Industrial Economics

Introductory Economics Reading Materials for BSc.
Industrial Chemistry Semester One AY 2009/2010
5.0 PRODUCTION
This is the process of transforming the natural resources of the land into consumer satisfying
consumption goods or productive capital goods. This transformation process involves the four
scarce resources or factors of production--labor, capital, land, and entrepreneurship. In their
natural state raw materials generally provide less satisfaction of wants and needs than they
do once processed, transformed, or fabricated into products. The opportunity cost of using
labor, capital, land, and entrepreneurship in the production of goods and services. The price
received by a seller must be high enough to cover production cost. The law of supply is based
on the proposition that production cost increases with an increase in the quantity produced
and supplied.
Production cost is important to the supply side of the market. Sellers base supply decisions on
the cost of production. In that production cost generally increases as more of a good is
production, the supply price also tends to rise with the quantity supplied. Production cost
includes the opportunity cost of using the four factors of production (labor, capital, land, and
entrepreneurship). It includes those expense items that are traditionally considered as the
"cost of doing business.
PRODUCTION FUNCTION:
This is a mathematical relation between the production of a good or service and the inputs
used. A production function captures the general relation between total production and one or
more inputs. The standard production function includes labor and capital as the inputs.
However, a production function is general enough that any number of inputs can be included
A production function provides an abstract mathematical representation of the relation
between the production of a good and the inputs used. A production function is usually
expressed in this general form:
Q = f (K, L)
where: Q = quantity of production or output, L = quantity of labor input, and K = quantity of

capital input.
If the production function takes the form of a specific equation (such as Q = 5L + 10K + 2LK),
then a total product curve relating total product and the variable input can be plotted.
However, to do so, one of the two inputs (L or K) must be designated as a variable input and
one designated as a fixed input. For most types of production, labor is more readily changed
than capital, so L is generally the variable input and K is usually the fixed input. A short-run
total product curve can then be derived by "fixing" K at a particular value, then plotting the
values of Q for alternative values of L.
While a great deal of economic insight into short-run production decisions of a firm and market
supply curves can be analyzed with a simple graph, when economists begin using
mathematical equations, such as the production function, Q = f(L, K), the possibilities are
almost unlimited. A wide assortment of additional input variables can be added to this
equation to make it, not only more sophisticated, but also more revealing.
For example, the effect of education and human capital on production can be seen by adding
the educational attainment of workers as another input variable. In addition, the alternative
impact on production of different types of capital, such as fixed structures and equipment can
be identified by separating capital into two variables. In addition, to identify how public
infrastructure, like highways and streets, affects production, then a variable for this input can
be added to the production function.
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Introductory Economics Reading Materials for BSc. Industrial Chemistry Semester One AY 2009/2010
FACTORS OF PRODUCTION:
Factors of production, also termed resources or scarce resources, are the elements used in the
production of goods required for wants-and-needs-satisfying process necessary for human life.
There are four types of factors of production; land, labour, capital and entrepreneurship
i) Labor: This is the mental and physical efforts of humans (excluding entrepreneurial
organization) used for the production of goods and services. Labor includes both the physical
effort of factory workers and farmhands often associated with labor, as well as the mental
effort of executives and supervisors.
ii) Capital: This is the manufactured, artificial, or synthetic goods used in the production of
other goods, including machinery, equipment, tools, buildings, and vehicles. Capital is the
produced factor of production. This factor must be produced using other factors of production,
which means that society is often faced with the choice between producing consumption
goods that satisfy wants and needs and capital goods that are used for future production. The
key role of capital in the production process is to make labor more productive.
iii) Land: This is the naturally occurring materials of the planet that are used for the
production of goods and services, including the land itself; the minerals and nutrients in the
ground; the water, wildlife, and vegetation on the surface; and the air above. The natural
resources and materials of the land become the goods produced. Without these materials of
the land, there is no production. Production is, in fact, the basic process of transforming
naturally occurring materials that provide little satisfaction in their natural state, to goods and
services that provide more satisfaction.
iv) Entrepreneurship: This is the special sort of human effort that takes on the risk of
bringing labor, capital, and land together to produce goods. Entrepreneurship is the factor that
organizes the other three. Without someone to organize production, the other three factors do
not produce. A key component of entrepreneurship is risk. This resource takes the risk of
organizing production before anything is produced and with no guarantee that production will
be successful.
Concept of a Firm: A firm is the smallest unit of production or sale. Firms may have different
organizational forms. A firm may be an individual enterprise, a partnership, a joint stock
company, a corporate body, a cooperative enterprise or a public utility agency. Again a firm
may be a producer, seller, trader, exporter or a financier. In any one of these capacities, firms
show similar basic tendencies. In order to maximize its profits a firm has to maintain as large a
difference between what it spends on resources or cost of production and what it earns by
selling goods in the form of revenue or returns. The difference between the two is the firm’s
profit. So the firm has to keep its cost of production as low as possible. On the other hand, it
has to charge a high price and sell as much quantity of products as possible. In this respect,
the firm’s actions are related to the behavior of consumers. Besides the limitation of cost of
production, the capacity of a firm to charge a suitable price is restricted by the consumer’s
willingness to pay.
Production Time Periods

These are alternative time periods used to differentiate between variable inputs and fixed
inputs that are key to the analysis of short-run production and long-run production by a firm.
The two primary time periods are short run and long run and are specified based on the
number of inputs that are fixed or variable. The primary production time period distinction is
between the short run and the long run.
♦ Short Run: The short run is the production time period in which at least one input
under the control of the firm is variable and at least one input is fixed. This time period
is relevant for short-run production analysis. In particular, with one fixed and one
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variable input, the law of diminishing marginal returns guides short-run production and
determines how a firm responds to changes in the market price.
♦ Long Run: The long run is the production time period in which all inputs under the
control of the firm are variable. This time period is relevant for long-run production
analysis. In particular, with all inputs variable, long-run production is guided by returns
to scale rather than marginal returns and the law of diminishing marginal returns.
Factors of Production and Product Output
Fixed and Variable factors: In the act of production a firm uses a variety of goods and
services called factors of production or inputs. These factors and services include plant and
machinery, factory premises, tools and equipment, land, raw materials, labor etc. Some of
these factors are fixed in size. A machine or manager has to be employed in its full capacity,
irrespective of the volume of the output. Other factors like labor and raw materials can be
employed in small or large units according to the varying quantity of output. These are
variable factors of production. Fixed factors are indivisible while variable factors are
divisible into small units. Fixed factors are supplementary in nature. Machines make
productive activity more convenient and efficient. However, even in their absence, output of
some volume can be produced. Variable factors are called prime factors without which no
output can be produced.
a) Total Product (TP): The total product (or total physical product) of a variable factor of
production identifies what outputs are possible using various levels of the variable input.
b) The average product (AP): is the total product divided by the number of units of variable
input employed. It is the output of each unit of input. If there are 10 employees working on a
production process that manufactures 50 units per day, then the average product of variable
labour input is 5 units per day. The average product typically varies as more of the input is
employed, so this relationship can also be expressed as a graph.
i.e
c) The marginal product (MP) of a variable input is the change in total output due to a one
unit change in the variable input (called the discrete marginal product) or alternatively the rate
of change in total output due to an infinitesimally small change in the variable input (called the
continuous marginal product). The discrete marginal product of capital is the additional output
resulting from the use of an additional unit of capital (assuming all other factors are fixed). The
continuous marginal product of a variable input can be calculated as the derivative of quantity
produced with respect to variable input employed.
The stages of production
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To simplify the interpretation of a production function, it is common to divide its range into 3
stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing
efficiency, reaching a maximum at point B (since the average physical product is at its
maximum at that point). The average physical product of fixed inputs will also be rising in this
stage (not shown in the diagram). Because the efficiency of both fixed and variable inputs is
improving throughout stage 1, a firm will always try to operate beyond this stage. In stage 1,
fixed inputs are underutilized.
In Stage 2, output increases at a decreasing rate, and the average and marginal physical
product is declining. However the average product of fixed inputs (not shown) is still rising. In
this stage, the employment of additional variable inputs increase the efficiency of fixed inputs
but decrease the efficiency of variable inputs. The optimum input/output combination will be in
stage 2. Maximum production efficiency must fall somewhere in this stage. Note that this does
not define the profit maximizing point. It takes no account of prices or demand. If demand for a
product is low, the profit maximizing output could be in stage 1 even though the point of
optimum efficiency is in stage 2.
In Stage 3, too much variable input is being used relative to the available fixed inputs: variable
inputs are over utilized. Both the efficiency of variable inputs and the efficiency of fixed inputs
decline through out this stage. At the boundary between stage 2 and stage 3, fixed input is
being utilized most efficiently and short-run output is maximum.
The law of diminishing returns,
It states that if one factor of production is increased while the others remain constant, the
overall returns will relatively decrease after a certain point. Thus, for example, if more and
more laborers are added to harvest a wheat field, at some point each additional laborer will
add relatively less output than his predecessor did, simply because he has less and less of the
fixed amount of land to work with. The point at which the law begins to operate is difficult to
ascertain, as it varies with improved production technique and other factors
THEORY OF COSTS
Production cost includes the opportunity cost of using the four factors of production (labor,
capital, land, and entrepreneurship). It includes those expense items that are traditionally
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considered as the "cost of doing business. Production costs categorically take two broad forms;
explicit costs and implicit costs.
An Explicit cost is an easy accounted cost, costs which are recorded in the books of accounts
such as wage, rent and materials. It can be transacted in the form of money payment and is
lost directly, as opposed to monetary implicit costs.
An implicit cost occurs when one foregoes an alternative action but does not make an actual
payment. (For instance, the explicit cost of a night at the movies includes the moviegoer's
ticket and soda, but the implicit cost includes the pay she would have earned if she had
chosen to work instead.) Implicit costs are related to forgone benefits of any single transaction,
also called opportunity cost.
Examples of implicit costs
• A firm's use of its own capital. This is considered an implicit cost because the
capital could have been rented to another firm instead. This rental income foregone, or
the implicit rental rate of capital, is the firm's opportunity cost of using its own capital.
This implicit rental rate can be broken down beyond interest forgone.
• A firm's use of its owner's time and/or financial resources.
• Economic depreciation.
TYPES OF COSTS
Cost of production is a function of the volume of output produced. Total cost is made up of two
components. Some of the inputs are fixed and indivisible. Their aggregate cost remains
constant and hence goes on falling in an average proportion as output increases. Other factors
of production are variable and go on increasing with the level of output produced. The costs
incurred on fixed and variable factor inputs are called fixed and variable costs respectively.
i) Fixed costs (FC) are expenses whose total does not change in proportion to the activity of
a business, within the relevant time period or scale of production. For example, a retailer must
pay rent and utility bills irrespective of sales to be considered part of fixed costs, but treated
differently. Unit fixed costs decline with volume, following a rectangular hyperbola as the
inverse of the volume of production.
ii) Variable costs (VC) are expenses that change in proportion to the activity of a business.
In other words, variable cost is the sum of marginal costs. Along with fixed costs, variable costs
make up the two components of total cost. Direct Costs, however, are costs that can be
associated with a particular cost object. Not all variable costs are direct costs, however; for
example, variable manufacturing overhead costs are variable costs that are not direct costs,
but indirect costs. Variable costs are sometimes called unit-level costs, operating costs, prime
costs, on costs and direct costs, as they vary with the number of units produced.
iii) Total cost (TC) describes the total economic cost of production and is made up of variable
costs, which vary according to quantity produced such as raw materials, plus fixed costs, which
are independent of quantity produced such as expenses for assets like buildings.
i.e
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Relationship between TC, TFC and TVC
iv) Marginal Cost: This is the change in total cost that arises when the quantity produced
changes by one unit. Mathematically, the marginal cost (MC) function is expressed as the
derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal
cost may change with volume, and so at each level of production, the marginal cost is the cost
of the next unit produced.
In general terms, marginal cost at each level of production includes any additional costs
required to produce the next unit. If producing additional vehicles requires, for example,
building a new factory, the marginal cost of those extra vehicles includes the cost of the new
factory. In practice, the analysis is segregated into short and long-run cases, and over the
longest run, all costs are marginal.
v) Average Fixed costs (AFC): This is total fixed costs per unit of output produced and is
given as;
vi) Average Variable cost (AVC): This is total variable costs per unit of output produced and
is given as;
v) Average Total costs (ATC): This is total costs per unit of output produced and are given
as;
Relationship between the short run costs
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Economies Vs Diseconomies of Scale
a) Economies of scale characterizes a production process in which an increase in the scale

of the firm causes a decrease in the long run average cost of each unit. Economies of scale can
be enjoyed by any size firm expanding its scale of operation. The common ones are purchasing
(bulk buying of materials through long-term contracts), managerial (increasing the
specialization of managers), financial (obtaining lower-interest charges when borrowing from
banks and having access to a greater range of financial instruments), marketing (spreading
the cost of advertising over a greater range of output in media markets). Each of these factors
reduces the long run average costs (LRAC) of production by shifting the short-run average total
cost (SRATC) curve down and to the right.
This should not be confused with increasing returns to scale which is represented by the
SRATC where simply increasing output within current capacity reduces the short run cost per
unit.
This is, of course, an extremely simplistic example and, in real life, there are countering forces
of diseconomies of scale. As these forces balance, an optimum production volume can be
found (referred to as constant returns to scale). This principle can be equally applied to an
organization resulting in firms within a particular industry tending to be similar sizes.
Economists have studied this effect as the theory of the firm.
A natural monopoly is often defined as a firm which enjoys economies of scale for all
reasonable firm sizes; because it is always more efficient for one firm to expand than for new
firms to be established, the natural monopoly has no competition. However, standard
economic theory also holds that on account of the unique shapes of the natural monopoly's
LRAC and SRAC, it can never experience economic profit and thus requires subsidies or other
government intervention to remain profitable.
In the short run at least one factor of production is fixed. Therefore the SRAC curve will fall and
then rise as diminishing returns sets in. In the long run however all factors of production vary
and therefore the LRAC curve will fall and then rise according to economies and diseconomies
of scale.
Note: Economies of scope are conceptually similar to economies of scale. Whereas

economies of scale primarily refer to efficiencies associated with supply-side changes, such as
increasing or decreasing the scale of production, of a single product type, economies of scope
refer to efficiencies primarily associated with demand-side changes, such as increasing or
decreasing the scope of marketing and distribution, of different types of products. Economies
of scope are one of the main reasons for such marketing strategies as product bundling,
product lining, and family branding.
Often, as the number of products promoted is increased and broader media used, more people
can be reached with each dollar spent. This is one example of economies of scope. These
efficiencies do not last, however, at some point, additional advertising expenditure on new
products will start to be less effective (an example of diseconomies of scope).
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b) Diseconomies of scale are the forces that cause larger firms to produce goods and
services at increased per-unit costs. They are less well known than what economists have long
understood as "economies of scale", the forces which enable larger firms to produce goods and
services at reduced per-unit costs.
6.0 MARKET STRUCTURES

The Market Environment
Each business firm faces two important decisions in the market:
i) Choosing how much it should produce
ii) Choosing what price it should set
If the business world was free of constraints, then any firm would set an arbitrary price and
produce and arbitrarily large output. A business firm faces two constraints on its business
decisions or actions;
a) Technological constraints summarized by the production function ie, Q = f( K, L).
The technology constraints lead to economic constraints which are also summarized by the
cost function.
b) Market constraints: A firm can produce whatever is physically feasible and it can set
whatever price it wants but can only sell as much as people are willing to buy. In an
environment constituting many firms, the constraints facing an individual firm will be
different. In this case, the firm has to guess how the other firms in the market will
behave when it chooses its price and output. The analysis of market equilibrium
therefore seeks to describe the determination of the market price and the quantity
bought and sold.
The classification of markets is based on whether they are many, few or one producer. Another
criteria used in distinguishing market structures include; product differentiation, the nature of
demand curve, a control over price by the market, the barriers to entry, the competitive
reaction of the market, the nature of persuasive advertising, etc.
Market Perfect Monopolisti Perfect Differentiat Pure

Structure competition c Oligopoly ed Monopoly
Factor competition Oligopoly
Number of Many Many Few Few One
producers
Product None Much None Much One product
Differentiati with no close
on substitute
Demand Perfectly Quite elastic Same as if None Inelastic
curve elastic market
collusion
exist
Control over None Little Some Some Much
price
Competitive None Little Much Much None
reaction
Barriers to None Slight or Some Some Strong or
Entry None much
PERFECT COMPETITION
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A perfectly competitive market is characterized by a large number of firms, each producing an

identical product. None of the firms is large relative to the market size as a whole. A perfectly
competitive market satisfies the following conditions:
1). Large number of firms and buyers: there are so many firms that none of them is in a
position to influence the price of that commodity. Each firm is free to produce as much output
as it wishes at the given market prices. The firm faces a perfectly elastic demand curve and
can sell all that it can produce at the ongoing market price, which is the industry equilibrium
price. Therefore, a firm under prefect competition is a price taker since the price is determined
by the industry.
2). Product homogeneity: Each firm produces and sells a homogenous product so that no
consumer has any preference of the product of any firm over the other. At the same time, the
producer does not discriminate between consumers.
3). Free entry and exit: Firms have free movement in and out of the industry. Any new firm
with capital is free to enter the production of the commodity without barriers. Firms are free to
leave the industry depending on the market conditions.
4). Perfect knowledge: Consumers and sellers have complete information of the market
conditions. Consumers know exactly all the alternatives products they can purchase and they
know the price of these products. Likewise, the producers have the same information
regarding price and output decisions.
5) Perfect mobility of factors of production: That is, factors can freely move and easily to
where they are needed, implying that factor prices are relatively the same in all markets.
6) No transportation costs: This condition implies that firms under perfect competition must
charge the same price since they do not incur transportation costs.
Others include;
• No persuasive advertising-it is only done to inform consumers about the product(s)
• No externalities
• There is perfect divisibility of the output
Note: a perfect competitive model is wider than pure competition in the sense that perfect
competition includes two basic assumptions;
• Perfect knowledge
• Perfect mobility of factors of production
Short Run Equilibrium under Perfect Competition.
The firm is in equilibrium when its total profits are maximized. Total profit is the difference
between total revenue and total costs.
The necessary condition, sometimes referred to as the first order condition for profit
maximization states that MR = MC
Graphical Illustration of the Equilibrium Position of the Firm in the Short Run.
In the short run, profits are maximized where MR = MC. Under perfectly competitive
conditions, the firm can be in equilibrium when it makes profits or losses. A firm will make
profits when average revenue or price exceeds average cost.
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From the diagram, point e is the equilibrium point, that is, MR = MC. At this point, output
produced is Q1 which is produced at an average cost of C 1 and sold at price P1. The revenue is
then equal to OP1eQ1 and the cost is given as OC1fQ1, giving a rise to a profit level of C1P1ef.
On the other hand, a firm will make loses when AR is less than average cost
Long Run Equilibrium Under Prefect Competition.
When firms make profits in the short run, other firms join the industry and when firms make
losses, other firms will leave the industry. This is so because of free entry and exit.
In the long run, the number of firms increases as a result of short run profits, the supply of
output increases and at the same time, the costs of factors of production increase. This leads
to a reduction in the profit levels and each individual firm will earn normal profits.
This is because as more firms join the industry, pressure emerges on the resource base
available, and the demand for factor inputs is high, which causes the an increase in costs of
production. Additionally, output rises since so many firms are producing an identical product.
An increase in output supplies would drive down the prices until the price is equal to the
minimum average cost. In other words, the demand curve becomes tangent to the minimum
point of AC curve. This point is also known as the optimum plant size.
MONOPOLY
In economics, a monopoly is defined as a persistent market situation where there is only one
provider of a kind of product or service. Monopolies are characterized by a lack of economic
competition for the good or service that they provide and a lack of close substitute goods.
Monopsony is a market setting where there is only one buyer of the product or service.
FORMS OF MONOPOLY
Monopolies are often distinguished based on the circumstances under which they arise;
a) Legal Monopoly
A monopoly based on laws explicitly preventing competition is a legal monopoly. When such a
monopoly is granted to a private party, it is a government-granted monopoly; when
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government itself operates it, it is government or state monopoly. A government monopoly

may exist at different levels of government (eg, just for one region or locality); a state
monopoly is specifically operated by a national government.
b) Natural Monopoly
This monopoly arises in industries where economies of scale are so large such that a single
firm can supply the entire market without exhausting them. In these industries, competition
will tend to be eliminated as the largest (often the first) firm develops a monopoly through its
cost advantage.
Natural monopoly arises when there are large capital costs relative to variable costs, which
arises typically in network industries such as electricity and water.
c) Local Monopoly
As local monopoly is a monopoly of a market in a particular area, usually a town or even a
smaller locality. The term is used to distinguish a monopoly that is geographically limited
within a country, and the assumption is that a monopoly covers the entire industry in a given
country.
Characteristics of Monopoly
There is a single firm in the industry. This implies that a monopolist has influence over market,
that is, can determine the price at which to sell the output.
Firms produce commodities that have no close substitutes
There is blocked entry, that is, there are barriers to entry to the market for other firms
The firm advertises informatively.
Short Run Equilibrium Position Under Monopoly
Like perfect competition, pricing and output decisions under monopoly are based on revenue
and cost conditions. Although cost conditions (AC and MC) in a perfectly competitive and
monopoly markets are generally the same, revenue conditions differ. The revenue conditions
(AR and MR) curves are different and the firm faces a downward sloping demand curve. This is
because a monopolist can reduce price and sell more, and can raise the price and still retain
some customers.
Also, since the monopoly firm and industry are the same, then the demand curve for the
industry is the demand curve for the firm. When the demand curve is downward sloping, the
MR curve lies below the AR curve and slope of the MR is twice that of AR.
Equilibrium position ……………… to be done in class
SECTION B: MACROECONOMICS
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Macroeconomics is the study of the aggregate economy, or the macro economy. it is

concerned with the analysis of aggregate economic behavior of all economic units in the
economy i.e. the overall outcome or consequences of all individual actions of the household
sector, business sector, the government sector and the external sector. The study therefore
focuses on economic aspects (activities) that affect the economy as a whole with a view to
understanding the interaction between economic aggregates such as national income,
employment and inflation.
The most important problems--unemployment, inflation, and stagnant production--relate to the

three macroeconomic goals of full employment, stability, and economic growth.
Unemployment, commonly measured by the average unemployment rate, indicates the

portion of the economy's total resources that are not being used for production. Inflation,
measured by the inflation rate, indicates whether the average level of prices are rising, falling,
or remaining stable. Problems related to aggregate production are measured by gross
domestic product, especially relative to potential gross domestic product.
The modern study of macroeconomics is an explanation of and remedy for, economic problems
through economic policies. The two most common macroeconomic policies are fiscal policy
and monetary policy. Fiscal policy seeks to stabilize the business cycle using government
expenditures and taxes. Monetary policy seeks to stabilize the business cycle using the money
supply and interest rates.
SECTORS OF AN ECONOMY
The aggregate sectors of the macro economy reflect key macroeconomic functions. There are
four aggregate macroeconomic sectors that form the foundation for macroeconomic analysis;
the household sector, the business sector, government sector, and foreign sector.
Each sector is responsible for a different expenditure on gross domestic product: consumption
expenditures by the household sector, investment expenditures by the business sector,
government purchases by the government sector, and net exports by the foreign sector.
• Household Sector: This sector includes the entire, wants-and-needs-satisfying and

consuming population of the economy. In a word, it includes everyone, all consumers,
all people, and every member of society.
• Business Sector: This sector contains the private, profit-seeking firms in the
economy that combine scarce resources into the production of goods and services. It
includes proprietorships, partnerships, and corporations.
• Government Sector: This sector includes all government entities that impose
resource allocation decisions, on the rest of the economy. It consists of the three
primary levels of central and local government divisions responsible for passing and
enforcing laws.
• Foreign Sector: This sector is comprised of everyone and everything outside the
political boundaries of the domestic economy. It includes households, businesses, and
governments in other countries.
Macroeconomic Functions of the Different sectors

Each of the four sectors has a distinct functional role to play in the macro economy.
• Consumption: The primary macroeconomic function of the household sector is the

consumption of goods and services that satisfy wants and needs. Promoting
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consumption by members of the household sector is, in essence, the ultimate objective
of economic activity.
• Production: The business sector exists to combine the resources used for the
production of the goods that satisfy wants and needs of the household sector. If not for
the productive efforts of the business sector, consumption would be less satisfying.
• Regulation: The macroeconomic function performed by the government sector is
regulation. The government sector establishes the "rules of the game" and regulates
resource allocation decisions of the other sectors.
• External: The foreign sector is responsible for any and all economic activity that
transpires beyond the political boundaries of the domestic macro economy. It is
responsible for all external activity, which directly or indirectly affect national output.
Linkage between the Macroeconomic Sectors
First, the household sector includes all of the consumption-seeking members of society--the
entire population. In effect, the economy exists to satisfy the wants and needs of the
household sector. Secondly, the household sector owns all of the factors of production, all
resources. Every resource, every worker, every factory, every acre of land, every risk-taking
entrepreneur is all owned by someone in the household sector. Lastly, the business and
government sectors exist to address the wants and needs of the household sector. The
business sector uses the resources owned by the household sector to produce the goods and
services consumed by the household sector. The government sector oversees the provision of
public goods and regulates economic activity so that the wants and needs of the household
sector are satisfied.
MACROECONOMIC MARKETS:
There are three sets of markets that make up the macro economy--product, financial, and
resource markets. These markets exchange three primary types of macroeconomic
commodities which include gross production, legal claims, and factor services. The four macro
economic sectors--household, business, government, and foreign--interact through these three
sets of markets.
• Product Markets: The product markets, also termed goods or output markets,
exchange the production of final goods and services, generally referred to as gross
domestic product. The buyers of this production are the four macroeconomic sectors--
household, business, government, and foreign. The seller of this production is primarily
the business sector.
• Financial Markets: The commodity exchanged through financial markets is legal
claims. Legal claims, or financial instruments, represent ownership of physical assets
(capital and other goods). Because the exchange of legal claims involves the counter
flow of income, those seeking to save income buy legal claims and those wanting to
borrow income sell legal claims.
• Resource Markets: The services of the four factors of production are traded through
resource markets. Resource markets, also termed factor markets, are used by the
business sector to acquire the factor services needed for production. Payment for
these factor services then generates income received by the household sector, which
owns the resources.
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EXPRESSIONS OF NATIONAL INCOME

a) Gross Domestic Product (GDP): This is the total value of goods and services produced
within a country's borders in a given period of time usually a year.
GDP = C + I + G
Where C: the household sector
I : The business sector
G: The government sector
b) Gross National Product (GNP): This is the total monetary value of goods and services
produced by nationals irrespective of where they are located excluding output by foreign
nationals in the domestic economy (net factor earnings from abroad). The GNP equals the
Gross Domestic Product plus income earned by domestic residents through foreign
investments (X) minus the income earned by foreign investors in the domestic market
(M). The (X – M) is also called the net foreign sector earnings, measured as the difference
between a nation’s value of exports and imports.
GNP = C+I+G+X-M
GNP = GDP + Net factor earnings from abroad
c) Net National Product (NNP)

This refers to Gross National Product minus depreciation.
i.e. GNP – Depreciation. NNP is a better proxy for estimating national income.
DEFINITIONS OF OTHER CONCEPTS
Disposable Income (Yd)
It is the amount of income available for an individual or household to spend after Tax plus
Transfer payments.
Yd = Y – T+ TR
Yd = Disposable income
Y = Gross income
T = Taxes
TR = Transfer payments that is, incomes from friends and relatives
MEASUREMENT OF NATIONAL INCOME

i) The Factor Income Method (Income Approach)
Under this approach, national income is calculated by adding up all the incomes accruing to
basic factors of production used in production of goods and services. The income method
records all the incomes received by each sector as a result of transactions that take place over
the period of time under consideration. This will include incomes received as wages and
salaries of employees and the self employed, money earned by corporations, money received
by the government from its activities, interest payments received, payments from rent and so
on.
i.e. NY = Rent + Wages + Interest + Profit in respect of the four sectors of the economy.
Therefore, NY= C+I+G+X-M. All transfer payments are excluded in national income
measurement to avoid double counting for example, gratuity and pocket money.
ii) The Expenditure Method
This is also known as the final product method. It measures national income at the final
expenditure stages. Expenditures include all money spent on goods and services at market
prices. These expenditures are computed and added to obtain the total value of products
finally sold. Hence, the expenditure approach involves aggregation of the household sector
expenditure (consumption), business firms’ expenditure (investment), government
expenditure (provision of social services) including net expenditure in the foreign sector (X-M).
NE=C+I+G+X–M
14
iii) The Value Added Approach/ the output method

All goods and services have a price. That price represents the value of the inputs that went
into the production of that item - land, labour, capital and enterprise. At each stage of the
production process therefore, the value of the output carried out can be recorded - this is the
value added.
We add the net value added at different stages in production of goods and services in an
economy per period of time. It is difficult to trace the intermediate stages under this
approach. The total value added is the price at which the commodity is sold .To avoid double
counting, it is only the net value that is added and not the intermediate values
Note: The three methods must yield the same results because the value of the goods and
services produced (O) must be equal to the total income paid to the factors that produced
these goods and services (Y) and the income paid to factors of production must equal to total
expenditures on goods and services (E)
Hence, O =Y=E
PROBLEMS OF NATIONAL INCOME MEASUREMENT
1. Definition of income: It is difficult to separate income that accrues to factors of
production arising from economic activity and the transfer payments.
2. The problem of double counting: Difficulty of differentiating between intermediate and
final goods especially in the product approach.
3. Errors of Omissions: This is due to insufficient statistical data. Some economic activities
are not considered (domestic related activities).
4. Errors of Commission: These arise because values of certain activities are not estimated
for example, effect of pollution and rate of exploitation of resources. These affect national
income figures.
5. Some of the transactions are informal and therefore not recorded for example, smuggling
6. Large subsistence sector (barter exchange)
7. It is a very expensive venture (inadequate funds)
8. Inadequate qualified personnel (statisticians , economists, etc)
IMPORTANCE OF NATIONAL INCOME

1. Used for policy analysis for example, policy on inflation, unemployment, exports and
imports.
2. For comparison purposes in respect of economic performance between two periods in
time.
3. For purposes of estimating Per-Capita Income
4. The information helps us to show the distribution of income among different sectors of the
economy for example, the Household Sector, the Business Sector, government etc
5. For budgeting purposes, allocation of resources to different sectors
6. Comparison in standard of living over time
7. Comparison of standard of living between two countries
8. To compare sector contribution to national economy.
NATIONAL INCOME AND WELFARE

Per-capita income refers to income per head of a given population.
It is denoted as Total National Income
Total Population
It may be used to determine the standard of living (welfare) of a given population.
Limitations of Using Per-Capita Income as a Measure of Standards of Living

i) Doesn’t take into account the type of goods produced. Some goods do not directly
improve on human welfare but increase national income and hence per capita income.
15
ii) Per Capita Income takes no account of the inputs used to produce the output. For
example, if everyone worked for twice the number of hours, then GNP might roughly
double, but this does not necessarily mean that workers are better off as they would
have less leisure time. Similarly, the impact of economic activity on the environment is
not directly taken into account in calculating GNP.
iii) Movements in exchange rates may distort comparison of Per Capita Income from one
country to another.
iv) Per Capita Income does not take into account many factors that may be important to
quality of life, such as the quality of the environment and security from crime, This can
lead to distortions - for example, spending on cleaning oil spill is included in GDP, but the
negative impact of the spill on well-being are not taken into account.
v) The per-capita income statistics does not consider income distribution. Some times total
national income or population may be wrongly estimated.
vi) Doesn’t consider the cost of living (prices for goods and services).
vii) Inflationary tendencies make comparison in standard of living very difficult.
SECTORS OF THE ECONOMY
There are basically FOUR sectors of the economy and these include;
 The household sector (C) Consumers
 The business sector (I) Investors
 The government sector (G) Government
 Foreign sector (X- M)
a) The Household Sector
This sector supplies labour as a factor of production and also contributes to government
revenue through taxes. Earns income from the business sector and all this income is spent of
purchase of goods and services that the business sector provides.
b) The Business Sector
It is composed of all the business units in the economy. It performs the functions of resource
mobilization, distribution and allocation. Provides employment opportunities to the HH sector
and contributes to government revenue through taxes.
c) The Government Sector
It allocates resources to most productive sectors especially of basic nature. It distributes
income through taxes and transfer payments. It also performs the function of economic
stabilization through macro economic management.
d) The Foreign Sector
It is concerned with international capital flow i.e. the relationship between domestic
investment abroad and foreign investments within the domestic economy. It also brings
foreign currency into circulation and provides employment opportunities to the household
sector.
CIRCULAR FLOW OF INCOME AND NATIONAL INCOME ACCOUNTING
National Income refers to the total monetary value of all the goods and services produced by a
nation during a specified period. It is the final outcome of all economic activities of a nation
expressed in monetary terms for a given period of time, usually one year. Two things must be
noted about this definition of national income, first, that it measures market value of annual
output i.e. national income is a monetary measure. Secondly, for calculating national income
accurately, all goods and services produced in any give year must be counted only once.
The simple circular flow of income

The simple circular flow of income shows the relationship between the Household (HH) and
Busies sector (I). Specifically, it explains the flow of factors of production from the (HH) Sector
16
to the business actor and goods and services from the business (I) sector to the (HH) Sector
and payments for them.
Illustration
The real flow of goods and services is shown in the illustration above. In the upper loop,
resources such as land, labor, capital and entrepreneurship flow from households to business
firms, in the opposite direction, money flow from business firms to the households as factor
payments such as wages, rent, interest and profits. In the lower part of the illustration, money
flow from households to firms as consumption expenditure made by households on the goods
and services provided by the firms, while the flow of goods and services is in the opposite
direction i.e. from businesses to households. Thus there is in fact, a circular flow of money or
income which will continue indefinitely.
This flow of money does not always remain the same in volume, e.g. in a year of depression,
circular flow will contract i.e. money flow become less in volume while during the years of
prosperity, it will expand. This is so because the flow of money is a measure of national income
and therefore it changes with the changes in national income
The assumptions made here are

i) Neither households save from their incomes nor the firms save from their profits
ii) The government does not play any part in the national economy i.e. it doesn’t receive
any money from the people by way of taxes, nor does the government spend any money
on goods and services produced by the firms or on the resources and services supplied
by the households
iii) It is a closed economy
Injections and leakages

Savings are a leakage from the economy, investments are an injection into the economy
Keynesian Theory of National Income determination
The Two-Sector Model (The Keynesian equilibrium) under aggregate demand and
aggregate supply functions
According to Keynes, the equilibrium income under the two sector model is determined where
aggregate demand (AD) equals aggregate supply (AS)
Aggregate supply refers to the total value of goods and services produced and supplied in the
economy per unit of time. Aggregate demand refers to the total value of goods and services
purchased in a given economy per period of time. If all that is produced is sold, then
aggregate supply grows at a constant rate of increase in income (Y).i.e AS =Y but Y= C + S.
I.e. AS=Y=C+S
Aggregate Supply Function
Agg SS Agg SS = Y=C + S
17
Income/ output
Aggregate Demand Function
In a two-sector model, aggregate demand is composed of demand by the household sector
and the business sector. I.e. it has two components.
i) Aggregate demand for consumption goods (C) dd by the hh

ii) Aggregate demand for capital goods (I) dd by the businesses
AD = C + I
In Keynesian theory framework, consumption is a function of income i.e. C = (Y).
However, the consumption function may be denoted as C = a + bY
Where a = Consumption at zero income i.e. autonomous consumption
(Autonomous consumption)
b= the marginal propensity to consume.
The Consumption Function
Investment Function
According to Keynes, investment is said to be Autonomous. I.e. The level of investment doesn’t
depend upon the level of income. I = Io
I
Io
I
Y
O
Determination of national income in a two, three and four sector model
MONEY AND BANKING
Definition of Money
Money can be defined as anything which is widely accepted in payment for goods and services
or in the discharge of other business obligation
The earliest form of exchange was done using the barter system which is the exchange of
goods for other goods. Various problems however were faced by people in the barter economy,
in other words, in a purely barter system, there was no generally acceptable medium of
exchange in the form of a particular good or asset which could be used to buy goods and
services and carry out other forms of transactions. Some of The problems of the barter system
were
18
1) double coincidence of wants;

2) lack of a standard unit of Account
3) impossibility of division of goods
4) lack of information
5) production of very large and costly goods was not feasible
Evolution of money
Commodity Money: many years ago, various commodities were selected as a medium of
exchange and thus came to be used as money. Sea shells, beads, furs , cowrie shells, skins etc
were adopted as money at different times in the early stages of development. With further
development in the pastoral stage, animals such as cows, goats, sheep started being used as
money. The use of animals as money suffer some disadvantages, first is that they all were not
identical and so could not serve as a standard unit of measurement, secondly, the supply of
these animals was subject to large and abrupt fluctuations, thirdly, animals cannot serve as a
satisfactory store of value
Metallic Money: with view of the above limitations of using animals as money, and with
further progress in human civilization, animals and ordinary commodities were replaced by
precious metals such as gold and silver as money. The advantage of using such metals as
money is that they are easily handled and stored, they do not deteriorate, they have just the
right degree of scarcity and they can be relied upon neither to increase nor decrease in
quantity except gradually. With the evolution of coins, it’s the gold and silver coins that came
to be used rather than simple bits and pieces of gold and silver whose value could not easily
be determined. It’s important to note that precious metals were used as money not because
they were valuable but because they were scarce. For a thing to serve as money scarcity is
more important than value- these days it is the scarcity if paper money that is responsible for
its efficiency as money
Paper money: as it came to be realized that for sound money, scarcity is more important
than value, precious metals were replaced by paper money. Paper money took the form of
bank notes
Bank deposits as money: in the developed countries the main type of money is not paper
notes issued by the central bank but the bank deposits which people hold with the commercial
banks and against which cheques can be drawn or credit and debit cards used. They serve as
money because through drawing cheques on them, they can be used to make payments for
good and services
Types of Money
• Coins: These are metallic monies. They are less than full-bodied because their
intrinsic (metallic) value is less than their face value.
• Currency notes: these are merely pieces of paper that have no intrinsic value of
their own.
• Deposit money: These are not like coins or currency notice. Deposit money is
treated as demand deposits of commercial banks on which cheques can be drawn
as money.
Coins and currency notice are legal tender, they serve as money on the order of
government i.e. under the law of the land, the money in question must be accepted in
settlement of all kinds. This is not true of demand deposits of payment because a payee
can legally refuse to accept payment made through a cheque and insist on payment in
19
cash. This is because there is no guarantee that the cheque will be accepted at issuer’s
bank.
Measures of money supply

Broadly money is characterized into two; i.e. narrow money and Broad money
• Narrow money M1 = CC + DD
Where CC = currency in circulation
DD = Demand deposits held by commercial banks
• Broad money M2 = M1 + TD + SD
Where M1 is narrow money
SD = Savings
TD = Time deposits
In the case of developed economies, money is defined as M3 = M2 + FD, where FD =
Foreign Deposits.
Qualities of Good Money

• Acceptability; money must be acceptable by everyone. i.e. People should have
confidence in it.
• Durability; money must be long lasting. This implies therefore that perishable items are
vulnerable to deterioration in physical quality and value; they cannot as such serve as
money.
• Divisibility; money should be divisible into smaller denominations or units in order to
enable the payment of smaller debts.
• Portability; money should be easily carried (portable) or transferable from one place to
another.
• Homogeneity; money should be similar in looking and nature in order to enable it to be
easily recognized. Change of materials out of which money is made can encourage forgery
for money.
• Scarcity; items used, as money must be generally scarce and difficult to obtain. This will
make money retain its value and services as a store of wealth.
Functions of Money
There are four major functions of money
1) A medium of exchange.
2) A measure of value
3) A standard of deferred payment
4) A store of value
The Central Bank and its functions

The central bank is the monetary authority of a country and aims at promoting economic
stability and development; it enjoys special status in the banking structure of the economy.
The principles on which it is run differ from ordinary banking principles. As ordinary banks are
run for profits, a central bank is primarily meant to promote financial and economic stability in
the country. The guiding principle of a central bank is that it should act only act only in the
public interest and for the welfare of the country without regard to profit as a primary
consideration. Earning profit for s central bank is thus a secondary consideration
Functions of Central Banks

• Issuing currency
20
• Acts as a banker to the country

• It acts as a banker to other banks
• It is a lender of last resort
• It regulates the interest rate
• It controls credit
• Etc
The demand for money, supply of money and interest rate of money is manipulated by the
central bank to see that its objectives are achieved. To do this, it uses the Monetary and fiscal
policies
Tools of the Monetary Policy

1) Bank rate: this is the minimum interest rate at which the central bank provides loans
to commercial banks. Through changes in the bank rate, the central bank can influence the
creation of credit by commercial banks through altering the cost of credit and thus the demand
for credit by the public
The extent to which this policy is effective largely depends on;

 The degree of dependency of commercial banks on borrowed funds. The policy may
therefore fail if commercial banks are in possession of excess reserves.
 How much commercial banks can borrow from other sources. The policy therefore
maybe ineffective if commercial banks have alternative sources to borrow from.
 The profitability in the market i.e. if firms expect high profitability then regardless of
the borrowing rate, borrowing shall continue.
2) Open Market Operations OMO: this refers to the purchase and sale of government
securities (treasury bills and bonds) by the central bank to the public. Selling securities
to the market is contractionary i.e. reduces the aggregate demand. When the central
bank buys securities from the market, the policy is expansionary. This increases
money supply in the market and therefore aggregate demand.
3) Legal Reserve Ratio Requirement.

This is money commercial banks are supposed to deposit with the central bank. A
reduction in the reserve ratio will lead to an increase in the amount of deposits held by
the bank while an increase will decrease the available money to borrowers
4) Cash ratio/ minimum reserve requirement

Commercial banks have two functions to perform;
 Accept deposits from the public
 Lend these deposits
By law, banks have to keep a certain amount of cash with themselves as reserves
against the deposits. E.g. if the cash ratio is 20%, if a bank has 20B in deposits, it will
have to keep 4B as reserves. The central bank has the authority to vary the cash ratio
depending on what it wants to achieve, e.g., lower the cash ratio to increase money
available to borrowers and vive versa
5) Selective credit control

The policy dwells on the selection of those sectors in the economy that are responsible
for economic instability or those that need assistance economically, it undertakes
directives given by the central bank on to commercial banks to extend or not to extend
21
or if they must, it should be on a discriminatory basis with regard to priority sectors

(productive sectors) and unproductive sectors. Discriminatory credit extension is also
called credit rationing.
6) Moral suasion; it is where the central bank advises the commercial banks either to
lend or not depending on the economic situation to achieve the set target.
The Fiscal Policy
Here the central bank uses the tools of taxation and government spending to control the
amount in circulation
Commercial Banks
Commercial banks are business organizations that seek to maximize profit by essentially
dealing in credit or borrowing funds. They accept deposits from the surplus spending units and
make profits through lending to the deficit spending unit.
Functions of Commercial Banks

• They accept and provide custody of deposits from customers
• Advances loans and overdrafts to customers. These loans can be short term, medium
term or sometimes-long term. It is out of these loans that commercial banks create
credit.
• Facilitates easy and quick means of settling obligations by use of cheques, standing
orders, bank drafts etc.
• All commercial banks perform the important functions of creating credit.
• Provides custody for customers valuable possessions
• They provide employment opportunities.
INTERNATIONAL TRADE
What is International Trade?
International Trade is the buying and selling of goods and services across the national borders.
It deals with the economic interdependence among Nations. It analyses the flow of goods,
services and payments between a nation and the rest of the world. This economic inter-
dependence among Nations is affected by and in turn influences the political, social, cultural
and military relations among Nations.
Starting with simplifying assumptions just mentioned, international Economic Theory examines
the basis for and gains from Trade, the reasons for and the effects of trade restrictions, policies
directed at regulating the flows of international payments and receipts, and the effects of
these policies on a nation’s welfare.
Trade Based on Absolute Advantage

The law of absolute advantage states that a country will produce that commodity in which it
is more efficient compared to the other country and export it for that commodity in which it
is not efficient.
According to Adam Smith, for 2 Nations to trade with each other voluntarily, both Nations
must gain. If one Nation gained nothing (lost) it would simply refuse to trade. He therefore
contended that trade between 2 Nations is based on absolute advantages
If two Nations have absolute advantage in the production of one commodity each, both
nations can gain by such specializing in the production of the commodity of its absolute
22
advantage and exchange part of its output with the other nation for the commodity of its
absolute disadvantage.
This process utilizes resources in the most efficient way and the output of both commodities
will rise. This increase in output of both commodities measures the gain from specialization if
the production available is to be divided between the two nations through trade. E.g. suppose
Uganda is efficient in growing bananas but inefficient in growing maize and Kenya is efficient
in growing maize but inefficient in growing the production of bananas. Then Uganda has
absolute advantage over Kenya in the production of bananas but an absolute disadvantage in
the production of maize and vice versa.
Under such circumstances both nations would benefit if each specialized in the production of a
commodity of its absolute advantage and then trade with the other nation.
In this case, Uganda would specialize in the production of bananas and produce more than
what is needed domestically such that it could exchange the surplus for maize produced by
Kenya. As a result more wheat and more bananas will be grown and consumed and both
countries will gain.
Illustration of the law of Absolute Advantage
Assuming one hour of labor time produces 6 tones of bananas in Uganda and only 1 tone in
Kenya. On the other hand 1 hr of labor produces 5 tones of maize in Kenya but only 4 tones in
Uganda. This means that Uganda is more efficient or has absolute advantage over Kenya in
the production of bananas while Kenya is more efficient or has absolute advantage over
Uganda in the production of maize.
With trade, Uganda would specialize in the production of bananas and exchange the surplus
with Kenya and likewise Kenya would specialize in the production of maize and exchange the
surplus with Uganda.
Illustration
Table 1 Kenya
Uganda
Bananas 6 1
Maize 4 5
From the table above, if Uganda exchanges 6 tones of bananas for 6 tone of maize with Kenya,
Uganda gains 2 tones of maize or saves ½ hours of labor since Uganda can only produce 6
tones of bananas and 4 tones of maize domestically. Similarly, the 6 tones of bananas that
Kenya receives from Uganda would require Kenya 6 hours to produce. Kenya would instead
use these 6 hours to produce 30 tones of maize (6hrs x 5tones). By being able to exchange 6
tones of maize for 6 tones of bananas from Uganda, Kenya gains 24 tones of maize.
The fact that Kenya gains much more than Uganda is not important at this time, what is
important is that both nations benefit from specialization in production and trade.
Absolute advantage however explains a very small part of world trade today such as trade
between developed and developing countries. It does not explain most of the trade especially
among developed countries.
Because of such inadequacies in the theory, David Ricardo came up with the law of
comparative advantage, which truly explains the basis for and gains from trade.
23
Trade based on comparative advantage

David Ricardo came up with the law of comparative advantage that truly explains the basis for
and gains from trade.
The law of comparative advantage is one of the most important and still un-challenged laws of
economics with many practical applications.
According to this law even if one nation is less efficient than the other (has absolute
disadvantage) in the production of both commodities there is still a basis for mutually
beneficial trade.
The first nation should specialize in the production and export of the commodity in which its
opportunity cost is less compared to another i.e. a commodity of which its comparative
advantage is greater.
Table II Uganda Kenya

Bananas 6 1
Maize 4 2
According to the above information, Uganda has a comparative advantage in production of

bananas in which it incurs less opportunity cost while Kenya has it in maize production.
Therefore, Uganda will specialize in production of bananas and export part of it to Kenya while
Kenya will specialize in production of maize in which it has a comparative advantage and
export part of it to Uganda.
To prove the law of comparative advantage, you must show that both Uganda and Kenya can
both gain by each specializing in the production and exportation of the commodity of its
comparative advantage. E.g. suppose Uganda receives 4 tones of maize from Kenya in
exchange for 6 tones of bananas, Uganda would be indifferent to trade since it can produce 4
tones of maize domestically and definitely Uganda will not trade if it receives less than 4 tones
of maize for 6 tones of bananas.
Similarly, Kenya will be indifferent to trade if it had to give up 2 tones of maize for each tone of
bananas it would receive from Uganda and certainly it would refuse to trade.
To show that both nations can gain, we suppose that Uganda can exchange 6 tones of bananas
for 6 tones of maize from Kenya, thus Uganda gaining 2 tones of maize. Kenya would also gain
if we consider the fact that the 6 tones of bananas it receives from Uganda would require it 6
hours of labor to produce. Kenya could instead use these 6 hours to produce 12 tones of maize
and give up only 6 tones of maize for 6 tones of bananas it receives from Uganda. Thus Kenya
would gain 6 tones of maize.
Once again the fact that Kenya gains much more from trade than Uganda is not important at
this point, what is important is that both nations can gain from trade even if one of them in this
case Kenya is less efficient than the other in the production of both commodities.
Free Trade vs. Protectionism
Free trade is based on the principle of non-interference by the government in the foreign
trade. The government neither helps nor hinders the movements of goods and services
between countries. With free trade, the distinction between domestic and international trade
disappears.
24
Protectionism on the other hand refers to the artificial barriers created to restrict the
international flow of goods and services. Protectionism takes various forms
i) Imposition of import tariffs. These may be customs or fees paid to import certain goods
into a country
ii) Imposition of quotas. This is the direct restriction on the physical amount of a commodity
that can be imported into a country
iii) Total ban. Here the government completely stops the importation of a certain
commodity
iv) Manipulation of the exchange rate. This is done to encourage or discourage imports
Advantages of International Trade

1) Gains in output and well being from specialization. This is based on the gain that a
country realizes from production of those goods in which it is relatively more efficient
and exporting part of them and in exchange getting those goods in which it is not
efficient from other countries
2) Gains from economies of scale

Trade enables countries to benefit from economies of scale- i.e. advantages because of
large scale production. If a country does not trade with others, its firms will produce
goods to meet the domestic demand; if domestic demand is small then each of them
will produce at a higher cost since they would not be able to enjoy economies of scale.
Thus trade expands the market for goods and enables the producers to enjoy
economies of scale
3) It promotes competition and prevents Monopoly

The case for free trade also rests on the fact that it promotes competition and prevents
the emergence of monopolies in the domestic economy the absence of trade and
therefore without facing any competition from foreign firms, domestic firms tend to
become inefficient which causes rise in costs per unit of output and therefore higher
prices of goods
4) Political gains from free trade

Free trade as seen from the above points increases well-being or standard of living of
the trading countries and this mutual welfare gains from trade make different
countries economically dependent on each other. The economic interdependence
lowers the likelihood of hostility between countries. Economic interdependence
provides powerful incentives for peaceful solution of disputes
Disadvantages of International Trade

i) Infant industry argument. The core of this argument is that industries in their infancy are
not mature enough to with-stand competition from highly developed and well
established industries e.g. of developed nations which have achieved a high level of
technical efficiency, economies of scale and financial strength as they would run the risk
of dying out in their infancy. The infant industries therefore need tariff protection until
such a stage when they have attained competitive strength.
ii) Nationalism. The argument for this is patriotism or nationalistic feeling. I.e. people of a
country should buy products of their domestic industries rather than foreign products.
I.e. be Ugandan, buy Ugandan, such a campaign appeals to Ugandans to buy locally
produced goods instead of imported goods
iii) Diversification of industries. The need for diversification of industries or balanced growth
of the economy in the long run is another argument fro protection. The theory of
25
comparative advantage encourages specialization in areas where countries are most

suited, this however would be a disadvantage say during a time of war, economic
upheaval, political rivalry exists between countries, etc.
iv) Anti dumping argument. Another important argument for protection is that foreign
producers compete unfairly by dumping cheap goods in another country. Dumping is a
form of price discrimination when producers of a country sell goods in another country at
lower prices than those charged in their home countries. The consumers in the country in
which the goods are dumped will benefit but the industries of the country suffer as they
are not able to compete with the dumped goods. There is even a more harmful case of
predatory dumping which implies that foreign firms try to sell goods in other countries
even below the cost of production to establish a world wide monopoly by driving
competitors out of the market. Once the local industries are out competed, they raise
prices to obtain monopoly profits.
v) Employment. Protection leads to increase in domestic employment or at least preserves

present domestic employment. It is often believed that imports of goods from abroad
reduce domestic employment. Besides. if the prices of imported goods are lower than
those locally produced, domestic producers will not be able to compete with them and
may be forced out of the market. This will destroy even present jobs in the domestic
industries.
26

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Introductory Economics Reading Materials for BSc.

Industrial Chemistry Semester One AY 2009/2010

where: Q = quantity of production or output, L = quantity of labor input, and K = quantity of

Production Time Periods

Factors of Production and Product Output

The stages of production

The law of diminishing returns,

Examples of implicit costs

Relationship between TC, TFC and TVC

Relationship between the short run costs

Economies Vs Diseconomies of Scale

a) Economies of scale characterizes a production process in which an increase in the scale

Note: Economies of scope are conceptually similar to economies of scale. Whereas

6.0 MARKET STRUCTURES

Market Perfect Monopolisti Perfect Differentiat Pure

A perfectly competitive market is characterized by a large number of firms, each producing an

Short Run Equilibrium under Perfect Competition.

Long Run Equilibrium Under Prefect Competition.

government itself operates it, it is government or state monopoly. A government monopoly

Macroeconomics is the study of the aggregate economy, or the macro economy. it is

The most important problems--unemployment, inflation, and stagnant production--relate to the

Unemployment, commonly measured by the average unemployment rate, indicates the

• Household Sector: This sector includes the entire, wants-and-needs-satisfying and

Macroeconomic Functions of the Different sectors

• Consumption: The primary macroeconomic function of the household sector is the

Linkage between the Macroeconomic Sectors

EXPRESSIONS OF NATIONAL INCOME

GNP = GDP + Net factor earnings from abroad

c) Net National Product (NNP)

MEASUREMENT OF NATIONAL INCOME

iii) The Value Added Approach/ the output method

IMPORTANCE OF NATIONAL INCOME

NATIONAL INCOME AND WELFARE

Limitations of Using Per-Capita Income as a Measure of Standards of Living

The simple circular flow of income

The assumptions made here are

Injections and leakages

Agg SS Agg SS = Y=C + S

i) Aggregate demand for consumption goods (C) dd by the hh

MONEY AND BANKING

1) double coincidence of wants;

Measures of money supply

Qualities of Good Money

The Central Bank and its functions

Functions of Central Banks

• Acts as a banker to the country

Tools of the Monetary Policy

The extent to which this policy is effective largely depends on;

3) Legal Reserve Ratio Requirement.

4) Cash ratio/ minimum reserve requirement

5) Selective credit control

or if they must, it should be on a discriminatory basis with regard to priority sectors

Functions of Commercial Banks

Trade Based on Absolute Advantage

Trade based on comparative advantage

Table II Uganda Kenya

According to the above information, Uganda has a comparative advantage in production of

Free Trade vs. Protectionism

Advantages of International Trade

2) Gains from economies of scale

3) It promotes competition and prevents Monopoly

4) Political gains from free trade

Disadvantages of International Trade