simply by trading
internationally!

The growth XE "growth" of globalisation is unstoppable, and with it is their power to

influence international trade. However, the extent to which the Zambian economy benefits from
MNCs is difficult to assess.

The assessment of the impact of MNCs on national economies is considered under various
costs and benefits. Direct foreign investment XE "investment" by an MNC should improve
economic welfare XE "welfare" as capital XE "capital" is transferred, capital inflow into a
relatively poor country, and it should also promote technology transfer. New technologies
being transferred without the research and development XE "research and development" costs.

In addition, local companies XE "companies" can copy superior processes and organizational
patterns. Employment can also be provided.

In practice, MNCs only transfer technologies at low levels, and once the profits from the
investment XE "investment" are remitted back, it becomes an outflow of foreign currency.

Most MNCs may decide to employ their own nationals in top management positions. The
worst part is that MNCs are offered grants, subsidies XE "subsidies" , tax relief etc., in order
to attract them into poor economies like the Zambian one, while MNCs can gain a cost
advantage, integrating vertically by establishing assembly plants in countries where there is
abundant cheap, high-quality labour XE "labour" .
Some MNCs pursue a policy of horizontal integration XE "integration" in order to gain new
markets and expand sales. The advances in communication, cheap air travel, development of
satellite systems has made it cheaper for MNCs to develop new markets in overseas countries.

2.0 REASONS FOR INTERNATIONAL TRADE

Products that are not produced in a certain country are available in other countries, thanks to
international trade. For instance, computers are not produced in Zambia, but are produced in the
United States.

Unequal distribution of skills and technology. In addition, some countries have a good
reputation in the production of some commodities than other countries. An example is a
country like Japan which is more skilled in the production of goods like cars.

Excess demand for locally produced goods may force countries to import to offset the shortage.

Unequal distribution of resources. For example, oil is found in Angola but not in Zambia, the
climate in South Africa is suitable for growing apples, but not the Zambian climate, etc.

2.1 THEORY OF COMPARATIVE ADVANTAGE

Comparative advantage is a country’s ability to produce a product at a lower opportunity cost

XE "opportunity cost" in terms of another country. The principle of comparative advantage XE
"comparative advantage" states that countries will benefit by concentrating on the production
of those goods in which they have a relative advantage.

A country is said to enjoy a comparative advantage XE "comparative advantage" over another

if, with the same input of resources, it can produce more of a good than another. A nation’s
comparative advantage is measured in relation to all goods and services it produces. A country
has a comparative advantage in those products that it can produce cheaply.

Any product can be produced in any country but what matters most is the cost of production. It
is therefore more beneficial for each country to use its resource in the production of those
goods in which it has a cost advantage, and to trade with other countries to obtain, those goods,
which cannot be produced locally or efficiently.
The law of comparative advantage XE "comparative advantage" , therefore, states that a country
should concentrate on producing those goods in which it has the greatest relative cost
advantage and imports from other countries those goods in which it has the greatest relative
cost disadvantage.

2.3 THEORY OF ABSOLUTE ADVANTAGE

Absolute advantage means that a country is more efficient in the production of both goods
under consideration than the other country being considered. A country’s absolute advantage is
measured in relation to other nations. If two countries are producing the same product, the
country that produces the product cheaply has an absolute advantage over the other.

Even if a country has absolute advantage over the other in all products, there is still a possibility
for the two nations to trade as illustrated in the example below.

For example, if two nations produce computers and cars as follows:

Computers Ratio (calculate opportunity cost XE

"opportunity cost" )
Country X 10, 000, 000 10:1 in favour of country X
Country Y 1,000,000

Cars
Country X 1,000,000 2: 1 In favour of country X again
Country Y 500,000

Given the scenario above, it is still possible for the two countries to engage in trade. Absolute
advantage cannot hamper international trade.
Country X has absolute advantage in both cases but the size of its advantage is greater in
computer production than in car production. Country Y’s disadvantage is smaller in car
production than in the computer production. So it would be more beneficial to both countries if
country X specializes in computer production and imports cars, while country Y specializes in
cars production and imports computers.

3.0 FREE TRADE AND ITS EFFECTS

Free trade is a situation whereby the flow of goods, services and capital XE "capital" are not
hindered by any artificial barriers. In theory, trade on an international level, should be free from
any restrictions, and those who advocate for free trade maintain that this, would lead to
numerous advantages, such as

Enabling countries to specialise and increase production bearing in mind that the surplus can be
exported.
Countries export surpluses and import what they lack.
Access to the world market, therefore enabling countries to benefit from economies of scale.
Allowing countries to develop their industries as a result of free movement of capital XE
"capital" .
Promoting beneficial political links and closer cooperation between countries.
Increasing efficiency due to competition from imports and limiting the creation of monopolies.
The efficient use of resources also leads to lower costs of production which in turn leads to the
reduction in the prices of goods and services.
Provision of goods that were previously unavailable, a wider choice of goods to consumers.
3.1 DISADVANTAGES OF FREE TRADE

It leads to unemployment especially in cases where imported goods are subsidised by the
countries of their origin.
It has negative effects on new industries.
Dumping of imports on the local market leads to unfair competition.
It may lead to the importation of undesirable products.
The government will lose revenue XE "revenue" because it can longer impose taxes on
imports.

4.0 BARRIERS TO INTERNATIONAL TRADE

In spite of the numerous advantages of international trading, countries the world over engage in
some form of protectionism. There are different forms of protectionism, and some of them
are:

Quotas. These are limits imposed on specified goods to be brought in the country. Import
quotas XE "quotas" restrict the quantity of certain products, which can be imported into
the country. If the product is homogeneous then a simple quota is imposed. If they are
heterogeneous, then the quota can take the form of a value of imports allowed in any
given currency.

The effect of quotas XE "quotas" is to reduce the volume of imports, raise the price of
imports and
encourage the demand for locally produced commodities.

Note that sometimes one country persuades another country to voluntarily reduce its
exports
of a product to a certain acceptable level, this is known as voluntary export restraints
(VERs). VERs is also known as orderly market arrangements emphasizing their
negotiated manner. VERs often apply to key industries, an example is VERs negotiated
by the United States of America on Japanese exports of motor vehicles.

Tariffs XE "Tariffs" or custom (import) duties. These are taxes that are levied on imports. It
can be a
fixed amount per unit (specific) or a percentage of the price (ad valorem).

The effect of tariffs is to raise prices of imports, and therefore reduce their demand,
encourage the demand for locally produced commodities, as well as raise revenue XE
"revenue" for the government.

Trade embargoes. This is a complete ban of imports from a particular country. Sometimes
it is a total ban imposed on particular products like drugs, from any country! During the
Iraq
 war of the early 1990s, the United Nations imposed a ban on Iraq’s exports.

Hidden export subsidies XE "subsidies" and import restrictions (Direct controls). This is
a range of
government subsidies and assistance for exports and deterrents against imports as
follows:

Subsidies. The government gives subsidies XE "subsidies" to local firms to allow them to
compete favourably in terms of pricing of goods, with foreign firms.
Export credit guarantees or insurance against bad debts for overseas sales.
Grants or any form of financial help is provided to firms in the export sector
Zero rating or reducing taxes on exported goods
State assistance provided for firms in the export sector via the foreign office.

In addition, imports are discouraged through

Health and Safety regulations. Countries sometimes put in place health and safety
regulations that limit the importation of certain goods. For example, the Zambian government
has put in place a regulation that stipulates that sugar sold in Zambian market must be fortified
with vitamin A regardless of whether this sugar is locally produced or imported.
Administrative procedures (bureaucracy). These are long, complex and costly procedures
that importers have to go through at border posts.
Exchange controls XE "Exchange controls" . These are aimed at restricting the amount of
foreign exchange that is available to importers.

4.1 ARGUMENTS IN FAVOUR OF PROTECTIONISM

To protect new and declining industries.

New industries need to be protected from foreign competition before they become strong
to
be on their own, while declining industries might quickly collapse and lead to mass
unemployment if not protected.

To reduce unemployment. Unfair competition from foreign products may lead to the closure
of home industries. Therefore, the government protects its industries in order to prevent the
closure of industries and unemployment.

To reduce or eliminate balance of payments deficits. Restricting imports will help to reduce
or eliminate balance of payments deficits.

To raise revenue XE "revenue" . The government raises revenue from import tariffs that are
imposed on imported products.

To protect strategic industries. Industries such as ship building, defence and aerospace are
of strategic importance to many countries. Therefore many countries protect these industries
from foreign competition

To protect against dumping of imported products on local market. Dumping is a situation

where goods are sold at lower prices in a foreign market than in the home market.

Retaliation against measures taken by another country that are unfair.

To prevent unfair competition. Governments may justify protectionism with reference to the
trading policies of its competitor nation, such as selling imitations at artificially low prices.

4.2 ARGUMENTS AGAINST PROTECTIONISM

The fear of retaliation. If a country imposes restrictions against other countries’ exports, the
affected countries can retaliate by imposing restrictions on its exports.

Reduction in industrial efficiency. Protecting industries from international competition

reduces their efficiency.

Cost to consumers. Protectionism is costly to consumers because they are forced to pay high
prices for goods of poor quality.

Restricted choice of products Protectionism leads to the reduction in the range of products
available to customers.

5.0 TERMS OF TRADE

The terms of trade are the ratio of an index of (visible) exports prices to an index (visible)
import prices. They measure the relative change of the price of exports and the price of
imports.

A base year is chosen, at which point the average price of exports is assigned an index value of
100, as is the average price of imports.

Suppose that in 2000, the base year, the average price of a basket of visible Zambian exports
was K450, 000, while the average price of a basket of imports was K500, 000. Each of these
prices would be assigned an index of 100, and the terms would be (100/100) = 1.

In fact, 100 multiply this ratio when the terms of trade are calculated. So the terms of trade for
the year 2000 are 100.
Now suppose that in the following year (2001) the average price of exports rose by 10%, to
K495, 000, while the average price of imports rose by 6%. The index for exports would rise to
100x 1.1 = 110, and the index for imports would rise to 106 (100x1.06). The terms of trade for
2001 would be (110/106) x 100 =104.

The rise in the terms of trade reflects the fact that export prices have risen more than import
prices. An increase in the terms of trade is called an improvement in the terms of trade, though
it may not always be desirable.

One reason for wanting an increase in the terms of trade is that a given quantity of exports will
now pay for more imports. In the example above, the foreign currency earned by exporting one
basket of exports in the year 2000 (K450, 000 worth) would buy 450/500 =0.9 or 90% of a
basket of imports.

When the terms of trade improved in 2001, so that the average price of exports was K495, 000,
while that of imports was K500, 000 x1.06 = K530, 000, one basket of exports would earn
enough foreign currency to pay for 495/530 = 0.9339 or 93.34 % of a basket of imports. This
means that, ceteris paribus, fewer exports are required to pay for imports.

An improvement in the terms of trade will be advantageous if it results in an increase in funds

coming in and/ or a decrease in funds leaving the country. This happens if the PED for imports
and exports is less than 1.

6.0 REGIONAL AND INTERNATIONAL ORGANISATIONS

6.1 THE SOUTHERN AFRICAN DEVELOPMENT COMMUNITY (SADC)

HISTORICAL BACKGROUND

The Southern African Development Community (SADC) came into existence in 1980, as an
alliance of independent Southern African States. The Southern African Development
Community (SADC) was formerly known as the Southern African Coordination Conference
(SADCC) and formed with the goal of helping countries in the Southern African region to
lessen dependence on South Africa. The SADC headquarters are in Gaborone, Botswana.

MEMBER STATES
The member states are Angola, Botswana, the Democratic Republic of Congo, Lesotho,
Madagascar, Malawi, Mozambique, South Africa, Swaziland, Tanzania, Zambia and
Zimbabwe.

OBJECTIVES OF SADC
The achievement of economic growth XE "growth" and development in member countries.
Promotion of peace and security
Promotion of common political beliefs and values
Promotion of self-sustaining development
Achievement of self- sustaining utilisation of natural resources XE "natural resources" and
protection of the environment.
The strengthening of long standing cultural links among the peoples of the SADC region.

ACHIEVEMENTS

Increase of trade among member sates.

Member countries have strengthened their bargaining power.

CHALLENGES

Each member state uses a different currency and this hampers free trade.
Over dependence on donor funding.
Lack of participation in decision-making and other SADC activities by ordinary citizens.

FUTURE OUTLOOK

SADC faces a bright future due to the following reasons:

Donor confidence has been increasing.

The SADC market is big with a population XE "population" of 60 million people and rich in
mineral resources.
The region is likely to attract more investment XE "investment" with attainment of peace in
Angola and the Democratic Republic of Congo (DRC).

6.2 COMMON MARKET FOR EASTERN AND SOUTHERN AFRICA

(COMESA)

HISTORICAL BACKGROUND OF COMESA

COMESA was established in 1993 in Uganda replacing the Preferential Trade Area (PTA) that
was founded in 1981. Its headquarters are in Lusaka, Zambia.
MEMBER STATES

These are Angola, Burundi, Comoros, Egypt, Eritrea, Ethiopia, Kenya, Lesotho, Madagascar,
Malawi, Mauritius, Mozambique, Namibia, Rwanda, Sudan, Swaziland, Tanzania, Uganda,
Democratic Republic of Congo (Zaire) Zambia and Zimbabwe.

OBJECTIVES OF COMESA

To achieve sustainable economic and social progress in all member countries.

To promote economic cooperation among member states.
To establish and maintain a Free Trade Area.
To remove all tariff and non- tariff barriers.
To create a Customs Union
To promote free movement of capital XE "capital" and investment XE "investment" .

ACHIEVEMENTS

Creation of the COMESA Free Trade Area (FTA).

Creation of an enabling environment for trade.
A wider, harmonised and more competitive market.
Greater industrial productivity and competitiveness.
Increased agricultural production and food security
More harmonised monetary, banking and financial resources.

CHALLENGES

Inability to participate effectively in the World Trade Organisation (WTO) negotiations.

Resistance to elimination of trade barriers
Lack of political stability in some member states like the Democratic Republic of Congo
(DRC).
Difficult to co-ordinate countries of vastly different economic, social and political backgrounds.
Undeveloped infrastructure such as roads and telecommunication networks in some member
states.

FUTURE OUTLOOK

COMESA faces a bright future for the following reasons:

COMESA’s population XE "population" of over 300 million people constitutes a potentially
large market and a huge reservoir of both skilled and unskilled labour XE "labour" .
The COMESA region covering an area of about 12.89 million square kilometres is rich is
minerals, lakes and rivers that can be exploited for irrigation, hydroelectric power and fisheries.
Increased regional integration XE "integration" in trade and investment XE "investment" will
lead to an expansion of the industrial and services sectors of member states.

6.3 THE EUROPEAN UNION (EU)

HISTORICAL BACKGROUND OF THE EU

The European union (EU) formed in 1992 is an intergovernmental union of 25 countries of the
European continent. Its headquarters are in Brussels, Belgium.

MEMBER STATES

The EU is made up of 25 countries namely Italy, United Kingdom, France, Germany, Greece,
Luxembourg, Netherlands, Ireland, Portugal, Spain, Belgium, Sweden, Finland, Denmark,
Austria, Cyprus (Greek Part), Czech, Estonia, Hungary, Latvia, Lithuania, Malta, Poland,
Slovakia and Slovenia.

OBJECTIVES OF THE EU

Abolition of remaining controls on capital XE "capital" flows.

Removal of all non- tariff barriers to trade.
Progress in harmonising tax rates.
Removal of frontier controls and bias in public sector purchasing to favour domestic producers.

ACHIEVEMENTS

Creation of a single market consisting of customs union, a single currency managed by the
European Central bank.
Establishment of a common policies in agriculture, trade, fisheries and foreign and security.
Abolition of passport control and custom checks at many of EU’s borders.
Creation of single space of mobility for EU citizens to live, travel, work and invest.

CHALLENGES

Adoption, abandonment or adjustment of the new constitutional treaty.

The EU’s enlargement to the south and east.
Resolving of the EU’s fiscal and democratic accountability.
Economic viability with the United States, China and India.

6.4 THE WORLD TRADE ORGANISATION (WTO)

HISTORICAL BACKGROUND OF WTO

The World Trade Organisation (WTO) was formed in 1995. It replaced the General Agreement
on Trade and Tariffs XE "Tariffs" (GATT) that was established in 1948. Its secretariat is
based in Geneva, Switzerland. The main purpose of WTO is to promote free trade by
persuading countries to abolish import tariffs and other barriers.

MEMBER STATES

In November 2005, membership of the WTO stood at 149 countries.

OBJECTIVES OF THE WTO

To promote free trade by persuading nations to abolish import duties and other barriers.
To oversee the rules of international trade.
To police free trade agreements.
To settle trade disputes between member countries.
To organise trade negotiations.

6.5 THE WORLD BANK (THE INTERNATIONAL BANK FOR

RECONSTRUCTION
AND DEVELOPMENT)

The World Bank came into existence in 1945 but commenced its operations in 1946. It is a
non-profit organisation owned by member governments and has its headquarters in
Washington, D.C in the United States of America.

OBJECTIVES OF THE WORLD BANK

To fight poverty and improve the living standards of people in developing countries.
To provide long-term loans and grants to developing countries.
To provide technical assistance to help developing nations in their quest to reduce poverty.
To provide assistance to developing countries on issues of economic development.

6.6 THE INTERNATIONAL MONETARY FUND (IMF)

The IMF was formed in 1944 by the Bretton Woods Agreement and started operating in 1947.
The principal function of the IMF is to help countries with balance of payment problems. Its
headquarters are in Washington, D.C in the United States of America.

OBJECTIVES OF THE IMF

To promote international monetary cooperation and international payments.

To encourage international trade among member states.
To promote exchange rate stability in member states.
To eliminate or remove of foreign exchange restriction
To provide advisory services to member states
To ensure that there is adequate supply XE "supply" of international liquidity.

7.0 CHAPTER SUMMARY

International trade is important because it allows countries to specialize according to the law of
comparative advantage XE "comparative advantage" .
The law of comparative advantage XE "comparative advantage" states that international trade is
most efficient and advantageous if each country sells the goods of which the country has the
most advantage in production relative to other goods received in exchange.

There are a number of advantages of international trading such as giving consumers in each
country more choice, encouraging efficiency in production, which is likely to result in lower
prices.

In spite of the numerous advantages of free trade, countries engage in protectionist policies for
various reasons. These include protecting employment, helping infant industries, preventing
unfair competition, protecting the balance of payments, and raising revenue XE "revenue" .

There are some arguments against protectionism. It is argued that they encourage inefficiency,
lead to misallocation of resources, raise the cost of living, and retaliation may occur.

The methods or forms which protectionism takes include tariffs, quotas XE "quotas" , hidden
import restrictions and export subsidies XE "subsidies" .

The terms of trade refer to the rate at which exports can be exchanged for imports. An
improvement in the terms of trade may not necessarily be beneficial as it reflects an increase in
export prices arising from domestic inflation. However, an improvement in the terms of trade
does reflect that fewer exports need to be sold to pay for each import because export prices are
rising faster than import prices.

There are a number of international institutions, which facilitate international trading. Some of
the international institutions are regional groupings that can take different forms, such as free
trade areas, customs union and/or common markets.

REVIEW QUESTIONS

International trade is based on which principle?

State the law of comparative advantage XE "comparative advantage"
State what you think is the comparative advantage XE "comparative advantage" of your
country, and what you think are Zambia’s non-traditional exports.
What are the terms of trade?
Give three arguments for protectionism
What does the world trade organization (WTO) attempt to do?
What is a multinational company?
Why have some companies XE "companies" become multinational in structure?
How can multinational companies XE "companies" benefit economies?
Differentiate tariffs from quotas XE "quotas" as barriers to free trade
What do a free trade area, a customs union and a common market mean?
The following data relates to the export and import prices of a country for three years.

N.B. Where 2004 = 100

Year Unit value of Unit value of

imports exports

2004 100 100

2005 112 106
2006 116 114

You are required to calculate the terms of trade in the years 2005 and 2006, and comment on
your results.

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EXAMINATION TYPE QUESTION 14.1

(a) Malawi and Zambia each produce both tobacco and maize in thousand of tons, as
shown
below:

Tobacco Maize
Malawi 20 200
Zambia10 150

Malawi appears to have an absolute advantage in the production of both commodities.

Would you advice that trade should still take place between the two countries? Justify
your answer. (6 marks)

(b) Despite the numerous advantages of free trade, countries engage in protectionism.
mention briefly four arguments for protectionism. (8 marks)

(c) Explain three forms of protectionism. (6 marks)

TOTAL: 20 MARKS

EXAMINATION TYPE QUESTION 14.2

a) Discuss five benefits of international trade. (10 marks)

b) Explain briefly
i) The comparative cost (comparative advantage XE "comparative advantage" ) theory
of trade. (5 marks)
ii) The terms of trade (5 marks)

TOTAL: 20 MARKS

CHAPTER 15

BALANCE OF PAYMENTS AND EXCHANGE RATES

__________________________________________________________________________________________
____

After studying this chapter, the students should be able to:

Explain the monetary aspects of international trade transactions

Understand the composition of the balance of payments account
Explain how to correct a deficit balance of payments
Appreciate of different types of foreign exchange systems
Discuss the merits and demerits of each exchange rate system.
Explain the difference between foreign exchange depreciation and appreciation
Understand factors influencing foreign exchange rates
___________________________________________________________________________
____

1.0 INTRODUCTION

Balance of payments (BOP) is a measure of the payments that flow into and out from a
particular country from other countries for a specific period usually a year. It is a statistical
‘accounting’ record of the international trading and capital XE "capital" transactions that have
taken place during that year. This is determined by a country’s exports and imports of goods,
services, financial capital and financial transfers, and since buying goods and services from
foreign countries is complicated by the fact that countries use different national currencies, this
last chapter also deals with the foreign exchange market XE "foreign exchange market" .

1.1 COMPOSITION OF BALANCE OF PAYMENTS

The Balance of payments consists of two parts namely

(a) The current account XE "current account" . This shows a record of net flow of
money XE "money" from transactions
involving the purchase of goods and services, and transfer payments XE "transfer
payments" . The current account
itself is divided into basically two parts namely

i) Trade in goods (known as visible or trade account)

The exports and imports of physical commodities such as copper and maize are
recorded on this account. The account may show a surplus or a deficit. Exports are
money XE "money" coming into a country and if the exports are higher than the
imports, then there is a surplus on thevisible trade account and vice versa.

ii) Trade in services (known as invisible trade account)

This is usually recorded as a net figure, implying the difference exports and imports
of
services such as tourism, insurance, civil aviation, patents, foreign aid, grants, gifts
etc.
It also includes the difference between factor incomes payable and receivable such
as
wages to foreign workers, interest on foreign debt, dividend payments on shares
held by
foreigners or income on any foreign investments. It is recorded as net transfer
income from abroad or paid abroad depending on whether there is a higher net
inflow or a higher net outflow of money XE "money" respectively. This account
can either be in surplus or deficit.
 The current account XE "current account" , being a combination of the two accounts
above, can either be positive
or negative, that is either a surplus or a deficit. When exports or money XE "money"
received from trade in goods, services and factor incomes exceed imports or money
paid for trade in goods, services and factor incomes, it means there a surplus or a
favourable current account balance. When imports exceed exports, it means there is a
deficit or an unfavourable current account balance. Note that this is what is referred to
as the surplus or deficit balance of payments account!

(b) The capital XE "capital" account. This account records all international financial
transactions in
the country,the external assets and liabilities. In general it records medium and long-
term capital XE "capital" inflows and outflows, including official reserves.

The inflows into the capital XE "capital" account:

Foreign loans
Investment by foreigners into Zambia
Aid from donor countries
A reduction in external reserves
Trade in shares in Zambian investments by people based outside Zambia.
Selling of assets that are based in other countries.

The outflows from the capital XE "capital" account:

Zambians investing in other countries.

Zambia giving aid or loans to other countries.
Trade in shares by Zambians in investments abroad
An increase in external reserves.
Selling of assets based in Zambia to people based outside Zambia.

In summary, if foreign ownership of domestic assets has increased more quickly than domestic
ownership of foreign assets in a given year, then the domestic country has a capital XE
"capital" account surplus. On the other hand, if domestic ownership of foreign assets has
increased more quickly than foreign ownership of domestic assets, then the domestic country
has a capital account deficit.

The capital XE "capital" account ‘finances’ or ‘covers’ the current account XE "current
account" , since a surplus or deficit on the current account must be ‘balanced’ by a deficit or
surplus on the capital account respectively. If for example there is a negative or a deficit current
account balance, then it must be ‘financed’ by inflows into the capital account and vice versa.

The above means the sum of the balance of payments account must always be zero. In practice,
an additional account is included to achieve the zero balance. This is known as net errors and
omissions or a balancing item.

1.2 Official Reserve Account

The official reserve account records the government's current stock of reserves. Reserves
include official gold reserves, foreign exchange reserves, and strategic defense reserves
(SDRs), such as the Strategic Petroleum Reserve.The Balance of Payments XE "Balance of
Payments" is the sum of the Current Account and the Capital Account. Therefore, Balance of
Payments = Current Account + Capital Account = Change in Official Reserve Account!
The balancing item is a change in the official reserves. A negative sign is an increase in official
reserves while a positive sign is a decrease in official reserves.

1.3 Zambia’s balance of payments (extracts from the B.O.Z annual

report)

The improvement in the terms of trade, on account of the increase in the international price of
copper, as well as the attainment of the enhanced HIPC Completion Point contributed to the
improvement in the performance of the external sector during the year. Consequently, the
deficit in the overall balance of payments declined. Preliminary information indicates that the
deficit in the overall balance of payments narrowed by 21.3% to US $274 million in 2005 from
US $348 million in 2004. This improvement in the overall balance was largely due to the
favourable performance in the capital XE "capital" and financial accounts despite the
deterioration in the current account XE "current account" . Project loans and grants, foreign
direct investment XE "investment" as well as portfolio inflows registered significant increases,
and enhanced the capacity to build-up Gross Official International Reserves (GIR) of the Bank
of Zambia. This development reinforced the positive effects of the improvement in the terms of
trade.

Current Account
The combination of continued strong economic activity and the appreciation of the Kwacha led
to an increase in the current account XE "current account" deficit through increased imports.
There was a decrease in the merchandise trade balance as well as the deterioration in net
services and income accounts. The merchandise trade balance declined by 28.0% to US $59
million in 2005 from US $82 million in 2004 while the net services and income accounts
deteriorated by 17.2% and 42.7% to US $252.0 million and US $605.0 million, respectively.
The decline in the trade balance resulted from a higher increase in the value of merchandise
imports than that of merchandise exports.

The value of imports increased by 19.7% to US $2,068 million from US $1,727 million
recorded in 2004. The increase in the import bill was in part explained by the continued high
investment XE "investment" activity in the mining sector and the rise in the price of oil on the
world market. The strengthening of the Kwacha against major trading currencies also
reinforced increased domestic demand for imports.

TABLE 17: BALANCE OF PAYMENTS IN US $ MILLION, 2003 – 2005

2003 2004 2005
Current account balance -700 -583 -826
Trade balance -311 82 59
Exports, f.o.b. 1,052 1,779 2,095
Metal sector 669 1322 1,557
Non-traditional 383 457 538
Imports, f.o.b. -1,393 -1,727 -2,068
Metal sector -169 -286 -306
Non-metal -1,224 -1,441 1,759
Goods procured in ports 29 31 32
by carriers
Services (net) -238 -215 -252
Receipts 165 232 246
Payments -403 -447 -499
Income (net) -148 -424 -605
Of which: interest -131 -121 -110
payments
Current Transfers (net) -3 -25 -28
Of which Official 20 0 0
Transfers
Capital Account 380 235 552
Project grants (capital 240 246 306
XE "capital" )
Financial Account 140 -11 246
Offi ci al l o an -141 -221 -105
disbursement (net)
Disbursement 101 110 120
Amortization (-) -242 -331 -225
Change in net foreign 48 -90 17
as s et s o f Co mmerci al
banks
Private capital XE 233 299 334
"capital"
(net)
Foreign direct 172 239 259
investment XE
"investment"
Erro rs an d o mi s s i o n s , -2 63 0
short term capital XE
"capital"
Overall balance -319 -348 -274
Financing 321 285 274
Change in net -161 -44 -341
international reserves of
BoZ (-increase)
Gross official reserves 89 -28 -81
of BoZ
BoZ liabilities -6 -6 -6
IMF (net) -244 -10 -253
Debt Relief 389 264 480
Debt relief (non-HIPC) 154 245 152
Deb t rel i ef (HIPC, 235 19 328
including IMF)
Of which IMF 169 2 229
Other Debt Related Items -10 0 0
Net change in arrears (+ 48 0 0
increase)
 Change in net -161 -44 -341
international reserves of
BoZ (-increase)
Gross official reserves 89 -28 -81
of BoZ
BoZ liabilities -6 -6 -6
IMF (net) -244 -10 -253
Debt Relief 389 264 480
Debt relief (non-HIPC) 154 245 152
Deb t rel i ef (HIPC, 235 19 328
including IMF)
Of which IMF 169 2 229
Other Debt Related Items -10 0 0
Net change in arrears (+ 48 0 0
increase)
BOP support grants 45 44 105
BOP support loans 10 21 29
Multilateral 10 21 29
Bilateral 0 0 0
Financing gap (+) 0 0 0
Memorandum items:
Nominal GDP (millions of 4,326 5,422 6,968
US $)
Current account balance -16.2 -10.7 -11.9
(% of GDP)
Terms of trade XE 4.2 21.9 2.1

"Terms of
trade" (p ercen t ag e
change)
Copper volume 353 393 417
(MT.'000)
Copper price (US$/lb) 0.78 1.20 1.52
Gross official Reserves 194 222 303
(In months of imports) 1.3 1.2 1.4
De b t s e r v i c e c a s h 192 371 162
payments (US $m)
(In % of exports) 15.4 18.2 6.8
Of which; official debt 108 114 129
service
Source: Bank of Zambia and Fund Staff Estimates
Notes: The figures reported in the Balance of Payments XE "Balance of Payments" table are
as estimated in October 2005

Total export earnings in 2005 increased by 17.8%, to US $2,095 million from US $1,779
million in 2004, with earnings of metal and non-traditional exports (NTEs) both rising by
17.8% to US $1,557 million and US $538 million, respectively. The increase in copper prices
was mainly due to sustained international demand particularly from China and India while
export volumes edged upwards as a result of continued recapitalisation of the existing mines
and commencement of full production at Kansanshi mine.

In contrast, cobalt exports declined. The 17.7% increase in Non-Traditional Export was
explained by growth XE "growth" in the exports of copper wire, sugar, burley tobacco, cotton
lint and electrical cables.

The deficit in the services account deteriorated to US $252 million in the past year, reflecting
large amounts of net payments made on trade-related services. With respect to the income
account, the deficit widened by 42.7% to US $605 million. This increase was in spite of a
9.0% decline in official interest payments on external debts to US $110 million from US $121
million over this period.

Capital and Financial Account

The surplus on capital XE "capital" and financial account rose to US $552 million in 2005
from US $235 million in 2004. This was largely due to increased donor inflows, foreign direct
and portfolio investments as well as a reduction in debt amortization. Increased external capital
inflows partly resulted from the rise in investor and donor confidence following the attainment
of the enhanced HIPC Initiative Completion Point in April 2005.
Financing
The deficit in the overall balance of payments was financed mainly by debt relief of US $480
million, inflows of BoP support grants amounting to US $105 million and BoP support loans
of US $29.0 million.
The Balance of Payments XE "Balance of Payments" Support came from cooperating partners.
Specifically, Zambia received from the European Union (EU), from the British Government
under the Poverty Reduction Budgetary Support (PRBS) to finance priority poverty reduction
programmes, from Finland, from Sweden, from the World Bank and from Norway.

2.0 THE PROBLEM OF BALANCE

When a country has an adverse or a deficit (negative) balance of payments, this is regarded
with serious concern. When a country has a favourable or credit (positive) balance, then there is
satisfaction.

Yet for all countries of the world, total payments must be equal to total receipts, since every
payment is at the same time a receipt. Since all countries cannot achieve favourable balances in
the same year, the aim should be an equilibrium balance of payments over a period of time.
Each individual country’s balance of payments must balance each year. When all items have
been taken into account, a balance is achieved by showing how the deficit or amount of credit
(favourable) balance has been ‘covered’ or ‘financed’.

If a country has a deficit in its balance, it must be ‘covered’ by inflows into the capital XE
"capital" account. If it has a credit or positive balance, then it is ‘covered’ by outflows from
the capital account.

2.1 CORRECTING A BALANCE OF PAYMENTS DEFICIT

- Devaluation/depreciation

Devaluation of a currency is a reduction in the exchange rate of the currency relative to other
currencies. The objective of devaluing a country’s currency to make exports cheaper and
imports expensive, by reducing the price of exports to foreign buyers (i.e. in foreign currency
terms) and increasing the price of imports in terms of the domestic currency.

If for example the Zambian Kwacha to the US dollar is devalued form $1 = K3200 to $1 = to
K4000, then foreign consumers and firms will be encouraged to switch to Zambian goods
because with the same $1, they are able to purchase more Zambian goods. They are able to
purchase K4000 worth of goods instead of K3200 worth of goods. In addition, local
consumers and firms will be discouraged from imports. They will need to have K4000 to
purchase a $1 worth of goods, before devaluation, they needed to have K3200 to purchase a $1
worth of goods.

Therefore, depreciation in the kwacha exchange rate should help to boost the overseas demand
for Zambian exports because Zambian firms will be able to supply XE "supply" more cheaply in
international markets.

The extent to which export sales rise following a fall in the exchange rate depends on the price
elasticity of demand for Zambian products from foreign consumers.

A lower exchange rate should also cause imports into Zambia to become relatively more
expensive, thus leading to a slowdown in import volumes and "expenditure-switching"
towards local goods. The significance of elasticity of demand is again important.

In the short run XE "short run" , even if elasticities are favourable, a depreciation/devaluation does
not immediately benefit a balance of payments in practice. It takes time for movements in the
exchange rate to affect trade flows. In the short run, demand for imports is likely to be fairly
inelastic, while exporters would be unlikely to increase the output to meet the increase in
demand due to the depreciation of the currency. Therefore, there is likely to be an initial
worsening of the current account XE "current account" because volumes are fixed.

In the long run XE "long run" , demand and supply XE "supply" become more elastic, production
and volume of exports rise, imports can be substituted and the volume of imports falls. This
improves the current account XE "current account" balance.

The effect of devaluation/depreciation of a currency on the current account XE "current account"

is called the j-curve effect. The exact shape of the curve depends on the assumptions made, and
it is usually assumed that the improvements in the current account eventually levels off.

Balance

0 Time (years)

- Deflation/Fiscal policy
This is contraction of the domestic economy. Deflationary measures are aimed at reducing
aggregate demand and this can be achieved by either increasing interest rate to discourage
borrowing or increasing tax rates in order to reduce consumption XE "consumption"
expenditure. The government can also reduce its own expenditure.
Some of the overall trade deficit is due to the strength of domestic demand for goods and
services. If and when the economy enters a slowdown phase, the growth XE "growth" of
imports will fall, and this should provide an element of correction for the trade deficit

The effect of the deflationary measures is to reduce the demand for goods and services,
including the demand for imports. If imports are high, demand for them is reduced by reducing
the demand in the economy in general, as long as the demand for imports is income inelastic. If
the fall in demand is accompanied by a reduction in inflation in the home market, the
competitiveness of exports improves (as long as demand for exports in price elastic). In
addition, firms are encouraged to switch to export markets because of the fall in domestic
demand.

Some of the overall trade deficit is due to the strength of domestic demand for goods and
services. If and when the economy enters a slowdown phase, the growth XE "growth" of
imports will fall, and this should provide an element of correction for the trade deficit. The
major problem associated with deflation is that a sharp fall in consumer spending might lead to
a steep economic slowdown (slower growth of GDP) or a full-scale recession.

- Direct controls (discouraging imports whilst encouraging exports).

These are the direct controls mentioned earlier under protectionism. A government can impose
trade restrictions like quotas XE "quotas" , import duty, exchange controls, health and safety
regulations etc. Increase exporters’ competitiveness on the international market by subsidising
exporters. A government may also adopt policies to promote exports e.g. zero-rating VAT on
exports, export credit guarantees etc. Eventually the policies result in more exports.

The problem with this policy instrument is that there is a danger of other countries retaliation,
as well as if the demand for imports is inelastic.

Raising interest rates XE "interest rates" .

High interest rates XE "interest rates" are likely to make Zambia attractive to foreign investors
and encourage inward investment XE "investment" , an inflow of foreign currency. This short-
term capital XE "capital" movement of currencies by international financiers/speculators is
known as ‘hot money XE "money" ’. Higher interest rates act to slowdown the growth XE
"growth" of consumer demand and therefore lead to cutbacks in the demand for imports. It is a
short-term measure, which eventually leads to an appreciation of the exchange rate.
Note that the key to long-term improvements in trade performance is to focus on supply XE
"supply" side policies. Controlling or reducing a balance of payments deficit in the long term is
to achieve relatively low inflation with sufficient productive capacity to meet the domestic
demand from consumers.
This requires a period of low inflation, low interest rates XE "interest rates" and a competitive
exchange rate matched with sufficient non-price competitiveness in overseas markets. Price is
not always the only deciding factor in winning the demand from buyers, investment XE
"investment" in research and development XE "research and development" and effective marketing
strategies can have long term effects in maintaining market share.

An outward shift of long run XE "long run" aggregate supply XE "supply" would provide the
economy with an increased capacity - permitting a reallocation of resources towards exporting.
Therefore, a sustained improvement in the balance of payments requires businesses exploiting
opportunities in export markets overseas, increased investment XE "investment" in services
(including business finance, tourism) as many services are exportable and have the potential to
earn huge sums in foreign currency. Improve efficiency and productivity in the export sectors.

3.0 EXCHANGE RATES

Exchange rates are the price of a currency expressed in terms of another currency. An exchange
rate is the price for obtaining one unit of a foreign currency. The exchange rate refers to the
value of one currency (e.g. the Kwacha) in terms of currency (e.g. the United States Dollar).

3.1 DETERMINATION OF EXCHANGE XE "DETERMINATION OF EXCHANGE"

RATES

The basic forces behind the determination of exchange rates are those of supply XE "supply"
and demand. Taking exchange rate for the kwacha against other currencies as an example, the
exchange rate set in the market will be affected by supply of and demand for Kwacha.

3.2 DEMAND

People and firms want the Kwacha for various reasons:

To pay for Zambian exports.

Investors based abroad wanting to invest in Zambia.
Speculation. Speculators will buy the Kwacha at the current exchange rate, if they think it going
to appreciate in the near future. They want to sell the Kwacha at a higher exchange rate in
future.
The central bank may want to buy Kwacha to push up its value on the foreign exchange market
XE "foreign exchange market" .

3.3 SUPPLY

Supplies of Kwacha arise when people buy foreign currency in exchange for Kwacha. The
factors affecting supply XE "supply" are as follow:

Zambian residents wishing to buy imports will require foreign currency, so they need the
Kwacha to acquire foreign currency.
Zambian residents investing abroad will sell the Kwacha and buy foreign currency.
If speculators think that the Kwacha is about to depreciate they sell it.
The central bank may sell the Kwacha to manipulate its value.

3.4 FIXED EXCHANGE RATES

This is where the government keeps the exchange rate at a fixed level, but if it cannot control
inflation, the real value of the currency will not remain fixed.

3.4.1 ADVANTAGES OF FIXED EXCHANGE RATES

They make international trade more stable because of the certainty to traders.
They make it possible for importers and exporters to predict profits.
They make investors more confident about investing in other countries.
Importers and exports can agree prices for future delivery without having to worry about
potential losses through exchange rate movements.

3.4.2 DISADVANTAGES

They require substantial official reserves. The Central Bank requires a large pool of foreign
currency to enable a prolonged period of intervention to support the exchange rate.

They complicate Economic co-operation among countries with different Economic objectives
and policies

Fixed exchange rates can lead to capital XE "capital" flight or outflows of capital if interest
rates XE "interest rates" are attractive in other countries.

3.5 FLOATING EXCHANGE RATES

Floating exchange rates are exchange rates that are determined by the market forces of supply
XE "supply" and demand. Under the Floating exchange rate system, the government does not
intervene in the foreign exchange market XE "foreign exchange market" . A system under
which exchange rates are not fixed by government policy but are allowed to float up or down in
accordance with supply and demand.

3.5.1 ADVANTAGES

The nation’s exchange rate will adjust automatically in the foreign exchange market XE
"foreign exchange market" to correct any balance of payments deficits or surplus.

The central bank does not need to large reserves maintain a certain exchange rate.

Monetary policy XE "Monetary policy" will be more effective.

There is no need to work out the new exchange rate because market forces of supply XE
"supply" and demand will determine it.

3.5.2 DISADVANTAGES

Floating exchange rates lead to uncertainty in international trade and this may hinder trade with
other countries.

Floating exchange rates encourages speculation, which in turn leads to increased volatility of
the exchange rates.

Fiscal policy will be less effective.

3.6 Note the following in relation to exchange rates: In markets where exchange rates
float,
an increase in the external value of a currency is referred to as an appreciation and
a decrease in the external value is referred to as a depreciation of the currency.

In markets where exchange rates are fixed, when authorities raise the external value of the
currency to a higher fixed parity, this is referred to as a revaluation and a change to a
lower parity is referred to as a devaluation of the currency.

3.7 MANAGED FLEXIBILITY OR DIRTY FLOATING EXCHANGE RATES

The system that exists in practice is a compromise between fixed and floating rates.

The market forces now play a more important role in the determination of exchange rates, but
the authorities often intervene to neutralise short run XE "short run" pressure on exchange
rates, to ensure that it remains fixed within a certain zone of flexibility. This system is known
as a managed float.

A central bank, on behalf of the government, buys and sells currency to stabilize the exchange
rate. When one reads in the newspapers that the Bank of Zambia has offloaded foreign
currency (from its reserves) to buy the Kwacha on the foreign exchange market XE "foreign
exchange market" , the bank wants to artificially stimulate demand, and make the Kwacha
appreciate in value, and vice versa.

However, because authorities do not always make it clear that they are using the reserves to
support a currency’s external value, and maintain an exchange rate target, which is usually
unofficial, the term dirty float is used.

4.0 CHAPTER SUMMARY

The balance of payments is an account showing the financial transactions of one nation with the
rest of the world, it records flows of funds between residents of a country and overseas
residents, normally for a period of one year.

The balance of payments consists of two parts, the current account XE "current account" and
the transactions in external assets and liabilities, known as the capital XE "capital" account.

The current account XE "current account" is made up of the visible and the invisibles XE
"invisibles" account, while the capital XE "capital" account shows the inflows and the
outflows of foreign currency. The overall balance shows how the difference between current
and capital XE "capital" accounts is financed.

In theory, the balance of payments always balances because of the double entry system used in
recording transactions. However, in practice, there is need to include a balancing item, which is
created by errors and omissions in measuring the figures.

A balance of payments deficit indicates that what was paid out is greater than what was
received. The deficit can be adjusted by devaluation and deflationary measures as well as direct
controls.

A balance of payments surplus can be adjusted by revaluation, and other measures to

encourage imports. Exchange rates are a ‘price’ of one unit of a currency expressed in terms of
another currency.

There are two basic exchange rate systems, the flexible or the floating and the fixed exchange
rate systems, in practice, most exchange rates fall in between these two extremes. A ‘dirty’ or
managed exchange rate is when the central bank intervenes in order to stabilize the exchange
rate.

The market forces of supply XE "supply" and demand for a currency determine the floating
exchange rate, and the central authorities determine the fixed exchange rate system. Both
systems have advantages and disadvantages. When there is a high demand for a currency due
to an increase in exports or other factors, the currency appreciates in value and vice versa.

REVIEW QUESTIONS

What does the capital XE "capital" account show?

Name one invisible earning
What do you understand by the current account XE "current account" of a country’s balance of
payments?
What can cause a country’s balance of payments on the current account to be in deficit?
How can deflation help a balance of payments deficit?
What does the ‘j’ curve show?
How can a fall in the exchange rate help an economy?
What is the difference between devaluation and depreciation of the exchange rate?
What is the main determinant of the value of floating exchange rates XE "floating exchange
rates" ?
Explain the term ‘managed’ floating system of exchange rate determination.
What is the advantage of freely floating exchange rates XE "floating exchange rates" ?
Give two advantages of a fixed exchange rate system.

--------------------------------------------------------------------------------------------

EXAMINATION TYPE QUESTION 15.1

What is a Balance of Payments XE "Balance of Payments" Account? Describe its

composition. (8 marks)

Explain:
Two ways of “financing” a balance of payments deficit and
Two ways of “correcting” a balance of payments deficit. (8 Marks)

The Zambian Kwacha rate of exchange to the United States Dollar was K8 to $1 in 1988,
fourteen years later in mid November 2002, it was over K5, 000 to $1.

Discuss two arguments in favour of a return to a system of fixed exchange rates XE "fixed
exchange rates" .
(4marks)

(Total: 20 Marks)

QUESTION 15.2

a) What policies can a government pursue to remove a large balance of payment deficit?
(12
marks)

b) The following data refers to a hypothetical balance of payment values of a country

 K’m
Exports 65 500
Interest, profits and dividends (net) 1 080
Services (net) 2 400
Imports 63 200
Current transfers -1 810
Increase in external assets 30 830
Increase in external liabilities 28 570
Balancing item 1 710

You are required to calculate the balance of payments account, showing clearly

- The visible trade balance

- The invisible trade balance
- The current account XE "current account" balance
- The capital XE "capital" account balance – the movement in external assets and
liabilities
(8 marks)

TOTAL: 20 MARKS

APPENDIX 1

SOLUTIONS TO REVIEW QUESTIONS

CHAPTER ONE

The basic economic problem facing all economies is the scarcity of resources
Positive economics is objective economic descriptions while normative economics is economic
value judgments and opinions of what ought to happen in an ideal world.
The main production decisions are what, where, how and for whom to produce
Land, labour XE "labour" , capital XE "capital" and enterprise.
Opportunity cost is the sacrifice of the next best alternative
A production possibilities curve shows the maximum of all possible combinations of two types
of products that can be produced with existing resources.
The central government authorities make most of the decisions on behalf of society.
An externality is a consequence of an economic transaction that affects people not party to the
transaction.
It is measured as the ‘real’ increase in output, the actual value of goods and services produced
in a country in any given year.
Unbalanced economic growth XE "growth" is where some sectors or areas grow faster than
others.

CHAPTER TWO

It is downward sloping from left to right

A shift in demand occurs when the conditions of demand change (a change in demand), while
an extension or expansion in demand is due to price changes (a change in the quantity
demanded)
Economically, it is not, because the price would go up if there were a very high demand for
some products, relative to the supply XE "supply"
A consumer surplus arises when consumers of a good or service gain because the market price
is less than what they were prepared to pay
Costs of production, government policy (i.e. taxation XE "taxation" and subsidy), weather
conditions (especially for agricultural products), technological changes, efficient use of existing
resources
Substitutes are goods that are alternatives to each other, competing on the market like butter and
margarine, celtel and zamtel, mosi and castle beer. Complementary goods are those goods
which are jointly demanded, they have to be bought together, such as cars and fuel, cassettes
and recorders, cell phone and sim card
A normal supply XE "supply" curve slopes upward from left to right.
When held above the equilibrium price, demand is less than supply XE "supply" , hence there
is a surplus or excess supply
i) Adverse weather is one of the factors that influence supply XE "supply" . Maize production
can be
influenced by either too much or too little rainfall (floods or droughts). The supply XE
"supply" curve
would shift to the left, and this would result in an increase in price, while the quantity of
maize traded on the market would reduce, as shown below.

Price D S1

S
P1

O Q1 Q Quantity

ii) Income changes greatly influence demand. When consumers have a lot of money XE
"money" to spend,
the demand of goods and services generally would increase. Therefore the demand
curve
would shift to the right. This upward shift in demand would cause the price and output
of
oranges to increase as shown below.

D1

Price D S

P1

O Q1 Q Quantity

CHAPTER 3

Price elasticity of demand measures the responsiveness of demand to changes in price.

20% ÷ 10% = 2, demand is elastic
Degree of necessity, habit forming, income, possibility of substitution, time period
A good for which demand falls as household income increases
Elastic
A normal or superior good such as a Mercedes Benz car.
Complementary goods or those goods, which are jointly demanded like cars and petrol
All the exceptional demand curves like ostentatious goods, Giffen goods XE "Giffen goods"
and most commodities during inflationary times when consumers expect further increases in
prices.

9. Price

Quantity

10.
 Price D
S1
P1
S
P

0 Q Quantity

100% of the burden of the tax is borne by the consumer as price rises from P to P1

CHAPTER 4

The long run XE "long run" is the time period when all resources are considered to be
variable, while the
short run XE "short run" is the time period when at least one factor of production is in
fixed supply XE "supply" .
Fixed costs XE "Fixed costs" are those, which do not vary, in direct proportion as changes in
output. Variable
costs change in direct relation to output.
In the long run XE "long run" all costs are considered to be variable, therefore all the costs
must be covered
in the long run XE "long run" .
Marginal cost is the change in the total cost caused by producing one more unit of output.
The firms’ demand for factors of production XE "factors of production" is derived from
households’ demand for the
Goods and services the firms produce.

Output (units) 100 101 102 103

a) Total costs 800 806 809 810
b) Average costs 8 7.98 7.93 7.86
c) Marginal costs - 6 3 1

7. Output (units) 20 30 40 50 60 70
i) Average costs 13.5 11 10 10 10.5 12
ii) Marginal costs - 6 7 10 13 21

Costs
25

20 MC
 15
AC
10

0
10 20 30 40 50 60 70 Output

8. The primary sector of the economy is concerned with the production of raw materials
such
as crops and minerals. The secondary sector manufactures these raw materials into
finished producer and consumer goods. The tertiary sector is the provision of services.

CHAPTER 5

1. Internal economies of scale are achieved within an individual firm, from the organization of
production. External economies are advantages to most firms in that industry because the
firms are ‘concentrated’ together.
2. The four categories of internal economies XE "internal economies" of scale
Financial, it is generally accepted that larger firms can raise funds more easily and cheaply than
small firms
Trading economies, reducing the cost of material purchases through bulk purchase discounts.
Stockholding becomes more efficient, the most Economic quantities of inventory to hold
increase with the scale of operations.
Organisational economies, when the firm is large, generalization of functions such as
administration, research and development XE "research and development" and marketing may
reduce the burden of overheads on individual operating locations.
Managerial economies, management costs remain constant, as they are not related to output. In
addition, large firms can afford to hire specialist managers to be in charge of different
departments or fields.
3. Diseconomies of scale XE "Diseconomies of scale" are problems of size and tend to arise
when the firm grows so
large it cannot be managed efficiently. Communication, coordination and control become
difficult. There is low morale in the workplace, and managers find it difficult to identify the
information they need because of large volumes available. Decisions are not made quickly.
4. External economies of scale are advantages, which accrue to most firms in an industry, as
it
grows in size. Not to an individual firm. For example, large skilled labour XE "labour"
force is created, and
educational services can be targeted at that industry. In addition, specialized and ancillary
industries develop in the area.
5. This is the level of output on the long run XE "long run" average total cost curve at which
average costs XE "average costs" first
reach their minimum point. The increasing returns to scale are not achieved indefinitely as
output rises, there will be increasing returns up to a certain minimum efficient scale XE
"minimum efficient scale" , this tends
to vary from industry to industry.
6. Vertical integration XE "integration" occurs to eliminate the transaction costs of
middlemen, increase entry
barriers, secure supplies of raw materials, improve distribution network, gain economies of
scale and make better use of existing technology.
7. Small firms benefit an economy because they provide employment and new ideas, new
products on the market, operate efficiently, provide employment etc.
8. At the level of output at which marginal cost is equal to marginal revenue XE "marginal
revenue"
9. The long run XE "long run" average cost curve eventually rises because of diseconomies
of scale.

CHAPTER 6

A market is where goods and services are bought and sold

A perfect market assumes a homogeneous product (a completely identical product), many
buyers and many sellers, who all have perfect information and there are no entry barriers.
The long run XE "long run" equilibrium of a firm under perfect competition is where marginal
cost is equal to marginal revenue XE "marginal revenue" , just like any other firms. However, it
is attained at the output level where the costs of production are at their minimum level, and the
supply XE "supply" is equal to demand, which means technical and Economic efficiency
respectively. In short, it is at a point where AC = AR = MC = MR = P = D.
Allocative efficiency refers to the best use of Economic resources, through the market forces of
supply XE "supply" and demand. It occurs at an output level where prices charged (demand),
equal the marginal cost of production (which is the supply curve) In theory, it occurs only in
perfect competition in the long run XE "long run" .
Reasons for the existence of monopolies:
Existence of natural monopolies
Existence of patents, copyrights etc.
Government legislation
Ownership of essential raw materials, or other inputs
Demand for the product.
Justification of monopolies are several, such as, to achieve economies of scale and thereby
lower the prices, they are necessary in an industry which faces strong competition, some
monopolies are natural, monopolies can afford to spend more on research and development XE
"research and development" since they earn supernormal profits, monopolies find it easier to
raise new capital XE "capital" etc.
Price discrimination is a practice whereby producer charges different prices to different
customers for the same product or service.
The conditions necessary to practice price discrimination XE "price discrimination" are:-
Being able to separate the markets.
Having different elasticities of demand in the separate markets.
Imperfections in the market, it cannot be practiced in a perfect market.
The aim of price discrimination XE "price discrimination" is to maximize profits.

(a) (b)

OUTPUT TR AR MR
(PRICE)

50 500 10 10
60 600 10 10
70 700 10 10
80 800 10 10
90 900 10 10
100 1000 10 10
110 1100 10 10
120 1200 10 10

c) Average revenue XE "revenue"

10 AR =MR =P = D

0 120 Quantity

d) It is perfect competition

12. (a) (b)

OUTPUT TR AR MR
(PRICE)

50 750 15 -

60 840 14 9

70 910 13 7

80 960 12 5

90 990 11 3

100 1000 10 1
 c) Average revenue XE "revenue"

15

10
AR = D= P

0 100 Quantity

d) It is a monopoly XE "monopoly" structure

13. The AR = P = D, when drawn under perfect competition, it has a horizontal demand
curve
signifying that demand is perfectly elastic. The monopolist is faced with downward
sloping normal demand curve.

The equilibrium position for a firm under perfect competition is where costs are at their
lowest level, but not for a monopolist, unless the price is lowered.

The monopolist produces where output is low but prices are high, this means a welfare
XE "welfare" loss to customers.

Monopoly advertising XE "advertising" not persuasive or wasteful but it is

informative. The super normal profits earned are sometimes used for the development
of new goods, as such society gains.

Monopolies are also beneficial in that organising for production in the most effective
way can be done easily for public utilities especially where there is strong international
competition. Monopolies enjoying economies of scale sell their products at a lower
price than that charged under perfect competition and there is greater technical efficiency
XE "technical efficiency" because of economies of scale.

In practice, monopolists have less incentive to be innovative. Supernormal profits are

earned both in the short run XE "short run" and in the long run XE "long run" as long
as the firm is able to create barriers to entry and undermine competition. Oligopolies are
complacent (“X” inefficiency). Occasionally, the firm sells at how prices to fend off
competition, knowing there are supernormal profits elsewhere.
CHAPTER 7

Products can be differentiated through extensive advertising XE "advertising" , attractive

packaging, use of brand names, and good after sales service etc.
Product differentiation is important because it determines the survival of the firm, it creates
customer loyalty for the firm to have some market power.
A cartel is an agreement on output and or pricing policies of each member
Firms operating under this market are interdependent.
If a cartel is not formed, the pricing and output decisions of one firm will still affect the price
and output of the rival firms
Non-price competition occurs when firms attempt to increase their sales by other means other
than changing prices. Sales can be increased through sales promotion or through other forms of
product differentiation.
The kinked demand curve XE "kinked demand curve" reemphasizes the stability of prices in
oligopoly markets even when cartels XE "cartels" are not formed. If an individual firm in an
oligopoly market decides to reduce the price in order to increase the market share, rival firms
would follow suit, while an increase in price is likely to lead to a reduction in the market share,
as the competitors would not increase their prices.
The kinked demand curve XE "kinked demand curve"
Price

D
Kink

D = AR = P

Quantity

CHAPTER 8

The value added method is based on measuring the total goods and services produced by
different sectors of the economy. The income method totals the individual factor incomes.
Wages and salaries, from both formal employment and self-employment, rent, interest, and
profit. The expenditure method is based on measuring total expenditure on goods and services,
that is, expenditure by households, firms and government, including exports minus imports.

GDP is the total market value of all final goods and services produced within a country.
While, GNP is GDP plus/minus net property income from abroad, which are goods and
services produced by citizens of a particular country. Net property income is the difference
between income earned by Zambian residents on overseas assets and income earned by foreign
residents on Zambian assets.
The nominal GDP is the current market value of all goods and services, while the real GDP
takes into account price changes. Therefore, real GDP is equal to nominal GDP minus inflation
rate.

These are payments made to a factor of production e.g. labour XE "labour" earning an income
when an individual has not been productive in a particular year, examples student grants,
unemployment benefit, pension etc.

Transfer payments come from taxes paid out of the incomes of productive people or being paid
to someone who was productive in the past or who will be productive in the future. Including
it in the national income XE "national income" figure for a given year other than when labour
XE "labour" was productive, would amount to double counting.

Net national income XE "national income" at factor cost + capital XE "capital" consumption
XE "consumption" + indirect taxes on expenditure – subsidies XE "subsidies" equals is
equal to gross national product at market prices

7. Government expenditure 40 000

Consumers’ expenditure 97 000
Capital formation 38 000
Value of physical increase in stocks 5 000

Total domestic expenditure at market prices 180 000

+ Exports 25 000
- Imports (53 000)

Gross Domestic Product XE "Gross Domestic Product" at market

prices 152 000
- Indirect taxes (30 000)
+ Subsidies 2 000

Gross Domestic Product XE "Gross Domestic Product" at factor

cost 124 000
+ Net property income from abroad 2 000

Gross National Product at factor cost 126 000

The figures are “gross” because capital XE "capital" consumption XE "consumption" or

depreciation, which is the wearing out of assets, has not been deducted.

CHAPTER 9

This means that consumption XE "consumption" is autonomous (a) it is independent of the

level of income. In addition, a proportion of consumption XE "consumption" is dependent
on income, as income changes, consumption XE "consumption" also changes (bY).
An economy is in equilibrium when injections are equal to withdrawals
However, in practice, the same people do not make the injections into and the withdrawals from
the circular flow of income.
Injections into the circular flow are investment XE "investment" , exports and government
expenditure
Aggregate demand is made up of C + G + I + (X-M). C, which is consumption XE
"consumption" expenditure, is an endogenous part of the circular flow of income.
The accelerator XE "accelerator" theory shows that changes in consumption XE
"consumption" expenditure may induce much
larger proportional changes in investment XE "investment" expenditure
The multiplier XE "multiplier" shows that the increase in expenditure, the injections into the
circular flow, will produce a much larger increase in total income through successive rounds
of spending. The formula for a simple economy is K = 1/(1 –MPC) or 1/MPS. For the
open economy it is K = 1/Marginal rate of leakages, that is savings XE "savings" + imports +
taxation XE "taxation" .
A trade cycle is a sequence of varying rates of growth XE "growth" . The correct sequence is
recession, depression, recovery and boom.
Income is either consumed or saved, an increase in savings XE "savings" means that money
XE "money" is withdrawn
from the circular flow of income, national income XE "national income" reduces as
investment XE "investment" is discouraged.
A deflationary gap XE "deflationary gap" occurs when aggregate demand is insufficient to buy
all the goods and services in the economy, when AD is less than the full employment level.

CHAPTER 10

1. Money is a medium of exchange, it is defined as anything that is generally acceptable as a

means of payment.

2 The characteristics of money XE "money" can be remembered using the acronym

ADDSUP. where A =
generally Acceptable
D = Durable
D = Divisible
S = Scarcity XE "Scarcity"
U = Uniformity
P = Portability, meaning, easy to carry around.

3 Functions of money XE "Functions of money" can be described as follows:

- Unit of account and measure of value
- Medium of exchange
- Store of value
- Standard of deferred payments
4. Narrow money XE "money" is currency in circulation plus demand deposits, it is money
that is
available to finance current spending, while broad money XE "money" includes narrow
money plus
balances held as savings XE "savings" , liquid assets used as a liquid store of value.

5. Broad measures of money XE "money" include notes, coins and bank deposits, both
current and fixed
deposits as savings XE "savings" .

6. Keynes argued that the demand for money XE "demand for money" is the desire to hold
liquid money XE "money" , and people want
to hold money XE "money" for three basic motives
- Transactions
- Precautions
- Speculative

7 . There is, an inverse or negative relationship between bond prices and interest rates XE
"interest rates" , therefore
if interest rates XE "interest rates" rise, bond prices will fall.

8 The real rate of interest XE "rate of interest" is defined as the nominal interest rate adjusted
for inflation.

9 High interest rates XE "interest rates" attract an inflow of foreign funds and investments,
and therefore cause a
currency to appreciate.
10 Liquidity preference is the demand curve for money XE "money" , as shown below.

Interest rate

LP = D

Quantity of money XE "money"

CHAPTER 11

1. Financial intermediaries
- Facilitate payments
 - Provide a means of transferring and distributing risk XE "risk"
- Raise the level of savings XE "savings" and investment XE "investment"
- Provide maturity transformation
- Act as mediums for implementing monetary policies
2. Financial disintermediation is when firms lend to and borrow from each other directly
without using a financial intermediary, and/or when individuals lend to and borrow
from each other directly without using a financial intermediary.
3. The amount of cash kept by commercial banks in readiness to pay withdrawals.
4. The most profitable assets to banks are loans.
5. Capital adequacy rules attempt to ensure that banks have sufficient capital XE "capital"
to cover potential bad debts on risk XE "risk" assets.
6. OMOS are purchases and sales by the Bank of Zambia of treasury bills XE "treasury
bills" in the money XE "money" market, as a way of influencing the money supply
XE "money supply" and the interest rates XE "interest rates" .
7. The problems with monetary policy are informational, supervisory, the effect on a
bank’s independence, and the conflicting objectives of either reducing or increasing the
money XE "money" supply XE "supply" .
8. Capital markets provide long term-finance for companies XE "companies"
9. A primary market is a market for the new issue of securities, while a secondary market
is where securities which are already issued, are traded.
10. Money markets provide short-term finance for companies XE "companies" , also a
profitable way of lending or investing surplus funds.
11. Instruments traded on the money XE "money" market are treasury bills XE "treasury
bills" , certificate of deposits, commercial paper, including IOUs, bills of exchange.

CHAPTER 12

1. The quantity theory of money XE "money" claims that there is a stable link between
the stock of money XE "stock of money" in the economy and the level of prices, if the
money stock increases, the price level will also increase.
2. Inflation is defined as a persistent increase in the general price level, and it is measured
using the retail price index (RPI), consumer price index (CPI).
3. Demand-pull and cost push inflation.
4. The principal cause is aggregate demand exceeding the supply XE "supply" of goods
and services. This could result from injections into the circular flow of income when the
economy is at or near the full employment level.
5. The Economic consequences of inflation are as follows:-
- It affects planning both at central government and at corporate business level.
- It also undermines business confidence.
- Inflation reduces a country’s international competitiveness and causes the currency to
depreciate given a low demand for exports.
- Inflation discourages savings XE "savings" , and ultimately, investment XE
"investment" .
 - It also distorts consumer behaviour, consumers purchase a lot of goods in the hope of
‘beating’ inflation.
- Inflation has a big impact on people who are on fixed incomes, their purchasing
power
and standard of living XE "standard of living" falls.
- Inflation results in money XE "money" being unable to perform its functions
properly.
6. The main types of unemployment are: structural, frictional, demand-deficient (cyclical)
and seasonal unemployment

7. The Economic consequences of unemployment are classified as Economic, financial

social or political costs:
- Labour is a factor of production, and due to unemployment, the Economic resource is
not being utilized, this is at a cost, the opportunity cost XE "opportunity cost" of
goods and services not produced, quality of workforce diminishes as idleness causes
labour XE "labour" to be less efficient, this in turn increases the cost of retraining it.
- Government revenue XE "revenue" is mostly from taxes, unemployment results in a
loss of government revenue, as the unemployed do not pay any tax, in some rich
countries they receive state benefits, which means that unemployment is a financial cost
to the government.
- Unemployment may lead to social undesirable behaviour like theft, vandalism, riots
or general discontent. The mental and physical health of the unemployed tends to
deteriorate, the unemployed are more prone to commit suicide. This is considered to be
a social cost.
- Whenever there are high levels of unemployment in the country, the political party
that forms the government, is likely to lose popularity, this is a political cost to the
government.

8. Keynesians believe unemployment is the result of demand deficiency, therefore the

government should increase aggregate demand (Keynesian demand management XE
"demand management" ).
9. The Phillips curve shows the relationship between the level of unemployment and the
rate of inflation.
10. Monetarists XE "Monetarists" prefer to concentrate on the ‘supply XE "supply" side’,
which affect production, supply and therefore reduce prices, rather than Keynesian
policies of boosting the economy through demand management XE "demand
management" , which tend to be inflationary.

CHAPTER 13

Fiscal policy is concerned with taxation XE "taxation" , borrowing and spending, and their
effects upon the
economy. Monetary policy XE "Monetary policy" is the government’s decisions and actions
regarding money XE "money" supply XE "supply" , interest rates XE "interest rates" ,
inflation and exchange rates.
The objectives of fiscal policy XE "fiscal policy" can be either a deflationary gap XE
"deflationary gap" , that is, to operate a budget deficit (reduce taxes and increase government
expenditure) in order to reduce the high levels of unemployment. Alternatively, a government
can aim for an inflationary gap XE "inflationary gap" , that is, operate a budget surplus
(increase taxes and reduce government expenditure) in order to check inflation.
Direct taxes are levied on income, and they are progressive, while indirect taxes are levied on
expenditure, and they are regressive.
A regressive tax takes a higher proportion of a poor person’s income than the rich.
A progressive tax takes a higher proportion of a rich person’s income, and a lower proportion
of a poor person’s income.
A proportional tax takes the same proportion of all incomes

The four canons or the principles of a good tax are:

- Equity, which means that taxes should be fair and therefore should depend on an
individual’s ability to pay. Taxes must be proportional to one’s income.
- Certainty, with regard to the amount to be paid, how, where and when it should be
paid.
- Convenience of payment and collection by the taxpayer.
- Economy, that is, the cost of collection should not be excessive especially in relation to
yield.
6. It would be a regressive tax as it would take a higher proportion of a poor person’s
income
than the rich
7. The term PSNCR has been recently introduced as the measure of the level of government
borrowing. It replaces the public sector borrowing requirement (PSBR). PSNCR is the
difference between the income of the public sector and its expenditure .
8. Fiscal stance describes the balance of government expenditure and revenue XE "revenue" ,
and whether this
is likely to raise or reduce aggregate demand in the economy.

9. Arguments for privatisation

a) Reduced burden on the public purse as the government no longer supports loss-making
nationalized companies XE "companies" . Privatisation allows a reduction in the public
sector borrowing
requirement and tax cutting, as it provides funds for the treasury when companies XE
"companies" are sold.

b) There is greater Economic freedom from detailed Economic control as privatized companies
XE "companies"
are not subject to state control.

c) Improved efficiency through competition in the market, this encourages producers to cut
their
 costs in order to be more competitive, and firms have to be innovative in the search for
profits.

d) In addition to the above, there is also improved quality since firms have to compete to
survive and have to be responsive to customer complaints.

e) If companies XE "companies" are not in state control, there is greater resistance to the
power of trade unions,
industries are more fragmented and difficult to organise.

f) Privatisation leads to a creation of a property-owning class, more people are able to buy
shares, this gives buyers market power, they work harder and strike less, a better
understanding of private profit motive and business problems.

g) Costs and inefficiency decrease as bureaucracy from nationalized companies XE

"companies" is reduced.

CHAPTER 14

International trade is theoretically based on the principle of comparative advantage XE

"comparative advantage"
The law of comparative advantage XE "comparative advantage" states that countries should
produce those goods in whose production they are relatively most efficient.
Zambia is most efficient in the production of copper, and the following are the country’s non-
traditional exports.

TABLE 18: TEN MAJOR NON-TRADITIONAL EXPORTS (C.I.F.) 2003–2005, US $’

MILLION

2003 2004 2005 2005 %

Change
Copper wire 29.2 60.1 102.7 70.9
White Spoon 30.6 33.4 68.0 103.6
Sugar
Burley 19.0 39.4 69.9 77.4
Tobacco
Cotton Lint 28.6 51.4 66.8 30.0
Electrical 16.2 32.7 46.2 41.3
Cables
Fresh Flowers 22.4 25.5 31.0 21.6
Cotton Yarn 22.1 23.9 23.4 -2.1
Fresh Fruit/ 26.9 23.2 21.0 -9.5
Vegetables
Gemstones 23.4 16.2 19.8 22.2
Gas oil 16.6 24.3 10.3 -57.6
Electricity 8.4 4.4 4.8 9.1
 Cables
Fresh Flowers 22.4 25.5 31.0 21.6
Cotton Yarn 22.1 23.9 23.4 -2.1
Fresh Fruit/ 26.9 23.2 21.0 -9.5
Vegetables
Gemstones 23.4 16.2 19.8 22.2
Gas oil 16.6 24.3 10.3 -57.6
Electricity 8.4 4.4 4.8 9.1

Source: Bank of Zambia

4. Terms of trade XE "Terms of trade" refer to the average price of a country’s exports
compared to the average price of imports
5. Governments protect infant industries, employment, prevent unfair competition, help
the balance of payments etc.
6. The WTO attempts to reduce the tariff barriers and other protective measures.
7. A multinational company is a company, which has a physical presence or property in
more than one country
8. To reduce costs and expand markets and sales
9. Direct foreign investment XE "investment" can boost domestic capital XE "capital"
fund, technological transfer, Improvement in production processes and organizational
structure, as well as employment gains.
10. Tariffs XE "Tariffs" are duties imposed on imported goods. They impede free trade by
increasing the prices of imported goods, thereby making them unattractive on the local
market. While import quotas XE "quotas" are the maximum limit on the quantity or
total value of specific imported goods, once the quotas are met, the imports are
completely cut off, and therefore, quotas can be more effective than tariffs as a barrier to
trade.
11. A free trade area exists if there is no restriction on trade between countries. This can be
extended to a customs union when common external tariffs are levied on imports from
non-member countries. A common market adds free movement of the factors of
production XE "factors of production" , especially labour XE "labour" , in addition,
their maybe harmonization of Economic policy in a common market.
12. Formula:

Terms of trade XE "Terms of trade" = Export price index ÷ Import price index X 100

In 2005 106 ÷ 112 X 100 = 94.64

In 2006 114 ÷ 116 X 100 = 98.28
There is an improvement in the terms of trade from 2005 to 2006.

CHAPTER 15

1. The capital XE "capital" account shows changes in Zambia’s external assets and
liabilities when Zambian residents buy or sell capital items such as international trade in
shares, foreign investments, issuance of loans abroad etc.
2. Invisibles include factor incomes like profit, dividend, interest and maintenance of
embassies abroad etc
3. A current account XE "current account" is a record of income and expenses, much like
a profit and loss account. A current account is divided into two parts, trade in goods
 (visibles), and trade in services (invisibles XE "invisibles" ).
4. A deficit is caused mostly by a lack of competitiveness on the international market for a
country’s exports, which results in more outflows from the current account XE "current
account" than the inflows.
5. Deflation can help the balance of payments by suppressing domestic demand for
imports and by releasing goods for export. If home sales are stagnant, that is not
competitive on the international market, deflation causes the price to reduce due to the
reduction in the aggregate demand.
6. The ‘j’ curve shows the likely effect of depreciation/devaluation on the current account
XE "current account" .
7. A fall in the exchange rate could help an economy by reducing the price of exports (and
increasing the price of imports), and thereby increasing sales of exports, which might
lead to more employment, more output and greater export earnings, that is, if demand is
elastic.
8. Devaluation occurs when a fixed exchange rate is lowered, whereas depreciation refers
to a floating exchange rate, which is moving downwards due to a decrease in demand
for exports and other factors, or an increase in the supply XE "supply" of imports and
other factors.
9. The exchange rate is determined by the demand for a nation’s currency. In theory this
demand is by traders, but in practice it is by international financial institutions.
10. ‘Managed’ exchange rates are where small fluctuations are allowed within certain
defined limits and governments (central banks) may intervene to smooth out
fluctuations.
11. The main advantage of freely floating exchange rate is that they are self-adjusting in
theory and therefore, automatically rectify balance of payments disequilibrium. In
addition, there is Economic use of foreign currency reserves and the government has
more time to concentrate on domestic policy.
12. The main advantage of a fixed exchange rate system is elimination of uncertainty, this
uncertainty is a major disincentive to exporters. Another advantage is that they
discourage speculative activity, hence the currency is not volatile.

------------------------------------------------------------------------------------
APPENDIX 2

SOLUTIONS TO EXAMINATION TYPE QUESTIONS

SOLUTION 1.1

(a)
i) The central problem in Economics XE "Economics" is that of scarcity and choice.
Economic resources are
scarce relative to people’s wants, so a choice has to be made to satisfy some wants and
forgo
or sacrifice other wants.

Therefore the “opportunity cost XE "opportunity cost" ”, is the cost of something in terms
of alternatives forgone.

In practice it is not always a complete rejection of one good in favour of another, but
having
to decide whether to have a little bit more of one and not quite so much of another. This is
illustrated using a production possibility curve or frontier.

ii) If a student spends her allowance on a pair of shoes then it is likely that she will
have to go without a textbook that she also wanted. In deciding to work overtime on a
Saturday afternoon, a worker forgoes leisure time and the football match he would
otherwise have watched.

A farmer, who sows maize on a piece of land XE "land" , accepts that he has to go
without groundnuts
which could also be grown on the same piece of land XE "land" .
 With the state, resource is required to build roads and hospitals, this means schools, and
colleges etc have to be forgone.

In all walks of life, having “this” means going without “that”.

(b)
(i) There is no opportunity cost XE "opportunity cost" for a free good, if the food is free,
then nothing has to be sacrificed in order to obtain it.

(ii) -Hedge trimmings are non-Economic goods since they are not wanted.
–A worn out suitcase is a non-Economic good since it is not wanted
–A Natech Certificate is a non-Economic good since it is not transferable.
–Sand in the Sahara is a non-Economic good since it is not scarce.

SOLUTION 1.2

(a) The law of diminishing marginal returns states that, if extra units of a variable factor are
added to a fixed factor, output will rise. However, after a point, the rate of rise of output
will
decline. This is the point of diminishing marginal returns.

Number of workers Output per year Addition to Output

1 100 100
2 210 110
3 300 90
4 250 -50

The figures are summarised on the following diagram.

Output 300

per

year 250
 200

150

100

50

0 1 2 3 4

Number of workers

Note that diminishing returns start after the second worker is employed, when the additions to
output start to decline from 110 to 90, and eventually being negative. It is no longer
worthwhile
to employ more workers on only one hectare of land XE "land" , it costs more to employ than
the additional
revenue XE "revenue" from an additional worker. Additional workers can only be employed
when more land XE "land" is
acquired, but this can only be achieved in the long run XE "long run" .

(b)
(i) In motor car production the fixed factor will be capital XE "capital" and the variable
factor will be labour XE "labour" . Note that unit cost of production will fall as the
capital equipment is used more intensively.

(ii) In wheat production the fixed factor will be land XE "land" and the variable factor
labour XE "labour" . In
other economies, the variable factor could be capital XE "capital" equipment and/or
fertilizer as
increasingly sophisticated production methods are adopted.

(iii) Listening to lectures may seem an unusual example but if you consider how effectively
you can concentrate in the first ten minutes and compare it with the final ten minutes,
 you have quite a useful example of diminishing returns.

c) The market system economy, production decisions are driven by the profit motive, and
therefore answers the key Economic questions as follows:

What to produce : Goods produced are for the benefit of consumers. Therefore, it is the
consumers who send the indicators or messages to producers concerning their preference
whenever consumers make a purchase. If consumers indicate low demand for a certain product,
price for that product will be low and as a result producers will supply XE "supply" very little
of such a product to the market, and vice versa. Thus, the market through the price determined
by the market forces of supply and demand answers the question “what to produce”.
How to produce: This is a question of technology, that is how to combine resources in order to
produce something. Resources need utilizing in the most cost-efficient manner. In theory, the
lowest unit cost. Production methods are regularly appraised in order to maximize output, and
therefore, profit. The price mechanism will indicate how to combine resources. If a country has
an abundance of a certain resource, relative to another resource, the price of that resource will
be relatively low. This will indicate that more of that resource should be used and less of the
other resource to produce goods. In other words, the forces of supply XE "supply" and
demand through the price mechanism will reveal the comparative advantage XE "comparative
advantage" of a country or organization.
How much to produce: Changes in the price mechanism will indicate to the producers how
much of a product should be produced in any given period. If the price is high, it is an
indication that more of a good should be produced, than if the price is low. If the price falls
below a certain level, ie below the value of the average variable costs XE "variable costs" ,
producers would not produce any more of that good.
For whom to produce: All production is ultimately for the sake of consumers. The decision for
whom to produce is largely determined by the political system. In a market system, the driving
force is profits, self-interest. As such, it is not all consumers who have access to all goods.
Rather, it is those who have effective demand, i.e. demand backed by money XE "money" .
SOLUTION 2.1

Economists refer to ‘a change in supply XE "supply" ’ when there is a shift in the supply curve
either to the right or to the left, as a result of some factors other than price, such as a change in
the cost of production, technological changes, a change in weather conditions etc. By contrast a
‘ change in the quantity supplied’ is used to indicate the effect of a change in the price of the
good on the amount, which firms wish to sell, as shown in the diagrams below.

A CHANGE IN THE QUANTITY SUPPLIED

Price

S
0 Quantity
 A CHANGE IN SUPPLY

S1

Price S

S2

S1

S2

0 Quantity

(b) The Zimbabwean government’s fixing of a maximum or ceiling price for mealie meal is
aimed at holding the price below its free market level to the benefit of consumers, instead of
allowing the market forces of supply XE "supply" and demand to determine the price of
mealie meal.
The government stipulated price of OP1 is below the equilibrium price of OP. At this low
price, consumers would like to buy more, OQ1 quantities, while producers can only supply
XE "supply"
OQ2 quantities. The effect is an excess demand or a market shortage, as shown in the
diagram
below.

Price D S

P1
 0 Q2 Q Q1 Quantity

The government stipulated price would in turn have other effects, such as ignoring the legal
price depending on how strictly the legal price is enforced. Millers may pay the fine and then
treat it as an additional cost, and pass it on to consumers in the form of higher prices.
It would also result in
- Rationing
- Black markets
- Tie in sales
- Corrupting policemen
- Long queues
- Govt subsidy to correct the imbalance between supply XE "supply" and demand

SOLUTION TO 3.1

On a straight-line demand curve:

Price
PED = ∞

PED>1

PED = 1 (mid point of the line)

PED<1
PE PED = 0

0 Quantity

As shown above, along the top half of the line, PED is greater than 1. We say that demand is
elastic. Along the bottom half of the line, PED is less than 1 and we say that demand is
inelastic.
Exactly half-way along the line, PED=1; demand is of “unitary elasticity’.
In general, demand is elastic at high prices, above K5000, while demand is inelastic at
lowprices, i.e. below K5000.
That is why the demand for expensive luxurious commodities such as cars, fur coats computers
etc is elastic, while the demand for cheap products such as matches, most vegetables is
inelastic.

(b)(i) Income elasticity of demand (IED) measures the degree of responsiveness of quantity
demanded of a product or a service to changes in household income. It is measured as
follows:-
Percentage change in quantity demanded
Percentage change in income.

There are three categories of income elasticity

Positive income elasticity, this applies to the demand for normal goods XE "normal goods"
which increases with income.
Negative income elasticity, this applies to the demand for inferior goods XE "inferior goods" ,
this tends to fall as income rises.
Zero income elasticity, for some goods, demand remains constant even if incomes
change, e.g. mealie meal.

(ii) IED is largely determined by the type of product or service in question, basics or
necessities such as mealie-meal, salt, milk etc usually have a low IED, with quantity
demanded increasing marginally as income increases.

The demand for “inferior” goods actually reduces as income increases. Expensive
luxurious products or services have a high IED, with more being bought as income
increases.

In view of the above, a firm pursuing long-term growth XE "growth" can produce
lower IED during
periods of recession of depression and produce more high IED products during
“boom”
periods.

SOLUTION TO 4.1
(a)(i) Total physical product 6 16 31 43

(ii) Average physical product 6 8 10.33 10.75

(b) The distinction between fixed and variable costs XE "variable costs" arise only in the
short-run period defined as that in which at least one factor of production is in fixed
supply XE "supply" to the firm. Fixed costs XE "Fixed costs" are those, which do not
change as output changes. Productive capacity is therefore constrained by the fixed
factor and the costs associated with it are the firm’s fixed costs. Typically, the fixed
factor is the firm’s physical capital XE "capital" or assets – its premises, machinery,
plant and equipment. Fixed costs thus tend to consist of rental payments, depreciation,
salaries, rates, interest on loans etc.

Variable costs are those associated with variable inputs of factors such as labour XE
"labour" and materials. Therefore variable costs XE "variable costs" are wages,
purchases of raw materials, electricity and water bills etc. These costs will increase as
the firm expands its output and they can be avoided completely, even in the short-run, by
closing down.

(c) The diagram is a generalised illustration of a firm’s short-run costs.

MC
AC
AVC

AFC

SOLUTION 5.1

i) (a) (b) (b) (c) (d) (e) (f)

Output Total cost Price TR MR AR FC MC AC Profit
 0 40 9 0 - - 40 - - -40
10 70 8 80 80 8 40 30 7 10
20 100 7 140 60 7 40 30 5 40
30 140 6 180 40 6 40 40 4.7 40
40 180 5 200 20 5 40 40 4.5 20
50 200 4 200 0 4 40 20 4 0

ii) The firm is operating in an imperfect market like monopoly XE "monopoly" or

monopolistic competition XE "monopolistic competition" , the average revenue XE
"revenue" curve, which is equal to the demand curve, is downward sloping,
AR ≠ MR.
iii) The firm will aim to produce 30 units of output, where MC = MR.
iv) AR is equal to price, since TR = Quantity x Price
AR = TR/Quantity, therefore, AR = Price.

SOLUTION 6.1
a) Features of perfectly competitive markets.
There are many buyers and sellers of the commodity each of which is too small in the relation
to the market to have perceptible effect on the price of the commodity.
The commodity is homogeneous, identical or perfectly standardized so that the output of each
procedure is distinguishable from others.
Resources are perfectly mobile.
Consumers, firm and resources owners have perfect knowledge of all relevant prices and costs
in the market.
There is free entry and exit.
There is not transport cost.
b) Long run equilibrium under a perfectly competitive market

REVENUE
AND
COSTS

If firms earn abnormal profits in the short run XE "short run" , in the long run XE "long run" ,
new firms will be attracted into the industry. Conversely, if the typical firm is making losses in
the short run, firms will leave the industry in the long run, until normal profits are restored.
Therefore all firms are earning sufficient revenue XE "revenue" to cover their full opportunity
cost XE "opportunity cost" . There exits no incentive for firms to enter or to leave the industry.
The firm produces output 0Q, where MC = MR = AR = P = AC and there exits no excess
capacity.

Long run equilibrium position under monopoly XE "monopoly" .

Price
Cost
Revenue MC
AC

D(AR)
MR
0 Q1 Quantity

A monopolist maximizes profits at a level of output where MC=MR.

whereas profits will attract additional firms into a perfectly competitive market structure until all
firms break even in the long run XE "long run" , it is not the case with monopoly XE
"monopoly" , a firm continues to earn abnormal profits in the long run due to entry barriers.
As opposed to perfectly competitive firm, a monopolist does not produce at the lowest point on
his long run XE "long run" average cost curve

SOLUTION 7.1

(a) ‘Monopolistic competition’ is a term used to describe a market type, which resembles
perfect competition in several respects. But models assume that there are a very large number
of buyers and sellers that there is free entry to and exit from the market, and that firms only
make normal profits in the long run XE "long run" .

However, the crucial difference between the two market types is that in monopolistic
competition XE "monopolistic competition" each firm’s product is similar to but differentiated
in some way from that of its competitors. This contrasts with the assumption of product
homogeneity in perfectly competitive markets.

Such product differentiation may take the form of geographical location (a corner shop
compared with a High Street store), colour, shapes, size packaging, the use of a brand name
and so on. This means that consumers will not be indifferent between purchasing one firm’s
good and that of its close substitutes. There will be some consumer loyalty, so that a price
rather higher than that of the firm’s competitors will not mean a total loss of sales, as would be
the case under perfect
competition. Putting this in a different way, the firm’s demand curve is not perfectly elastic;
rather, it slopes downwards as illustrated in diagram (i).

MC
Cost
and
Revenue
AC
A B

D C

MR D(AR)

0 Q1 Quantity

With a downward-sloping demand curve, the firm’s position resembles that of a monopolist.
In the short run XE "short run" , at least, the firm may set marginal cost equal to marginal
revenue XE "marginal revenue" at output Q1 and obtain supernormal profits represented by
the area ABCD. However, given the assumption that there are large numbers of competitors,
with free entry to the market, these profits are unlikely to persist. New firms will enter the
field, or existing competitors vary their prices or products, and
attract away many of the firm’s customers.

This will lead the firm’s demand curve to shift downwards and to the left. This process will
continue until all the excess profits disappear and the firm is just making normal profits at
output Q2 as illustrated in diagram (ii).

(b)

Price MC Diagram
Cost
Revenue AC
 D (AR)
MR
0 Q Quantity

This is the firm’s long-run equilibrium position. However, it still has a downward-sloping
demand (or average revenue XE "revenue" ) curve. If average costs XE "average costs" equal
average revenue, as they must do if the firm is making normal profits, this implies that the firm
is in equilibrium on the downward-sloping section of its long-run average cost curve. This is,
of course, vary different from the case of the firm in perfect competition, where long-run
equilibrium occurs at the minimum point on the average cost curve.

(c) Product differentiation gives the products some market power by acting as a barrier to entry
as a firm under monopolistic competition XE "monopolistic competition" monopolises the
industry by giving consumers the impression that what they are offering is better than the
competitors’ product. Such product differentiation may take the form of geographical location,
the use of brand names, attractive size packaging, extensive advertising XE "advertising" , offer
of guarantees and after sales service and so on.

SOLUTION 8.1

(a) MEASUREMENT OF NATIONAL INCOME

The income method

This approach involves adding up the flow of pre-tax incomes accruing to owners of factors of
production XE "factors of production" (wages, salaries, rents, dividends, interest payments,
undistributed profits), which are generated in a given year or other relevant period. Notice that
factor incomes arise from the sale of productive services of various kinds. This means that we
must take income figures before tax, for it firms are prepared to pay these amounts they must
value factor marginal products at least as highly. It also means that we must therefore exclude
from national income XE "national income" any transfer payments XE "transfer payments" ,
such as social security benefits, pension payments etc.

The output method

Factor incomes arise from the sale of goods and services produced in the economy, so in
principal another method of calculating national income XE "national income" is to add up the
value of all output created in the relevant period, mainly for sale in the market. The output from
different sectors (primary, secondary and tertiary) of the economy is added up. When the
national income is measured in this way, it is referred to as the national product. Normally this
value is measured by the supply XE "supply" price of output, i.e., the price a firm receives for
its product (supply price can differ from the price to the consumer if there are indirect taxes or
subsidies XE "subsidies" ).

The expenditure method

Spending of all kinds provides the incentive to supply XE "supply" output and thus create
factor incomes. Adding up all that is spent on a country’s output is the third way of calculating
the national income XE "national income" ; it gives us what is called expenditure on the
national product.
Thus the government expenditure plus investment XE "investment" expenditure plus
consumption XE "consumption" expenditure are
all added up plus exports minus imports.

A particular problem here is that the country’s total expenditure exaggerates the value of
incomes and output if there are indirect taxes (like VAT) and underestimates it if the
government pays subsidies XE "subsidies" for the production of various goods and services.
In either case, the
price to consumers does not reflect the real cost of using the resources necessary to produce the
commodities in question.

(b) The national income XE "national income" or product is a measure of the value of a
country’s total income from
domestic output and from overseas. Estimates are made in three ways-measurement of
income, of output and of expenditure on output, and this is clearly shown on the
CIRCULAR
FLOW OF INCOME.

(c ) If the total income is divided by the population XE "population" we have a figure of

average income per
head. After conversion at the appropriate exchange rates, these figures are often used to
compare living standards between countries. However, the data so obtained can at best
give
only very crude comparison and there are many problems, which need to be taken into
account when using data internationally:

Income distribution Income per head is an average and there can be wide differences in
distribution of income around the average. In many developing countries, income is highly
concentrated and to that extent may exaggerate incomes for the mass of the population XE
"population" .

Non-consumption XE "consumption" output Much output does not satisfy consumer needs
and wants. A proportion goes in investment XE "investment" in capital XE "capital" goods,
which may arise income in the future but actually reduces current living standards if investment
resources come from reducing consumption. Government spending, for example, on defence
or building prestige office blocks again may reduce current household incomes without raising
future income. The figures of national income XE "national income" therefore need to be
adjusted to show the income available for household spending. The proportion of national
product in the form of non-consumption output varies widely between countries.

Non-marketed output Substantial non-marketed output is not counted in the official

income accounts. Production of goods and services in the household-housework,
do-it-yourself activities, growing fruit and vegetable-is not usually recorded but
may account for a substantial percentage of output. In poor agricultural economies
much of a peasant’s real income is from food and other goods for direct
consumption XE "consumption" in the household and recorded income per head
may thus be misleadingly low. There is a similar problem with government
services, such as education and health, provided free at the point of consumption.
Output is measured by the cost of provision, which is likely to underestimate the
market value.

Exchange rates these often fail to reflect the relative purchasing power of different
currencies in the domestic economy. Official fixed exchange rates XE "fixed
exchange rates" are frequently badly under – or over-valued and floating rates are
distorted by capital XE "capital" flows. Calculating ‘purchasing power’ exchange
rates though there are still problems, for instance, which country’s relative prices
should be used to value output, can make corrections.

Inflation over a period of time national income XE "national income" figures in money XE
"money" terms must be corrected for inflation to show the trends in real terms. Adjustments
are necessarily very crude in countries with high rates of inflation.

Errors and unrecorded income Much of the income, output and expenditure have to be
estimated. The inevitable inaccuracies may be magnified in developing countries with a large
proportion of non-marketed income and poor data collection. Also, there is the problem of the
‘black economy’ consisting of unrecorded, usually illegal, transactions such as working for
cash to avoid paying tax. This is though to be very large in some countries whose national
income XE "national income" may therefore be badly understated.

SOLUTION 8.2

K’B

Consumers’ expenditure 8 000

Government final consumption XE "consumption" 3 000
Gross domestic fixed capital XE "capital" formation 2 400
Value of physical decrease in stocks (10)
 Total domestic expenditure at market prices 13 390

+ Exports 2 000
- Imports (2 500)

Gross Domestic Product XE "Gross Domestic Product" at market prices 12

890

- Indirect taxes (1 750)

+ Subsidies 1 000

Gross Domestic Product XE "Gross Domestic Product" at factor cost 12

140

+ Property income from abroad 300

- Property income paid abroad (500)

Net property income from abroad (200)

Gross National Product at factor cost 11 940

- Capital consumption XE "consumption" /Depreciation (1 500)

Net National Product at factor cost 10 440

SOLUTION 9.1

(a) Investment represents one of the main injections into the circular flow of income.
Investment, whether undertaken by the government or by private businesses, is
one of the key components of aggregate demand and any change in the level
of investment XE "investment" will have a multiple effect on the level of national income
XE "national income"

In addition, investment XE "investment" is an important determinant of the long-term

growth XE "growth"
rate of an economy. Investment can be seen as current consumption XE "consumption"
forgone in
order to achieve a higher rate of growth XE "growth" and hence a higher level of
consumption XE "consumption" in the future.

capital XE "capital"
goods
 C

B
O Consumption goods

An economy choosing to produce at a point such as B will have a higher current level
of
consumption XE "consumption" but a lower growth XE "growth" rate that an
economy choosing to produce at point A. The
higher level of investment XE "investment" at A will enable the economy to achieve an
outward movement of the entire curve and hence consume a higher level of both capital
XE "capital" and consumer goods in future, such as at C.

(b) There are a number of ways in which the government might seek to encourage a higher
level of business investment XE "investment" . One of the first options it might
consider is to controlling interest rates XE "interest rates" . The rate of interest XE "rate
of interest" is often a major factor is determining the level of business investment,
which will only be undertaken if the expected return from the investment exceeds the
anticipated cost of financing it.

Although the government may attempt to stimulate investment XE "investment" by

reducing the rate of interest XE "rate of interest" , it may be unsuccessful where the level
of business confidence is low. If the Economic outlook is poor or uncertain, firms are
unlikely to be willing to undertake new or additional investment, as they cannot be
confident of a sufficient demand for the output the investment will generate.

The government can provide direct encouragement to businesses, for example by

offering
investment XE "investment" grants or by providing tax incentives.

c) ‘Multiplier’ is the name given to the process of circulation of income, whereby an

injection of a certain size leads to a much larger increase in national income XE
"national income" . The firms or
households receiving the injection use at least part of the money XE "money" to
increase own consumption XE "consumption" . This provides money for other firms
and households to repeat the process and so on. The value of the multiplier XE
"multiplier" may be calculated as 1/MPS or 1/1 - MPC
Where MPC is the marginal propensity to consume XE "marginal propensity to
 consume" . If MPC were equal to 0.9, the multiplier XE "multiplier" would be 10 and
an injection of K1m would lead to a rise in national income XE "national income" of
K10m as the money XE "money" circulated. MPC is always less than one because of
the effect of saving the original injection gradually diminishes.

d) In the circular flow of income, saving and investment XE "investment" are associated
but not all money XE "money" is
invested in the domestic economy; some is invested overseas and some held on as cash.
Since extra saving don’t necessarily result in additional investment XE
"investment" (either because people don’t want to invest or because entrepreneurs’ are
not prepared to invest), three conclusions follows

The fall in consumption XE "consumption" resulting from a rise in saving adversely affects
entrepreneurs’
expectations XE "expectations" , and therefore the decision to reduce
investments.
A reduction in investment XE "investment" , through the multiplier XE "multiplier" , causes
greater reductions in
national income XE "national income" .
Since national income XE "national income" falls, household have smaller income and
therefore save less.
Thus greater saving without greater investment XE "investment" ends with ends
with smaller incomes
and smaller saving. This is the paradox thrift.

SOLUTION 13.1

The public sector net cash requirements (PSNCR) are the total amount the public sector needs
to
borrow from the private sector and from overseas for the year. It consists of borrowing by the
central government, by the local authorities and by the public corporations, the largest
component being the central government borrowing requirements (CGBR). Part of the CGBR
is
on lent to other institutions within the sector, and to this extent reduces the amount that the rest
of the public sector needs to borrow. In other words, only that part of borrowing by local
authorities and public corporations that has not been lent on by the central govt adds to the
PSNCR.

There are several methods of financing the PSNCR. One of the main methods is by borrowing
from the non-bank private sector through the sale of govt securities, treasury bills XE "treasury
bills" , local authority bonds and so on, to private companies XE "companies" and individuals.
In addition, the banks may buy private sector debt. The most publicized aspect of the PSNCR
is its effect on the supply XE "supply" . The money XE "money" supply will not increase
when private to the public sector finances the PSNCR, but it will increase in bank deposits. As
a result, a government attempting to control the money supply XE "money supply" will try to
avoid financing the PSNCR from the banking sector.
It may also be financed through borrowing from overseas. Another method is issuing notes
and coins in circulation. Lastly, through the privatization of public corporations.
The size of the PSNCR essentially reflects the extent to which the expenditure of the public
sector exceeds its income. It follows that, to reduce the PSNCR, a govt will need to cut its
expenditure or raise its revenue XE "revenue" .

The main component of public sector income is the govt receipt from taxation XE "taxation" ,
and these may be
changed over time in various ways. There have been a number of changes in tax system such
as
reduction in the rates of income and corporation tax, increase in the thresholds and allowances
and replacement of some income tax XE "income tax" bands, and these changes will have
some impact on the
amount of tax revenue XE "revenue" generated. In addition, tax receipts will vary with the
general level of
Economic activity: In a recession, incomes and profits will fall and so too will the associated
tax
revenue XE "revenue" while, in an upturn, tax revenues will tend to rise.

A policy of increase direct taxation XE "taxation" on personal incomes or corporate profits in

order to reduce
the PSNCR faces the problem that incentives may be reduced and entrepreneurs may be less
willing to take risks.

A government could raise indirect taxes, but these tend to be regressive, and the government
may
not raise these for political reasons.

The government can also reduce its own expenditure, but this would affect the level of
Economic activity as government expenditure is a component of aggregate demand (Keynesian
demand management XE "demand management" ). This will have a deflationary effect on the
economy.

Another source of finance is privatization, unfortunately, it is the profitable and successful

organisations that can be easily sold off.

A reduction in aggregate demand would have a deflationary effect on the economy, and as a
result, some firms may go out of business, while others would reduce in size. Investment by
firms would be cut, and by the multiplier XE "multiplier" effects, the economy would move to
a recession.
SOLUTION 13.2
(a) Direct taxes are levied on income and profits or on wealth XE "wealth" . The impact or
incidence and its
burden are borne by the same person.

Indirect taxes are levied indirectly once an expenditure is made. The impact or incidence and
its burden can be transferred to the consumer depending on the elasticities of demand and
supply XE "supply" on the product.

Examples of direct taxes

income tax XE "income tax"
social security contributions
company tax
personal levy
Examples of indirect taxes
value added tax XE "value added tax"
excise duties
other expenditure taxes

(b) Fiscal policy is the management of the economy through public expenditure, taxation
XE "taxation" and public borrowing. The key aspect is the relationship between
spending and taxes. Government expenditure operates as an injection into the circular
flow of national income XE "national income" ; taxation as a withdrawal from it. It, in
a given year, the government spends more money XE "money" than it collects in taxes,
this is termed a budget deficit. A deficit has an expansionary or inflationary effect upon
the economy. This might be considered appropriate if there is much unemployment. If
the government collects more in taxes than it spends this is referred to as a budget
surplus. A surplus has a restraining or deflationary effect upon the economy. This
would be considered an appropriate policy at a time of significant inflation.

For any given year, the application of fiscal policy XE "fiscal policy" may lead to a
quite different outcome in respect of both expenditure and taxes than had been planned.
The government might have become committed to unexpected areas of expenditure,
while tax revenue XE "revenue" might be more or less than was expected.
(c) A good tax system should be
- Equitable
Taxes should be levied according to the ability to pay of the taxpayer. This can be
extended to the argument that people in similar circumstances should pay similar
amounts of money XE "money" .
- Economical.
The tax should be cheap to collect, otherwise much revenue XE "revenue" collected
will be wasted.
- Certain
The tax payer should know when the tax should be paid, how much should be paid
and
know which transactions give rise to a tax liability. The tax should be unavoidable.
- Convenient
The tax should be convenient to pay, not involving the tax payer in time consuming
activities.

SOLUTION 14.1

a) Malawi has an absolute advantage in the production of tobacco and maize, she can produce
both commodities more than Zambia. However, international trade should still take place
between the two countries because of the theory of comparative advantage XE "comparative
advantage" , the two countries
can gain from trade when each specializes in the production of a commodity in which it has
the lowest opportunity cost XE "opportunity cost" .

The opportunity cost XE "opportunity cost" of 1 ton of tobacco is 10 tons of maize in

Malawi, while in Zambia, the
opportunity cost XE "opportunity cost" of 1ton of tobacco is 15 tons of maize. This means
if Malawi forgo 1 ton of
tobacco, she would acquire 10 tons of maize only, Zambia would get 15 tons of maize from
forgoing 1ton of tobacco.

The opportunity cost XE "opportunity cost" of 1 ton of maize is 0.1 ton of tobacco in
Malawi, while in Zambia the
opportunity cost XE "opportunity cost" of 1 ton of maize is 0.06 ton of tobacco.

Therefore, Zambia has a comparative advantage XE "comparative advantage" in the

production of maize, and should
import tobacco from Malawi, while Malawi should concentrate on the production of tobacco
and import maize from Zambia.

b) ARGUMENTS IN FAVOUR OF PROTECTIONISM

- To protect new and declining industries.

New industries need to be protected from foreign competition before they become
strong to
be on their own, while declining industries might quickly collapse and lead to mass
unemployment if not protected.

- To reduce unemployment. Unfair competition from foreign products may lead to the
closure of home industries. Therefore, the government protects its industries in order to
prevent the closure of industries and unemployment.

- To reduce or eliminate balance of payments deficits. Restricting imports will help to

reduce or eliminate balance of payments deficits.

- To raise revenue XE "revenue" . The government raises revenue from import tariffs
that are imposed on
imported products.

- To protect strategic industries. Industries such as ship building, defence and

aerospace
are of strategic importance to many countries. Therefore many countries protect these
Industries from foreign competition.

- To protect against dumping of imported products on local market. Dumping is a

situation where goods are sold at lower prices in a foreign market than in the home
market.

- Retaliation against measures taken by another country that is unfair.

- To prevent unfair competition. Governments may justify protectionism with

reference to

the trading policies of its competitor nation, such as selling imitations at artificially low
prices.

c) There are different forms of protectionism, and some of them are:

Quotas. These are limits imposed on specified goods to be brought in the country. Import
quotas XE "quotas" restrict the quantity of certain products, which can be imported into
the country. If the product is homogeneous then a simple quota is imposed. If they are
heterogeneous, then the quota can take the form of a value of imports allowed in any
given currency.

The effect of quotas XE "quotas" is to reduce the volume of imports, raise the price of
imports and encourage the demand for locally produced commodities.

Note that sometimes one country persuades another country to voluntarily reduce its
exports of a product to a certain acceptable level, this is known as voluntary export
restraints (VERs). VERs is also known as orderly market arrangements emphasizing
 their negotiated manner. VERs often apply to key industries, an example is VERs
negotiated by the United States of America on Japanese exports of motor vehicles.

Tariffs XE "Tariffs" or custom (import) duties. These are taxes that are levied on imports. It
can be a
fixed amount per unit (specific) or a percentage of the price (ad valorem).

The effect of tariffs is to raise prices of imports, and therefore reduce their demand,
encourage the demand for locally produced commodities, as well as raise revenue XE
"revenue" for the
government.

Trade embargoes. This is a complete ban of imports from a particular country.

Sometimes it is a total ban imposed on particular products like drugs, from any country!
During the Iraq war of the early 1990s, the United Nations imposed a ban on Iraq’s
exports.

Hidden export subsidies XE "subsidies" and import restrictions (Direct controls). This is
a range of
government subsidies and assistance for exports and deterrents against imports as
follows:

- Subsidies. The government gives subsidies XE "subsidies" to local firms to allow

them to compete
favourably In terms of pricing of goods, with foreign firms.
- Export credit guarantees or insurance against bad debts for overseas sales.
- Grants or any form of financial help is provided to firms in the export sector
- Zero rating or reducing taxes on exported goods
- State assistance provided for firms in the export sector via the foreign office.

In addition, imports are discouraged through

- Health and Safety regulations. Countries sometimes put in place health and safety
regulations that limit the importation of certain goods.
For example, the Zambian government has put in place a regulation that Stipulates that
sugar sold in Zambian market must be fortified with vitamin A regardless of whether
this
sugar is locally produced or imported.

- Administrative procedures (bureaucracy). These are long, complex and costly

procedures that importers have to go through at border posts.

- Exchange controls XE "Exchange controls" . These are aimed at restricting the

amount of foreign exchange that
is available to importers.
SOLUTION 14.2

a) Benefits of international trade

- It enables countries to specialise and increase production bearing in mind that the surplus
can
be exported.
- Countries can export surpluses and import what they lack.Access to the world market
enables
countries to benefit from economies of scale.
- It allows countries to develop their industries as a result of free movement of capital XE
"capital" .
- It promotes closer cooperation between countries.
- Competition from imports increases efficiency and limits the creation of monopolies.
- Provision of goods that were previously unavailable.

b)
i) The theory of comparative advantage XE "comparative advantage" is based on the idea
of opportunity cost XE "opportunity cost" .
Within a country, opportunity cost XE "opportunity cost" for any category of product
may be established in terms
of the most advantageous use of national resources.
If two countries produce different goods most efficiently and can exchange them at an
advantageous rate in terms of the comparative opportunity cost XE "opportunity cost"
of importing and home
production, then it will be beneficial for them to specialise and trade. This applies even
if
one country has an absolute advantage in both goods.

The theory of comparative advantage XE "comparative advantage" was devised by

David Ricardo to demonstrate the
gains from specialisation XE "specialisation" and free trade, and it requires
assumptions such as no barriers, no
transport costs, mobile factors of production etc.

ii) International trade is influenced by changes in the relative prices. The terms of trade
indicate a relationship between the average price of a nation’s exports and the average
price of its imports.
The rise in the terms of trade reflects the fact that export prices have risen more than
import prices. An increase in the terms of trade is called an improvement in the terms of
trade, though it may not always be desirable.

One reason for wanting an increase in the terms of trade is that a given quantity of
exports will now pay for more imports. In the example above, the foreign currency
earned by exporting one basket of exports in the year 2000 (K450, 000 worth) would
buy 450/500 =0.9 or 90% of a basket of imports.
Formula: Terms of trade XE "Terms of trade" = Export price index ÷ Import price index X
100
Note that the terms of trade are only a guide to competitiveness because they only measure
visible trade, that is, trade in goods. Trades in services are excluded.

SOLUTION TO 15.1

(a) The balance of payment (BOP) is a statistical record, in the case of Zambia, of debits and
credits covering all financial transactions between Zambia and the rest of the world
recorded
in a particular period.

The BOP accounts are in two parts. There is the current account XE "current account" ,
through which the export and
import of goods and services are posted, and the capital XE "capital" account through which
capital flows.

By definition, the balance of payments account must always balance overall. Individual
sections
of the accounts may, however, be in deficit or surplus. In the case of Zambia, the current
account deficit is usually partially offset by surpluses on the capital XE "capital" account (i.e.
transactions in
assets and liabilities). Usually, reference to a balance of payments deficit is intended to mean a
deficit on the current account XE "current account" .

The visible trade balance

This is the net difference between the value of visible credits from exports and visible debits
from imports at a particular period of time. By ‘visible’ here we mean goods that you can
touch
and see, examples being food, basic materials like iron, oil and manufactured goods like cars
and
washing machines.

The invisible trade balance

This is the net difference between the value of invisible credits from exports and invisible
debits
from imports at a particular period of time. By ‘invisible here we mean services like travel,
civil
aviation, shipping and financial and government services. Invisible also include interest,
profits,
dividends and ‘transfers’.
The current account XE "current account" balance

The current account XE "current account" balance is the visible trade balance and the invisible
trade balance added
together. In effect, it shows the country’s trading account with the rest of the world.

Transactions in external assets and liabilities (the capital XE "capital" account) may involve
governments,
corporations and individuals, and may be either short or long term.

Such transactions include direct and portfolio investments, bank lending, Zambia banks to
residents overseas, other private lending and overseas deposits, changes in official reserve
balances and other external transactions of the government.

Exports of capital XE "capital" will increase a country’s external assets and will show us an
outflow in the
account (negative). Conversely, imports of capital XE "capital" increase liabilities for the
country and will
show as an inflow (positive).

Overall, the balance of payments will sum to zero. It consists of a current account XE "current
account" and an asset
and liabilities (capital XE "capital" ) account. A deficit on one account should match a
corresponding surplus
on the other. A deficit or surplus on current account XE "current account" implies an outflow
or inflow of currency,
which must be offset, ‘financed’ or covered by the sale of assets or by a reduction in liability.

Changes in official borrowings and foreign currency reserves in the assets and liabilities
accounts should be expected to achieve an overall balance with the current account XE "current
account" . However,
because of inadequacies in compiling statistics, the official record shows a balancing item.

(b)
(i) The process of financing or covering is that by which any deficit or surplus on the
current account XE "current account" , and this is the part through which trade in
goods and services flows, are
met or balanced by capital XE "capital" balances in the capital flows section.

- Borrowed from ‘official sources’ such as the International Monetary Fund;

- Taken from a country’s gold and foreign currency reserves; or
- Borrowed from overseas central banks.
- Sale of overseas investments.
- Buying on credit
- Accepting gifts etc.
 These borrowings might be obtained from overseas sources with repayments being
made
Over say 5, 10 or even 20 years. However, the borrowing powers and foreign
currency reserves of a country are finite, and so over the longer term a current account
XE "current account" deficit is not sustainable indefinitely.

(ii) Correcting a balance of payments deficit means reducing the potential deficit to a lower
level.

A deficit on current account XE "current account" might be rectified by one of more of

the following measures: -

- A depreciation of the currency (called devaluation when deliberately instigated by the

government, for example by changing the value of the currency within a controlled
exchange rate system);

- Direct measures to restrict imports, including tariffs or import quotas XE "quotas" or

exchange control
regulations;

- Domestic deflation to reduce aggregate demand in the domestic economy.

- Interest rate to attract foreign exchange.

Deflationary measures aim to reduce expenditure, while other policies are ching
expenditure.
For example, devaluation of the currency will make a country’s goods cheaper in export
markets while imports will become more expensive in the home economy. Such a
change in the relative prices of exports and imports should, it is hoped, encourage
expenditure switching in favour of the country’s products.

As noted above, direct protectionist measures, for example in the form of tariff or non-
tariff
barriers to trade, might be used to correct a deficit.

(c) The proponents of a return to fixed exchange rates XE "fixed exchange rates" concentrate
primarily on the experience
since the early 1970s with floating rates. In particular, it is pointed out that flexible
exchange rates have been extremely unstable with frequent and often large fluctuations
particularly against the US dollar and the pound sterling. There is some controversy about
the causes of exchange rate instability. But what is clear is that since the 1970s there has
been a vast growth XE "growth" in the volume of liquid funds held by governments,
multinational
corporations and other institutions which are prepared to shift them around between bank
 deposits and other financial assets denominated in different currencies in order to maximize
the overall returns in the form of interest and capital XE "capital" gains.
Thus, funds are shifted into, say, dollar deposits when, other things being equal, and there
is
a rise in US interest rates XE "interest rates" . A major factor in exchange instability,
therefore, has been the
divergence in the monetary policies of major countries. The instability, in turn, is often
aggravated by speculation whereby treasurers and fund managers form expectations XE
"expectations" about
exchange rate movements.

Exchange instability, it is claimed, imposes costs on traders and investors. Exporters,

importers
and investors face additional risks from adverse exchange rate movements which may reduce
the
volume of trade and investment XE "investment" since the avoidance of exchange money XE
"money" movements and
speculation may become out of line with the rates which would be more appropriate to the
country’s fundamental Economic position. Particularly with regard to its trade and balance of
payment.

However, while the case for a return to fixed rates seems strong there are also good arguments
against it. In particular, fixed parities inevitably become out of line with the rates necessary for
balance payments equilibrium. Countries with higher inflation will find their goods becoming
uncompetitive and their trade and payments deteriorating into deficit. Low-inflation counties
will tend to run growing surpluses. Eventually, deficit countries may be forced to lower their
parities (devalue) to restore competitiveness.

Thus, those in favour of floating rates argue that they automatically keep payments in
equilibrium and correct for divergent inflation rates. Also, it is said that they allow countries to
pursue independent monetary policies and to isolate themselves from excessive inflation in
other countries. There is also an Economic use of foreign currency reserves. The major
advantage of fixed exchange rates XE "fixed exchange rates" is that they remove uncertainty
and so encourage international trade and investment XE "investment" .

SOLUTION 15.2

a) Policies required in restoring a balance of payments to equilibrium

- Devaluation/depreciation

Devaluation of a currency is a reduction in the exchange rate of the currency relative to other
currencies. The objective of devaluing a country’s currency to make exports cheaper and
imports expensive, by reducing the price of exports to foreign buyers (i.e. in foreign currency
terms) and increasing the price of imports in terms of the domestic currency.
If for example the Zambian Kwacha to the US dollar is devalued form $1 = K3200 to $1 = to
K4000, then foreign consumers and firms will be encouraged to switch to Zambian goods
because with the same $1, they are able to purchase more Zambian goods. They are able to
purchase K4000 worth of goods instead of K3200 worth of goods. In addition, local
consumers and firms will be discouraged from imports. They will need to have K4000 to
purchase a $1 worth of goods, before devaluation, they needed to have K3200 to purchase a $1
worth of goods.

Therefore, depreciation in the kwacha exchange rate should help to boost the overseas demand
for Zambian exports because Zambian firms will be able to supply XE "supply" more cheaply in
international markets.

The extent to which export sales rise following a fall in the exchange rate depends on the price
elasticity of demand for Zambian products from foreign consumers.

A lower exchange rate should also cause imports into Zambia to become relatively more
expensive, thus leading to a slowdown in import volumes and "expenditure-switching"
towards local goods. The significance of elasticity of demand should is again important.

In the short run XE "short run" the change in import demand is likely to be fairly small - it takes
time for movements in the exchange rate to affect trade flows.

- Deflation/Fiscal policy

This is contraction of the domestic economy. Deflationary measures are aimed at reducing
aggregate demand and this can be achieved by either increasing interest rate to discourage
borrowing or increasing tax rates in order to reduce consumption XE "consumption"
expenditure. The government can also reduce its own expenditure.

Some of the overall trade deficit is due to the strength of domestic demand for goods and
services. If and when the economy enters a slowdown phase, the growth XE "growth" of
imports will fall, and this should provide an element of correction for the trade deficit

The effect of the deflationary measures is to reduce the demand for goods and services,
including the demand for imports. If imports are high, demand for them is reduced by reducing
the demand in the economy in general, as long as the demand for imports is income inelastic. If
the fall in demand is accompanied by a reduction in inflation in the home market, the
competitiveness of exports improves (as long as demand for exports in price elastic). In
addition, firms are encouraged to switch to export markets because of the fall in domestic
demand.

Some of the overall trade deficit is due to the strength of domestic demand for goods and
services. If and when the economy enters a slowdown phase, the growth XE "growth" of
imports will fall, and this should provide an element of correction for the trade deficit. The
major problem associated with deflation is that a sharp fall in consumer spending might lead to
a steep Economic slowdown (slower growth of GDP) or a full-scale recession.

- Discouraging imports whilst encouraging exports.

These are the direct controls mentioned earlier under protectionism. A government can impose
trade restrictions like quotas XE "quotas" , import duty, exchange controls, health and safety
regulations etc. Increase exporters’ competitiveness on the international market by subsidising
exporters. A government may also adopt policies to promote exports e.g. zero-rating VAT on
exports, export credit guarantees etc. Eventually the policies result in more exports.

The problem with this policy instrument is that there is a danger of other countries retaliation,
as well as if the demand for imports is inelastic.

- Raising interest rates XE "interest rates" .

Higher interest rates XE "interest rates" act to slowdown the growth XE "growth" of consumer
demand and therefore lead to cutbacks in the demand for imports. High rates would make
Zambia attractive to foreign investors and encourage inward investment XE "investment" , an
inflow of foreign currency, giving a surplus on the capital XE "capital" account.

b) Balance of Payments XE "Balance of Payments" account

K’m K’m
Current account
Visible trade: Export 65,500
Imports (63,200)
Visible balance (balance of trade) 2,300
Invisible trade: Service 1,400
Interest, profit and dividends 1,080
Current transfers (1,810)
Invisible balance 1,670

Current account balance 3,970

K’m K’m
Transaction in assets and liabilities

Increase in external assets (net) (30,830)

Increase in external liabilities (net) 28,570

Net transactions (2,260)

Balancing item (1,710)
(3970)
Total 0
APPENDIX III MOCK EXAMINATION

NATIONAL ACCOUNTING TECHNICIAN/ADVANCED CERTIFICATE IN ACCOUNTING

JOINT EXAMINATIONS
___________________

FOUNDATION STAGE
___________________

T4: ECONOMICS
___________________
 SERIES: MOCK EXAMINATION
___________________

TOTAL MARKS - 100 TIMES ALLOWED: THREE (3) HOURS

__________________

INSTRUCTIONS TO CANDIDATES

1. There are SEVEN questions in this paper. THREE in Section A and FOUR in Section
B. You are required to attempt a total of FIVE questions – TWO from Section A,
TWO from Section B and ONE from either Section.

2. Enter your student number and your National Registration Card Number on the front of
the answer booklet. Your name must NOT appear anywhere on your answer booklet.

3. Do NOT write in pencil (except for graphs and diagrams).

4. The marks shown against the requirement(s) for each question should be taken as an
indication of the expected length and the required depth of the answer.

5. All workings must be done in the answer booklet.

6. Present legible and tidy work.

7. Graph paper (if required) is provided at the end of the answer booklet.

SECTION A (MICRO-ECONOMICS)

Answer at least TWO questions in this section.

QUESTION ONE

(a) Mention any six (6) advantages of the planned (command) Economic system.
(6 marks)

(b) (i) Explain with the aid of a diagram the meaning of the term change in supply XE
"supply" . (2
marks)
(ii) Mention any four (4) factors that can cause a change in supply XE "supply" .
(8 marks)

(c) The price and quantity of cars are in equilibrium. Suppose there is a large increase in the
price of fuel, explain with the aid of an appropriate diagram the new price and quantity
traded in cars. (4 marks)

(Total: 20 marks)

QUESTION TWO

(a)
(i) Explain the four (4) features of monopolistic competition XE "monopolistic
competition" . (4 marks)

(ii) With the help of a diagram, explain the demand curve of a firm operating u n d e r
conditions of monopolistic competition XE "monopolistic competition" .
(2 marks)

(iii) “In the long run XE "long run" , a firm under monopolistic competition XE
"monopolistic competition" rarely makes profits”. Discuss this statement
and illustrate with an appropriate diagram.
(6 marks)

(b) Some countries have set up Monopolies Commissions in order to regulate

monopolies. Discuss:

(i) In favour of monopolies. (4 marks)

(ii) Against monopolies. (4 marks)

(Total: 20 marks)

QUESTION THREE

(a) Distinguish between fixed costs and variable costs XE "variable costs" giving two (2)
examples of each.
(4 marks)

(b) Explain what is meant in Economics XE "Economics" by:

(i) Short run. (2 marks)

 (ii) Long run. (2 marks)

(c) Explain what causes the cost curves to be ‘U’ shaped in the:

(i) Short run. (3 marks)

(ii) Long run. (3 marks)

(d) The table below shows units and prices for ‘Z’ limited company.

Quantity (units) 1 2 3 4 5 6
Average revenue XE "Average revenue" 8 7 6 5 4 3
Total revenue XE "revenue" - - - - - -
Marginal revenue XE "revenue" - - - - - -

You are required to calculate:

(i) Total revenue XE "revenue" . (3

marks)

(ii) Marginal revenue XE "revenue" . (3

marks)

(Total: 20 marks)

SECTION B (MACRO-ECONOMICS)

Answer at least TWO questions in this section.

QUESTION FOUR

(a) Explain the four (4) functions of money XE "money" .

(8 marks)

(b) Sketch and explain a liquidity preference schedule XE "liquidity preference schedule" .
(6 marks)

(c) Explain any four (4) Economic consequences of an increase in the rate of interest XE
"rate of interest" .
(6 marks)

( T o t a l: 2 0
marks)

QUESTION FIVE
(a) Distinguish between direct and indirect taxes giving two (2) examples of each.
(6 marks)

(b) Mention three (3) advantages each, of

(i) Direct taxes. (3 marks)

(ii) Indirect taxes. (3 marks)

(c) Explain how a government can control inflation using fiscal policy XE "fiscal policy" .
(8 marks)
(Total: 20 marks)

QUESTION SIX

(a) Explain any five (5) principal Economic benefits that a country obtains by engaging in
international trading. (10 marks)

(b) Explain the composition of a balance of payments account. (6 marks)

(c) Give a brief explanation of four (4) ways of ‘financing’ or ‘covering’ a deficit balance
of payments account. (4 marks)
(Total: 20 marks)
QUESTION SEVEN

The Zambian Kwacha rate of exchange to the United States Dollar was over K5 000 to $1 in
mid November 2002. The Kwacha has appreciated to around K3 400 to $1.

You are required to give a brief explanation on:

(a) Any four (4) reasons that can lead to an appreciation of a floating exchange rate.
(4 marks)
(b) Three (3) advantages of a floating exchange rate system. (6 marks)

(c) Three (3) disadvantages of a floating exchange rate system. (6 marks)

(d) (i) Appreciation and depreciation of a currency. (2 marks)

(ii) Revaluation and devaluation of a currency. (2 marks)

(Total: 20 marks)

END OF PAPER
 T4: ECONOMICS

SUGGESTED SOLUTIONS

SOLUTION ONE

(a) The three advantages of the planned Economic system are as follows:-
Adequate resources are devoted to community goods
No unemployment of resources
Introduce more certainty into production through the planning the allocation of resources
Eliminates the inefficiencies resulting from competition
An attempt to distribute resources equally
Weaker members of the society are taken care of
Provision of basics such as food, clothing and shelter.

(b) Economists refer to ‘a change in supply XE "supply" ’ when there is a shift in the supply
curve either to the
right or to the left, indicating a reduction or an increase in supply respectively.

A CHANGE IN SUPPLY
Price
S1

S
S2

Quantity

ii) The four factors that can cause a change in supply XE "supply" are as follows:-
Changes in the cost of production
Weather conditions
Technological changes
Government policy such as taxation XE "taxation" and subsidies XE "subsidies"

(c) Petrol and cars are complementary goods, therefore, any change in the market for petrol
would affect the market for second hand cars. The demand for petrol is likely to be price
inelastic since there is no substitute for it.
However, a large increase in the price of fuel is a rise in the cost of owning and running a car.
There will, therefore be a fall in the demand for cars. The price and the quantity traded will
reduce

PRICE

D S
1
D

P
1
P

1
0 Q Q Quantity

SOLUTION TWO

(a) (i) ‘Monopolistic competition’ is a term used to describe a market type, which combines
the
features of perfect competition and monopoly XE "monopoly" in some respects. The
models assume that
there are a very large number of buyers and sellers that there is free entry to and exit
from
the market.

In monopolistic competition XE "monopolistic competition" each firm’s product is

differentiated in some way from that of
its competitors.

(ii) When a firm monopolises the industry through product differentiation, it has some
market
power, and like a monopolist, it becomes a price maker. However, if the firm sets a
high
price the quantity is low, but at low price the quantity demanded is high.

The firm’s demand curve slopes downwards as illustrated in the diagram below
Price

AR = D

Quantity

(iii) One of the features is that there are no barriers to entry. New firms will enter after
being attracted by the supernormal profits that firms under monopolistic competition XE
"monopolistic competition" earn in the short run XE "short run" just like a monopoly XE
"monopoly" .

This will lead the firm’s demand curve to shift downwards and to the left. This
Process will continue until all the excess profits disappear and the firm is just making
normal profits at output Q2 as illustrated in the diagram below.

This is the firm’s long-run equilibrium position. However, it still has a downward-
sloping demand (or average revenue XE "revenue" ) curve. If average costs XE "average
costs" equal average revenue, as
they must do if the firm is making normal profits, this implies that the firm is in
equilibrium on the downward-sloping section of its long-run average cost curve.

Price MC Diagram
Cost AC
Revenue

MR
 D(AR)

0 Q2 Quantity

(b) (i) Arguments FOR monopolies

To achieve economies of scale, and therefore lower the prices
Supernormal profits used on research and development XE "research and development"
Research and development leads them to be innovative
Easier to raise new capital XE "capital"

(ii) Arguments AGAINST monopolies

Output lower prices higher
Supernormal profits are at the expense of customers
Practice price discrimination XE "price discrimination" which is a restrictive practice
‘X’ inefficiency, complacency, not innovative
Lower costs just used to stifle competition
Diseconomies of scale XE "Diseconomies of scale"

SOLUTION THREE

(a) Fixed costs XE "Fixed costs" are those costs, which do not vary with output, examples
rent, interest on loan, depreciation, rate administration costs etc.

Variable costs are those costs, which vary with output, examples cost of raw materials,
electricity, wages etc.

(b) (i) The short run XE "short run" in Economics XE "Economics" is defined as that period
when at least one factor of
production is in fixed supply XE "supply" .

(ii) The long run XE "long run" is a period when all the factors of production XE "factors
of production" are considered to be
variable.
(c) (i) The diminishing returns cause the short run XE "short run" cost curves to be ‘U’
shaped. Average
costs (AC), start from a high level because of high fixed costs (FC). As output
increases, AFC decline, because same level of FC is divided by a higher output.
The average variable costs XE "variable costs" are relatively constant. Therefore, ATC
decline, they
will continue to decline until diminishing returns set in. After that point, the fixed
factor(s) of production need to be increased. Since this is not possible in the short
run, the AC increase, hence the ‘U’ shape in the short run XE "short run" .
 When AC are declining, MC decline faster, and when AC are increase, the MC increase
faster because they only deal with the VC of production.

ii) The diseconomies of large scale production, i.e. their disadvantages cause the long
run cost curves to be ‘U’ shaped.

When a firm grows in size, there are human and behavioural problems of managing a
large organisation. Such as increasing bureaucracy, communication is hampered, morale
and motivation fall, there is ‘X’ inefficiency etc.

(d)
i. TR 8 14 18 20 20 18
ii. MR - 6 4 2 0 -2

SECTION B

SOLUTION FOUR

Money performs the following functions:

Medium of exchange This is the most important function it serves as a means of payment.
Instead of the barter system and its serious drawbacks. Money allows purchases and sales to
be conducted independent of each other. With no double coincidence of wants. Money
facilitates the exchange of goods.

Unit of account Money can act as a common measure or standard of value of the unit of goods
and services. The value of goods and services are measured in monetary terms. Money is the
common denominator, and to perform this function effectively, the value of money XE
"money" should itself be stable……

Store of value Money is a way of storing surplus wealth XE "wealth" . While surpluses can be
stored in the form of other assets, it is usually held in the form of money XE "money" because
it is the most liquid asset. Therefore money is the most convenient method of storing wealth for
use whenever it is needed, again it has to be stable……

Standard of deferred payments Money facilitates credit transactions. Borrowing and lending in
the economy is simplified. Loans and debts are usually expressed in terms of money XE
"money" . Money is the link that connects the values of today with those of the future,
implying again that it must be stable…..

(b)
Keynes argued that the demand for money XE "demand for money" , which he defined as
liquidity preference – in that money XE "money" is the most liquid of assets – was made up of
three elements as follows:

Transactions motive XE "Transactions motive"

Individuals and firms need money XE "money" to pay day-to-day purchases, so money is held
because it performs a function of a medium of exchange.

Precautionary motive XE "Precautionary motive"

Household and firms hold money XE "money" in order to meet unforeseen contingencies.
Money is the most liquid asset and for this reason it is held to deal with sudden misfortunes,
for example an emergency repair to the motor, or to take advantage of an unexpected bargain or
in case expenses or costs turn out to be higher than budgeted for.

Speculative motive

Keynes argued that money XE "money" may be held over and above that required for
transactions and precautionary purposes because people wish to hold money as an asset, ie
people wish to hold money because it performs a function of a restore of value.

There is an inverse relationship between bond prices and the rate of interest XE "rate of
interest" . If bond prices fall the rate of interest rises, while if bond prices rise the rate of
interest falls.

If the interest rate is expected to rise (ie bond prices are expected to fall), people will prefer to
hold money XE "money" balances rather than bonds.

The liquidity preference schedule XE "liquidity preference schedule"

We bring the three motives together in a diagram form to give a total demand curve for
money XE "money" ; this is called the “liquidity preference schedule XE "liquidity preference
schedule" ” (schedule’ is simply another
name for “curve”, as in “demand schedule”).

Liquidity
Preference
schedule
 a b c

0 M

The liquidity preference schedule XE "liquidity preference schedule"

The lines a, b and c represent the three motives for holding cash. The total cash held at each
level of interest would be the sum of the amounts held to satisfy each motive. This is shown
graphically by adding the three lines horizontally. Some shapes of the curves representing the
transactions and the precautionary motives are only slightly affected by the interest rate, the
shape of the liquidity preference schedule XE "liquidity preference schedule" is influenced
most by curve”c”, the speculative motive.

(c) The rate of interest XE "rate of interest" is the price of borrowing money XE "money" ,
which must be paid by the borrower to the lender. Interest rates are prices, which will vary with
the nature of the lending ‘product’ involved.

A large rise in the rate of interest XE "rate of interest" will affect the following:

- It will raise the price of borrowing

- It will therefore reduce the levels of investment XE "investment" . High cost of credit deters
spending.
- It will lead to a reduction in consumption XE "consumption" . Savings increase because of
the high interest rates XE "interest rates" .
Income is either saved or consumed and once savings XE "savings" increases, consumption
reduces.
- Inflation falls. A reduction in investment XE "investment" expenditure and consumption XE
"consumption" expenditure, which are
both components of aggregate demand, causes a reduction in Economic activity and therefore
reduces inflation.
- Asset values fall. There is an inverse relationship between bond prices and interest rates XE
"interest rates" .
- Foreign funds increase. High rates of interest cause an increase in the inflow of foreign
funds,
‘hot money XE "money" ’. This in turn
- Raises the exchange rate. The currency appreciates because of the high demand, which pulls
up
the ‘price’.

SOLUTION FIVE

(a) Direct taxes are levied on income and profits or on wealth XE "wealth" . They are paid
directly to the revenue XE "revenue" authorities. The impact or incidence and its burden are
borne by the same person.

Indirect taxes are levied indirectly once expenditure is made. The impact or incidence and its
burden can be transferred to the consumer depending on the elasticities of demand and supply
XE "supply" on the product.

Examples of direct taxes

Income tax
Social security contributions
Company tax
Personal levy

Examples of indirect taxes

Value added tax
Excise duties
Tariffs XE "Tariffs" or import duties

(b) (i) The advantages of direct taxes are

A high and elastic yield

Certainty
Convenient
Equity through the progressive system of taxation XE "taxation"
Redistributes income and wealth XE "wealth" more equally
(ii) The advantages of indirect taxes are
- Difficult to evade
- Not harmful to effort and initiative
- Adjustable to specific objectives of policy e.g.
1. To protect infant industries
2. To strengthen political links
3. Safeguard citizen’s health
4. Improve balance of trade
(c) Fiscal policy is the management of the economy through public expenditure, taxation XE
"taxation"
and public borrowing. The key aspect is the relationship between spending and taxes.
Government expenditure operates as an injection into the circular flow of national
income; taxation XE "taxation" is a leakage.

If the government collects more in taxes than it spends this is referred to as a budget
surplus. A surplus has a restraining or deflationary effect upon the economy.This
would be considered an appropriate policy at a time of significant inflation.

Whenever the government aims for a budget surplus, it increases direct taxes, which
increases government revenue XE "revenue" while reducing its own expenditure.
Government
 revenue XE "revenue" is mostly from taxes. An increase in taxes lowers the disposable
income of
both individuals and firms, their purchasing power is reduced.

A reduction in both government expenditure and consumption XE "consumption"

expenditure reduces
aggregate demand. The curve shifts to the left and inflation is lowered.

PRICE AS
AD
1
AD

P
1
P

0 Q Q1 Quantity

SOLUTION SIX

(a) The Economic benefits of international trade are:-

- Some countries have minerals or some products can be grown in some countries b u t
not in others, thanks to IT all the products are available in all the countries
- Society has a wider choice of products
- IT opens up domestic markets to more competition
- It also promotes beneficial political links between countries
- Increased competition results in efficient use of resources, which lowers costs.
Therefore consumer prices are reduced which leads to a much higher standard of living
XE "standard of living" .
- The market is global, which leads to large scale production and therefore benefits o f
economies of scale.
- There is wider specialisation XE "specialisation" and international division of labour
XE "labour" , which leads to an increase in total world output.
(b) The balance of payment (BOP) is a statistical record, of debits and credits
covering all financial transactions between for example, Zambia and the rest of
the world recorded in a particular period, usually a year.

The BOP accounts are in two parts. There is the current account XE "current account" ,
through which the export and import of goods and services are posted, and the capital XE
"capital" account through which capital flows.

By definition, the balance of payments account must always balance overall. Individual
sections of the accounts may, however, be in deficit or surplus. In the case of Zambia, the
current account XE "current account" deficit is usually partially offset by surpluses on the
capital XE "capital" account (i.e. transactions in assets and liabilities). Usually, reference to a
balance of payments deficit is intended to mean a deficit on the current account.

The visible trade balance

This is the net difference between the value of visible credits from exports and visible debits
from imports at a particular period of time. By ‘visible’ here we mean goods that you can
touch and see, examples being food, basic materials like iron, oil and manufactured goods like
cars and washing machines.

The invisible trade balance

This is the net difference between the value of invisible credits from exports and invisible
debits from imports at a particular period of time. By ‘invisible here we mean services like
travel, civil aviation, shipping and financial and government services. Invisible also include
interest, profits, dividends and ‘transfers’.

The current account XE "current account" balance

The current account XE "current account" balance is the visible trade balance and the invisible
trade balance added together. In effect, it shows the country’s trading account with the rest of
the world.

Transactions in external assets and liabilities (the capital XE "capital" account) may involve
governments, corporations and individuals, and may be either short or long term.

Such transactions include direct and portfolio investments, bank lending, Zambia banks to
residents overseas, other private lending and overseas deposits, changes in official reserve
balances and other external transactions of the government.

Exports of capital XE "capital" will increase a country’s external assets and will show us an
outflow in the account (negative). Conversely, imports of capital increase liabilities for the
country and will show as an inflow (positive).
Overall, the balance of payments will sum to zero. It consists of a current account XE "current
account" and an asset and liabilities (capital XE "capital" ) account. A deficit on one account
should match a corresponding surplus on the other. A deficit or surplus on current account
implies an outflow or inflow of currency, which must be offset, ‘financed’ or covered by the
sale of assets or by a reduction in liability.

Changes in official borrowings and foreign currency reserves in the assets and liabilities
accounts should be expected to achieve an overall balance with the current account XE "current
account"

However, because of inadequacies in compiling statistics, the official record shows a balancing
item.

Students should mention the account and examples of items found in each
account

(c)
The process of financing or covering is that by which any deficit or surplus on the
current account XE "current account" , met or balanced by capital XE "capital"
balances in the capital flows section.

Borrowed from ‘official sources’ such as the International Monetary Fund;

Taken from a country’s gold and foreign currency reserves; or
Borrowed from overseas central banks.
Sale of overseas investments.
Buying on credit
Accepting gifts etc.

These borrowings might be obtained from overseas sources with repayments being made over
say 5, 10 or even 20 years. However, the borrowing powers and foreign currency reserves of
a country are finite, and so over the longer term a current account XE "current account" deficit
is not sustainable indefinitely.

SOLUTION SEVEN

(a) The market forces of demand and supply XE "supply" of a currency determine a floating
or a flexible
exchange rate. A currency can appreciate if demand for a currency is high or the
supply for
that currency is low. This can be due to:
- People demanding the Kwacha for example to pay for Zambian exports, i.e. Zambian
goods and services.
- Overseas investors who want to invest in Zambia will need the Kwacha.
- Speculators who think that the kwacha is about to become more valuabe in terms of
other
currencies
- High interest rates XE "interest rates" will encourage people to put money XE
"money" in Zambian financial institutions, in Kwacha.
- Central authorities such as the Bank of Zambia might want to offload the dollar,
pound etc to push up the value of the Kwacha.
- Any other inflow of foreign currency such as borrowing……

(b) The advantages of floating exchange rates XE "floating exchange rates" are:-

- Automatic adjustment to the balance of payments disequilibrium, without

government intervention.
- There is greater freedom to pursue domestic goals, since the government does
not need to intervene in the exchange rate.
- There is Economic use of the foreign currency reserves.

Thus, arguments in favour of floating rates argue that they automatically keep
payments in equilibrium and correct for divergent inflation rates. Also, it is said that
they allow countries to pursue independent monetary policies and to isolate themselves
from excessive inflation in other countries. There is also an Economic use of foreign
currency reserves.

(c) The disadvantages of floating exchange rates XE "floating exchange rates" are:-
- The main disadvantage is uncertainty
- There is increased speculative activity
- The above leads to increased volatility.

It is pointed out that flexible exchange rates have been extremely unstable with frequent and
often large fluctuations particularly against the US dollar and the pound sterling. There is some
controversy about the causes of exchange rate instability. But what is clear is that since the
1970s there has been a vast growth XE "growth" in the volume of liquid funds held by
governments, multinational corporations and other institutions which are prepared to shift them
around between bank deposits and other financial assets denominated in different currencies in
order to maximise the overall returns in the form of interest and capital XE "capital" gains.

Thus, funds are shifted into, say, dollar deposits when, other things being equal, and there is a
rise in US interest rates XE "interest rates" . A major factor in exchange instability, therefore,
has been the divergence in the monetary policies of major countries. The instability, in turn, is
often aggravated by speculation whereby treasurers and fund managers form expectations XE
"expectations" about exchange rate movements. Exchange instability, it is claimed, imposes
costs on traders and investors. Exporters, importers and investors face additional risks from
adverse exchange rate movements, which may reduce the volume of trade and investment XE
"investment" since the avoidance of exchange money XE "money" movements, and
speculation may become out of line with the rates, which would be more appropriate to the
country’s fundamental Economic position. Particularly with regard to its trade and balance of
payment.

(d) (i) In markets where exchange rates are flexible or they float, an increase in the external
value
of a currency is referred to as an appreciation, while a decrease in the external parity is
referred to as a depreciation of the currency.

This means that an economy is following a floating exchange rate system, and the
market
forces of supply XE "supply" and demand are determining the rate of exchange.

(ii) When the currency is made cheaper with respect to another currency e.g dollar, the
adjustment is called devaluation. A revaluation results when a currency become more
expensive with respect to another currency.

INDEX \h "A" \e " " A

accelerator 107, 114, 116, 204
Accelerator 107
advertising 65, 82, 87, 89, 202, 222
Arc elasticity of demand 31
average costs57, 59, 62, 63, 64, 66, 78, 82, 83, 199, 221, 244
Average revenue 71, 240
B
Balance of Payments 184, 187, 194, 236
bank of Zambia 120
bank’s assets and liabilities 133
C
capital5, 13, 38, 50, 51, 56, 58, 64, 67, 77, 83, 90, 96, 98, 99, 100, 101, 102, 103, 105, 106,
110, 114, 115, 116, 125, 127, 128, 129, 131, 135, 137, 138, 141, 146, 153, 159, 161, 164,
168, 169, 171, 177, 178, 183, 184, 185, 186, 187, 188, 190, 191, 193, 194, 195, 200, 203,
204, 206, 209, 210, 213, 218, 223, 224, 225, 231, 232, 233, 234, 236, 245, 250, 251, 252
Capital Adequacy 135
cartels 90, 202
closed economy 113
companies51, 59, 66, 82, 90, 98, 103, 125, 128, 129, 130, 156, 158, 159, 168, 169, 180, 206,
208, 209, 227
comparative advantage170, 179, 180, 181, 209, 214, 229, 231
complements 47
consumption8, 15, 23, 96, 98, 99, 100, 105, 106, 107, 108, 109, 110, 114, 115, 116, 118, 123,
141, 142, 153, 156, 160, 189, 203, 204, 222, 223, 224, 225, 226, 236, 248, 249
consumption function 109
Corporation Tax 155
CREATION OF MONEY 130
CROSS ELASTICITY OF DEMAND 46
current account164, 183, 184, 185, 188, 189, 193, 194, 195, 210, 232, 233, 250, 251
D
deflationary gap 111, 115, 116, 166, 204, 207
demand for labour 146
demand for money117, 121, 122, 123, 124, 205, 246
demand management110, 111, 112, 116, 149, 207, 227
DETERMINATION OF EXCHANGE 190
Diseconomies of scale 63, 66, 199, 245
diversification 69, 73, 165
division of labour 52
E
Economics2, 3, 6, 11, 55, 60, 73, 95, 124, 211, 240, 245
Elasticity 26, 29, 34, 35, 38, 45
Enterprise 5
Equilibrium position 81
Exchange controls 173, 231
expectations 17, 115, 226, 234, 253
F
factors of production2, 3, 5, 7, 11, 13, 38, 48, 50, 53, 58, 59, 62, 64, 78, 82, 97, 98, 112, 169,
198, 210, 222, 245
fiscal policy152, 160, 163, 166, 167, 168, 207, 228, 241
Fixed costs 54, 60, 198, 218, 245
fixed exchange rates 194, 223, 234, 235
floating exchange rates 194, 252
foreign exchange market125, 169, 183, 191, 192, 193
fractional reserve system 130
Functions of money 118, 205
G
Giffen goods 46, 197
Gross Domestic Product 96, 204, 224
GROSS DOMESTIC PRODUCT 98, 99
growth3, 7, 8, 11, 49, 65, 66, 67, 73, 97, 101, 102, 105, 110, 114, 129, 146, 148, 149, 161,
162, 164, 165, 169, 176, 187, 189, 190, 196, 204, 217, 225, 234, 236, 252
I
income effect 15, 46
INCOME ELASTICITY OF DEMAND 45
income tax 154, 227, 228
inferior goods 34, 46, 217
inflationary gap 110, 112, 115, 142, 166, 207
Inheritance tax 155
integration 62, 68, 73, 74, 170, 177, 199
interest rates64, 109, 110, 115, 120, 121, 122, 123, 124, 133, 142, 143, 144, 164, 190, 191,
205, 206, 207, 225, 234, 236, 248, 252, 253
INTERNAL DISECONOMIES 66
internal economies 74, 199
international monetary fund 134
investment96, 97, 98, 100, 103, 107, 110, 112, 113, 114, 115, 116, 123, 126, 128, 129, 130,
133, 141, 142, 143, 150, 153, 155, 159, 169, 176, 177, 185, 186, 190, 204, 206, 207, 209,
222, 223, 225, 226, 234, 235, 236, 248, 253
invisibles 193, 210
K
kinked demand curve 90, 91, 92, 93, 202
L
labour5, 7, 10, 13, 38, 48, 50, 52, 53, 58, 59, 64, 65, 66, 67, 82, 97, 103, 105, 110, 145, 146,
147, 150, 151, 168, 170, 177, 195, 199, 203, 207, 210, 213, 218, 250
land 3, 4, 5, 7, 13, 58, 64, 102, 103, 212, 213
Lateral Integration 69
liquidity preference schedule124, 125, 241, 247, 248
LOCATION OF INDUSTRY 68
long run5, 35, 38, 48, 53, 59, 60, 62, 64, 74, 78, 80, 81, 84, 85, 86, 88, 89, 93, 149, 189, 190,
198, 199, 200, 202, 213, 219, 220, 239, 245
Long run costs 53
M
marginal costs 50, 59, 60
marginal propensity to consume108, 113, 115, 226
marginal revenue75, 78, 85, 86, 199, 200, 221
merit goods 9, 10, 153
Microeconomics 2
minimum efficient scale 199
Monetarists 122, 140, 145, 149, 207
Monetary policy 135, 192, 207
money13, 51, 54, 64, 71, 97, 98, 102, 107, 110, 117, 118, 119, 120, 121, 122, 123, 124, 125,
126, 127, 128, 129, 130, 131, 132, 133, 135, 136, 137, 138, 139, 140, 141, 142, 143, 144,
147, 150, 151, 155, 156, 159, 160, 165, 166, 183, 190, 196, 204, 205, 206, 207, 214, 224,
226, 227, 228, 234, 241, 246, 247, 248, 252, 253
money supply107, 120, 122, 124, 132, 135, 139, 140, 142, 206, 227
monopolistic competition76, 87, 88, 89, 93, 219, 220, 222, 239, 243, 244
monopoly76, 80, 83, 85, 86, 87, 89, 93, 158, 159, 201, 219, 220, 243, 244
multiplier107, 110, 112, 113, 114, 115, 116, 132, 204, 226, 227
N
Narrow Money 120
national income7, 95, 96, 97, 98, 101, 102, 103, 104, 105, 106, 107, 110, 111, 112, 113, 114,
115, 142, 144, 157, 203, 204, 222, 223, 224, 225, 226, 228
nationalised industries 153
natural resources 3, 8, 58, 105, 176
normal goods 46, 217
O
Oligopoly 77, 93
open market operations 138, 143
opportunity cost6, 8, 11, 147, 170, 171, 207, 211, 212, 219, 229, 231
P
PARADOX OF THRIFT 115
partnerships 50, 51, 59
PERFECT COMPETITION 76
population5, 17, 46, 101, 102, 103, 161, 167, 176, 177, 223
Precautionary motive 247
price discrimination76, 82, 83, 84, 85, 200, 245
PRICE ELASTICITY OF SUPPLY 35, 38
Primary production 52
public goods 9, 10
Q
quantity theory of money 140
quotas 172, 180, 190, 210, 230, 234, 236
R
rate of interest121, 122, 123, 124, 135, 137, 143, 205, 225, 241, 247, 248
research and development65, 66, 83, 103, 169, 190, 199, 200, 245
revenue5, 26, 40, 41, 42, 48, 55, 56, 62, 71, 72, 75, 77, 81, 82, 85, 86, 147, 152, 153, 154,
155, 156, 157, 160, 161, 163, 164, 165, 166, 168, 172, 173, 180, 201, 207, 208, 213, 219,
221, 227, 228, 229, 230, 240, 244, 248, 249
risk 5, 123, 126, 127, 128, 133, 206
S
savings96, 107, 109, 115, 116, 121, 123, 124, 125, 126, 127, 128, 137, 143, 150, 204, 205,
206, 207, 248
Scarcity 2, 205
Secondary production 52
short run35, 38, 48, 53, 54, 59, 60, 62, 78, 79, 81, 88, 140, 188, 193, 198, 202, 219, 221, 235,
244, 245
social costs 8, 72, 153
sole traders 50, 51, 59
specialisation 231, 250
Speculative Motive 120
standard of living7, 23, 46, 101, 102, 104, 149, 150, 207, 250
stock of money 120, 206
subsidies19, 24, 48, 98, 105, 150, 153, 170, 173, 180, 203, 222, 223, 230, 243
substitute goods 16, 19
substitution effect 15, 46
supernormal profit 160
supply2, 3, 5, 9, 13, 17, 18, 19, 20, 21, 22, 23, 24, 25, 26, 35, 36, 37, 38, 39, 40, 42, 43, 44,
48, 53, 58, 59, 65, 68, 69, 77, 78, 79, 80, 81, 82, 83, 84, 107, 110, 111, 117, 120, 121, 122,
123, 124, 132, 133, 135, 136, 137, 139, 140, 141, 142, 143, 144, 145, 146, 148, 149, 150,
151, 152, 157, 159, 165, 179, 188, 189, 190, 191, 192, 193, 196, 198, 200, 206, 207, 210,
214, 215, 216, 218, 222, 227, 228, 235, 239, 242, 243, 245, 248, 252, 253
T
Tariffs 172, 178, 210, 230, 248
taxation22, 24, 26, 48, 96, 109, 115, 141, 153, 155, 160, 161, 165, 167, 168, 196, 204, 207,
227, 228, 243, 249
technical efficiency 89, 202
Terms of trade 104, 186, 209, 210, 232
Transactions motive 246
transfer payments 105, 183, 222
treasury bills 135, 163, 206, 226
U
Unitary elasticity 27, 36
V
value added tax 141, 156, 228
variable costs53, 54, 59, 60, 61, 83, 214, 218, 240, 245
velocity of circulation 140
W
wealth3, 5, 8, 9, 10, 83, 119, 144, 153, 154, 155, 160, 164, 228, 246, 248, 249
welfare2, 7, 11, 101, 105, 146, 155, 161, 162, 169, 202
world bank 134

Business Sector

Personal Sector

Government sector
Surplus Unit

Financial Intermediary

Deficit Unit

Surplus Unit

Deficit Unit
MC

AC

P= AR= MR

QUANTITY

MC

Q*

PRICE

OUTPUT

CO

LMR

Economic Profit

MC

Q*

OUTPUT

CO

MR

Economic Profit
Boom

Recessions

Depression

Recovery

TIME

GROWTH (%)

HOUSEHOLDS

FIRMS

Income

Consumptiiiiion

Goods Market

Factor Markets

SAVINGS

TAXATION

IMPORTS

INVESTMENT

GOVERNMENT

EXPORTS

HOUSEHOLDS

FIRMS

Income

Consumption

Goods Market

Factor Markets

Personal
sector

Business
sector

Financial
Intermediaries

Overseas
sector

Government
 sector

MC

AC

P= AR= MR
Q

QUANTITY