Notes

Unlimited Wants

In order to arrive at the definition of economics, an important fact that should be

remembered is that society’s material wants and needs are unlimited. However, resources,
i.e. the means of production or the means of acquiring goods and services are limited or
scarce.

SCARCITY

Scarcity is a basic problem that affects both the rich and the poor. Resources everywhere in
the world are scarce. Resources are all over the world are limited, while on the other hand
human wants are unlimited. All resources everywhere in the world are insufficient, they
are not enough to satisfy the wants off all the people to the point of total satisfaction.

In economics, scarcity is defined as the condition of human wants and needs exceeding
production possibility. In other words, society does not have sufficient productive
resources to fulfil all its wants. Alternatively, scarcity implies that not all of society’s goals
can be fully attained at the same time, so that trade-offs are made of one good against the
other.

And because resources are scarce people have make choices on how they are going to use
the scarce resources, to satisfy human wants. There is no society in the world that has all
that it wants at any given time.

Definition

Economics therefore can be defined as a social science that studies how individuals and
society chooses to use the scarce resources, to satisfy human wants. Or, Economics is a
social science that studies the production, distribution, and consumption of goods and
services.

Economics hence is about making choices on limited resources against unlimited wants. It
tries to strike a balance about managing limited resources to satisfy everyone’s wants.
WHY STUDY ECONOMICS

We study economics to understand how the distribution of wealth of the country also the
production of goods and services in order to improve the welfare of the people.

The Central Economic Problem

There are many economic problems that that we encounter every day. In summary every
economic set-up has to answer the three basic questions.

1. What to produce? What is to be produced with the scarce resources

2. How should be it be produced? Given that we have basic resources of land, labour,
and capital, how should we combine them to produce the goods and services that
will satisfy our wants?
3. To whom shall it be produced to? Once we have produced these goods and services,
to whom are we distributing them to?

MICRO and MACRO Economics

Economics is divided into two major branches. There is micro economics and macro
economics

Micro Economics

Micro economics is broadly concerned with the behaviour of individual firms, and the
behaviour of individual economic decision-making units, that is firms and households.
Firms choices about what to produce and how much to charge, and the household’s choices
about what to buy and how much to buy, helps to explain why the economy produces the
things that it does. Another big question addressed by micro economics is who gets the
things that are produced. Wealth households get more than poor households and the forces
that determine this distribution of output are the province of micro economics.
Macro Economics

Macroeconomics on the other hand looks at the whole economy. Instead of trying to
understand what determines the output of a single firm or the consumption patterns of a
single household, macroeconomics examines the factors that determine national output, or
national product. Its looks at the aggregate economy.

Opportunity Cost

What happens in an economy is the outcome of thousands of individual decisions.

Households must decide how to divide their incomes among all the goods and services
available on the market. People must decide whether to work or not to work, whether to go
to school or not, and they must decide how much to save or not. Businesses must decide
WHAT to produce, HOW to produce it, and to WHOM it should be produced.

All decisions involve trade off. The full cost of making a specific decision includes what we
must give up by not making the alternative choice. The best alternative that we forgo or
give up, when we make a choice is called the OPPORTUNITY COST of the decision.

The opportunity cost of going to a movie is the value of other many things that you could
have done with the same money and time. Part of the opportunity cost of coming to college
is the income you could have earned by working full time instead of coming to school. In
making everyday decisions it is important to think of the opportunity cost.
The Production Possibility Curve or Frontier (PPF or PPC)

The PPF illustrates the principle of constrained choice, opportunity cost and scarcity. The
PPF is a graph that shows all the combination of goods and services that can be produced if
all of society’s resources are used efficiently.

Diagram of PPF

Definition of 'Production Possibility Frontier - PPF'

A curve depicting all maximum output possibilities for two or more goods given a set of
inputs (resources, labor, etc.). The PPF assumes that all inputs are used efficiently.

As indicated on the chart above, points A, B and C represent the points at which production
of Good A and Good B is most efficient. Point X demonstrates the point at which resources
are not being used efficiently in the production of both goods; point Y demonstrates an
output that is not attainable with the given inputs.

According to the diagram, on the Y-Axis we measure the quantity of capital goods
produced, and on the X-axis we measure the quantity of consumer goods. All points below
and to the left of the curve represents a combination of capital and consumer goods that
are possible for society given the resources available and existing technology.

Points above and to the right of the curve such as point Y represents combinations that are
cannot be reached or not possible because of scarce resources that society has.

If the economy was to end up at point A on the graph, it would be producing capital goods
only and no consumer goods. If the economy were to end up at point B, it would be
devoting all of its resources to the production of consumer goods and none of its resources
to the formation of capital goods.

Points that are actually on the PPF, are points of full resources employment and production
efficiency – production efficiency is a state in which a given mix of output is produced at
least costs. Resources are not going to waste or unused. Points that lie inside the curve and
to the left of the curve represent either, unemployment of resources or production
inefficiency. An economy producing at point D on the graph, can produce more capital and
consumer goods for example by moving to point E, this is possible because resources are
not fully used at point D.

Therefore the PPF illustrates a number of economic concepts. One of the most important is
opportunity cost. The opportunity cost of producing more capital goods means producing
less or fewer consumer goods. Moving from point E to point F, the number of capital goods
increases from 550 to 800 units, but the number of consumer goods decreases from 1, 300
to 1, 100 units.

It is however important to note that an economy can start producing at points such as G in
the diagram. This happens during times of economic growth and when there is an
improvement in the existing technology or the state of the art. This means that the entire
PPF will shift to the right indicating an increase in production. Economic growth is
characterized by an increase in total output of an economy. It occurs when society acquires
new resources or when society learns to produce more with the existing technology. The
production and use of new machinery and equipment increase workers’ productivity.
Improved productivity also comes from technological advances and innovation, and the
discovery and application of new and efficient production technics.

Firms and Households

Firms are the primary producing units in an economy, and households are the primary
consuming units in an economy.
Firms exists when a person or a group of persons decide to produce by transforming
inputs into outputs, that is, products sold on the market. Some firms produce goods and
others produce services. All firms exist to transform resources into things that people want,
and to make profit to their owners.

Households on the other hand are the consuming units in an economy. A household may
consist of a single person, or married couple with children or dependants. Households buy
what they want and what they can afford. Households make decisions presumably based
on taste and preference.

The Circular Flow Diagram

A useful way of seeing the economic interactions among the four sectors of the economy,
i.e. households, firms, the government, and the rest of the world, is a circular flow diagram.
The circular flow diagram shows the income received and the payments made by each.

Households work for firms and the government and they receive wages for their work. The
diagram shows a flow of wages into the household sector as payment for those services.
Households also receive interest on corporate and government bonds and dividends from
firms. Many other households receive other payments from the government such as social
security and welfare payments. Economists call these kinds of payments from the
government which the recipient does not supply goods and services or labour as transfer
payments.

Households spend by buying gods and services from firms and by paying taxes to the
government. These make the total payments paid by households. The difference between
the total receipts and total payments of the households is the amount that households save
or dis-save. If households receive more than they spend, then they save, if they receive less
than they spend then they dis-save. In the circular flow diagram, household spending is
shown as a flow out of the household sector. Saving by households is termed as a leakage
from the circular flow as it withdraws income or current purchasing power from the
system.

Firms sell goods and services to households and the government, these sales earn revenue,
which shows in the circular flow as a flow into the firm sector. Firms pay wages, interest,
and dividends to households, and they pay taxes to the government. These payments are
shown flowing out of the firm sector.
The government collects taxes from firms and households. The government also makes
payments, its buys goods and services from firms, pays wages and interest to households,
and also makes transfer payments to households.

Finally households spend some of their income on imports – goods and services produced
in the rest of the world. Similarly, people in foreign countries purchase (exports) goods and
services produced by domestic firms and sold to other countries.

One lesson of the circular flow diagram is that everyone’s expenditure is someone’s
receipts.

Summary

To produce goods and services, firms buy inputs (labour) from households. Households
earn their income by working, they supply their labour in the labour market to firms that
demand labour and pay workers for their time and skill. Households may also loan their
accumulated savings to firms for interest when households buy shares or stock in a
corporation. In the capital markets, households supply the funds firms use to buy capital
goods. Households may also supply land or other real property in exchange for rent in the
land market. Inputs into the production process are called factors of production, and
these are land, labour, and capital.

Economic Systems

There are basically three economic systems used in the world.

1. Command Economy
In a pure command economy, the basic economic questions are answered by the
central government directly or indirectly. Through a combination of government
ownership of state enterprise and central planning, the government either directly
or indirectly sets output targets, incomes, and prices. In a command economy, the
government also sets the wages and salaries of the workers. Everything in the
economy is determined by the central government.
However, planned economies have not fared well and the planned economies of the
Eastern Europe and the former Soviet Union have completely collapsed. China and
Cuba however remains committed to many principles of a command economy.
Zambia was a command economy during the first and second republic under first
president Dr Kenneth Kaunda, where all the means of production were controlled
and owned by the state, such ZESCO, United Bus Company of Zambia (UBZ), Zambia
Airways, Post and Telecommunication Corporation (PTC), etc

2. Laissez faire Economy – The Free Market Economy

At the opposite end of the command economy is the laissez faire economy. The term
laissez faire means, “allow them to do”, implies a complete lack of government
involvement in the economy. When the Movement for Multi Party (MMD)
government came into power in Zambia in 1991, they introduced a free market
economy or a liberalised economy., with such phrases as “government shall have no
business in business”. In this type of an economy, individuals and firms pursue their
own self-interest without any central direction or regulation from the government.
The sum total of millions of individual decisions determines the entire basic
economic outcome. The central institution through which a laissez faire system
answers the basic economic questions of what shall be produced, how it should be
produced, and for whom it shall be produced is the Market, a term that is used in
economics to mean an institution through which buyers and sellers

3. Mixed Systems, government and markets

In the real world set-up, pure command economy and laissez faire economies do not
exist. All the systems are mixed in some sense. There is no market economy that
exists without government involvement and government regulation. The US
government directly employs 16 percent of all workers, and taxes about 30 percent
of total income of the economy. The Zambian government redistributes income by
means of taxation and social welfare expenditures, and it regulates many economic
activities, like the setting up of the floor price of maize through the Food Reserve
Agency (FRA), government also determines the Value Added Tax (VAT), which has a
bearing on price and the general economy.
Theory of Demand and Supply

The theory of demand and supply examines the interaction of economic forces of supply
and demand and how they determine the market price of goods and services. Economists
study demand in order to understand consumer behaviour and the determination of price
levels. In the absence of government intervention, prices are determined by forces of
demand and supply.Supply and demand is perhaps one of the most fundamental concepts
of economics and it is the backbone of a market economy. Demand refers to how much
(quantity) of a product or service is desired by buyers. The quantity demanded is the
amount of a product people are willing to buy at a certain price; the relationship between
price and quantity demanded is known as the demand relationship. Supply represents how
much the market can offer. The quantity supplied refers to the amount of a certain good
producers are willing to supply when receiving a certain price. The correlation between
price and how much of a good or service is supplied to the market is known as the supply
relationship. Price, therefore, is a reflection of supply and demand.

Definition – Demand is the willingness and the ability to buy a commodity at a given price
and time. There are two types of demand, and that is, individual and market demand.

Individual demand for a commodity is defined, as the quantity of a commodity or good an

individual is willing and able to buy at a given price and time.

While market demand for a good X is the sum of all individual demands in the economy.

Theory of Demand

The theory of demand states that the quantity of goods and services people are willing to
buy depends on price. Quantity demanded is the amount of a good that a household would
buy at a current price in a given period.

The Law of Demand

The law of demand states that, the higher the price ceteris paribusthe lower the quantity
demanded, and the lower the price ceteris paribus, the higher the quantity demanded.
There is thus a negative or inverse relationship between quantity demanded and price. The
demand curve is drawn on the assumption that only price changes and all other factors that
affect demand remains constant or the same. We use the term ceteris paribus or remains
constant or remains the same because there are a number of factors that can affect the level
of demand, so to make a law, we should assume that other factors remain constant or are
not changing.

Table of the Demand Curve

There exists at any one time a definite relationship between the market price of a good and
the quantity demanded of that good. The relationship between market price and quantity
demanded is called the Demand schedule or demand curve.

Table

Price quantity demanded

Draw a demand curve and fit these figures

Demand Curve Slope Downwards

The law of the downward sloping demand curve states that, when the price of a good is
raised at the same time all other things being held constant, less of it will be demanded or
bought. If so many of a good is brought on the market, and all other things being held equal,
it can only be sold if the price is reduced or at a lower price because lowering the price
brings in new buyers, because many people now will be able to afford it.

It however be observed that certain goods do not obey the law of demand.

Sir Robert Giffen

He observed that there is a special kind of goods that do not obey the law of demand, and
he called them giffen goods. Giffen goods are a special kind of inferior goods whose demand
decreases as the price decreases. Examples are black and white television sets, salaula etc.

Thostein Veblen

Also Veblen observes that there are certain goods who demand increases when the price
increases. He called them Veblen goods. These are luxury goods with a snob appeal. Goods
of status, goods bought to display status quo, wealth or bought for their intrinsic value such
as expensive perfume.

Determinants of Demand

Other than price, the other determinants of demand are income (Y), price of related goods
(Pr), Taste(T), Change in Consumer Expectation (E), Advertisement, and population.
Income (Y) households with a higher income or wealthy can afford to buy more things than
those with less income. Those with higher income/wealth demand more things than those
with lower income. Goods for which demand goes up when income rises and for which
demand goes down when income is lower are called Normal Goods. Goods for which
demand tends to fall when income rises are called Inferior Goods. An increase in income
means an increase in buying or purchasing power hence buying more things. As
consumers’ income change, the demand for goods and services will change. For most
products, demand increases when consumers have larger incomes.

Price of Related Goods PR – Substitute Goods

Demand schedule or demand curves are drawn on the assumption that the prices of all
other related goods are held constant (ceteris paribus). When we draw the demand curve
for butter for instance, we assume that the price of margarine remains unchanged or
constant.

Related goods are those goods whose demand is interdependent. A change in the price of
one good shifts the demand to another good. If the price of butter goes up, people will stop
buying butter and then start buying more of margarine; hence the demand for margarine
will rise.

For complementary goods, goods that “go together”, a decrease in the price of one results in
an increase in the demand for the other, and vice versa. If the price of fuel goes down for
instance, people will demand or buy more cars.

When the price or a related good change, demand may increase or decrease. If products can
replace one another, then they are called Substitute goods. A change in the price of one
good will change the demand for its substitute. For example, if the price of chicken
increases, people will substitute chicken for its substitute and buy more beef. The demand
for beef will hence rise or increase.

When products are used with one another or go together, they are called Complements or
complementary goods. When the price of a product changes, the demand for its
complement will also change. For example, fuel and cars are used with one another. If the
price of fuel increases, people will purchase less cars, since fuel is used in cars, people will
buy less cars. The demand for cars will decrease.

Taste (t) and Preference

A change in taste in favour of a consumer product will lead to an increase in its demand.
Fashion can fall under this category. Changes in preference do manifest itself in consumer
behaviour. Some people prefer chicken legs, other meats, sausage etc. some prefer goods
while other prefer cats. Few years ago, few people in Zambia would take part in the inter-
company relay, but now several companies and people are taking part in sports activities,
hence increasing the demand for sports facilities. As consumers’ tastes or preferences
change, the demand for products will also change.

Change in Expectation (E)

Expectations of future relative prices play an important role in determining demand. If

suddenly there is an expectation of a rise in the future relative price of a good X, ceteris
paribus, then people will demand now demand for more of good X today for storage,
therefore increasing the demand and vice versa.

Changes in consumer expectation about the future can cause changes in the current
demand for a product. For instance, if people hear that there is a breakdown at Nakambala
Sugar company that will result in a shortage of sugar in the country, which will eventually
lead to a future increase in the price of sugar, so people will demand for more sugar today
for storage before the anticipated price increase.

Population

An increase in population in an economy leads to an increase in the number of buyers in

the market, therefore increasing the quantity of goods and services demanded. If more
buyers enter the market, the demand for the product will also increase.

Advertisement

If a good or service is well advertised, people will demand more of it than a good or service
that is not advertised.

Government Policy

If tax increases, for instance an increase in Pay As You earn (PAYE), or Value Added Tax
(VAT), disposable income is reduced and this will mean a reduction in the purchasing
power hence reducing demand for most commodities.

Movement Along the Curve and Shifts in the Demand Curve

The effects of a change in price of good causes a movement along a given demand curve.
The effects of changing the price of a good X ceteris paribus, can cause movements along a
given demand curve. A change in price causes a change in the quantity demanded. If only
price changes, quantity demanded will change – and this causes a movement along a given
demand curve. So a change in the quantity demanded is brought about by the change in
price only.

An increase in other factors of demand such as income, price of related goods, population,
etc, will cause an entire demand curve to change, the whole demand curve will shift to the
right to indicate an increase in demand or to the left to indicate a decrease in demand. A
reduction in a non-price factor of demand such as income etc will cause the entire demand
curve to shift to the right or to the left indicating an increase or a decrease in demand. The
change in demand is brought about by changes in non-price factors of demand, such as a
change in income, causing a shift in the demand curve, resulting in a new demand curve all
together.

Elasticity of demand

The principle of supply and demand enables us to ascertain the predictions about how
households and firms will behave in an event that prices changes. When the price of goods
rises for instance, households will purchase less of it and firms are likely to supply more of
it. The size or magnitude of these reactions can be very important.
Elasticity of demand measures the extent to which the quantity demanded of a good
responds to change in one of the factors of demand.

The main measures are price, elasticity of demand which measures the responsiveness of
the quantities demanded as the result of change in the price. The price elasticity of demand
is equal to the percentage in the quantity demanded over the percentage change in price.

Elasticity of demand = Percentage change in quantity demanded

Percentage change in price

The theory of demand states that quantity demanded and price inversely related.
Therefore, the price elasticity of demand is always negative, since an increase in price will
lead to a decrease in quantity demanded and a decrease in price will lead to an increase in
the quantity demand.

Categories or types of Elasticity of Demand

Demand is elastic if a small percentage change in price brings about a bigger or greater
change in the quantity demanded so as to influence total revenue. To increase revenue for
price elastic goods, have to increase/reduce the price so increasing demand.

Price elasticity of demand

Determine the price elasticity of demand if, in response to an increase in price of 10%,
quantity demanded decreases by 20%. Is demand elastic or inelastic?

Elasticity =(-1)*(%change in Quantity Demanded/% change in price)

Therefore, the answer to your question;

Elasticity=(-1)*(-20%/10%)

=-2

Since your elasticity is more than 1, the demand is elastic, which means that you actually
get less revenue when you increaseyour price.

Total revenue= Price X Qty Demanded

Demand is inelastic if a percentage change in price brings about a small change in the
quantity demanded so as to influence total revenue.

Demand is unitary inelastic if a percentage change in price brings about an exact

percentage change in the quantity demanded so as to influence total revenue.

Perfectly inelastic demand -demand in which quantity demanded dose not respond at all
to a change in price.
Perfectly inelastic demand

Perfectly elastic demand - demand in which quantity demanded drops to zero at the
slightest increase in price.

Perfectly elastic demand

THE RELATIONSHIP BETWEEN ELASTICITY AND TOTAL REVENUE.

TABLE
FACTPORS AFFECTING ELASTICITY OF DEMAND

EASY OF SUBSTITUTION- Goods that can easily be substituted by other related products
are said to have an elastic demand. Thus if the price of coffee rises, people will buy less
coffee and substitute it with tea, i.e. that is the demand for tea will rise as the demand for
coffee falls due to a price rise of coffee.

PROPORTION OF INCOME SPENT ON THE PRODUCT – when only a very small

proportion of one’s income is spent on the good e.g., matches, tooth pest, salt, e.t.c no great
effort is made to look for substitutes even if there is a price change, demand for such goods
is relatively inelastic. On the other hand if the income spent on the good is fairly large, a
rise in price would provide considerable incentive to look for substitutes.

PRICE OF OTHER GOODS- a rise in the price of a related product will have an effect on the
demand of the other good. Complimentary and substitute goods have such a tendency. A
rise in the price of butter will have an effect on the demand for margarine.

THE PERIOD OF TIME- there are long-run and short-run changes that affect demand.Since
it takes time to find substitutes or a change in the spending habits. Elasticity may be
greater, if the period of review is longer. The longer the price change persists, the greater
the price elasticity of demand.

NUMBER OF USES – if a product has numerous uses its demand is likely to be inelastic,
people will purchase it for one cause or the other. Products like salt, steel, oil will always
have demand.

OTHERS ELASTICITIES
While price elasticity of demand is the most important indicators of sensitivity of demand
and has many important applications, we must not ignore two other types of elasticities,
which are associated with change in conditions of demand.

INCOME ELASYTICITY OF DEMAND

Income elasticity of demand measures the degree of responsiveness of the quantity

demanded for a product due to a change income. A change consumer’s income will
normally lead to a change in the level of demand for some goods, and income of elasticity of
demand measures the extent of this change. It is denoted by the formulae:

INCOME ELASTICITY OF DEMAND =PERCENTAGE CHANGE IN QUANTITY DEMANDED

PERCENTAGE CHANGE IN INCOME

Income elasticity which will normally be positive is hardly of great importance as far as
individuals are concerned, but does have a significant explanation for particular goods to
be low (hence explaining in part the difficulties of developing countries in expanding the
markets for their agricultural products)and the income elasticity of demand from leisure
activities to be high (explaining in part the growth of private transport and continental
holidays). Products which have a positive income elasticity are called normal goods. In case
of inferior goods increase in disposable income will lead to decrease in demand so that
income elasticity of demand will be negative.

There are basically three types of income elasticity of demand, negative income elasticity of
demand positive income elasticity of demand, and zero income elasticity of demand.

Negative income elasticity of demand.

Negative income elasticity of demand means that when incomes increases demand is
reduced. This is true of inferior goods. The demand for inferior goods such as salaula cloths
is reduced when people’s income are raised.
Zero Income Elasticity

Zero income elasticity means that when the real income of the people are increased, the
demand remains unchanged.

Positive Income Elasticity

This means that as the real income increases the demand of the product also increases.

Cross Elasticity of Demand

Cross elasticity of demand measures the degree of responsiveness of the quantity

demanded of one good X to a change in price of another good Y. it is represented by the
formula –

Cross elasticity of demand = percentage change in qty demanded of good X

Percentage change in price of good y

Cross elasticity refers to substitutes and complementary goods. In case of substitutes

products, cross elasticity of demand will be positive; an increase in the price of good B will
lead to an increase in the demand for good A, and vice versa. As the price of apples rise, the
demand for pears increases.

In case of complementary products, the cross elasticity of demand will be negative; an

increase in the price of good

B will lead to a decrease in the demand for good A, and vice versa.
Summary

 A change in the quantity demanded comes is brought about by a change in price

only
 A change in demand is brought about by a change in the non-price factors of
demand
 A change in demand shifts the entire demand curve either to the right to indicate
an increase in demand or a shift to the left to indicate a decrease in demand; while a
change in the quantity demanded involves a movement along a given demand curve
and is cause by a change in price only.
 Demand curves are drawn on the assumption that non price factors of demand are
held constant
 If the price changes, there is a movement along a given demand curve and there is a
change in the quantity demanded, if other factors of demand such as income
changes, the entire demand curve will shift and there is a change in demand.

Utility and Demand

Utility is the capacity of a product or service to satisfy consumer wants i.e. the want-
satisfying power that a good or service posseses. Utility is the satisfaction someone gains
from consumption of a good or service. A person buys a product because it provides utility.
Any good has utility as long as consumption of it satisfies needs and wants. It is assumed
that in choosing amounts of a goods and services, a consumer will attempt to gain the
greatest possible utility subject to the size of his income.

Diminishing Marginal Returns

Marginal utility is the increase or additional satisfaction gained by consumption or use of

one more unit of something. The additional utility gained from the last unit consumed is
defined as the marginal utility of the product.

The major issue about the utility theory is that of diminishing marginal utility. The law of
diminishing marginal utility states that, as consumption of a good increases, we normally
expect individual satisfaction or utility to increase but it will do so at a diminishing rate. As
more and more of a good is consumed the less its utility it becomes, e.g. a consumer will be
willing to spend K5, 000 for an ice cream, if it offers him high utility. The second ice cream
will have less utility so that the consumer is only willing to pay K2, 000 for it. So, as
marginal as marginal utility increases there is a corresponding diminishing marginal
willingness to pay. A first cup of tea in the morning may provide someone with high level of
satisfaction. A second cup might also be very welcome buy unlikely to yield much utility as
the first, the third cup will provide an even lower level of satisfaction.

Total Utility

Total utility is the total utility obtained from the consumption of all goods and services
while marginal utility is the satisfaction obtained from consumption of the last unit.

The reduction in total utility from the consumption of a good or service as more is
consumed is what is referred to as diminishing marginal utility.

Supply

Supply is the quantity of goods and services that a producer is willing and able to make
available for sale at each price over a period of time. Market supply of a good is the sum of
the quantities of that good that individual firms are willing and able to offer for sale over a
period of time. Supply is the relationship between price and the quantity supplied.

Law of supply- states that the higher the price, ceteris paribus, the higher the
quantity supplied, and the lower the price, ceteris paribus, the lower the quantity
supplied. At higher prices, a larger quantity will generally be supplied than at lower prices
ceteris paribus. Thus there is generally a direct relationship between quantity supplied and
price, that is as the price rises, the quantity supplied also increases and vice versa.
Producer are normally willing to produce and sell more goods at a higher prices than at
lower prices ceteris paribus.

DRAW A DIAGRAM HERE ……………………..

The supply curve is upward sloping which shows a direct or positive relationship between
price and the quantity supplied other things being equal.

WHY A DIRECT RELATIONSHIP

THE THEORY OF INCREASING COSTS

As society takes more and more resources and applies them to the production of any
specific item, the opportunity cost for each additional unit produced increases at an
increasing rate. The law of increasing costs exists because resources are generally suited
for some activity , more and more units of it will have to be used to get the same increase in
output as we expand production.

Incentives for increasing production

Consider a situation in which nothing else increases except the price per tonne of wheat
obtainable in the market. If this occurs, farmers will find it more rewarding monetary than
it was before to spend more of their resources and time in the production of wheat than
they used to. They will switch more of their production to wheat. The farmer may even find
it more profitable to add the use of more labour and machinery to the production of wheat
because of its higher market price.

Determinants of supply

When the supply curves are drawn, only the price changes and it is assumed that other
things are held constant.

Price of inputs or factors of production.

IF one or more inputs prices fall, the supply will increase , that is , more will be supplied at
each and every price because the cost of production would have reduced, and the opposite
is also true, if the price of the factors production used by producers rise, so does the firm’s
costs of production. This will cause supply to fall as some firms will reduce output and
those with less efficiency enventually make losses and leave the industry.

Price of good x

As price of good x rises with all costs and the price of other goods unchanged, production of
x becomes more profitable. Existing firms will expand their output and supply and
eventually news firms will be attracted into the industry and increase supply.
The state of the Art (technology)

Supply curves are drawn on the assumption of a given technology or state of the art.
Technological advances will reduce the cost production and increase output margins. If
better production techniques becomes available, the supply curve will shift to the right
indicating and increase in supply.

Price of certain other goods

If the price of certain other goods say x should rise, with the price of y unchanged, some
firms producing y will change to x production.

Taxes and subsidies

Certain taxes, such as sales tax are effectively an additional to production costs and
therefore reduces supply. A subsidy will do the opposite ; every producer would get a gift
from government and thus reduce production costs and therefore increase supply. A
subsidy will do the opposite; every producer would get “gift” from government and thus
reduce production costs and increase supply.

Price Expectations

A change in the expectation of the future relative price of a product will affect a producer’s
current willingness to supply, just as price of expectation affect a consumer’s current
willingness to purchase. Farmers may withhold from the market part of their product if
they anticipate a higher price in the future.

DIAGRAM UNDER here ……………….

The increase in price will cause supply to increase or an extension in supply, while a
decrease in price causes contraction of supply. In both cases there has been a movement
along the supply curve as shown in the diagram. Thus a change in price of good results in a
change in the quantity supplied.
DIAGRAM

An increase or decrease in supply is caused by changes in the non-price factors of supply.

An increase in the cost of production for instance will decrease supply at any given price.
When there is a fall in the cost of production, there will be an increase in supply.

Thus they will be a shift in entire supply curve either to the right to indicate an increase in
supply or a shift to the left to indicate a reduction in supply.

Thus changes in the conditions of supply will result in a change in supply which will either
be an increase in supply or a decrease in supply.

SUPPLY CURVE

The supply curve of a good X shows the relationship between the price of a good X and the
quantity that a firm is willing and able to supply (sell) at a given price, holding other factors
constant.

SX=f (Px) ceteris paribus

Good x qty supplied

10 0

100
 200

300

20

30

40

In a competitive market where profit motive is a major objective of a firm the relationship,
between supply and price is direct, meaning the higher the price, ceteris paribus the higher
the quantity.

DIAGRAM

Movement Along and Shift in the Supply Curve

The effect of a change in price of a good x ceteris paribus will cause a movement on the
supply curve of the quantity supplied of a good x

DIAGRAM

A change in price will cause a movement along the supply curve, while a change in the non-
price factors of supply will cause a shift of the entire supply curve.

Diagram………….

A change in price leads to a change in the quantity supplied. A change in the non-price
factors or determinants of supply leads tom change in supply.

Elasticity of Supply
This is the measure of the extent to which the quantity supplied of a good responds to a
change in one of the influencing factors of suppl. In our case we shall concentrate on the
price of elasticity of supply. Price elasticity of supply is the measure of the change in the
quantity supplied due to changes in the price of a good. If producers are responsive, supply
is elastic, if on the other hand producers are relatively insensitive to changes in the price,
then supply is inelastic.

Price Elasticity of supply.

Price elasticity of supply shows how much the supply of good changes in response to the in
price. Price elasticity of supply measures the responsiveness of the quantity supplied of a
commodity to a change in its price. It is the percentage change in quantity supplied divided
by percentage in price.

HEREUNDER A FORMULAR.

If one percent increase in price elicits greater than one percent increase in the quantity
supplied, then supply is elastic. If on the other hand, a one percent increase in price causes
a less than one percent increase in price causes a less than one percent increase in the
quantity supplied, the supply is elastic. If a percentage increase in price equals the
percentage increase in the quantity supplied, we talk about unitary elastic of supply.

DIAGRAM…………..

Factors Affecting Elasticity of supply.

Time

A firm’s response to an increase in the price of a product x depends on its ability to shift
resources from the production of other goods. So, the longer the time allowed for
adjustment, the firms are able to figure out ways of increasing production in an industry.
The longer the time allowed, the more resources could flow into an industry through
expansion of existing firms.

We therefore talk about long run and short run price elasticity of supply.

Market periods.

Marketing period is the immediate period, so short a time that producers cannot respond
to a change in demand and price of goods they supply on the market.
There is insufficient time to change output, and supply is perfectly inelastic.

DIAGRAM.

Short Run

Short run is defined as the time period during which full adjustment has not yet taken
place. Not all factors are variable factors in the short run, at least one factor will remain a
fixed factor in the short run.

Long Run

This is time period during which firms have sufficient time to adjust fully to the change in
demand and price. Long run is the time period in which all factors are available. The time
which individual firms can expand, news firms can enter or leave the industry, new
machinery can be bought, land etc. Supply is more elastic in the long run.

DIAGRAM………..

The longer the time allowed for adjustment the greater the price elasticity supply. Consider
a given situation in which the price is P and quantity supplied Q. in the short run a vertical
supply scheduled S1S1. We assume that suppliers are unable to do anything in the very
short run even when there is a price increase to P1, therefore there will be no change in the
short run in quantity supplied, it will remain at Q. given some time of adjustment the
supply curve will rotate at price P to S2S2. The new quantity supplied will shift out to Q1.

Finally the long run supply curve is shown by S3S3. The quantity supplied again increases
out to Q2.

DIAGRAM………………

The longer the time allowed for adjustment the greater the price elasticity of supply.
Consider a given situation in which the price is P and quantity supplied Q. in the short run a
vertical supply schedule S1S1. We assume that suppliers are unable to do anything in the
very short run even when there is a price increase toP1, therefore there will no change in
the short run quantity supplied, it will remain at Q. given some time of adjustment the
supply curve will rotate at price P to S3S3. The quantity supplied again increases out to Q2.

DIAGRAM………………………….
Determination of market price

So far we have discussed the factors that influence the amounts that households demand
and the amount that firms will supply on the market.

In a free market, the price of a good or service is determined by the interaction of the forces
of supply and demand. Understanding how demand and supply interact is essential to
understanding how prices are determined in our economy and other economies where the
forces of supply and demand are allowed to work themselves out.

DIAGRAM…………………..

Equilibrium is a position where quantity demanded is equal to the quantity supplied at the
current price.

The diagram above shows that the market price for a particular good will be OP given the
existing demand and supply schedules. This is equilibrium price at the OQ will be demand
by consumers and supplied by producers. Equilibrium means a balance between sides of
market. Equilibrium in any market is defined as a situation in which the plans of buyers
and the plans of sellers exactly mesh or meet, causing the quantity demanded to equal the
quantity supplied at the price in a market place for goods services.

Price OP is the market clearing price at which there will be no excess surplus or shortage in
the market. Demanders are able to get all they want at the price; and suppliers are able to
sell the amount they want at that price. Any price above OP would result in a situation of
excess supply (supply would exceed demand); Any price below OP would result in a
situation of excess demanded (demanded would exceed supply). This is illustrated by the
diagram below.

Diagram

If the market price was K50, consumers would demand a quantity of 3 tons of a commodity,
but producers attracted by a high price on the market would wish to supply a quantity of 9
tons. Thus there is an excess of supply at this price as shown by the area of Es, Ed, Ds. This
situation would pressure the market price to fall to the equilibrium price at K30.
Excess supply or surplus, exists when the quantity supplied exceeds the quantity
demanded at the current price. When this occurs producers might offer discounts on their
goods or reduce prices to encourage people to buy.

If the market price was at K10, consumers would demand the quantity of 10 tons, but
producers would be willing or prepared to supply quantity of 2 tons only because of the
low price prevailing on the market. Thus there would be a shortage or excess demand at
this price as shown by the area Jo, Oe, Ej, indicating a state of excess demand. In this case
there would be pressure on the market to push the price to rise to the equilibrium price of
K30.

Excess demand or shortage exists when quantity demanded is greater than quantity
supplied at the current price. This is when demand outstrips supply. When excess demand
occurs in a market, there is a tendency for price to rise as demanders compete against each
other for limited supply.

Changes in Equilibrium Price and Quantity

When supply and demand curves shift, the equilibrium price and quantity changes.

We have seen that changes in the condition of demand and supply will cause more or
less of a good to be demanded or supplied at any price. The demand and supply
curves will shift to the right or to the left resulting in a new equilibrium price and
quantity demanded and supplied. The effect of the changes in the underlying
conditions of demand and supply as shown below.

Diagram : shift in equilibrium

If the original equilibrium was at E, an increase in the consumer disposable income, ceteris
paribus, will shift the demand curve to the right from d to d1, and this will result in a new
equilibrium position at point C. the price will increase from OP to Op1, and the quantity
supplied will increase from OQ to OQ2.

To take another example, if a rise in workers’ wages increased, this will mean an increase
in the cost or production for firms, then firms will reduce their output and then the supply
curve will shift to the left from S to S2. This will give a new equilibrium position at B. the
price would rise to OP1 and quantity supplied would fall to OQ1.

Production

Production is the process through which inputs are combined and transformed into
outputs. Firm vary in size and international organisation, but they all take inputs and
transform them into things for which there is some demand.

Production is the creation of wealth which in turn creates the welfare of society.
Economists are always faced with questions of

1. What shall be produced?

2. How shall it be produced?
3. For whom it should be produced?

In a free market or mixed economy, the decision to produce is entirely in the hands of the
private sector. The government only creates an enabling environment to enhance
production. In the quest to advance production, job creation will be increased.

The aim of all production is to satisfy human wants. Its purpose is to increase the economic
welfare of the people, that is, to raise the standard of living of the people by enabling them
to satisfy more fully a greater number of their wants. Economic welfare clearly depends in
first place on the volume production, and consequently to expand the volume of production
will generally increase economic welfare, and make possible to raise the standard of living.

The many different activities which lead to the production of goods and services can be
grouped into three broad categories.

 Primary production – this is carried out by what are generally known as extractive
industries because they extract natural resources from the Earth’s surface and from
the ocean. Primary industries therefore include farming, mining, oil extraction,
fishing etc.
  Secondary Production – this includes those industries which process the basic
materials into semi-finished and finished products. They are generally described as
manufacturing and construction industries.
 Tertiary production – industries in the tertiary sector do not produce any goods, but
they produce services. These services are supplied to firms in all types of industry
and directly to consumers. Examples of tertiary industries include banking,
insurance, law, education, transport and communication.

A Firm and its Objectives

A firm is a decision making production unit which transforms resources (inputs) into goods
and services (output) which ultimately are bought by consumers, the government, and
other forms.

The objectives of the firm includes

a. To maximize profits
b. To maximize sales.

The significance of the divorce between the ownership and the control of modern firms
has occupied many economists in that, the owners of large public companies, the
shareholders, delegate their authority to a board of directors who in turn place the
effective control of the company in the hands of professional managers. The interest of the
shareholders and the managers may diverge. The shareholders are presumably interested
in obtaining the maximum dividends possible over a reasonable time period which implies
that a firm should aim at maximizing its long term profits. The manager who though do not
necessary share profits or greater sales revenue which they feel bring them more prestige,
greater security or higher salaries. The managers can not forget about profits in order to
declare reasonable dividends to keep shareholders satisfied.

A firm has to decide what level of output to produce. This decision will in turn determine
the firm’s purchases of factor inputs and may also influence the price at which its output
can be sold. The firm’s production decision will be conditioned by the type of market it
operates in. some firms operate in highly competitive markets, such as mobile
telecommunication services, restaurants, foreign exchange dealing, agriculture, etc. A firm
operating in a perfectly competitive cannot charge a price higher than that of its
competitors, otherwise no one will buy its products.

Some firms dominate the market, each of which reacting to each other’s action thereby
constituting an oligopoly. A market dominated by two large firms producing a good is
called a duopoly.
A market dominated by one single firm producing a good for which there are no close
substitutes is called a monopoly e.g. ZESCO in Zambia

Types of Business

Sole Proprietor or One Man business

This is the most common type of firms. It is mostly a one man business venture. It is a small
scale operation employing at most a handful of people.

Advantages

The proprietor himself is normally in charge of the operation of the business, with the
effect that he is likely to be motivated as he benefits directly from any increase in profits. As
a one man business, it can provide a personal service to its customers and can respond
flexibly to the requirements of the market. Decisions can be taken quickly as the owner
does not take time to consult with any other directors as in a company.

Disadvantages

 The owner can not specialize in a particular function but must be a “jack of all
trades”.
 The finance available for expansion of the business is limited to that which the
owner can raise.
 There is no legal distinction between the owner and what the owner has, in other
words, he has unlimited liabilities, for any debt incurred by the business, so that in
the eventuality of bankruptcy, all assets e.g. his house and any other assets can be
liable to seizure.

One man business is common in retailing, farming, and personal services such as
hair dressing.

Partnership
An ordinary partnership contains from two to twenty partners. The main
advantages are:
a. More finance is likely to be available with the influx of partners, and
 b. Each partner may specialise to some extent e.g in the market production or
personnel function.
The major disadvantage is that of unlimited liability. As each member is
able to commit the other partners to agreements entered into,
others may suffer from the errors of one unreliable member.
Partnerships are often found in professions such as doctors, lawyers,
accountants, dentists, solicitors etc. Ultimately the upper limit on the
number of partners is likely to restrict the amount of finance available to
the partnership and so help limit on its growth. This together with the
disadvantage of unlimited liability, means that many growing businesses
eventually form joint stock companies.

Joint Stock Companies

The liability of stockholders or shareholders is limited to the amount they have subscribed
to the firm’s capital and each shareholder knows the extent of his potential loss in an event
that the company goes bankruptcy. To make information available to potential
shareholders, all joint stock companies details of their profits, turnover, assets and other
relevant financial information such as remuneration of the director.

A joint stock company can either be a private limited company (Pvt) of public limited
company (Plc).

The share or stock of a private company cannot be offered for sale to the public and thus
are not traded on the stock exchange. The shares cannot be transferred without the
consent the other shareholders. Private companies require a minimum of two and a
maximum of fifty shareholders or members, though the upper limit may be exceeded in the
case of the company e.g lever brothers, Amanita Zambia, Zambia airways.

The shareholders of a public limited company can be offered for sale to the public. A plc
company requires a minimum of two shareholders but there no upper limit. Shares are
easily transferable and a company is required to hold Annual General Meetings (AGM)
where shareholders are able to question directors, to change the company’s article of
association, to elect or dismiss directors, to sanction the payment of dividends, to approve
the choice of auditors and to fix their remuneration. Examples of public companies are
Chilanga Cement PLC, Zambia Sugar PLC, Zambeef PLC, Bata PLC, etc.

Public Corporation

A public corporation is a form of public enterprise that has developed in areas where the
government has decided to place production in the hands of the state. The government
appoints the chairman and the board of directors. In Zambia Indeni, ZESCO, Zambia State
Insurance Corporation, ZNBC, are good examples of corporation. In a corporation members
cannot buy shares as is the case in a public limited company.

Cooperatives

Are retail outlets formed by members of the public when they get together and put the
resources together to create or engage in production.

The Growth of Firms

Motives for Growth

A firm may have one or more motives for growth. The motive which cause a firm to grow in
size are many and complex, but there are three distinct ones which are;

 The desire to achieve economies of scale, i.e. the advantages of producing on a large
scale in the form of reduced average costs
 The desire to obtain a greater share of the market and hence greater market power.
 The wish to achieve greater security by extending the range of products and the
markets.
Some firms see expansion as a way of ensuring their survival in the long run. They may fear
that if they should stagnate at their present size, they may become the target of a take-over
bid.

Diversification may similarly be seen as a key to survival and the best prospect for growth.
It can be agued that a diversified firm will better able to withstand depressed trading
conditions because while the market for some of its products maybe stagnating or failing in
size, other markets maybe growing. In the recent years, for instance, cigarette and tobacco
firms have been faced with relatively stagnant traditional markets largely because of
negative publicity given to the health risks of smoking and discouragements by the
Christian faith. This has forced many firms in this industry to diversify into new areas; the
diversification of the Imperial Group ( formally the Imperial Tobacco Group) into areas
such as food production, packaging, education supplies, woolen textiles and distribution.

Another possible motive for growth is to achieve higher profits. These may result first from
the likely fall in unit production costs as the firm expand and secondary through the firm
increasing its market share, and therefore, its ability to control the price of its products. A
firm with a dominant position in a market maybe acknowledged by other firms as the price
leader. Alternatively with the expansion of the firm, they may engage in form of collusion
whereby they all charge similar prices.

The Ways in Which Firms Grow

A firm can grow as a result of internal or external growth. Internal growth occurs when a
single firm expands its scale of operation within its original management structure. This
process is easier if the markets for the firm’s product are expanding rapidly and if the firm
is efficient relative to its competitors. The raising of finance maybe able to plough back
some retained profits into the business or it may be able to borrow funds from one of more
financial institutions. The large public company is able to raise finance by floating a share
issue, but this option is normally expensive for smaller firms.

External growth occurs when two or more firms join together to form a larger firm. This
may be a result of a take-over where a dominant firm acquires a controlling interest in a
small firm which then looses its separate identity. Alternatively two or firms may agree to
merger or amalgamate to form a new company. We can clarify the integration of firms into
three categories and that is, verticle, horizontal, and conglomerate.

Verticle Integration

This occurs when a merger takes place between firms engaged in the same industry but at
different stages of the productive processes. It is verticle in the sense that the combination
is a movement up or down the productive process which runs from extraction to
distribution. Thus a large manufacturer of tea may take over a tea plantation, a
manufacturer of tyres may acquire rubber plantations, or a car manufacturer may
amalgamate with a car body-building firm.

Integration Backwards

When a movement is towards a source of supplies, we speak of verticle integration

backwards. The examples above are all of this type. It is often carried out so that a firm may
exercise greater control of the quantity and quality of supplies and be in a position of
greater financial security with regard to their delivery. It may also have the aim of
restricting the availability of such supplies to its competitors. An additional motive might
be the absorption of the intermediate profit margins.

Forward integration

Where the movement is towards the market outlets, the process is described as verticle
integration forward e.g. large oil companies now control most of the filling stations. The
desire is to secure an adequate number of markets and the prospect of extra profits which
formerly occurred to the acquired firm. Also it may wish to improve the marketing of the
final products with a view of increasing its sales since manufacturers bear the burden of
advertising.

Verticle integration may give rise to economies of scale in production and may lead to
reduction in costs of production e.g. an iron and steel industry where the location of iron
and steel production on a single site enables the molten pig-iron to be transformed directly
into steel hence serving energy costs, transport costs are also reduced.
Motives for Verticle Integration

Important motives for this type of combination are desired to secure an adequate number
of market outlets. Since manufacturers carry the main burden of advertising costs it is only
natural that they should be concerned that their products reach the public in a form and in
an environment which represents the image created by advertising. Firms maybe forced to
take over some market outlets when a major competitor has already made a move in this
direction – they may react or face the prospect of being squeezed out of the market. Other
motives maybe to give rise to economies of scale that is producing with a minimum cost or
at a cheaper cost.

Horizontal Integration

This is a merger of firms engaged in producing the same kind of goods and services and at
the same stage of production.

When firms producing the same kind of goods are brought under unified control or
combination of firms that produce at a similar stage of an industry’s production.
Horizontal integration may be undertaken to achieve economies of scale, i.e. a reduction in
the average production costs. Alternatively it maybe undertaken to carryout the
rationalization of capacity. If two firms have excess capacity they maybe able to close one
or two plants and still be able to meet the market demand.

Motives for Horizontal Integration

Market domination is undoubtedly one of the motives leading to horizontal integration.

The motive for horizontal integration is market domination that is to have a much greater
proportion of the total market supply to control. When firms producing the same or similar
products merge to form a single firm there is clearly a reduction in competition allowing
the new firm to exercise greater control of the market. Horizontal integration also enables
the joint capacity of the almalgamated firms to be operated with a greater degree of
specialisation. In many cases, horizontal integration is carried out with a view of obtaining
economies of scale.

The major criticism of horizontal integration derives from the obvious tendency towards
monopoly as the number of firms in an industry is reduced.
Formation of Conglomerates is mergers between firms or take-overs involving firms which
produce goods or services that are not directly related. These mergers are neither
substantially vertically or horizontal e,g, a firm producing cigarettes may take-over a firm
producing potato crisps.

The major aim of conglomerate is clearly to obtain a diversification of output so as to

reduce the risk of trading .conglomerates mergers may also arise where a firm believes that
there is little scope for further growth for its existing production.

Thus one justification of conglomerates might be that it has the effect of replacing an
inefficient one. Because of replacing an inefficient management by a more efficient one
because conglomerates are mergers leads to increased concentrations in ownership of
resources the merger has been questioned by some observers. In some cases, the skills
required for effective management has been specific to an industry and the mergers have
not been successful.

Another type of a conglomerates merger has occasionally occurred ailing companies with a
depressed stock market valuation has been over with a view to “asset stripping”. This
involves the running down of a company and the scale of the company asset, such as
factories, land and machinery, so that the workforce loses its livelihood. An example of a
conglomerate among others is the Anglo-American corporation, Lonrho, Zambeef etc.

Quasi Integration

In order to secure markets for its products without owning retail outlets a firm may
consider forward quasi integration. This may the form of selling franchises, perhaps
requiring the franchisee to purchase supplies or ingredients from the franchiser. It may
some form of financial support to the retail outlet, as with breweries grant low interest
loans to the public houses or clubs that agree to sell particular brands of beer and spirits.
Another example is the granting of a loan by a petroleum company to an independent
petrol station to develop new facilities on condition that the petroleum company is sold.

The Factors of Production

Production cannot take place unless the necessary resources are available. These resources
include factories, railway, farms, mines, human skills, offices, etc. These resources can also
be called the factors production or inputs.

There are many differences into most production processes. The production of pig-iron for
instance requires a blast furnace, iron ore, coal and limestone in addition to the human
effort necessary to control the production process. F or the purpose of analysis economists
typically place each of the many different factor inputs into the categories- land, labour, and
capital.

Definitions

1. Land – refers to all humans attributes, physical and mental, that are used in
production.
2. Labour – refers to all human attributes, physical and mental, that are used in
production.
3. Capital – consists of goods which are not for current consumption, but whichwill
assist goods to be produced in the future.

Sometimes a fourth factor of production enterprise is added to the list, this organises
the factors of production.

Land

The term “land” is used to describe all those natural resources which are used in
production. Land as a factor of production includes, minerals, forests, water, rivers, lakes,
and all other natural resources as well as the land itself used in agriculture and as site
upon which economic activities take place. The supply of land is limited, and land is
geographically immobile, it cannot be increased. However, its use can change, the same
land can be used to plant maize, and then wheat at the other time. The reward for land is
rent.

Labour

Labour is human effort – physical and mental – which is directed to the production of goods
and services. Labour is a special factor of production as it is not only a factor of production,
it is also the reason why economic place.

Clearly labour is not homogeneous factor of production as some jobs require little, if any,
training for instance, ice cream sales people, fuel pump attendants, whilst others require
several years of training for example surgeons, civil engineers.

The education that is invested or embodied in training labour is sometiesreffered to as

human capital.
The compelling argument for retaining the distinction between labour and capital is that
whereas capital yields future services that can be slavery coming in. it must be borne in
mind that it is the services of labour which are sold and bought, and not labour itself. Firms
cannot buy and own labour in the same way that capital and land can be bought and
owned.

The labour force in Zambia consists males aged from 16 to 55 years old and females 16 to
50 years old. Not everybody of course in these age groups is either working or actively
looking for work. Many women and few men are unable to work because of family
commitment. Many young people are still in full time education ; some people retire early ;
and there are many other reasons why some members of the potential workforce are not in
a position to work. Labour is heterogeneous. The reward for labour is wages.

Capital

Capital is a man-made resource. It is used in the production of other goods and services.
For example machines, factories, offices, vehicles, etc people use capital not to satisfy any
personal craving, but to produce other goods and services.

Capital goods (sometimes is called investments or producer goods) are not wanted for
their own sake but because of the contribution to production. Most definations of capital
also include all inter-mediate goods. What all these have in common is that they are not to
be consumed in the current period but they enable a greater flow of consumer goods to be
available in the future.

Capital is a stock that is to say it exists at a point in time. In principle, the capital stock
could be measured at a particular moment. With an army of investigators, a list colud be
made of all lorries, cranes power tools – in fact of every piece of plant and machinery, and
inventory in an economy – together with the stock of finished and intermediaries goods
make up capital.

The heterogeneity of capital and the problem of valuation have led some economists to
argue that capital stock cannot be measured in a meaningful way. Depreciation (or capital
consumption ) is a measure of the extent to which the capital stock falls in value as a result
of use (or wear and tear) during the relevant time period, normally a year.

Note: that the purchase of new plant and machinery by firms is called investment.
Investment is a flow – that is to say, it can only be measured as ‘so much per time period’.
Nsince part of total (or gross investment is needed to make good depreciation of the capital
stock, it is only net investment (that is gross investment minus depreciation) which
represents an additional to the capital stock. The reward for capital is profit.
Enterprise

Some economists identify a fourth economic resource – enterprise of entrepreneurship. It

is the entrepreneur who organises the other factors of producton, he decides what to
produce, how to produce it and where to produce i.e the location of the enterprise. He
decides what goods to produce, receiving any revenue from the sale of the finished goods.
Id he has chosen to produce a successful product, he will make a profit , if not then it’s a
loss. Whoever takes these decisions and the consequent risks, is known as an entrepreneur.
The entrepreneur is the person who undertakes production with a view to make a profit.
He is the risk bearer.

The production function

Production involves the transformation of resources into finished goods and services. The
relationship between inputs and outputs is a technological relationship which economists
summariese in a production function. Suppose that the production function of a good X
requires inputs of capital, land, and labour. Using the functional notation. We can write the
same as follows:

Qx = f (K,Ib,id)

Where Qx – is the output of x per time period; f id the functional relationship; and , k, ib,id
represents the inputs of services of capital, land and labour respectively into the
production process. The production function states that output of a good x id a function of
(or depends on) the inputs of the services of capital, ; land and labour i.e to say Qx depends
on all the variables included in the brackets.

Technological efficient – a method of production is said to be technologically efficient if

for a given level of factor inputs, it is impossible toobtain a higher level of output, given the
state of the given technology. The existing state of technology acts as a constraint on the
production possibilities. An improvement in technology of course would enable more
output to be produced from a given level of inputs and this is a possible source of economic
growth for the purposes of analysis. However we assume that the state of technology only
improves in the long run.
THE SHORT RUN AND LONG RUN

Given the state of technology, and assuming technological efficiency, a firm can only
increase its level of production by employing more inputs. Very often though, a firm that
wishes to increase production, quickly is unable to increase the input of all the factors of
production that it employs. For instance, a manufacturing firm wishing to increase its
outputs is unable to have a bigger factory built over night and so in the short-run, it will
only produce more by employing more of it’s variable factors such as labour, raw materials,
and fuel. Only in the long-run can factors such as capital be increased. In so far as the
firm’s production decisions is concerned the distinction between short-run and long-run
are:

a. The short run is the period over which the inputs of at least one factor of production
cannot be varied. Those factors which can e varied in the short-run (typically
labour, raw materials, fuel) are called Variable factors. Those which cannot be
varied (typically capital and land are called fixed factors.
b. The long run is that the period of time over which the inputs of all factors of
production can be varied. Consequently, all factors are variable factors in the long
run. Note, that the actual length of the short run does not correspond precisely to
any particular time period. It varies from industry to industry and from firm to firm.
In the north sea oil industry, for example, it may take several years to install a new
platform and to make is operational; meanwhile, output can only be increased by
intensive use of existing capital stock. In case of a shirt factory, on the other hand,
the company can probably acquire extra equipment and have it installed within a
few weeks. Under these factors such as land and capital also undergo changes
unlike in the short run category where only labour changes. It implies that new
equipment may be bought, and construction of new infrastructure.

Three things occur during changes. In production in the short run and these are total
product (TP), average product (AV) and marginal product (MP).

Assumptions on which the table is based are as follows

 Labour is the only variable factor

 All factors of variables are equally efficient
 There are no changes in the techniques of production.
 No. Of Workers Total Product Average Product Marginal Product
L TP AP MP

1 4 4 4
2 14 7 10
3 25.5 8.5 11.5
4 40 10 14.5
5 60 12 20
6 72 12 12
7 77 11 5
8 80 10 3
9 81 9 1
10 75 7.5 -6

The maximum production output is achieved when nine workers are employed. As the
number of workers increases from 1 to 9, total output continues to increase, but this is not
true of average product (AP) and marginal product (MP). As more workers are employed,
both AP and MP begin to rise, reach a maximum and starts to fall. When the tenth worker
is added output begins to fall, because there are too many workers employed on a fixed
area of land and they begin to get on each other’s way.

It is apparent that the marginal product of labour is at maximum when five workers are
employed; the fifth worker adds 20 tonnes to the production output. After this point,
marginal product of labour declines. As the number of workers increases from 1 to 5 the
marginal product of labour is increasing. When the number of workers exceeds 5MP of
labour begins to fall, an indication that the proportions between fixed factors and variable
factors are becoming less favourable. MP begins to fall before AP. Diminishing marginal
returns after the employment of the 6th worker.

This leads to the law of diminishing returns.

→the law of diminishing returns states that as additional unites of variable factors
are added to a given quantity of fixed factors, with a given state technology, the
average and marginal production of variable factors will eventually decline.

The point at which marginal product reaches its peak is known as the point of
diminishing marginal returns and the point at which average product reaches its
maximum is known as the point of diminishing average returns. Notice from the chart
that MP begins to fall before AP does.
A firm operating with a fixed factor may eventually be encountering diminishing returns if
it is producing at a level of output below the point where diminishing marginal returns
sets in. Any firm increasing its output with a fixed factor, though , must eventually come up
against diminishing returns. Improvement in technology may offset the law as the case has
been in western agriculture wher productivity has greatly increased over time despite a
relative fixed supply land for agriculture.

Graph of the chart

Returns to scale

The returns to scale describes the relationship between output ans inputs when the scale
changes but factors of production held constant. The return to scale can be constant,
increasing or decreasing. In economics, returns to scale is when the producer increases
inputs, labour or capital, the output will increase proportionally.

Increasing returns to scale – increasing returns to scale are usually associated with
falling average costs which can also bereferredto as economies of scale. This is because, in
the absence of changes in the costs of inputs, if outputs increases by a greater percentage
than inputs, each unit will becomecheaper to produce. Increased returns to scale is what
you gain with an increase in labour force, an increase in output in relation to input.

Decreasing returns to scale – in the same way decreasing returns to scale are usually
matched by diseconomies of scale, with average costs rising as output increases more
slowly than the change in scale of production. This occurs when output decreases in
relation to input.

Constant returns to scale – in economics, when input is increased as equal returns will be
expected. This simply means there is an assumption that there is a constant returns to
scale in production.
Determinants of returns to scale

Determinants of returns to scale includes technology, renovation and expansion.

THEORIES OF A FIRM

This theory is concerned with how firm decide what output they should produce and at
what price they should sale bearing in mind how price reflects.

The Costs of Production

The Cost in the Short Run

Total costs (TC) – short-run total costs represents the sum of fixed and variable costs. TC
is the total cost of producing any given rate of output. TC is divided into two, that is total
fixed cost and total variable cost.

Fixed costs

Total fixed costs does not vary with output. Total cost are sometimes refferd to as
overhead costs. Sometimes known as unavoidable cost or indirect cost. They are
unavoidable because they are incurred whenever the factory is functional or if the factory
is not functioning, through payments of rates, rent electricity , security, insurance,
maintenance etc all constitute fixed costs. When output is zero, total costs will be equal to
fixed costs since variable costs will be zero. When production starts, total costs will begin
to rise as variable costs start to increase.

Variable costs
These are costs which are related directly to output and so change output changes. All
costs that vary directly with output are calledvariable costs often known as directed cost.
The most obvious items of variable costs are the salaries/wages, the cost of raw materials,
transportation etc. variable costs are no incurred when output is zero.

Total cost is equal to total fixed cost plus total variable cost
TC=TFC+TVC

So, to increase total cost, you need to increase the total variable cost.

Average total cost

Average total cost (AFC) – the average fixed cost of producing any given output is the cost
of producing it divided by the number of units (which is not per unit). When output is
small, average cost will be high because fixed costs will be spread over a small number of
units of output.

ATC= TC or AFT+ AVC

OP

Average fixed cost (AFC) – this is fixed cost divided by output – as you increase output, the
AFC decreases – so reduce on the average total cost. It is better to produce moe in order to
cut total cost.

AFC = FC
OP

Average variable cost (AVC) – is the total variable cost divided by output

AVC = TVC
OP

Average total cost (ATC) – these show the real average cost per unit. ATC can either be
found by adding average fixed cost and average variable cost = AFC + AVC or Dividing total
cost by output = TC
OP

It is better for a company to continue operating when it is making zero profit than shutting
down. This is so because it will be paying for fixed costs and hence incur cost as they cant
produce.

→ fixed cost – these are costs which do not vary as output varies. They are obvious the
cost associated with the fixed factors of production and include such items as rent, rates,
insurance, interests= or loans and depreciation. Fixed are also referred to as overhead
costs, or indirect costs.

→variable costs – are costs directly related to output which includes salaries/wages of
labour, cost of raw materials, fuel,power. They are sometimes referred to as direct or
prime costs.

→ Average costs –is equal to total cost divided by output TC/Output. When output is
small average cost will be high because fixed costs will be spread over a small unit of
output. As output increases or rises costs are reduced.

Marginal Cost

Marginal cost is what happens to total costs when output is varied by some small output.
Marginal cost is the change in total costs when output is changed as a result of an increase
of one more unit of inputs.
MARKET STRUCTURES

Perfectly Competitive Markets

Market structures describes the different levels and forms of competition in which firms in
different industries can operate. Economists identifyfour forms of market structures.
These are perfect competition, monopoly, monopolistic competition, and oligopoly.

The economist’s model of perfect competition is largely theoretical but it does provide a
useful tool for economic analysis. The market structure is used as a means of assessing the
degree of competition in a real world market.

Perfect competition

Perfect competition is an industry in which there are many firms, each small relative to the
industry, producing identical or similar products andin which no firm is large enough to
have any control over price. In perfectly competitive industries, new firms can freely enter
and exist the market.

A perfect competitive market model is based on a number of assumptions.

 There are many buyers and sellers so that the behaviour of any one buyer, or any
seller, has no influence on the market price.
 There no barriers to entry and exit. There is freedom of entry and exits in the
industry
 There is perfect mobility of factors of production.
 There is perfect knowledge of the market. Buyers are assumed to have perfect
knowledge of the market conditions. They know what the qualities and the prices
being charged for the product available in the market. Equally sellers are fully
aware of the activities of buyers and other sellers.
 All products are homogenous products i.e one product is the same as another. So
buyers have no preference for the products of any particularr seller.
 There is no advertising

These characteristics mean that in a perfect market there will be one market price which is
beyond the control of any one buyer or any seller to influence.

In a perfectly competitive market the price is determined by demand from buyers and
supply from the sellers. The interaction of the forces of supply and demand is key in the
determination of the price or equilibrium price. The quantity demanded reduces as the
price increases while supply increases as the price increases. However, that there are no
surplus products forces the price down. This means that there are no barriers to new firms
entering the industry (an industry being a collections of firms dealing in the same product).
It is also assumed that all buyers and sellers are perfectly informed about the qualities,
price and all other factors leading to market procedures. Costs of adverting are also cut off.
Homogenous products means that each unit of a product produced is identical so that
buyers can have no preference between the different units.

Perfect competition and welfare

With a freely operating price mechanism, the economy’s decision of what, how, and for
whom to produce are not taken consciously by individual’s consumers and firms. There is
a no central authority for fixing prices or setting output targets, so that both prices and
output levels are determined by the interaction of free forcers of supply and demand.
Firms supply goods and services which will maximise their utility.

By the phrase perfect condition, we mean a situation in which there are many buyers and
sellers competing freely with each other in markets for homogenous goods and services
that no individual buyer and seller is in a position to influence the market price by his own
action. Sellers are Price takers. The demand is perfectly elastic demand curve, a
horizontal line i.e no matter how many units the firm sells, it cannot change the price.

Argument – perfect competition leads to inefficiency or optimal allocation of resources for

profit maximisation of a firm and will choose that combination of factors which will have
nominal cost for utility maximisation. A firm will choose a product which has optimal
income allocation.

Monopolistic Competition

Monopolistic competition is a market structure in which there are a large number of firms
producing similar but differentiated products. The assumptions of this model are similar to
that of perfect competition with one exception. It is assumed that there are a larger
number of similar but differentiated products. The differentiation of products offered by
individual producers implies whilst each firm is likely to face relatively elastic demand
curve, it will not lose all its sales as would be the case in a perfect competition. Some
customers would continue to buy the product because of the qualities that differentiate it
from competing products and brand loyalties.

Characteristics
There are a large number of firms with similar products but each firm’s product is
differentiated from those of its competitors. There are no barriers to entry into the
industry.
Firms may seek to gain extra customers by advertising and by improving the good or
service by improving packaging or in case of a car repair by staying open late.
As there are a large number of firms in the industry, each with an insignificant share of the
market, each one will act independently. When deciding on their pricing and output
strategy they will not be concerned about how their rivals will react.

Monopoly

This is an extreme end of the market structure to perfect competitive structure. A pure
monopoly is a single supplier of goods and services for which there no close substitutes,
this means a firm has no direct competitor. In general terms we can say that the cross
elasticity of demand between the monopolistic product and all other product is zero. In
other ways a rise in price of a commodity leads to no increase in demand for any other
product.

A pure monopoly can best be regarded as a theoretical model as it is unusual or utopia to

find a 100 percent monopolistic product or market share. It is however possible for a
group of firms or companies to engage in collusion over prices or production levels and
hence act as a monopoly. Such a situation is known as a CARTEL. In a pure monopoly
sellers are the Price Makers.

A monopolist has the power to determine either

 The price at which he will sell the product
 The quantity he wishes to sell

In a monopoly, there are barriers to entry into the industry, that is, new firms wishing to
enter the industry will encounter obstacles. A monopoly can determine both price and
quantity hence making supernormal profits because the monopoly has the power to charge
consumer’s above average variable cost. The monopolist’s power to influence price and to
earn supernormal prices depends on the monopoly to restrict the entry and exit of new
firms into and out of the industry.

Critics of the monopoly say that monopolists will use their market power to restrict supply
and thereby drive above the cost. Consumers may suffer from prices being higher and
output lower than allocatively efficient levels. The lack of competition will also mean that
monopolies may not feel the need to seek to lower prices, innovate and improve the quality
of the product.

Oligopoly

An oligopoly is a market dominated by a few large producers. In other words a small

number of very large firms account for practically the whole output of the industry.
Many markets that at first sight appear to be monopolistically competitive are in reality
dominated by a few major producers who each manufacture a large number of different
brands. These markets can best be described as oligopolies. In an oligopoly the number is
small enough for each seller to talk account of the actions of the other sellers in the market.
Sellers realise that they are mutually dependant. The model is sometimes called
“competition among the few”, and relatively common in manufacturing industries such as
motor cars, industries producing oil, detergents, tobacco industry etc. The special case of a
market dominated by two firms is called a DUOPOLY.
Because of uncertainties involved, there is no satisfactory comprehension theory of
oligopoly. Nevertheless, many oligopolistic behaviour have been developed including
“market sharing” and “dominant firm” models.

Characteristic

The goods produced in an oligopoly maybe homogeneous such as cement or sugar. There
are barriers to entry in the industry dominated by an oligopoly market structure. The firm
in this industry are capable of earning supernormal profits in the long run. The firms in an
oligopoly are interdependent, they will know a considerable amount of information about
each other and will be influenced by expectations about how the other firms react.

Oligopolies may engage in non-price competition meaning that the price is the same. This
may include product differentiation by means of brand image, packaging, free gifts, styling
and after sale service . By means of this non-price competition, firms may attempt to
capture a particular market segment or generate consumer brand loyalty through actual or
perceived in the product offered.

Cartel

It is possible for a group of oligopolists to engage in collusion, that is, to make an agreement
relating to the price to be charged and or the level of output to be produced. The objective
is for the oligopolist to act like a monopolist, restricting output and raising price, thereby
earning the maximum profits that can be attained in an industry. Such a collusion or
agreement maybe OVERT so that the terms of agreement are generally known, as is the
case of OPEC, more likely however, the cartel agreement will be COVERT (that is, known
only to the participant). In practice the members of the cartel will have to set up a central
authority with power to fix the price and quota for individual producers. A cartel includes
firms producing separately but acting as one firm in determining price and output. This is
true of oil producing countries.

Cartels are likely to break down in the long run as individual producers may have different
costs of production and hence want to charge a different price or other firms may have an
incentive to cheat by producing in excess of their quota and under cutting the agreed price.
However, other firms buy off others and become price leaders or dominant firms.

Dominant markets

A dominant market is a market in which the dominant firm will set the price and the
smaller ones will follow suite. Dominant markets are price leaders.
MACRO ECONOMICS

Macroeconomics is focused on the movement and trends in the economy as a whole, while
in microeconomics the focus is placed on factors that affect the decisions made by firms
and individuals.

Macro economics

Macro economics deals with the economy as a whole. Macro-economics is the filed of
economics that studies the behaviour of the aggregate economy. Macroeconomics
examines the entire economy. Macroeconomics examines the entire economy-wide
phenomenon such as changes in unemployment, national income, rate of growth , gross
domestic product, inflation and price levels, etc.

Macro economics focuses on the determinants of total national income; it deals with
aggregates such as aggregate demand, aggregate consumption, aggregate supply, and
aggregate investment, and looks at the overall price-level instead of individual
prices.Aggregates is used in macroeconomics to refer to sums or totals. When we speak of
aggregate consumption of aggregate income, we are speaking of the total consumption of
total income in an economy
Macro economics is concerned or deals with the behaviour of broad or larger aggregates in
the economy. In micro economics, it was explained how prices of individual goods and
services are determined in the market, and how the output quantities of individual firms
are determined in the market, and how the output quantities of individual firms are
determined.
In macro economics, we turn to the problem of the nation as a whole and to the question of:

a. What determines the general price levels in the economy?

b. What determines total output for the economy as a whole?
c. Employment levels in the country?
d. What determines the national budget?
e. What determines inflation?

Classical view of the economy

Before the great depression of the 1930s, economists applied microeconomic models,
sometimes referred to as “classical “or “’market clearing’. This revolves around the idea of
self –regulating markets. In other words economist believed that recession
(downturnsinthe economy) were self-correcting. This micro economic view in all-market
clear themselves is known as “the general equilibrium theory.” This was propagated by
Jean Baptists. He was of the view that the free enterprise economy will automatically reach
an equilibrium where there is no unemployment and no inflation. As output falls and the
demand for labour shifts to the left or declines, the arguments went, the wage rate will
decline, thereby raising quantity of labour demanded by firms, who will want to hire more
workers at the new lower wage rate. Before the great depression, in the 1920s, had been
prosperous years in the US economy, virtually everyone who wanted a job could get one,
incomes rose substantially, and prices were stable. But beginning of the late 1929, 1.5
million people were unemployed, by 1933, 13 million people were out of labour force
However during the great depression unemployment remained very high for nearly ten
years. In large measures, the failure of the simple classical models to explain the prolonged
existence of high unemployment provided impetus for the development of macro
economics.

The Keynesian theory

Keynesian Revolution – one of the most important works in the history of economics, the
General Theory of Employment, Interest and Money, by John Maynard Keynes was published
in 1936.

The idea of self-regulating economy become increasing unattained in the 1930’s during the
great depression, when there was a continuous chronic unemployment. The classical view
of the economy was over-turned by John Maynard Keynes – The General Theory of
Employment, interest and money. According to Keynes it is not price and wages that
determine the level of employment, as the classical model had suggested, but instead the
level of aggregate demand

He said the economy was not a self-regulating mechanism and that equilibrium in the
economy was determined by aggregate demand, a desire for goods and services among
people who have the money to pay for them.

Keynes therefore believed that since the economy is not self-regulating, it is necessary for
the government to intervene in the economy and affect the level of output and
employment. The government’s role during periods when demand is low, Keynes argued,
is to stimulate aggregate demand and, and by so doing, to lift the economy out of a
recession. He asserted that the government using a combination of deficit spending and
regulating of taxes rates and money supply, to ensure a satisfactory level of national
income.

The neo-classic economic theory

The worsening problem of inflation and unemployment led to many to believe in market
oriented policy description. These were known as neo-classic economists commonly
known as Monetarists. These concentrated on the money supply side of the economy. One
of the notable economists was Milton Friedman. He became associated with notable
politicians such as Ronald Reagan and Margaret Thatcher.
Macro-Economic concerns
Three major concerns of macro-economics are;
 Inflation
 Output growth
 Unemployment
Government policy makers would like to have low inflation, high output growth, and low
unemployment.

Government in the economy

Much of our discussion of macro-economics concerns the potential role of government in
influencing the economy.
1. Fiscal policy
2. Monetary policy
3. Growth or supply-side polices

Fiscal policy

One way through which the government affects the economy is through its tax and
expenditure decisions, or fiscal policy. The government collects tax from households and
firms and spends these funds on items ranging from roads, transfer payments, education
etc. both the magnitude and composition of these taxes and expenditures have a major
effect on the economy.
One of Keynes main ideas in the 1930s was that fiscal policy could and should be used to
stabilise the level of output and employment.

Monetary policy

Taxes and spending are not the only variables the government can control. Through the
central bank which is the Bank of Zambia, the government can determine the quantity of
money in the economy. Most economist agree that the quantity of money supplied can
affect the overall price level, interest rates, unemployment rate, and level of output.

Growth polices

Many economists are sceptical about the government’s ability to regulate the business
cycle with any degree of precision using monetary and fiscal policy. Their view is that the
focus of the government should be to stimulate aggregate supply – to stimulate the
potential growth of aggregate output and income.

The determination of National income are:

Aggregate Demand = Consumption + Investment +Government Expenditure + Export –
Imports(x-m) = national income

A change in national income comes about from –

 A change in consumer expenditure (C)
 A change in investment (I)
 A change in government spending (G)
 A change in the difference between export and imports (x-m) or net exports

NATIONAL INCOME

Circular Flow of Income

A useful way of seeing the economic interactions among the four sectors of the economy,
that is, households, firms, the government, and the rest of the world, is a circular flow
diagram, which shows the income received and payments made by each.

Households work for firms and the government, and the receive wages for their work. The
diagram shows a flow of wages for their work. The diagram shows into the household
sector as payment for those services. Households also receive interests on corporate and
government bonds and dividends from firms. Many other households receive other
payments from the government, which the recipient does not supply goods or services or
labour, as transfer payments.

Households spend by buying goods and services from firms and by paying taxes to the
government. These items make up the total amount paid out by households. The
difference between the total receipts and total payments of the households is the amount
that households save or dissave. If households receive more than they spend then they
save, if they receive less they dis-save, in the circular flow diagram, household spending is
shown as a flow out of the household sector. Saving by households is sometimes termed as
a leakage from the circular flow as it withdraws income, or current purchasing power from
the system.

Firms sell goods and services to households and the government. These sales earn
revenue, which shows in the circular flow as a flow into the firm sector. Firms pay wages,
interest, and dividends to households, and they pay taxes to the government. These
payments are shown flowing out of the firm sector.

The government collects taxes form household and firms. The government also makes
payments, it buys goods and services from firms, pays wages and interest to households,
and makes transfer payments to households.
Finally households spend some of their income on imports-goods and services produced in
the rest fo the world. Similarly people in foreigncountries purchase (exports)goods and
services produced by domestic firms and sold to other countries.

One lesson of the circular flow diagram is that everyone’s expenditure is someone’s
receipts.

To produce goods and services, firms buy inputs (labour) from households. Households
earn their income by working, they supply their labour in the labour market to firms that
demand labour and pay workers for their time and skill. Households may also loan their
accumulated savings to firms for interest when households buys shares of stock in a
corporation. In the capital markets households buys shares of stock in a corporation. In
the capital markets households supply the funds firms use to buy capital goods.
Households may also supply land or other real property in exchange for rent in the land
market. Inputs into the production process are called factors of production, and these are
land labour and capital.

Goods and Money

Circular flow looks at the total flow of economic activity within a country. The model could
be called a closed economy with no government sector. To make our starting model
effective it is assumed that households receive their income by selling the use of whatever
factors of productionthey own, and that businesses sell their entire output immediately to
households, and that households spends their income on consumer products.

The concept of the circular flow of income as out lined has identified three basic principles;
1. In every economic exchange, the seller receives exactly the same that the buyer
spends.
2. Goods and services flow in one direction and money flows in the other.
3. There is a closed relationship between income, output, and expenditure

Households are consumers of goods and services and work in firms to produce as they
earn income.
Now we wish to take account that not everything that is earned by households is spent on
goods andservices. Households save part of their income. Saving can be defined as the act
of not consuming whatever is earned.
Saving is the withdrawal from the flow undertaken by households or firms. An injection is
an addition to the circular flow of income. It means the total withdraw must equal (=) total
injection.

Total income = total output = total expenditure.

Total income is the amount paid to the resource suppliers.

SAVINGS when households receive their income they spend or save. Saving are part of the
income that is not consumed or spent on current goods and services. In other words it is
income minus consumption also known as a Leakage. This does not contribute to the
growth of the economy if they are done on hoarding basis, unless by banking.

WITHDRAWAL: is any part of income that is not spent or passed on within the circular
flow. Savings represent a leakage (withdrawal) from the circular flow of income because it
is part of the income paid out by firms which is not returned to them through spending by
households. When savings take place, firms expenses will be greater than their receipts
and some of their output will remain unsold. They will react by reducing output so that
income and employment will fall.

INVESTMENT: is any addition to the real capital stock of the nation. Expenditure on
capital goods adds to the circular flow, it has an opposite effect to a leakage and causes
output and income to expand. Investment is an injection. It is often referred to as spending
which is not for the currentconsumption, but for future consumption or to increase the
capacity to produce in the future.

Domestic savings are made in banks which contribute to national income.

Withdrawals and injections

 Tax (t) is a withdrawal, government collectors tax uses the money to pay public
officials.
 Open economy is one which takes part international trade. The sell and buying of
goods and services overseas, or an economy that is some way dependant on one or
more other economies.
 Imports (I) is a withdraw because the money paid for goods and services goes out of
the economy. Imports are goods and services that have to be paid for with foreign
exchange. Zambia imports a very wide range of services and goods because the
local industry is relatively undeveloped.
 Exports (E) are an injection because people overseas are creating income for
domestic households. Exports are thus goods and services that earn foreign
exchange. The main Zambian export still remains copper. Buyers of Zambian
copper pay for it in their own currency which are later sold to the Bank of Zambia.
Importers therefore buy foreign exchange from BoZ paying for it in Kwacha. If there
is excess of foreign money for imports then BoZ stock of foreign currency will rise.
This stock for foreign currency is called the country’s foreign exchange reserve.
 More imports than exports = trade deficit (m>x)
 More exports than imports = trade surplus (x>m)
Government both local and central influence the circular flow of income. Taxes (t) are a
withdraw from the circular flow. While government expenditure (g) is an injection.

Withdraws Injections
Savings (s) investments (i)
Tax (t) Exports (x)
Imports (m) Government expenditure (G)

S,T,M = I,X,G (withdrawals = injection)

National income (y) = C+I+G+(x-m)

(AD) = C+I+G+(x-m) net export

An economy is in equilibrium when withdrawals are equal injections. i.e Savings + Tax +
Imports + Investments + Exports + Government expenditure.

Closed Economy

An economy is an economy that does not take part in international trade, it does not
interact with other countries, it is in Autarky – an economic policy or situation in which a
nation is independent of international trade and not reliant upon imported goods or a
nation that is economically self-sufficient. (Y=C+I) such an economy has household and
firms with one withdraw-savings and one injection –investment. There is no government
intervention.In a closed economy.
In a closed economy, equilibrium is when Investment is equal to savings.

Savings and Investments

Savings are defined as income not spent. These can either be undertaken byhouseholds or
firms. While investments are any addition to the real capital stock of the nation.
Investment income therefore, consists of the purchase of new capital equipment,
construction of new buildings and any additions to the stock.

Open Economy
In an open economy that is an economy open to outside interaction (imports and exports)
income = consumption + Investment + government expenditure + (export – Imports)

Y = C+I+G (x-m)

Government and the circular flow

Government involvement in the circular flow of income – taxes are a withdrawal from
circular flow and government expenditure is an injection in the economy because it adds to
real output and creates employment. Taxes are a withdrawal because they remove
purchasing power from the system. The importance of government spending and taxation
lies in the fact that they are deliberately manipulated by government to influence the level
of output and employment.

Fiscal policy

Earlier we saw Keynes said government should intervene in the economy to regulate the
flow of government expenditure and taxes, done by varying the amount of government
spending and taxes.
Directing the economy in this manner is known as fiscal policy.

A budget deficit (government spending more than it collects in taxes) will have an
expansionary effect. If there was inefficiency of demand in the economy so that there was
unemployment, the government would increase the level of aggregate demand by running
a budget deficit – that is spending more than it collects in taxes.

AD = C+I+G+ (x-m)
Aggregate demand >budget deficit = G>T

And a budget surplus (taxation exceeding government spending) has a depressing effect on
income. If government wanted to reduce the level of national income maybe with the idea
to solve inflation, it could withdraw more from the economy in taxes than government
expenditure. This is termed as budget surplus. The government here withdraws more
from people to pump in the firms. This model shows the economy can be in equilibrium. If
the withdraws are equal to the total injection, i.e S+M+I = I+X+G.

THREE METHODS OF MEASURING NATIONAL INCOME

The main measure of national income is Gross Domestic Product GDP. GDP is the total
output produced by resources located within a country. Rent, Profit, Wages and Interest
are incomes. National Income can be measured in three different ways:

 The Income Method

 The Output Method
 The Expenditure Method

The three methods give us GDP, and by adding net factor income from abroad, we get gross
national product GNP.
 A. Income method
Using this method the value of national product is obtained by adding together all
incomes by the basic Factors of Production. Total value of national product using
this method is known as “national product at factor cost” and counts all incomes
from productive activities such as wages, salaries, profits and rent.
Only incomes which are a reward for productive activities should be counted. All
transfer payments must be excluded (pension, sickness, benefits, interest on
national debts etc. such payments are not included because they are not payments
for services rendered – their is no contribution to current output by the recipient.

B. Output method
The most direct method of measuring the national output or income is to use output
figures of all the firms in the country. In the case of this method it is very important
to avoid double counting. Adding up the total output of all firms in the economy will
give a total many times greater than the true value of the national output. The
problem arises because output of some firms is the input of other firms. To avoid
double counting, national output can be obtained by adding the value of final
products, or totalling the values added at each stage of production.
It is sometimes referred to as the value added method. This method has the
advantage in that is shows> the separate contribution of all sectors to total output;
and ,> as all firms keep accounts of goods and services purchased and total sales. It
is easy to calculate their value added. The monetary value spent in the production
of final goods and services in the country over a period of one year.

c. The expenditure methods

Here we add up all the expenditure on the final goods and services. Only
expenditure on final goods must be counted. Expenditure on intermediate goods
must be excluded. Expenditure of second hand cars must be excluded. Total
expenditure will include, personal consumption expenditure (C) – that is household
spending on consumers goods.
Domestic investments (I) – spending by firms on new capital, government
consumption and investment (G), and net exports (x-m) – exports minus imports.
Adding all expenditure in an economy gives the figure for national product at
market price.
The expenditure approach calculates GDP by adding together these four
components of spending, i.e GDP = C+I+G+(x-m)

Ideally all three methods should arrive at the same amount. However the three methods
often do not come to the same amount and it is a common practice for the average of the
three to be taken as most accurate measurement of the country’s GNP.

Consumption

Consumption is the largest part of expenditure. In economics we always assume that what
is earned is all spent .
  National income = national expenditure-consumer expenditure. Consumption is the
most important determinant of national income. The more people earn the higher
the level of national income.

Consumption function
Consumption (C) is the amount households spend on goods and services to satisfy their
current wants. As income increases so does consumption but the proportion devoted to
consumption may decrease as income increases. This happens so that you start to save.
The proportion of disposable income (Y) which people spend is called the average
propensity to consume.

It is also true that savings = income – consumption

S=Y-C

Consumption within consumption

People can consume some quantities of goods and services regardless of the levels of
income. This is termed as autonomous consumption. The propensity to consume depends
on income. This theory is based on the fact that those that are well to do save when they
have more while the poor consume only. So the poor consume more.
 We have a small manufacturing industry
 The liberalisation of the economy came without safety values
 There is lack of political inculcation of social will to make people appreciate the local
products

Diagram (autonomous consumption)

Autonomous consumption is part of consumption that does not depend on the level of
disposable income. Induced spending is spending which depends on the level of income.

Propensity to consume and save

Marginal propensity to consume (MPC) is the fraction of an increase in income that is

consumed. The marginal propensity to save (MPS) is the fraction of an increase in income
that is saved.
The amount saved or consumed expressed as a proportion of income are known as
propensity to consume and propensity to save.

Average propensity of consumption = consumption

Income

Average propensity to consumption is the proportion of disposable income devoted to

consumption. As income increases the average propensity to consume decreased and this
leads to savings.
e.g a man earns – K 100 consumes K100
K150 and comsumes K110
K200 and consumes K120

Average propensity to save

The average propensity to save is the proportion of disposable income devoted to savings.
Savings decreases as income decreases.

APC + APS = I
APS =S
Y

If a household was getting one million kwacha then their income increases to two million it
will first increase consumption and later look at savings. If national income were to
increase the proportion of this income will be saved and the rest will be consumed.

Determinants of consumption

1. Distribution of income – income remains unequally distributed and different

marginal propensity of consumption. A less evenly distribution of income may
reduce spending. This is because the rich who receive higher incomes will not
significantly increase their spending where-as the middle and low income groups
experiencing reductions in their income will reduce their spending by quite large
amounts.
The MPC is high to lower income groups than the rich people. A movement to a
more equal distribution of income should therefore lead to a high MPC to the
economy as a whole. NI=AD=Y=C+I+G+(x-m). the more you evenly distribute your
income the MPC will also increase thus a well distributed standard of living.

2. The permanent income hypothesis – people in the short run have a concept of
permanent income level. If income increases in the short run they will spend
roughly the same amount. People know how they live on a permanent income level.
If they get more then it will be saved.

3. Consumer’s expectation – consumer spending norm is influenced by the future

expectation, especially unemployment and inflation. Consumption decreases as
 inflation increases. If a household expect loss of income, the household will save
more and consume less.

4. Cost and available of credit – since many durables are bought with the aid of hire
purchase or with other forms of credit. The higher the level of hire purchase the
higher the level of consumption.

5. Indirect tax – a rise indirect taxes will be likely to reduce consumption.

Savings

Savings (S) is disposable income which is not spent, it is a withdrawal from the circular
flow of income. The proposition of disposable income which is saved is called the average
propensity to save.

Y=C+S
S=Y–C

Savings is a proportion of disposable income that is not consumed. These can be

undertaken by firms, government, and households. As income rises both the total amount
saved and the proportion saved tend to increase.

Types of savings.

There are two types of savings. Personal savings can be divided into two and these are
contractual an discretionary savings.

Contractual Savings
These are savings which a person contracts to save a certain or specific amount of money
monthly. There are many typese.g life assurance, pension etc

Discretionary savings
These are savings where people are not obliged to save a specific amount e.g bank deposits,
building society savings, and lending to the government,

Savings and income

Since savings are defined as income not consumed or spent. An increase in income will
lead to an increase in savings. S= Y-C

Hoarding
Since savings are monies taken out of the circular flow of income, it decreases the level of
income. However, hoarding is keeping of savings of income at home. Since most of the
savings are deposited with financial intermediaries they are made available through
borrowing for investments. If savings are not placed with financial institutions but
hoarded, this has a negative effect to the economy because the money is not injected in the
economy. It is a withdrawal from the income hence there is need to keep money at the
bank.

Motives of savings

There are many reasons for people to save. Among the reasons for savings are:
a. Deferred purchase – this is a saving up to buying something in the future such as a
car, a house, a farm, and other durables. You should have a low average propensity
to consume for you to defer your purchase.
b. Contractual obligation – savings in form of insurance premium. It is the high income
group that has the ability of contractual obligation.
c. Precaution motive – people save to avoid problems when they fall into trouble. So
that they will just withdraw to solve that problem.
d. Habit and custom – some societies save because it is part of their custom for
instance western countries. The Japanese are the world’s thriftiest people. They
save one third of their income.
e. Age – people save or dis-save at different times of their lives. Old people save for
their retirement. While young people save in order to buy assets.
f. Expectation – expectation of the future economic situation will affect savings.

Savings and interest rates

Interest rate is the cost of borrowing money. Interest rates can as well be described as the
payment for the use of money. It is the price that has to be paid for the services of capital.
It is true that high interest rates may discourage savings while low interest rates may
discourage savings. If banks are offering a high interest rates, many people will be
encouraged to save money in the bank and earn high interest on it, but if interest rates are
low few people will be willing to save money.

Interest rates (real) is arrived at by subtracting the rate of inflation from the rate of
interest. Two types of interest rates are real and nominal interest rates.

Real interest rates = interest rate – inflation rate

If the interest is 8 percent and inflation at 18 percent, then real interest rate is;

RIR = 8-18 = -10%

If a person has a K100 it will mean that he will loose purchasing power worth K10 and the
true value of his money will be K90 if RIR is – 10% if the inflation is higher than the
interest rate, here inflation will discourage savings. E.g
But if the inflation rate is lower than the interest rate, for instance if inflation is 5% and the
interest rate is 8%, then real interest rate will be,
RIR = interest rate – inflation rate
RIR = 8-5 = 3%

If you save K100 then you have at the end an increment of K3 and hence a K103. Such a
situation will encourage households to save.

Paradox of thrift

An interesting paradox can arise when households attempt to increase savings. If

households become concerned about the future and want to save more, the plan to save
more is the plan to consume less, and the resulting drop in spending leads to a drop in
output and hence in incomes. Therefore in an attempt to save more households have
caused a contraction in output, and thus in income. They end up consuming less, but they
have not saved any more.

The paradox of thrift refers to the outcome of increased savings in the saving function .with
initial increase in saving, planned leakages will exceed planned injections and hence
consumption will fall because aggregate expenditure will be less than current output
hence stocks piling up. Then firms will cut production and later reduce on employment ,
and hence a reduction in incomes. Some income will fall and fall in income means savings
will also fall hence a paradox.

Investment and That Rate Of Interest

Investment is spending over a period of time on the production of capital goods (houses,
factories, machinery, etc) oron net additions to stock or inventories (raw materials, and
consumer goods in a shop). Investments takes place only when there is an actual net
addition to capital goods or stock.

Investment is an important component and a determinant of the level of national income.

It is not homogenous, it can be in different forms. Determinants of investments are
autonomous or induced investments. Induced investments are brought about by changes
in levels of national income. An increase in the level of income will increase savings and
finally induce increase in investments.

Autonomous investments are not affected by any other factor. For autonomous investment
if bank rates are high, investment rates are low and vice versa. To encourage investment
rates, you have to mobilise domestic savings. Interests rates are the cost of borrowing
money saved. These are market determined and plays a significant role in the economy. If
they are high they have a prohibitive role to play in terms of investment.

Government expenditure
Government plays a very important role in the economy. Government spending and
taxation decisions are important and have a major effect on aggregate demand and output.
Changes in the level, timing, and composition of government spending and taxation has a
significant impact on the economy.
Government expenditure consists of
1. Current expenditure – this is spending by government on the day to day running of
the public services, e.g spending on civil servants, teachers and doctors salaries, the
presidents trips abroad, the armed force etc
2. Capital expenditure – this is spending by government on the social infrastructure
and includes spending on new hospitals, schools, roads, etc. capital expenditure
adds to the country’s capital assets.
3. Transfer payments – these are payments to e.g pensioners, the unemployed and
subsidies to producers. They are designed to provide income or increase the
income of vulnerable groups.
4. Debt interest – this is payment to the holders of government debts, e.g government
bonds, treasury bills.

Government is a big investor and a big player in the economy. Government expenditure is
a large component and tax affects household income.

Fiscal policy is the government’s decision about spending and taxation. For instance, if the
government wants to put up a school, it may engage Tomorrow Investments or China
Henan, through a tender, then Tomorrow Investments or China Henan will do the job by
engaging local people as workers. The more government spends, the more it creates jobs
for indigenous people. The government should put more money into the private sector.

Stabilisation policy is the government’s action to control the level of output in order to
keep GNP close to its full employment capacity.

Budget deficit is the excess of government spending over government receipts or taxes.
Government runs a deficit if it spends more than collects in taxes.

Fiscal policy

Fiscal policy means the use of taxation and expenditure decisions to achieve political and
economic ends. These ends are many, one of which is to achieve economic objectives and
stability. It can as well be further broken into three categories of, redistributing income
and wealth, allocation of resources, and macro economic control of the economy.

The government has a substantial effect on the allocation of resources towards

consumption, investment, and exports. It achieves this by partly through the operation of
the tax system. Tax reduces disposable income and therefore personal consumption. This
may affect both the pattern and level of investment. Further, discriminatory taxes on firms
affect the profitability and therefore, the level of investment. Also because fiscal policy
affects aggregate demand, it influences the levels of inputs and indirect of exports.

In seeking to control the economy, the government will try to promote economic growth,
stable process, low levels of unemployment and will try to avoid balance of trade deficit.

Expansionary fiscal policy – any government policy aimed at stimulating aggregate

output (income) is said to be expansionary. An expansionary fiscal policy is an increase in
government expenditure aimed at increasing aggregate output(income). Government can
stimulate the economy by either increasing government spending or by reducing taxes.
Though the impact of a tax cut is somewhat smaller than the impact of an increase in
government expenditure, both have a similar effect in stimulating the economy. If
government wants to stimulate the economy, it can run a deficit, that is, spending more
than it collects in taxes.

Expansionary fiscal policy will promote economic growth and high levels of employment.

Contractionary policies – any government policy that is aimed at reducing the level of
aggregate output (income) is said to be contractionary. Contractionary fiscal policy is
usually used if government wants to reduce inflation but also growth and employment.

A contractionary fiscal policy is a decrease in government spending and an increase in

taxes, and is aimed at decreasing aggregate output(income).
Government can run a surplus in order to reduce the level of output, that is, government
spending less than it collects in taxes. A contractionary fiscal policies are used to slow
down the economy.

The government influences the allocating of resources on a macro economic level. By

taxing some products and subsiding others a particular consumption pattern is promoted.
Fiscal policy is also used to redistribute income and wealth. Progressive income taxes
raises funds which can provide benefits for those who are badly off.

Domestic gross product – GDP

The key concept in the national income and products is the gross domestic product GDP.

GDP is the total market value of a country’s output. It is the market value of all final goods
and services produced within a given period of time by factors of production located with a
country.

Gross Domestic Product GDP measures the output produced by factors of production
located in the domestic economy regardless of who owns these factors. GDP measures the
value of output produced within the economy. Most of this output will be produced by
domestic factors of production but there are some exceptions.
Final goods – first note that GDP refers to final goods and services. Many goods produced
in an economy are not classified as final goods, but instead as intermediate goods.
Intermediate goods are produced by one firm for use in further processing by another firm.
For example tyres sold to car manufacturers are intermediate goods. The value of
intermediate goods is not counted in GDP, this is done in order to avoid double counting.
Suppose Toyota in producing a car pays $100 FOR tyres to Goodyear. Toyota uses the tyres
and other components to assemble a car which it sells at $12 000. The value of the car
including its tyres is $12 000 not $12 000 + $100. The final price of the car already reflects
the value of all its components. To count in GDP both the value of the car tyres sold to the
consumers would be result in double counting .
Double counting can also be avoided by counting the value added to a product by each firm
in its production process.

The value added during some stage of production is the difference between the value of the
goods as they leave that stage of production and the cost of the goods as they enter that
stage. E.g the four stages in the production of fuel are (I) Oil drilling (2) refining
(3)shipping (4)retail.
The refiner pays the driller $50 per litre and charges the shipper $65, the value added to
the refiner is $15. The shipper then sells the fuel to retailers at $80. The value added at
this third stage of production is $15. The shipper then sells the fuel to retailers at $80. The
value added at this third stage of production is $15. Finally the retailer sells the fuel to the
consumer for $100, the same as the value at each stage or production ($50 + $65 + $80 +
$100 = $295) would significantly over estimate the value of fuel per litre. But the correct
value is $50 + $15 + $20 = $100.
In calculating GDP we can either sum up the value added at each stage of production or we
can take the value of final sale. We do not use the value of total sales in an economy to
measure how much output has been produced.

Exclusion of used goods – GDP is concerned with new or current production. Old output
is not counted in current GDP because it was already counted back at the time it was
produced. It would be double counting to count sales of used goods in current GDP. If
someone sells a used car to you, the transaction is not counted in GDP, because no new
production has taken place. GDP ignores all transactions in which money or goods has
changed hands but in which no new goods and services are produced.

Exclusion Of Output Produced Abroad By Domestically Owned Factors Of Production

– the three basic factors of production are land, labour and capital. The labour of Zambian
citizens counts as a domestically owned factor of production for Zambia. The output of
Zambians produced abroad e;g Zambian citizens working for foreign companies is not
counted in profits earned abroad by Zambian companies are not counted in Zambia’s GDP.
However the output produced by foreigners working in Zambia is counted in Zambia’s GDP
because the output is produced with Zambia.

It is however useful to have a measure of output produced by factors of production owned

by a country’s citizens regardless of where the output is produced. This measure is called
Gross National Product GNP.
Closely related to the concept of value added is the distinction between final and
intermediate goods. Final goods are goods purchased by the ultimate user. They are either
purchased by households or capital goods such as machinery which are purchasedby firms.
Intermediate goods are partly finished goods which form inputs to another firm’s
production process and are used up in that process. Thus ice cream is a final good but steel
is an intermediate good which some other firm use as an input to its production.

Finally GDP measures the total amount of goods and services produced in a country. It is a
very economic indicator as every growth in GDP is associated with economic growth. GDP
will therefore help us in calculating the percentage of economic growth by comparing it
with the previous year’s output. Always note that real GDP takes care of inflation and that
foreign investors also influence GDP positively.

Gross national product – GNP

Real gross national product (real GNP) measures the total income of the economy. It tells
the quantity of goods and services the economy as a whole can afford to purchase. It is
closely related to the total output of the economy, increases in real GNP are called
economic growth.

If Toyota has a plant in Zambia for instance, when the car factory owned in Zambia, someof
the profit will be sent back to Japan to be spent or saved by Japanese households. Similarly,
when immigrant workers send some of their wage pockets back home to support their
relatives, or foreign owners of Zambian property rents or dividends, this is part of GNP.
Conversely, Zambian households earn income from factor services that they supply to
foreign countries. Since most of these incomes flow between countries are not labour
income but income from interest, dividends, profits and rent, they are shown in the
national accounts as the flow of property income between countries. The net flow of
property income into Zambia is the access of inflows of property income arising from the
supply of factor services by foreigners in Zambia.
When there is a net flow of property income between Zambia and rest of the world, the
output and expenditure measure of GDP will no longer equal the total income earned by
Zambian citizens. We use the term GNP to measure GDP adjust for the net property income
abroad. So GNP measure total income earned by domestic citizens regardless of the
country in which their factor services were supplied. GNP equals GDP plus net property
income from abroad.

GNP = GDP + Net property from abroad.

Per capital GDP/GNP

GDP and GNP are sometimes measured in per capita terms. Per capita GDP or GNP is a
country’s GDP or GNP divided by its population. It is better measure of a well-being for the
average person than is total GDP or GNP.

GDP per capita is measured by

GDP per capita = GDP

POPULATION

Nominal and real GDP

Nominal GDP is – GDP measured in current prices or the current dollars. In many
applications of macroeconomics, nominal GDP is not a very desirable measure of
production. Assume there is only one good – say pizza. In each year 1 and 2, 100 units of
pizza were produced. Production thus remained the same for year 1 and year 2. Suppose
the price of pizza increased from $1 per unit in Year 1 to $2 per unit in year 2. Nominal
GDP in year 1 is $100 – (100 X $1 = $100), and nominal GDP in year 2 is $200 – (100 X$2).
Nominal GDPhas increased by $100, even when no more units of pizza have been produced.
If we use nominal GDP to measure growth we can be misled into thinking production has
increased when all that has really happened is a rise in the price level.

REAL GDP
Nominal GDP adjust for price changes is called real GDP. These is always a base year that is
use, and it is the prices of that base year that is used when calculating real GDP. For
instance Zambia is still using the 2004 prices as the base year to measure its GDP and the
rate of inflation respectively.

USES OF GNP

1. To measure the total wealth, and therefore, the standard of living in the country
2. To measure the rate of economic growth of the country
3. To assist the process of government planning for the economy
4. To compare the rate of economic change and living standard of different countries
in order to reach certain decisions.

Factors determining a country’s material standard of living

1. Internal
A. Nature of people; the quality of the labour force i.e the health of the population,
skills, abilities, enterprise education and training.
 B. Original national resources: covers minerals, source of energy, climate, agriculture,
and fisheries. Exclusion of mineral resources reduces output. Countries dependant
on agriculture are subject to fluctuation of output annually.
C. Capital equipment; essential for development of natural resources and labour.
D. Organisation of factors of production to achieve maximum output the factors of
production must be organisation efficiently.
E. Political situation; a stable government is an incentive to investment particulary in
long-term capital projects.

2. External
a. Term of trade; the rate at which a country’s goods and services exchange against
those of other countries. If terms of trade are more in the nations favour, it means
that it gets a larger quality of imports for a given quality of its own exports.
b. Goods and grants from abroad; when gifts and grants are used to further the
economic development of the country receiving them, the standard of living
improves.

Inflation

Inflation can be defined as a persistent general increase in the price levels of goods and
services. It is a situation where there is a sustained rise in weighted average of all prices. If
the average of all prices rising year in and year out, then it is inflation and not just a one-
time price increase.

In an extreme form of inflation, prices rise at a phenomenal rate and terms such as
hyperinflation, runaway inflation, and galloping inflation have been used to describe these
conditions. Under hyperinflation prices can be increasing at probably every hour, as result
it can cause a breakdown of the entire economy. Germany experienced this kind of
inflation in 1923, and recently in Zimbabwe.

Under conditions of hyperinflation people loose confidence its currency and loose
confidence in the country’s ability to carry out its functions. A country under
hyperinflation can suspend its currency and adopt another currency such as United States
dollar as what has happened in Zimbabwe, the country now uses the US dollar in the
purchase of goods and services.

Inflation is measured using the Consumer Price Index (CPI). The CPI measures the
changes of average prices of the food basket of those goods and services on which most
households spend their incomes. This enables economist to assess the purchasing power
of money.
The food basket can contain mealie meal, sugar, salt, tomato, onion, vegetables, cooking oil,
foods, etc, inflation can be a percentage in retail price index over a period of time.
Inflation tends to reduce the standard of living on price. It affects all in the economy. It
sometimes can cause

Causes of inflation

There are many different explanations for inflation. Inflation occurs either because of an
increase in total demand, pulls up prices (demand pull inflation) or because of an increase
in the cost of production pushes up the prices of final goods (cost push inflation )

1. Demand pull inflation

When total aggregate demand in the economy is rising while the available output of
goods is limited, demand-pull inflation occurs. Goods and services maybe in short
supply either because the economy is fully utilised or because the economy cannot
grow fast enough to meet the increasing level of demand as a result prices will rise.
This type of inflation is often experienced as an economy approaches and reaches
its full employment level. When demand rise faster than the growth of supply.

2. Cost push inflation

It occurs when there is an increase in the average cost of production. It pushes up
general prices levels of goods and services. This is inflation from the supply side of
the economy. As the cost of production rises, firm will increase the prices of goods
and services. Cost push inflation is caused by some of the following, union power,
big business power, increases in prices of raw materials.

3. Wages increases
Unions decide to demand a wage-rise that are sometimes not warranted by
increases in their productivity. Since unions are powerful, employers give in for
high wages hence increasing the cost of production. Therefore to maintain their
usual profit margin, firms will raise the price of goods and services and turns out
into a wage spiral.

4. Import prices –
Import costs play a vital role in prices, the rise in price of oil, which is an imported
commodity, has a significant effect on the domestic prices of goods and services in
Zambia. This is called imported inflation.

5. Exchange rates
The depreciation in the external value of the Kwacha has certainly been inflationary.
If the Kwacha depreciates in value against its major trading currencies, it will mean
that imports have become more expensive than before, hence the price of imports
will go up, the prices of imported goods and services will rise and affect domestic
prices as well. But if the Kwacha appreciates, it will mean that imports have become
cheaper than before, and the price of imported goods and services is expected to
have an opposite effect to a depreciation.
 6. Monetary inflation
Inflation is ever-there and is everywhere, a monetary phenomenon in the sense that
it can be caused by rapid rise in the quantity of money than output. According to
monetarist; inflation is too much money chasing too few goods.

Controlling inflation

Through fiscal policy – this is based on the demand management, that is, lowering
or raising the level of aggregate demand. Government can act upon any of the
components of aggregate demand. The most appropriate is when it reduces
government expenditure and increases tax rates. Wages are one of the biggest
factors in the control of inflation.

Monetary policy
This supplements the fiscal policy. The prescription is to control the supply of
money by using medium term financial strategies. The central bank regulates
money supply by Open Market Operations (OMP), using instruments such as
treasury bills, interest rates etc.

Direct interventions
Prices and incomes policy, government takes measures to restrict the increase in
income and wages. This ensures that income and prices suit and not rise faster than
the improvement of productivity in the economy. This is done in two ways.

a. Through statutory – this is when government passes a legislation to limit or

freeze wages and prices.
b. Voluntary – this is when government tries through persuasion or otherwise
called moral suasion and argument to improve a wage and price freeze.

Inflation and economic growth

Effects of inflation on the economic growth. Inflation brings about uncertainty and
discouragement in savings. This brings about a drop in investment. A certain percentage
of inflation can stimulate savings and so economic growth in the economy. So a certain
degree of inflation is said to be permissible. Indicators of inflation will thus range from
strikes, more money and shortage of goods and services, high interest rates, a low
productivity.These will indicate high inflation.

Inflation and distribution of income

A fall in the value of money will reduce the purchasing power on those living on fixed
incomes and redistribute it towards those who draw their living on prices (sellers).
Inflation tends to favour those living on prices (sellers) and disadvantages the fixed income
earners. Fixed income constitutestudent grants, old age pension, and long term contracts.
Inevitably these payments do not cater for unanticipated inflation. Persons who solely
depend on fixed income lose purchasing power during periods of inflation e.g if a person
earns K1 000 and if there is an increase of 10%, that will mean that purchasing power will
be reduced to K900

Inflation and employment

Reducing inflation will cause more unemployment and increasing inflation generally is
supposed to have an adverse effect in the balance of payment to that effect.

Money and Banking

Money is anything that is generally accepted as a medium of exchange, its anything we use
as a medium of exchange. Money is anything accepted as a means of payment for delivery
of goods and services or the settlement of debt. Before money was, barter system was used
which is simply a direct change.

Functions of money

There are four traditional functions of money –

1. Medium of exchange
2. As a unit of account
3. As a store of value
4. As a standard of deferred payment

Money as a medium of exchange

As a medium of exchange money allows individuals to specialise in any area in which they
have a comparative advantage and to receive money payment for the fruits of their labour.
Money can then be exchanged for the services of labour. It is a medium through which
people exchange goods and services. The benefit of money as a mediumof exchange is
appreciated by imagining a barter economy. A barter economy has no medium of
exchange. Goods are traded directly or swapped for other goods. In a barter each (buyer
and seller) want something the other wants to offer. Each is simultaneously a seller and a
buyer. In order to watch a movie, you must hand over in exchange a good or service that
the cinema manager wants, there has to be a double coincidence of wants.
In barter economy, trading is very expensive as people spend a lot time and effort looking
for things and other people with whom they can mutually satisfactory swap. Since time
and effort are scarce resources, a barter economy is wasteful. Therefore money is more
simpler and more efficient.
Money as a unit of account
As a unit of account, money is used as a way of placing a specific value on economic goods
and services. Prices are quoted and amounts kept. The monetary unit is used to measure
the value of goods and services relative to other goods and services; it’s a common
denominator.

It enables individuals to compare easily the relative value of goods and services.
Government uses money prices to measure national income each year. A firm uses money
prices to calculate profits and loses as its unit of account.

Money is also a standard of value that allows economic transactions to compare the
relative worth of various goods and services. In short it acts as an economic yardstick. In
Zambia prices are quoted in Kwacha and Ngwee.

Money as a Store Of Value

Consider the following example: a fisherman comes into port after several days of fishing.
At the going price of fish that day, he has one million kwacha worth of fish. Fish is not a
good store of value because if the fisherman keeps the fish long, it can go bad or rot. But if
the fisherman sells the entire catch and receives money and saves it. Money is therefore a
store of value because it can be used to make purchases in the future.
However, increase in the rate of inflation however reduces the value of money, making
money therefore, a rather poor store of value. So to protect this, people may buy houses,
equities or shares, paintings etc, these kind of properties will appreciate in value if prices
rise in times of inflation.

Money As A Standard Of Deferred Payments

In less technical terms this simply means that money can be used as a means of entering
into agreements regarding future payments. This function therefore, simultaneously
involves money as a medium of exchange and a unit of account and are paid with a
monetary medium of exchange. The negotiation of future payments is an essential feature
of any complex society. Workers negotiate a salary for payment for completion of a job;
landlords negotiate a rent that will be paid at regular intervals in the future, shareholders
expect dividends, a portion of their firm’s profit each year, and so on.
It is interesting to notice that not all countries will use their own national monetary unit to
specify future payments.

Different Kinds of Money

In prisons of war camps, cigarettes saved as money. In the 19 th century money was mainly
gold or silver coins. These are examples of commodity money, ordinary goods with
industrial uses (gold) and consumption (cigarettes) which also serve as a medium of
exchange. To use commodity money, society must either cut back on other uses of that
commodity, or devote scarce resources to produce additional quantities of that commodity.
Token money is another which is simply a means of payment, whose value or purchasing
power as money greatly exceeds its cost of the production or value in uses other than as
money. A K10 note is worthy far more as value of most coins exceeds the amount you
would get by melting them down and selling off the metal they contain.

By collectively agreeing to use token money, economises on scarce resources required to

produce money as a medium of exchange. The essential condition for survival of token
money is the restriction of the right to supplyit. Private production is illegal. Society
enforces the use of token money by making it a legal tender.
When prices are rising very quickly like in Zimbabwe domestic token money maybe a very
poor store of value and people will be reluctant to accept it as money of exchange. Shops
and firms will offer discount for people paying in gold and foreign currency.

Measuring Money Supply

The two most common measures of money are transactional money also known as MI, and
broad money also called M2.

M1 – or transactions money is money that can directly be used for transactions. This
consists of coins and kwacha notes, as well as higher denomination of currency. Cheques,
too, can be used to buy things and can serve as a store of value. Bankers call cheques,
demand deposits, because depositors have the right to go to the bank and cash in (demand)
their entire checking account balances at any time. This makes cheques (checking )
account balance virtually equivalent to bills in your wallet, and it should be included as the
amount of money you hold.

If we take the value of all currency held outside the bank vaults and add to it the value of all
demand deposits, travellers’ cheques, and other checkable deposits, we have defined M1, or
transactions money. This is money that can directly be used for transactions that is to buy
things.

A checkable deposit is any account with a banking or financial institution on which a

cheque can be written.

M1 = currency held outside banks+ demand deposits + travellers’ cheques + other

checkable deposits.
M2 – Broad Money: although M1 is the most widely used measure of money supply, there
are others. Savings accounts should be counted as money, because many of these accounts
cannot be used for transactions directly, but it is easy to convert them into cash or cash or
transfer funds to checking accounts. M2 or broad money, therefore, is M1 plus savings
accounts, money market accounts, and other near monies.

Banking

The goldsmith bankers were an early example of financial intermediary. A financial

intermediary is an institution that specialises in bringing lenders and borrowers together.
In the 15th century citizens and many lands used gold as money, particularly for lar5ge
transactions. But because gold is inconvenient to carry around and susceptible to theft,
people began to place their gold with goldsmiths for safe keeping. On receiving the gold, a
goldsmith would issue a receipt to the depositor, charging him a small fee for looking after
the gold. After a time, these receipts themselves, rather than the gold that they represented
began to be traded for goods. The receipts became a form of paper money, making it
unnecessary to go to the goldsmiths to withdraw the gold for a transaction. Goldsmiths
functioned as a warehouse where people stored their gold for safe keeping. The goldsmiths
however found that people did not often come to withdraw the gold, because they had
receipts they had functioned as goldand could easily be converted to gold and were as good
as gold itself. As a result, goldsmiths had a large stock of gold continuously on hand.
Because they had what amounted to extra gold sitting around, goldsmiths gradually
realised that they could lend some of this gold and earning interest on itwithout any fear of
running out of gold and hence the origin of modern banking. They started making money
on the gold without adding any real gold to the system, the goldsmiths increased the
amount of money in circulation by creating additional claims to gold.

Commercial Banks

A commercial bank is mostly private owned, and profit seeking institution. Commercial
banks accept money from their customers and use them to make profits. They accept
money from the public by creating them with a deposit. The deposit is a liability of the
bank. It is money owed to the public. In turn the bank lends money to the firms,
households, or the government wishing to borrow.

There are different types of banks which operate within the banking system.

a. Clearing Banks – operate the clearing system for settling payments (e.g payments
by cheque by bank customers)
b. Retail Banks – the term retail is used to describe the tradition high street banks.
The term wholesale bank refers to banks which specialise in lending large quantities
to major customers. The clearing banks are involved in both retail and wholesale
banking but are commonly regarded as the main retail banks.
c. Investment Banks – (which used to be referred to as merchant banks) offers
services, often of a specialised nature, to corporate customers.
d. Commercial Banks – make commercial banking transactions with customers. They
are distinct from the country’s central bank.

Functions of Commercial Banks

Providing a payment mechanism – the clearing system is a major payments mechanism

and enables individuals and firms to make payment by cheque. The banks are also a source
from which individuals and firms can obtain notes and coins.

Lending money – commercial banks lend money in the form of loans and over drafts.

Acting as a financial intermediary – commercial banks are intermediaries between

depositors and borrowers.

Commercial banks – also provide customers with a means of obtaining foreign currency,
commercial banks play an important role in the foreign exchange markets.

Commercial banks also help in providing assistance to exporters and importers, for
example helping exporters to obtain payment from buyers abroad, and helping importers
to pay for goods they buy from foreign suppliers. Commercial banks also give investments
advice. They also act as insurance brokers for insurance companies by selling some
insurance policies. Banks as well do assist and advise companies to issue shares on the
stock market.

One unique component about banks is their ability to create credit or create money. When
you deposit money in a bank, the banks are able to create credit of a much greater
magnitude than the amount of money originally deposited. If a customer deposits one
million kwacha the bank will, we will assume, re-lends all the deposit to other customers
(borrowers). The customers will use the money they have borrowed to buy goods and
services and they pay various firms and individuals for these purchases. If the firms and
individuals receiving payments then put the money into their own accounts with the bank,
the bank’s deposits will have doubled. It is this fact most additions to bank lending end up
as money in someone’s bank account, adding to total customer deposits with the banks,
that gives banks this special ability to create credit.

Commercial banks have other common features, they all have extensive branch networks
and are major participants in the clearing system (this involves the daily settling of debts
between banks that are generated by customer cheques). In banking, clearing system are
set of arrangements in which debt between banks are settled by adding up all the
transactions in a given period and paying only the net amounts needed to balance inter
bank accounts. Suppose you bank with Stanbic and you issue a cheque to someone who
banks with ZANACO. You write your cheque against a deposit at Stanbic. The recipient
pays this cheque into his account at ZANACO , and in turn ZANACO presents the cheque to
Stanbic by an equivalent amount. Because you signed a cheque to a user of a different
bank, a transfer of funds between the two banks is required Crediting and debiting one’s
bank account to another bank is the simplest to achieve this.

In addition to all payments made by cheque, further billions are transferred by electronic
methods, for instance, all those payments made by direct debit, standing order, credit
cards, or electronic money transfer.
Commercial banks are sometimes known as retail banks because they offer services to a
large number of customers, many quite small in scale. They take deposits and lend to
borrowers who wish to spend on customer or investment goods. Banks make profit by
charging interest on money they lend or loan out to customers.
In the transaction of money, customers with fixed or deposit accounts can write cheques to
their creditors.
Commercial banks also offer advisory services to their customers, banking investment, and
taxes, etc they also offer financial intermediaries, insurance companies, pension funds,
building societies, discount houses, national savings banks, etc. the crucial feature of
banks, is that some of the stock of money.
Commercial banks may be termed joint stock bank due to their operation; they exist to
create profit for their shareholders and services for the clients.

The Central Bank

At the head of the monetary sector, there is a central bank. Every country in the world has
central bank, it is frequently owned and operated by the government.
In Zambia, the central bank is the Bank of Zambia (BOZ). It is responsible for the smooth
running or working of the banking sector. The central bank i.e Bank of Zambia is a bank
which acts on behalf of the government; it is the banker’s bank and the banker of the
government. Commercial banks are by law required to have accounts at the central bank.
The BOZ is run by the Board of directors, the Governor, the Deputy Governors, and other
executive directors.

Functions of the Central Bank (BOZ)

 a. It acts as a banker to the central government; all government revenue goes to the
Bank of Zambia (BOZ).

b. It is the central note issuing authority in Zambia. It is responsible for issuing notes
being the Kwacha and Ngwee in Zambia.

c. It is the manager of the national debt. i.e it deals withlong-term and short-term
borrowing by the central government and the repayment of government debt.
Government borrows from domestic residents by selling financial securities and
government bonds to the public through an open market operation.

d. It is the manager of the national foreign exchange reserves.

e. It also acts as an advisor to the government on monetary policy.

f. It acts as an agent for the government in carrying out its monetary policy. It has
operational responsibility for setting interest rates at the level it considers
appropriate in order to meet the government’s inflation target.

g. The central bank is also a bankers’ bank in that, it acts as a banker to commercial
banks. Commercial banks and other financial institutions keep accounts at the Bank
of Zambia. And the BOZ monitors how commercial banks and other financial
institutions operate to ensure efficient financial system stability.

h. It is the lender of the last resort to the banking system. When the banking system is
short of money, the bank of Zambia will provide the money banks need.

i. The Bank of Zambia also supervises the operations of commercial banks and other
financial institutions such as insurance companies, and pension’s institutions like
NAPSA etc.

Lender of the Last Resort

To avoid financial panics, it is necessary to ensure that people believe that banks can never
get into trouble in the first place. There must be a guarantee that banks can get cash if they
really need it. And there is only one institution that can manufacture cash in indefinite
quantities and that is the central bank. The threat of financial panic can be avoided, or at
least greatly diminished, if it is known that the bank of Zambia stands ready to lend to
banks and other financial institutions when panic threatens the financial institutions.
It reduces the uncertainty in the day-to-day process of monetary control. By acting as a
lender of the last resort, BOZ can maintain confidence in the banking system.
The Bank and The Money Supply

The quantity of money available in circulation is called money supply. The central bank is
responsible for controlling the money supply.
How does the bank of Zambia control or affect the money supply in the economy? The
narrowest measure M1 of the money supply is currently in circulation outside the banking
system plus demand deposits, and other checkable deposits.

Three important instruments through which the central bank affect the money supply are,
the minimum reserve requirement ratio, the discount rate, and open market operations
(OMP).

Minimum Reserve Requirement

A required reserve ratio is a minimum ratio of cash reserve to deposits that the central
bank requires commercial banks to hold. When the central bank increases the minimum
reserves requirement ratio, the effect is to reduce the creation of bank deposit and hence
reduce the money supply for any given monetary base. If the central bank increases the
minimum required reserve ration, commercial banks will have less money to create credit
through offering loans, hence reduce the money supply. When the central bank increases a
reserve requirement ratio therefore, banks will be creating less deposits and undertake
less lending inform of loans. Thus a reserve requirement ration acts like a tax on banks by
forcing them to hold a higher fraction of their total assets as bank reserves and lower
fractions as loans earning higher fraction of their assets to offer as loans and hence create
more credit and hence increasing the money supply.

The Discount Rate

The second instrument of monetary control available to the central bank is the discount
rate.
The discount rate is the interest rate that the bank charges when the commercial banks
want to borrow money. If the discount rate is high, it will discourage commercial banks
from borrowing extra money from the central bank to make loans, and hence reducing on
the money supply. But when the central bank reduces the discount rate, it will encourage
commercial banks, to borrow extra money from the central bank to lend out as loans and
hence increasing the money supply.
Suppose, the central bank announces that, although the market interest rate are 8 percent,
it will lend to commercial banks only at the penalty rate of 10 percent. Now a bank with a
cash reserve of 12 percent may conclude that it is not worth making extra loans. There is
too high risk that sudden withdrawals will then force the bank to borrow from the bank at
a penalty of 10 percent interest. It makes more sense for commercial banks to hold some
excess cash reserves against the possibility of sudden withdrawals.

Thus, by setting the discount rate at a penalty level in excess of the general level of interest
rates, the bank can induce commercial banks voluntarily to hold additional cash reserves,
hence reducing on the money supply.

Open Market Operations

An open market operation occurs when the central bank alters the money supply base by
buying or selling financial securities in the open market.
The primary way in which the central bank controls the money supply is through open
market operations, which is the purchase and sale of government bonds.

To increase the money supply, BoZ will use Kwacha to buy back government bonds and
hence increasing the money supply. This purchase of government bonds by the central
bank increases the amount of Kwacha in circulation. If the government purchases
government bonds from the public, institutions or banks worth ten billion, then exactly ten
billion worth of cash has been injected into circulation, indicating an increase in money
supply.

If government wants to reduce the money supply, the government through BoZ will offer
for sale government bonds, and people, banks and institutions will have to pay for them
using liquid cash or cheques, hence government will have withdrawn money from
circulation. If government sells government bonds worth ten billion, and the public
purchases all the government bounds, then ten billion worth of cash would have been
withdrawn from circulation, hence reducing the money supply. By open market operation
in financial securities, the bank alters the monetary base, bank’s cash reserves, and the
money supply.

International Trade

International trade involves the exchange of goods and services across international
boundaries. There maybe restrictions Imposed by governments and international
organisations on the movements of products into and sometimes out id, countries.
Engaging in international trade gives firms access to greater markets. Consumers can also
gain from international trade. They are able to purchase goods not made in their
owncountries, and have a greater variety or products and can benefit from increased
competition in the form lower-priced and better quality products.

International trade arise because the production of different goods and services requires
different kinds of resources used in different proportions and because the various types of
economic resources used in different proportions and because the various types of
economic resources are unevenly distributed throughout the world. The international
mobility of resources is limited. Land is obviously restricted by barriers of language and
custom and immigration restrictions. Capital is more mobile geographically but it only
crosses international boundaries when favourable conditions exist such as political
stability, no threats of confiscation, no barriers to taking profits out of the country etc.
Since it is difficult to move resources between nations, the goods and services which
represent the resources must move. Nations which have an abundance of land will tend to
concentrate on land-intensive commodities such as wheat and meat. They will exchange
these goods for labour-intensive products such as manufactured goods made by countries
which have an abundance of labour and capital relative to land.

Gains from International Trade

Consider two countries, country A and country B. it is assumed that only two commodities
are produced, tractor and wool. There are no barriers to trade and no transport costs.

Each country can produce one commodity

Here the gains from international trade are self-evident. It increases the variety of goods
available to each country. There are certain goods and services a country may not be able
to produce or may experience difficulty producing. Japan for instance relies on foreign
trade for most of its raw materials.

Each Country Has an Absolute Advantage

We also assume that each country is more efficient than the other in the production of one
of the commodities. Country B produces wool more efficiently than country A, while
country A has the advantage in producing tractors.

Example
Total output increases. In order to obtain the benefits of specialisation these countries
must exchange some part of their individual outputs.
World output of goods and services will increase if countries specialise in the production of
goods and services in which they have a comparative advantage.

Absolute Advantage

A country enjoys absolute advantage over another in the production of a product if it uses
fewer resources to produce that product than the other country does. Suppose country A
and country B produces maize, but country A’s climate is more suited to maize and its
labour is more productive. Country A will produce more maize per acre than country B and
uses less labour in growing it and bringing to the market. Country A enjoys an absolute
advantage over country B in the production of maize.

A country is said to have absolute advantage in the production of a good when it uses fewer
resources to produce that good, or is more efficient than another country in the production
of that good i.e when it can produce more of a particular good with a given amount of
resources than another country.

Comparative Advantage

A country enjoys a comparative advantage in the production of a good if that good can be
produced at lower cost in terms of other goods than it could be in the other country.

A country is said to have a comparative advantage over the other if it can produce a good
cheaper than another country in the production of the same good.

The law of comparative advantage (or comparative costs) states that two countries can
gain from trade each when each specialises in producing goods that they can produce
relatively cheap.

Zambia has a comparative advantage in the production of maize than Russia because
Zambia can cheaply and easily produce maize because of the favourable weather
conditions for maize production in Zambia than Russia which is covered with snow at
most of the year.

Barriers to Trade

There are many barriers to trade because governments try to protect home or domestic
industries against foreign competition. Protectionist measures may be taken against
imports of cheap goods that compete with higher-priced domestically produced goods, and
so preserve output and employment in domestic industries. This is necessary to counter
dumping of surplus production by other countries at an uneconomically low price. Those
in favour of protectionism also say it is necessary in order to protect infant industries that
have not yet developed to the size where they can compete in international markets.
Protection as well is seen as a means for a country to reduce its trade balance deficit by
imposing a tariff or a quota on imports.

Protectionism can be practised by government in several ways.

 Tariffs or customs duties

 Import quotas
 Embargoes
 Hidden subsidies for exporters and domestic producers
 Import restriction

Tariffs or Customs Duties

A tariff is a tax on imports.

Tariffs or customs duty are taxes on imported goods. Tariffs act exactly the same way as a
tax by artificially raising the price of foreign products as they enter the country. The effect
of a tariff is to raise the price paid for the imported goods by domestic consumers. This
makes the price of imported goods by domestic consumers. This makes the price of
imported goods more expensive hence discouraging domestic consumers from consuming
foreign produced goods and start buying local goods which will remain cheap relative to
imported goods which have been taxed. The government collects revenue from tariffs
charges.

Import Quotas

A quota is a limit on the quantity of imports.

Import quotas are restrictions on the quantity of a product that is allowed to be imported
in the country. The quota is not a tax but a restriction or physical limitation on the quantity
or the volume of a good to be imported or enter the country. Zambia for instance has
import quota on the amount of sugar and cement that can be brought into the country from
Zimbabwe or South Africa. Importers cannot bring into the country more sugar or cement
than what has been stipulated by the quota. The quota has similar effect on consumer
welfare to that of import tariffs, though government collects no revenue from quotas.

An Embargo

An embargo on imports from one country is a total ban on the importation of goods and
services from the country in question.it is effectively a zero quota.
Export Subsidies

Export subsidies – are government payments made to domestic firms to encourage exports.
When a government gives grants to its domestic producers, for example regional
development grants for new investments in certain areas of the country or grants to
investment in new industries, the effect of these grants is to make production costs lower.
Most governments including the Zambian government heavily subsidies there agricultural
products. For export subsidies it can be in the form of export credit guarantees (insurance
against bad debts for overseas sales), financial help. This helps reduce the price of
domestic products and making imported goods expensive, and hence less competitive.

However, the world is now championing on reducing barriers to trade. Organisation such
as the World Trade Organisation (WTO), have been formed with the aim of reducing
existing barriers to trade. The European Union, the Common Market for Eastern and
Southern Africa (COMESA), the Southern Africa Development Community (SADC), and
others are all driving towards a free international trade.

Undesirable Effects of Protection

Protection, however, has a negative effect on the country’s businesses. Protection is likely
to raise costs to domestic businesses; domestic producers of inputs will take advantage of
the reduction in competition to raise their prices. Rising prices of imports and domestic
goods will lead to increased wage demand.

Foreign trading partners are likely as well to retaliate with protective measures of their
own, this reducing export demand. Home consumers will find their real incomes declines
as costs rises, and thus domestic demand will decline.

Countries will thus gain more by trading with each other.

Trade Surplus and Trade Deficits

When a country exports more than it imports, it runs a trade surplus. When a country
imports more than it exports, it runs a trade deficit.