Introduction to Economics

Economics is a social science which studies the allocation of scarce resources which have alternative uses among competing and usually limitless wants of the consumers in the society. It is thus concerned with the way people apply their knowledge, skills and effort to the gift of nature in order to satisfy human their material wants

It is also defined as the study of how human beings strive to satisfy their unlimited wants using limited resources.

Basic Economic Concepts


This are basic needs that human beings need to function normally this include; food, shelter, clothing and air. Things like radio, education, watches, and vehicles are not very basic. They are meant to have an individual have a happy and comfortable and luxurious life.

  • Form utility-This is created through changing the form of a raw material to a finished product. It is usually done during various manufacturing processes. The finished goods are in a better form for use than the raw materials.
  • Time utility-this is created through warehousing or storage
  • Possession utility-This is created through trade or exchange.
  • Place utility-this is created through distribution. After goods have been produced, they must be moved to the places where they are required for use.

Characteristics of human wants.

  • They are many, numerous and unlimited.
  • They continually change with time and other factors.
  • Some are repetitive e.g. supper, lunch etc.
  • Wants are competitive
  • Wants are complementary-Used together e.g. shoe polish and a shoe.
  • Wants are habitual that they always occur e.g. toothpaste, perfume etc.
  • Wants are universal-Everybody wants them.

Characterisics of basic wants.

  • One can’t do without them.
  • They are felt needs
  • Can’t be postponed
  • They are satisfied before secondary wants.

Difficulties in satisfying human wants.

Although human wants are there to satisfy man with lives requirements, it is not always possible to have them this is because;

  • They are too many and new ones keep cropping up.
  • Resources to satisfy them are never enough (limited).
  • They are repetitive hence people will always strive for more resources.
  • They continually change with time and other factors like age and gender.
  • Some are habitual making life unbearable without them.
  • Due to scarcity of resources, a problem of deciding which want to satisfy first with scarce resources arise.

Types of human wants.

They are classified into two groups.

1.Basic human needs-This are things one cannot do without  e.g. food. They always come at the top for the scale of preference and failure to satisfy them one can lead a miserable life or even die.

  1. 2. Secondary human wants-they are things one cannot do without. They help one lead a happy meaningful and comfortable life e.g. TV set, radio, cars, education, sodas etc. must satisfy basic needs before attaining secondary wants.

Since the resources to satisfy human wants are scarce, one has to select on what wants are to be satisfied first and which can wait.

2 Economic Resources These are ingredients that are available for providing goods and services in order to certify the human wants. A resource must be scarce and have money value.

Characteristics of economic resources.

  1. They are scarce in relation to their uses
  2. They have a monetary value.
  3. They have alternative uses.
  4. They are unevenly distributed
  5. They have utility
  6. Can be combined to produce goods and services. They are transferrable from one place to another.

Types of economic resources.

There are three main ways of classifying economic resources namely;

  1. Natural resources-They are also called the gifts of nature and are fixed in such by they are held in trust by the government for the citizens. They include; forest, river, mountain, minerals and lakes.
  2. Artificial resources-They are created by people through various production activities e.g. machinery,tools,roads,railway,airport,dams,bridges,h.e.p,harbours,soaps,books.
  3. Human resources-They are mental/physical efforts offered by people to the production society. These efforts cannot be separated from their providers e.g. teaching, health services, mechanics, carpentry, engineers etc.

3Natural Resources refer to anything given by God or nature such as fertile soil, rivers, lakes, mountains etc.

4 Man Made Resources refers to anything created by man to assist in further production such as tools, equipment’s, roads and buildings etc.

5 Scarce and Choice if the resources available are not enough to produce goods and services to satisfy all the wants then they are said to be scarce. As a result, individuals and society cannot have all the things that they want. Since resources are limited, choices have to be made. The choice to satisfy one want implies others are forgone. Individuals have to make choices e.g. consumers with their limited income and unlimited wants have to choose how they spent their income.

Importance of scarcity.

  1. Makes people to work hard
  2. Stimulates usage of available resources

6 Opportunity Cost refers to the value of benefit expected from the best second alternative forgone. It is based on the fact that resources being scarce have competing alternative uses. The choice to satisfy one alternative means that another is forgone. The value of the second best forgone alternative is the opportunity cost.

7 Utility-this is the quality of that commodity that satisfies human want.


9.Economy-this is the country’s financial position.

  1. Economies-this are the benefits of large scale.

11.Ceteris paribus-this is a major concept meaning, other factors held constant

  1. Pareto efficiency-this is a situation in which it is not possible to make someone better off without making someone worse off.

13.Consumer sovereignity-this refers to the freedom of individuals and households to decide for themselves what they want to buy in a given market.

Production Possibility Frontier/Capacity (PPF/PPC)

It provides a graphical illustration of the problem of scarcity and choice which is the basic economic problem. The curve shows what a country produces with existing supply of land, capital and entrepreneurship ability. With limited supply of economics resources a country has a wide variety of options and variety of goods and services it can produce. Assume a simple hypothetical economy where a country produces two types of goods i.e. agriculture and manufactured goods. The two extreme possibilities are:

  1. a) The country commits all its resources to the production of agriculture and non to manufacturing.
  2. b) All the resources are put to manufacture and none to agriculture.

These two extreme cases are unlikely and the country will most likely choose to produce goods of both commodities. The opportunity cost of producing either of them is increasing which the law of diminishing return.

The main branches of economics are:

  1. Microeconomics

This is the study of the smallest economic decisions making units of the society. Microeconomics theory is a branch of economics that studies the behavior of individual decision making units such as consumers, resource owners and business firm as well as individual markets in a free market economy. The aim of microeconomics is to explain the determination of prices and quantities of individual goods and services. Microeconomics also considers the impact of government regulation and taxation of individual markets. For example, microeconomics analyses the forces that determine the prices and quantities of television sets sold. Microeconomics can be considered as the ultimate cellular structure of economics. It is the study of individuals, households and firms. The major areas are

demand and supply analysis , market equilibrium ,consumer theory , theory of the firm , market  structure and distribution theory


This is the study of bigger and complex systems. Macroeconomic theory is the study of the behavior of the economy as a whole whereby the relationship is considered between broad economic aggregates such as national income, employment and prices. The economy is disaggregated into broadly homogenous categories and determinants of the behavior of these aggregates are integrated to provide a model to the entire economy.

Macroeconomics focuses on the economic stabilization whereby government policy is used to moderate business cycles and encourages real economic growth. Macroeconomics became a separate topic of discussion in the aftermath of John Maynard Keynes and the great depression. The line between microeconomics and macroeconomics is, however, blurred and there are many areas of overlap between the two. Key areas of macroeconomics are:

national income ,economic growth and development , money and banking , public finance unemployment ,inflation  and international trade

Why Study Economics?

It is useful to study economics for the following reasons

  1. Economics provides the underlying principles of optimal resource allocation and thus enables individuals and firms to make economically rational decisions. Thus for example the preparation of budgets involves knowledge of demand and elasticity analysis. The making of price policy decisions draws heavily on the concept of elasticity in economics. Additionally, the theory of production in economics is concerned with the principles that facilitate the optical combination factors of production.
  2. A study of economics enables individuals and organizations to appreciate the constraints imposed by the economic environment within which any entity operates. Thus an individual or firm is more fully enabled to appreciate the implications of the annual budget considering how for example the increased liberation of the economy will affect a particular business entity and the economy in general. Additionally, the student of economics is able to appreciate the effects of such economic variables as inflation, exchange rates, interest rates money supply and so on.
  • The area of development economics is fundamentally concerned with the reasons why societies develop and means of accelerating development. It is vital for individuals as citizens to appreciate the parameters that determine the development process so that they contribute more fully to facilitate and contribute to solving the economic problems that characterize their society.
  1. Economics is an analytical subject and its study can help develop logical reasoning which is never superfluous.
  2. It is an examinable and mandatory for students perusing business courses
  3. Students appreciate the effect of economic variables e.g. inflation, exchange rate, interest rate, money and supply etc.

The Methodology of Economics

The methodology used in studying and applying economics can be divided into three. This are basically the methods of solving economic problems.

  1. Positive economics is concerned with what is, or how the economic problem facing societies are actually deals with facts using positive statements. for example; “Kenya is a member of the East African community” and “Uganda is currently Kenya’s major trading partner” are positive statements. For example a dispute over whether Uganda is currently Kenya’s major trading partner can be settled by looking at the statistics of Kenya’s trade with its partners.
  2. Normative economics refers to the part of economics that deals with the value of judgments. This implies that normative deals with what ought to be, or how the economic problems facing the society should be solved. Normative statements usually reflect people’s moral attitudes and are expressions of what particular individuals group thinks ought to be done. A statement such as “Uganda to should join the Southern Africa

Development Community” or “upper income classes ought to be taxed heavily”, are normative statements.

  1. Scientific method

Economics make use of scientific method to develop theories. Inquiry is generally confined to positive questions. One of the major objectives of sciences is to develop theories. A theory is a general or unifying principle that describes and explains the relationship between things observed in the world around us. The purpose of a theory is to predict and explain. The search for a theory begins whenever a regular pattern is observed in the relationship between two or more variables and one asks why this should is so. A theory refers to a hypothesis that has been successfully tested. It is important to note that economics hypothesis is not tested by realism of its assumptions but its ability to predict accurately and explain. The following procedures are adopted in the scientific method:

  1. i. The concepts are defined in such a way that they can be measured in order to be able to test the theory against the facts.
  2. ii. A hypothesis formulated..

iii. The hypothesis is then used to make predictions.

  1. The hypothesis is tested by considering whether its predictions are supported by facts.

Economic Systems

These refer to the way in which different societies solve the three different basic economic problems which are: which goods should be produced and in what quantities?

  1. How should various goods and services be produced?
  2. How should various goods and services be distributed?

To answer this question, various political and economic structures have been put in place, whereby we have;

  • Free market/capital system/laser faire economy

It refers to a system where decisions about allocation of resources are made by individuals on the basis of prices generated by forces of market prices of demand and supply.


  1. Private property individuals have the right to own or dispose off their property as they may consider it fit.
  2. Freedom of choice and enterprise Individuals have the right to buy or hire economic resources, organize them for production purpose and sell them in the market of their choice. Such persons are referred to as entrepreneurs.
  3. Self interest in the pursuant of personal goals. The individuals are free to do as they wish and have the motive of economic activity in self-interest.
  4. Competition There is a large number of buyers and sellers such that each buyer and seller accounts for but is insignificant to influence the supply and demand and hence prices.
  5. Reliance on price mechanism .This is an elaborate system of commerce in which numerous choices of consumers and producers are aggregated and balanced against each other. The interaction of demand and supply determine prices.
  6. No government intervention hence no price controls, taxes and subsidies.
  7. There are property rights provided and enhanced by the government through copy rights patents, trademarks etc. e.g. on innovating and inventing one is protected from absorption and thus you enjoy the benefits.
  8. There is excessive advertising.

Advantages of free market economy

  1. There is the matching of demand and supply. Production takes place in response to demand hence a balance between what is produced and consumed. No wastage.
  2. There is flexibility of the market in responding to changes in demand and supply conditions thus variety products are offered.
  3. There are no resources wasted in planning as no planning is required
  4. Consumer sovereignty and competition gives rise to a wide variety of goods and services giving consumers a wide range to choice from.
  5. Higher rates of economic growth due to the incentive available for hard work which is motivated by profits.
  6. No wastage of resources on unrealistic projects because investment decision are based on profits.
  7. The costs associated with government bureaucracy are highly reducing encouraging entrepreneurship in the economy.
  8. Better quality products are produce due to innovation and inventions
  9. Intensive innovation and invention is prevalent due to competition.
  10. Affordable prices of products.

Disadvantages of free market economy

  1. Income inequality the ability of some people and firms to acquire excessive market power leads to greater inequality in income and wealth.
  2. There is likelihood of developing Monopoly powers whereby one firm controls the production and distribution of commodities.
  3. The price mechanism on its own cannot allocate resources to production of public goods e.g. schools, security etc.
  4. Instability in economy and unemployment. This is due to trade cycle i.e. recession, depression, recovery and boom.
  5. The inability to deal with structural changes caused by wars, natural calamities among others.
  6. Inadequate provision of merit goods. Merit goods are goods of importance to the community such as health, education, security among others
  7. Due to excessive advertising consumers are likely to make irrational choices at the expense of moral life/health
  8. Over-exploitation of resources
  • Planned economy/command/government controlled/socialism/communism

It refers to an economic system where the crucial decisions are determined a body appointed by the state. The body takes up the role of mechanism which prevails in a free market economy

Features of a command economy

  1. Leadership and control of economies. All important means of production (resources) are publicly owned such as land, power generation, housing among others.
  2. Rationing of certain commodities if supply of such fall below demand.
  3. Existence of production targets for different sectors of the economy. The government determines how resources are allocated through planning.
  4. Fixing of prices and wages
  5. Occasional existence of restricted labor market in which workers take up jobs assigned to them.

6 Government decides what is to be produced, how it will be produced and for whom to produce.

Advantage of planned economy

  1. Avoids economic instability
  2. Minimize negative externalities
  3. Makes adequate provision of public and merit goods ie education, health and safety.
  4. Facilitate the shift of resources in pursuant of grand schemes such rapid industrialization
  5. Puts checks on monopoly power which are controlled by state monopolies (Parastatals).
  6. Ensures there is full employment.
  7. Low inflation rate is being experienced.
  8. Minimum waste of resources.
  9. Minimum inequalities of wealth and income
  10. Easier government control.


Disadvantages of Planned economy

1There is wastage of resources in production because consumers demand is judged in advance without the use of price mechanism.

2 The cost of gathering information for planning is expensive to the state.

3 There is no individual incentives and initiative for hard work and innovation.

4 The power of consumer sovereignty is curtailed.

5 There is no incentive for hard work and this discourages the suppliers

6  Some resources may end up being underutilized

  1. Difficulty in estimating demand due to different time frames i.e. Decembers and end month and sometimes during certain occasions such as valentine demand tends to rise.

(c) Mixed economy

Refers to an economic system where resource allocation is determined by the state-i.e. the government and price mechanism. Both the government and private sector have a role to play in resource is widely adopted in many countries and results varied depending on nature of the economy. The government normally intervenes when the private sector of market fails to allocate resources effectively as long as the objective of the economic growth and development is achieved.

Advantages of mixed economic systems.

  1. Optimal utilization of nations resources
  2. Relatively wider tax base
  3. Consumers are protected from consumption of harmful products
  4. A considerable degree of consumer sovereignity.
  5. High quality products and services due to competition
  6. More equal istribution /allocation of resources.
  7. Relatively stable prices.

Role of government.

  1. Checking quality of products.
  2. Offering government subsidies
  3. Offering import and export tariffs.
  4. Ensuring price controls
  5. Foreign exchange market
  6. Taxation by ensuring there is redistribution of income through a system of taxation.
  7. To create a framework of regulations and rules to ensure fair competition thus promoting competition between firms both small and big ones.
  8. Government intervention can prevent market failures in price mechanism.
  9. Stabilization of the economy.
  10. The government is able to maintain competition by controlling monopoly power.







  1. Introduction
  2. Body
  • Conclusion
  1. References
  2. Type-times new roman, font-1.5, line spacing 1.5, page numbers-must.



The theory of demand and supply enables us to understand the determination of prices and quantities in different markets. For example, why the prices of agricultural commodities such as tomatoes, apples, mangoes and cabbages increase and decrease at certain times of the year, why have the prices of computers, music systems and television sets been steadily declining over time. An understanding of the working of the price system provides us with the answers to some of these questions. The price system provides the basis for determining the prices of factors of production.

Definition of Demand

Demand refers to the quantity of a commodity that consumers are willing and able to purchase at any given price over a given period of time, holding other factors constant. It is important to realize that demand is not the same thing as want, need or desire. Only when want is supported by the ability and willingness to pay the price does it become an effective demand and have an influence on the market price. Hence demand in economics means effective demand. It is different from desire in that it has to be supported by the ability to purchase the product/service.

The price of a commodity is most important factor/determinant of demand. All factors affecting demand other than the price are referred to as conditions for demand. While analyzing the relationship between price and quantity of demand economists assume that all factors affecting demand remain constant. An individual demand for a given good can be presented in a form of a demand schedule. A demand schedule is a table showing quantity of a commodity that could be purchased at various prices. The Table 2.1 shows an individual’s demand for commodity X.


From the table, 65 units of commodity X will be demanded per week if the price is Kshs 6 per unit.

A demand schedule can be represented in the form of a graph known as a demand curve. Figure 2.1 shows the demand curve for commodity X. The curve shows graphically the relationship between quantity demanded and the price of the commodity. A demand curve has a negative slope. It slopes downwards from left to right showing that as the price of a commodity falls demand increases. The inverse relationship between the price of a commodity and the quantity demanded is what is referred as the law of demand.

This law states that, “ceteris paribus (other things remaining constant), the lower the price of a commodity the greater the quantity demanded by the individual and vice versa”.

 Exceptions to the Law of Demand

There are some demand curves that slopes upwards from left to right showing that as the prices of a product rise more is demanded and vice versa. This type of demand curve is known as regressive, exceptional or abnormal demand curve and occurs in the following situations:

  1. When there is fear of a more drastic price changes in the future. This will causes consumers to increase their quantity demanded to avoid paying a higher price in the future. This situation is often found in the stock exchange where there is often an increase in the demand of shares of a company if its shares are expected to increase.
  2. In the case of giffen goods. This refers to basic foodstuffs that constitute a high proportion of the budget of low income families. When the price of a giffen good rises, the proportion of the total income of individuals who consumes these giffen goods rises and since such consumers are worse off in real terms, they can no longer afford to consume other more expensive commodities like meat and fruits. To make up for the goods they can no longer afford to buy, they are more likely to purchase more of basic foodstuffs; conversely when the price of basic foodstuffs falls. They become better of in real terms and are likely to buy more or relatively more expensive foodstuffs and less basic foodstuffs. Ie ugali and meat.
  3. Goods of ostentation (Veblen goods). These are commodities whose prices falls in the upper price ranges and that have a snob appeal. The wealthy are usually concerned about status. Believing that only goods at high prices are worth buying and worth the effect of distinguishing them from other consumers. In the case of such commodities, a firm increasing its prices may find that the sales of its product increase and at lower prices less of the commodity may be bought as the commodity is rejected as being substandard. Consumers often in making comparisons between similar products with different prices opt for relatively more expensive product believing it to be better. As prices increase demand increases this is referred to as snob effect. Examples of goods of ostentation are expensive perfume, jewellery, cars clothes, etc. The demand curve will be positively slopping as indicated in Figure 2.2.



4.inferior goods- these are goods assumed to be of low  quality compared to others available that can be used to satisfy same increase in price of an inferior good may be taken to mean an improvement in quality. Demand for such commodities will hence tend to increase with increase in prices.

  1. Expectation of future shortages
  2. Necessities-they are necessary for life. Demand will not change even if prices go up.

7.Habitual goods and services-a consumer will consume certain goods and services at same quantity at any price because these goods have become habitual and one can’t do without them e.g. addictive’s ie drugs.

The Determinants of Demand

The demand of the product can be considered from the standpoint of either individual demand or market demand. Demand for any commodity can be considered from two points of view:

(a) Individual demand is the amount the individual is willing and able to buy at a given price and over a given period of time. Factors affecting individual demand are;

  1. The price of the product.

When deciding whether or not to buy a particular product, an individual will compare the price of the product and the amount of utility or satisfaction expected to be received from the product. If the price is considered worth the anticipated utility the individual will buy the product and if not will not buy. A decrease in the price of a product will probably increase individual’s demand for it since the amount of utility obtained is likely to be worth the lower price. Conversely a rise in the price of a product will probably result in a fall in demand, as the amount of utility received is less likely to be worth the higher price to be paid. An example of this phenomenon is the hotel industry in Kenya. There is usually an increase in domestic tourism during the low season when many Kenyans consider the lower hotel prices to be worth the level of satisfaction they are receiving. During the high season when the hotel prices are high, many do not consider the satisfaction they are receiving to be worth. If the amount a consumer is willing and able to purchase due to change in the price, a change in the quantity demanded is said to take place. If on the other hand the amount the consumer is willing and able to purchase changes because of a change in the price of a given commodity leads to a change in the quantity demanded will be undertaken later in utility analysis and indifference curve analysis.

  1. The prices of related goods.

The demand for all goods is interrelated in that they are competing for consumer‟s limited income. Two peculiar interrelationships can be; Substitutes goods such as tea and coffee butter and margarine, beef and mutton, a bus ride and a matatu ride, a mango and an orange, CDs and cassettes. Two goods, X and Y are said to be substitutes if a rise in the price of one commodity, say Y, leads to a rise in the demand of the other commodity X. If the price of tea increases consumers will find coffee relatively cheaper to tea as a result demand for coffee increases. Substitutes are commodities that can be used in place of other goods. This phenomenon is illustrated in Figure 2.3. The graph shows the relationship between the prices of tea over the quantity for coffee. If the price of tea increases from P1 to P2 the quantity


Compliments goods such as shoe and polish, pen and ink cars and petrol, computers and software, bread and margarine, hamburgers and chips, tapes and tape recorders. Demand for some commodities can also be affected by changes in the prices of the complementary if a rise in the price of one of the goods, say A leads to the fall in the demand of another food, say B. Complimentary goods are usually jointly demanded in the sense that the use of one requires or is enhanced by the use of the other. Figure 2.4 illustrates the relationship between complementary goods graphically. For example if the price of cars is lowered demand for petrol increases because more cars will be bought/demanded. The curve shows the relationship between the price and of a car and quantity demanded for petrol. If the price of cars falls from P2 to P1 the quantity demanded for petrol increases from Q1 to Q2.

  1. Changes in disposal real income.

 An individual‟s level of income has an important effect on the level of demand for most products. If income increases demand for the better quality goods and services increases. This relationship however, depends on the type of goods and level of consumers‟ income. The three types of are goods; Normal goods these are goods whose demand increases as income increases. The demand for normal goods increases continuously with increase in income. It tends to become gently as people reach the desired level of satisfaction.

Inferior goods refer to goods for consumers with low income levels such that as income increases its demand falls. At low level of income, these individuals will tend to consume large amount of these goods but as income increases they buy other goods which they consider superior thus demanding less of the inferior goods. At very low level of income an inferior good behave like a normal good only to behave inferior as income increases. Necessities these are goods which consumers cannot do without such as salt, match boxes among others. Their income demand curve tends to remain constant other than at the lowest levels of income as indicated in Figure 2.5


  1. Changes in consumer tastes, preferences and fashion

Personal tastes play an important role in governing the consumer’s demand for certain goods. For example, preferring to consume imported commodities despite them being extremely expensive. Prevailing fashions are an important determinant of tastes. The demand for clothing for example, particularly is susceptible to changes in fashion.

  1. Level of advertising is also an important determinant of demand. In highly competitive markets, a successful advertising campaign will increase the demand of a particular product while at the same time decreasing the demand for competing products. Increase in advertising will increase demand in the following ways;

– it helps inform about the product of a firm

– Can introduce new products to the market.

– Induce individuals to frequently use the product/service

Factors affecting advertising policies

– cost of advertising

– mode of advertising

– impact of advertising on the demand of the product

– The target group (old, young)

– number of competitors and quality of their products

– The market share of the firm and the degree of competition

– Future expectations in price changes

– Government policies and taxes

– Appropriate time to make advertisements

– Cultural background

– Language

6.The availability of credit consumers.

This factor especially affects the demand for durable consumer goods which are often purchased on credit. For example a decrease in availability of credit or the introduction of more stringent credit terms is likely to lead to a reduction in the demand of some durable consumer goods.

7.The government policy

The government may influence the demand of a given commodity through legislation. For example making it mandatory for everyone to wear seatbelts. The consumers inevitably get to purchase more seatbelts as a result. Subsidies it’s the opposite of taxation. When the government grants subsidies prices of goods falls leading to increase in demand and vice versa. Price controls and legislations are also government methodologies that will affect demand

8.Climate change demand of various goods varies depending on weather. For instance there is high demand for woolen clothes during rainy reasons


It’s a horizontal demand sum of the demands for individual consumers. It refers to quantity demanded in the market at each price by individual consumers. For this reason all the factors affecting individual demand will affect market demand. The market demand for a commodity can be derived graphically as in Figure 2.6.


Where P1, P2 and P3 are individual prices Q1, Q2 and Q3 are individual quanties demanded. Pmk is the market price qmk is market quantity demanded. Other factors affecting market demand Change in population market demand is influenced by the size of the population, the composition of the population in terms of age sex as well as geographical distributions. Distribution of income more evenly distribution of income may increase demand for normal goods while at the same time it may lower the demand for luxuries.

Movement Along and Shift in Demand Curve

Demand is a multi- variant function in the sense that it is influenced by so many factors such as the price of the commodity, the price of other related commodities, consumer incomes etc. The price of the commodity is the most important determinant of demand and its relationship with the quantity demanded give rise to a demand curve. Movement along demand curve is demonstrated by a change in the price of a good as shown in Figure 2.7 by movement from one point to another on the same demand curve.



A change in price of a good from P1 to P2 causes a movement from point A to B along the demand curve. This movement along demand curve shows a change in quantity demanded which is an increase or a fall in the quantity demanded. A shift in the demand curve is caused as a result of a change in any factor affecting demand other than price such as changes in consumer income tastes and preferences. For this reason all other factors affecting demand other than price of the product are also referred to as shifting factors as illustrated in Figure 2.8 Any change in the shifting factors will cause changes in demand (an increase or a fall in demand). A shift to the right (dd to d1d1) shows an increase in demand while a shift from (dd to d2d2) shows a decrease in demand.



(a) Joint demand it is the demand whereby two commodities are always demanded together. One good cannot be demanded in the absence of the other such as car and petrol.

(b) Competitive/rival goods it is the demand for goods which are substitutes such tea and coffee.

(c) Derived demand where goods are demanded in order to provide goods such as cotton is required to produce cotton wool

(d) Composite demand (several uses) where some goods are used for different purposes such as steel for cars machine etc.


Elasticity of Demand

It can be defined as the ratio of the relative change of a dependent variable to changes in another independent variable. Elasticity can be analyzed in terms of demand and supply. It can also be defined as a measure of responsiveness of quantity demanded of a good in to changes in income or prices of other related goods. There are three types of elasticity; price elasticity of demand, cross elasticity of demand and income elasticity of demand. Price elasticity of demand it‟s the measure of responsiveness of the quantity demanded of a commodity to changes in its own price. It is also referred to as own price elasticity. It abbreviated as PED/ED. It is calculated as follows



If changes in prices cause more than proportionate change in quantity demanded it is said to be price elastic, in this case ED >1. If changes in the price causes less than proportionate change in quantity demanded, then demand is said to be price inelastic this is represented by ED < 1. If changes in price causes proportionate change in quantity demanded then, demand is said to be unit elastic or unitary elastic where ED= 1

To illustrate price elasticity consider the Table 2.3 which shows demand schedule of commodity X.


This price elastic because 3 >1 The price elasticity of demand is classified into two:

(i) Point elasticity

(ii) Arc elasticity

The point elasticity of demand measures elasticity at a particular point along the demand curve. It is calculated using the formulae


Calculate the point elasticity of demand given that Qd= 4P +2p3 -3 Q = 4+2-3 =3Where P =1


Arc Elasticity of demand

This measures the elasticity of demand between two points on the demand curve. Arc elasticity is the coefficient of the price elasticity between two points on the demand curve. It is therefore an estimate of the elasticity along a range of the demand curve. This estimate improves as the arc becomes small and approaches a point in the limit. Arc elasticity can calculated for both linear and non-linear demand curves using the following formula: It is illustrated as in Figure 2.26



There are five types of elasticity of demand.

(i) Perfectly elastic demand. Demand is said to be perfectly elastic when the consumers are willing to buy an amount of a commodity at a given price, but non at a slightly higher price. In this case elasticity of demand is equally to infinity. The will be a horizontal straight line as illustrated in Figure 2.28. This is a case of a commodity in a perfectly competitive market. Where an increase in price may lead to a loss of all customers.


(ii) Elastic demand. Demand is said to be price elastic when a charge in price causes more than proportionate change in quantity demanded. In this case the value of elasticity of demand is greater than 1 and the demand curve will be gently sloped as indicated in Figure 2.29. This implies that if prices increase from P1 to P2 the quantity demanded falls in greater proportion from Q1 to Q2 and vice versa. This is a case of luxury commodity which consumes can do without or a case of a substitute


(iii) Unity elastic demand. Demand is said to unit elastic if changes in price cause proportionate change in quantity demanded. If price increase quantity falls in the same proportion and vice versa. ED = 1 and the demand curve will be rectangular hyperbola as illustrated in Figure 2.30. This is a case of a good that lies between a luxury and necessity such as soap opera film or movie


(iv) Inelastic demand. Demand is said to be price inelastic if changes in price causes less than proportionate change in quantity demanded. If prices increases the quantity falls in less proportion and if the prices falls the quantity demanded increases in less proportion ED < 1 as illustrated in Figure 2.31. This is a case of a good which is a necessity. These are goods which consumers cannot do without but need not be consumed in fixed amount like an absolute necessity such a staple food like ugali and milk. It also applies in the case of habit forming goods like beer and cigarettes


(v) Perfectly inelastic demand. Demand is said to be perfectly price inelastic if changes in price has no effect on the quantity demand (ED= 0). In this case the demand curve will be vertical straight as illustrated in Figure 2.32. This is a case of a good which is an absolute necessity. A good that consumes cannot do without and have to consume in fixed amounts such as salt.



(i) Substitutability. If a substitute is available in the relevant price range, quantity demanded will be elastic. The demand for a particular brand of cigarettes maybe considered being elastic because if there is existence of other brands that are close substitutes. However, the total demand for cigarettes may be inelastic because there are no close substitutes for cigarette. It can hence be said that the greater the number of substitutes for a given commodity, the greater will be its price elasticity of demand.

(ii) The proportion of a consumer’s income spent on the commodity. If this proportion is very small as in the case of match boxes , the quantity demanded will tend to be inelastic. On the other hand if this proportion is relatively large as for example in the case of meat, demand will tend to be elastic. This implies that the greater the proportion of income which the price of the product represents, the greater price elasticity of demand will end to be.

(iii) The extent to which the product is habit forming. Habit forming products like cigarettes or alcohol have a low price elasticity of demand. In the case of in addiction to, say drugs, the price elasticity of demand is likely to be even lower.

(iv) The number of uses of a commodity. The greater the number of uses of the commodity, the greater the price of elasticity. The elasticity of aluminum for example is likely to be much greater than of butter because butter is mainly used as food while aluminum has hundreds of uses such as electrical wiring and appliances.

(v) The length of adjustments. The longer the period allowed for adjustment in the quantity demanded as a commodity the greater its price elasticity is likely to be. This is because it usually takes some time for new prices to be known and for consumers to make the actual switch. Consumers adjust buying habits slowly.

(vi) The level of prices. If the ruling price is at the upper end of the demand curve, quantity demanded is likely to be more elastic than if it was towards the lower end. This is always true for a negatively sloped straight line demand curve.

(vii) Necessities and luxuries Demand for luxury is likely to be price elastic while the demand for necessities is generally price inelastic. However, this depends with availability of close substitutes.

(viii) Width/size of the market the wide definition of the market of a good, the lower is the price elasticity of demand. Thus for wide markets demand will tend to be price inelastic while for a small market demand will tend to be price elastic.

(ix) Time demand for most goods and services tend to be more elastic in the long run as compared to the short run period. This is because consumers will take some time to respond to price changes. For instance, if the price of petrol falls relative to diesel, it will take long for motorists to respond because they are locked in existing investment in diesel engines.

(x) Durability of the commodity durable goods have low elasticity of demand or they are price elastic while perishable goods are price inelastic.


Importance of price elasticity of demand/economic application of the concept of elasticity

(a) The consumer needs knowledge of elasticity when spending income where more income is spent on goods whose elasticity of demand is inelastic and vice versa.

(b) The government imposes taxes with inelastic demand and vice versa. Devaluation when a country devalues or lowers the value of its currency. The currency is made cheaper relative to other currencies. This makes a country’s exports cheaper for foreigners. Its import expensive for the residents. For a country to benefit by increasing exports, the elasticity of demand must be high.

(c) Business/producers They use elasticity of demand on deciding on whether to charge high or lower prices or even deciding on commodities to bring to the market especially those which are price inelastic.

Income Elasticity of demand

It is the measure of responsiveness of demand due to change in income.


Where income elasticity is positive this is a normal good. Where income elasticity is negative this is an inferior good. When the demand of a good does not change with increase in income then income elasticity is zero. In wealthy countries for instance basic clothes will tend to have low income elasticity of demand while foreign will have high elasticity of demand as income increases. In poor countries basic commodities will have high income elasticity compared to manufactured expensive ite


(i) Business firms- if demand of a commodity is elastic to price, its possible to revenue by reducing prices. Businesses use specific information to know which price to increase to eliminate shortages or which price to reduce to eliminate surpluses.

(ii) Government uses elasticity to determine the yield of indirect taxes. Inelastic commodities are highly taxed. However, if demand of a commodity is elastic an increase in tax will hinder production

(iii) Price elasticity is relevant for a country considering devaluation as a means of rectifying balance of payment disequilibrium. Devaluation decreases imports and increases exports. However, this will depend on demand of import and export elasticities.

(iv) It helps to explain price instabilities in the agricultural sector

(v) Monopolists apply price discrimination by understanding the demand elasticities. High price is charged to those markets with lower price elasticity


(i) Nature of the need that the commodity covers. For certain goods and services the percentage of income spent declines as income increases such as food.

(ii) The initial level of income of a country (level of development) TV sets, refrigerators, motors vehicles are considered as luxuries in underdeveloped countries while they are considered as necessities in countries with high per capita income.

(iii) Time period. The demand for most goods and services will tend to be income elastic in the long run as compared to short run period. This is because the consumption pattern adjusts with time and also with change in income.


It is the measure of responsiveness of quantity demanded of a good due to changes in the price of another related good. It is abbreviated as EXY where X and Y are to goods. It is calculated as follows:

EXY = Proportionate change in quantity demanded of a good X/ Proportionate change in quantity demanded of a good Y

ΔQx .Py ΔPy Qx The sign of cross elasticity of demand is positive if the good X and Y are substitutes and negative if X and Y are complimentary. The higher the absolute value of cross elasticity of demand the stronger the degree of substutability or complimentaribility. The main determinant of cross elasticity is the nature of the commodity relative to their uses. If two goods can certify equally the same need the cross elasticity will be high and vice versa.


(i) Protection of local industries. If the government imposes a tariff on a good with the intention of protecting a local industry then the local product and the imported product must be close substitutes for the government to achieve its objectives

(ii) If a firm is in a competitive market, there a high positive elasticity of demand between its products and those of competitors. For such a firm, it will not be in its interests to increase the price of its product as this may result to more than proportionate reduction in its sales. However, it might consider lowering the prices of its products in the hope of attracting customers from other firms.

(iii) For product with high degree of complementarity, a fall in price of one of the goods due to increase in supply will benefit the producers of a compliment product due to an increase in sales. E.g. if there is a fall in prices of vehicles, due to an increase in supply the suppliers of fuel experience an increase in sales because more cars will be bought.


Definition of Supply

Individual supply refers to the quantity of a given commodity that a producer is willing and able to sell at a given price over a specific time period.

Market supply refers to horizontal summation of individuals producers/firms supply in the market. The supply schedule and the supply curve demonstrate the relationship between market prices and quantities that suppliers are willing to offer for sale. Supply differs from “existing stock” or the amount available because it is concerned with amounts actually brought to the market.

The basic law of supply states that, “a greater quantity will be supplied at a higher price than at a lower price”, holding other factors An individual producer’s supply schedule shows alternative quantities of a given commodity that a producer is willing and able to sell various alternative prices for that commodity ceteris paribus (other things remaining constant).



A supply curve show the relationship between the price of the commodity and the quantity supplied. The relationship is a direct one as the supply curve slopes upwards from left to right. The direct relationship is a graphical representation of the law of supply which states that other things remaining constant a greater quantity will be supplied at higher prices and vice versa. DETERMINANTS OF SUPPLY

The supply of a good is influenced by the following factor

  1. Price of the good as the price of a given commodity say X rises, with the costs and the prices of all other goods remaining unchanged, the production of commodity X becomes more profitable. The existing firms are therefore likely to expand their profit and new firms are to be attracted into the industry. It should be noted however, that not just the current rise but also expectations concerning the future increases prices may motivate producers. The total supply of goods is expected to increase as the prices rise.
  2. Prices of other related goods changes in the prices of other commodities may affect the supply of a commodity whose price does not change. Substitutes; two goods X and Y are said to be substitutes in production if the supply of good X is inversely/negatively related to the price of Y. For instance barley and wheat or tea and coffee. If a firm producing both tea and coffee notices that the price of tea is rising may decide to allocate more resources to tea at the expense of coffee. The supply of coffee will therefore fall as the price of tea increases. However, the movement of resource from one use to the other is dependent on the mobility of factors of production. Complimentary goods; two goods X and Y are said to be compliments if an increase in the price of X causes an increase in the supply of Y such as a vehicle and petrol. Jointly supplied goods; two goods X and Y are said to be jointly supplied if an increase in the price of X causes an increase in the price of Y such as petrol and paraffin. If the demand for petrol increases the supply of petrol will rise and at the same time the supply of paraffin will increase. N/B The extent to which firms can move from one industry to another in search of higher profits depends on occupational and geographical mobility of the factors of production.
  3. Prices of factors of production as the prices of factors of production used intensively by producers of a certain commodity rise, so do the firm costs. This will cause the supply to fall since some firms will eventually leave the industry. Similarly, if the price of one factor of production, say land, increases, some firms may move out of the production of land intensive products into the production of goods that are intensive in other factors of production which are relatively cheaper. Finally other less efficient firms will make losses and eventually leave the market.
  4. The state of technology

This refers to a  a society’s pool of knowledge concerning industrial activities and its improvements. Technological improvements or progress such as improvements in machine performance, management and organization or an improvement in quality of raw materials leads to lower costs through increased productivity and increases the profit margin in every unit sold. This leads to increase in supply.

5.Future expectations of price change Supply of a good is not only influenced by the current prices but future expected price as well. For example, if the price of a good is expected to rise the firm may decide to reduce the amount of supply in the current period. This is to enable them pile stock which they can offer for sale when prices increase in the future. This is known as hoarding. 6.Government policies

  • through tax imposition on goods increases the cost of production hence decline in production and supply
  • Through subsidies -a grant to citizens of a country which lowers the cost of production hence encourages production and increases in supply.
  • Through price control can either by price minimization where prices are fixed above equilibrium encouraging producers to produce more hence increase in supply. It may be undertaken through price maximization where prices are fixed below equilibrium discouraging production hence decline in supply.
  • Though quotas where the government puts restriction or limit production of various goods which leads to decline in supply.

7.Weather /climate

The supply of agricultural products is considerably affected by changes in weather conditions. Output in agriculture is subject to variations in weather from year to the next. An excellent growing season associated with favorable weather conditions will result in a bumper harvest leading to an increase in supply. An unfavorable season that results in a poor harvest may be viewed as an increase in the average costs of production because a given expenditure on inputs yields a lower input than it would in a good/ favorable season. A bad harvest is represented by a leftward shift of the supply curve.

8.Objectives of the firm

a business may pursue several objectives such as sales maximization, market leadership, quality leadership, survival, profit maximization, social responsibility. Firms with sales maximization as an objective aim at supplying greater quantities of its product than a firm aiming at profit maximization where the later supplies less quantities but at a higher price in order to maximize the profit.

  1. Incidence of strikes lead to a reduction in supply of a product. The supply of manufactured goods is particularly likely to be affected by industrial disputes because of generally stronger unions in the industrial sector.


The market supply curve represents the alternative amount of a good supplied per period of time at various alternative prices by all the producers of goods in the market. The market supply of goods therefore will be influenced by all the factors that determine individual producer supply and all the number of producers of goods in the market. This concept is illustrated in Figure 2.10 It therefore follows that the market supply curve will have a gently slope than individual supply curves. Figure 2.10 Derivation of market supply curve



The relationship between price of a commodity and quantity supplied give rise to a supply curve. Any changes in the price of a good causes change in the quantity supplied. This can be traced by the movement along supply curve as shown in Figure 2.11 The movement from point A to B is caused by changes in price from P1 to P2 which bring fourth the movement along the supply curve.


A shift of supply curve is caused by a change in any other factors affecting supply other than the price of the goods. This shift indicates changes in supply as a result of e.g. advances in technology which makes it cheaper to produce goods and services and therefore their supply will increase. Similarly incase of increase in cost of production will lead to a fall in quantity supplies as shown in Figure 2.12. A shift to the right from S1S1 to S3S3 shows a fall in supply.



It is the measure of responsiveness of quantity supplied of a commodity to change in the factors affecting supply. Price elasticity of supply -It is the measure of responsiveness of quantity supplied of a commodity to change in its own price. It is abbreviated as ES and calculated as:


ES will have a positive value because of the direct relationship between the price of the product and quality supplied.

If ES is greater than 1, then the supply is said to be price elastic

If Es <1 then supply is price inelastic

If Es =1 then supply is unit elastic.


  1. Perfectly elastic supply
  2. Elastic supply
  3. Unit elastic supply
  4. Inelastic supply
  5. Perfectly inelastic supply.


a) Mobility of factors of production If they are highly mobile then supply will be price elastic since more factors can be employed quickly when the prices increase thus increase in supply

b) The level of employment of resources It refers to the utilization and allocation of resources. If the factors are fully utilized supply will be price inelastic due to the fact that all the facts are occupied and thus can not be mobilized in order to increase supply. However if they are under employed, supply will be price elastic.

c) Production period for product that take short period of time to produce their supply tend to be price elastic. While thus that take a longer period will be price inelastic because it will take a while before the products can reach the market.

d) Nature of the commodity Price elasticity of supply for perishable goods tend to be inelastic due to the fact that the goods do not respond to price fall as they can not be easily stored. On the other hand supply for durable goods tend to be price elastic since they can be store when the price falls thus contracting supply.

e) Risk taking If the entrepreneurs are willing to take risk then supply of the products will be price elastic. Risk taking will in return be determined by the prevailing conditions in the economy. E.g. Political stability, security, government incentives, infrastructure, etc.

f) Level of stock If it‟s high supply will be price elastic because if the price of a good increases more of the good will is supplied from the stock

g) Time period Supply for most goods and services will tend to be more elastic in the long run than in the short run because producer need more time to reorganize factors of production so that they can increase supply of the products.



i) If supply of a good is price elastic thus an increase in demand will benefit both the producer and consumer of products because the producer will be in apposition to supply relatively more of their products and consumer will eventually pay a relatively lower price.

ii) If the supply of commodity I price inelastic business may risk losing revenue when there is a fall in the price of their products. This is because they will be forced to sell their products at a loss or a reduced price margin, e.g. In the case of perishable goods, however in the supply of the goods is price elastic the business people may store their products when price fall thus contracting supply e.g. the case of durable goods.


a) Elastic demand Increase in price will reduce the total revenue while a fall in price increase the total revenue

b) Inelasticity demand Increase in price will reduce the total revenue while a fall in price causes reduction in total revenue.

c) Unit demand change in price will leave the price unchanged.


  1. Products/services pricing decisions
  2. Customer spending programs

iii. Production decisions

  1. Government policy orientation -Taxation policy

-Evaluation policies -Price control/minimum

  1. Price discrimination
  2. Shift of the tax burden



The price of an item is the point where supply at a given price intersect demand at a specific price

The Concept of Equilibrium in Economics

Equilibrium in economics refers to a situation in which the forces determine the behavior of variables are in balance and therefore exert no pressure on these variables to change. In equilibrium the actions of all economic agents are mutually consistent. Market equilibrium occurs when the quantity of a commodity demanded in the market per unit equals the quantity of the commodity supplied to the market over the same period of time. Geometrically, equilibrium occurs at the intersection point of the commodity’s market demand and market supply curve. The price and quantity at the equilibrium are known as the equilibrium price and equilibrium quantity respectively. The price Pe is also referred to as market clearing point. At this equilibrium point the amount that producers are willing and able to supply in the market is just equal to the amount that consumers are willing and able to demand. Both consumers and producers are satisfied and there is no pressure on prices to change and thus the market for goods is said to be at equilibrium.

This is illustrated in Figure 2.13 Equilibrium point Figure 2.13


Equilibrium can be defined as a state of rest or balance in which no economic forces are being generated to change the situation. These economic forces are excess demand and supply and are illustrated in Figure 2.14. At P1, the quantity demanded by consumers is Q1 units but producers are willing to supply at price a quantity of Q2 units. Therefore there is an excess supply equal to (Q2 –Q1). Excess supply refers to a situation where quantity demanded is less than quantity supplied at prevailing market price. Producers may therefore react to the excess supply by lowering prices of their products so as to sale the unsold stocks. Excess supply is referred to as a buyer’s market since suppliers may be obliged to lower their prices in order to dispose of excess output a situation which is favorable to buyers. Excess supply represents an economic force that exerts downward pressure on prices. At P2 the quantity demanded is Q2 but producers are willing to supply Q1 units of goods. Therefore, there will be excess demand equal to (Q2-Q1). This situation of excess demand is referred to as sellers’ market because competition among buyers will force up the price due to the existing shortage Excess supply is a situation where quantity demanded is greater than quantity supplied at prevailing market prices.


In this case, the price of goods will rise because of competition among buyers. Excess demand represents an economic force on prices which exerts upward pressure. Prices P1 and P2 are disequilibrium prices and market is said to be at disequilibrium. Therefore, the general rule for eq

The following economic function has been derived by the finance manager of Kenya Breweries ltd. Qa = 3p2 – 4p

6p – 4 – supply

Q6 – 24 – p2

Where P represents prices and Q represents quantity

Which of the two function could represent in demand curve and supply curve and why. At what value of price and quantity is the market in equilibrium?


In studying equilibrium, our objective is to determine the market price and quantity and try to identify the forces that influence such a price and quantity.

  • Equilibrium can be defined as a state of rest. It is a situation whereby quantity demanded is equal to quantity supplied  e.
  • In this case, we say that the market is clearing and there are no economic forces generated to change this point hence it is stable.
  • We determine this graphically by the interpretation point of the demand and supply curves as below.


  • In the above diagram it can be seen that the forces of demand and supply determine the price in the market, i.e. a price at which both consumers and sellers are happy and where quantity supplied equals quantity demanded. That price is known as the equilibrium price.
  • In the diagram, should the price be above the equilibrium price, forces of demand and supply will work together and lower the price towards the equilibrium price until the equilibrium price is reached. For example at consumers will only be willing to buy  from the market while sellers will by willing to supply. In this case an excess supply equals to  will be created. Because of this excess supply, sellers will have to reduce the price in an attempt to encourage consumers to buy more. Prices will be reduced until is reached where quantity demanded equals quantity supplied.
  • Should the price be below the equilibrium price (e.g. at ) again the forces of demand and supply will work together to ensure is restored. At suppliers are willing to supply only because they consider to be very low. On the other hand, consumers will be willing to buy since very many of them can afford to pay . In this case an excess demand (shortage) equal to will be created. Because of shortages, consumers will compete among themselves for the little that is available and because of this competition, prices will be pushed upwards towards until eventually is reached.


Example 2

Demand function:

Supply function:

Question: determine the equilibrium market price and quantity.


At equilibrium



  1. Stable equilibrium
  2. Unstable equilibrium
  3. Neutral equilibrium

Stable equilibrium: if there is a force that disrupts the market equilibrium, then there would be adjustments that bring back to the initial equilibrium. This type of equilibrium is well explained in the previous section.

Unstable equilibrium: this occurs when the deviation from the equilibrium position tend to push the market further away from the equilibrium conditions of unstable equilibrium occurs when the demand curve is positively sloped as in the case of a giffen good or when the supply curve is negatively sloped as in the case of labor supply.

Neutral equilibrium:-this occurs when the initial equilibrium is disturbed and the forces of disturbances lead to a new equilibrium point. It may occur due to shift of either demand of supply curve, and through effects of taxes etc.

The effect of a shift of demand and supply on market equilibrium.

(A) 1 .Shift in demand Increase in demand.

Consider Figure 2.16 which illustrates the effect of an increase on demand on market equilibrium. An increase in demand is represented by a shift of the demand curve from d1d1 to d2d2. The immediate effect will be shortage and this will force prices to rise leading to increase in quantity supplied until equilibrium is re-established at Pe. Fall in demand Consider Figure 2.17 which illustrates the effect of a fall in demand on the market equilibrium. A fall in demand is represented by a shift of demand curve to the left from d1d1 to d2d2. The immediate effect will be a surplus and this will force the producers to lower the price in an attempt to get rid of excess stock. This fall in price will led to decline in quantity supplied until a new equilibrium is established at Pe1; Qe1


  1. Shift in demand decrease in demand.

(B) Shift in supply

Increase in supply Consider Figure 2.18 which illustrates the effect of an increase of supply on the market equilibrium. An increase in supply is represented by a shift of supply curve to the right from S1S1 to S2S2. The immediate effect will be surplus and this will force the producer to lower their prices in order to get rid of excess stock. This fall will lead to an increase in quantity demanded until a new equilibrium is established at Pe.

A fall in supply Consider the Figure 2.19 which illustrates the effect of a fall in supply on the market equilibrium. A fall in supply is represented by a shift of supply curve to the left from S1S1 to S2S2. The immediate effect will be shortage and thus will force the prices to go up leading to a fall in quantity demanded until a new equilibrium is established at Pe1, Qe2.


Price Control

This refers to a deliberate action by the government to artificially impose through legislation the prices of certain goods and services. Such imposed prices are referred to as flat prices. These flat prices may be a maximum or a minimum price. A maximum price refers to that price above which a good or a service cannot be sold. A minimum price refers to that price below which a good/service cannot be sold. The government may find it necessary to control the prices of certain good/service because:

(i) Cheapness It may be objective of the government to keep price of certain goods and services at a level at which they can be afforded by most people hence protecting the consumer being exploited by producers

(ii) Maintenance of income. The government may want to keep the income of certain producers at a higher level than that which would be supplied by market forces demand and supply. Thus the government is able to maintain the low income producers in the market.

(iii) Price stability if there is a wide variation in the price of product year to year the government may wish to iron out these variations for the interests of both producers and consumers. This price control will act as one of the methods to curb inflation.

Maximum price control/price ceiling

Consider Figure 2.23, if the government imposes a price ceiling, given by P1 there will an excess demand or shortage equivalent to Q2- Q. Under normal circumstances this economic force of excess demand will exert an upward pressure prices. However, in this case the price cannot go above P1, since P1 is the maximum price. This price is unable to fulfill the rationing function leading to a demand for a centrally administered system of rationing of the good in question.


Other effects of Price controls

(i) Rise of black market where goods are sold above legal price even above the equilibrium price.

(ii) Shortages are likely to become chronic as producers move away from production of price controlled goods.

(iii) Research and development will be encouraged as the producers move from the price controlled industry.

(iv) There will be increased costs efficiency in production by firms as profits can only be increased by reducing costs.

Minimum price/price floor

This refers to the action taken by the government to set a price below which a good/service cannot be sold. They are normally imposed above the equilibrium price since the government feels that the price determined by forces of demand and supply is too low as illustrated in Figure 2.24 If the government imposes a minimum price by P1, the immediate effect will be surplus given by Q1 Q2. Under normal circumstances excess supply exerts a down ward pressure on prices, but in this case prices cannot go below P1 for it is a minimum price. The government then has to intervene by buying excess stock or limiting it to prevent prices from going down.


Other effects of price floors

(i) In the case of a minimum produce price floor, (low income producers) will have a stabilizing effect on their income.

(ii) In the case of minimum wages employed workers will be guaranteed an income compatible with the cost of living.

(iii) Some producers may be willing to dispose off their product below the minimum legal prices especially in the case of labor.

(iv) In the case of minimum wage rate, it will lead to reduction in employment.

Advantages of price control

(a) Protects consumers, especially the low income consumers from price increases by producers.

(b) Ensures that producers have a reasonable income which is subject to inflation

(c) Contributes to industrial peace especially if they constitute part of the comprehensive income policy and a maximum price is fixed on some basic goods.

(d) It may be associated with a decrease in price and an increase in output such as the case of a monopolist overcharging for its products and is forced to lower prices. In this case the monopolist may accompany the fall in price with an increase in output in order to compensate for loss in revenue. (e) It may be used as on



Production refers to the creation of wealth for the sole purpose of utility in order to improve the welfare of people. It is creation of goods and provision of services to satisfy human wants.

Types of production/Forms of production.

It can be undertaken either directly or indirectly

  1. Direct production

This refers to the process where goods and services are produced for one’s own use. It’s another name is subsistence production. This production was very common in past though still practiced in some developing countries. Examples of such production include growing of crops, fishing, keeping poultry and hunting.

Characteristics/features of direct production/reasons for direct production.

  • The goods or services produced are mainly for one’s own use.
  • It is usually carried out in small scale.
  • The methods used for production are usually simple
  • It involves little or no specialization.
  • The quantities produce are relatively low
  • There is usually no surplus for the market.
  • Indirect production

It refers to where goods and services are produce for can also be described as production for the market or commercial production.

Characteristics/features of indirect production.

  • Goods and services produced are mainly for sale-income got
  • Modern technology is extensively used in the production process-capital intensive
  • Production is usually on large scale-thus one enjoys economies of scale
  • Surplus goods are produced-no deficit
  • Producers tend to specialize in different areas.-efficiency
  • The goods and services produced are usually of higher quality.

Today, most production is of the indirect type because most people and countries goods and services are for sale.


Production is a broad process which includes five main activities and they include extraction, manufacturing, trade and distribution, warehousing and the provision of services. Productive activities are closely linked to what is generally referred to as levels of production. Production may be divided into three levels e.g.

  1. Primary production/extraction.

The main activity is extraction of natural may also involve looking after natural resources. The products may be consumed in their natural state, cooked before eating, or used as raw materials for producing other goods. The occupations involved here ranges from quarrying, mining, forestry, fishing, farming and lumbering.

  1. Secondary production

This involves changing of raw materials into finished products. In this level, raw materials extracted at the primary level are processed into finished goods. This creates more utility in the in the goods mainly through a process called also includes construction  activities e.g. some of the raw materials of quarrying are used in construction of buildings, roads and bridges. The main occupations include processing, manufacturing, oil refining and construction of roads, buildings and bridges. Machines and modern technology is usually used.

  1. Tertiary production.

This involves activities carried out in provision of services. The two main types include direct and commercial services.

  1. Direct services-they are provided directly to the consumers who are involved in occupations like. Health care, legal services, domestic services, security, lighting, education, preaching, nursing and entertainment. They are produced both in private practice and in the government through local authorities. Public facilities include garbage collection, sewerage services trucks, hospitals and schools. Current economic systems allow the private individuals to use their private facilities to do so.
  2. Commercial services-they are services that support various production processes. They include transport, communication, warehousing, advertising, banking and insurance. These services are important in creating place and time utility in goods. They are referred to as aids to trade.


  • Consumer goods.These are goods which satisfy human wants directly. They are categorized into durable and non-durable goods.
  • Producer goods.This refers to categories of goods which give indirect utility to the consumer.
  • These are intangible economic goods. E.g. teaching, insurance


To produce adequate goods for the satisfaction of human wants a combination of natural and artificial and human resources must be present. These economic resources are referred to as factors of production. The natural resources are represented by land-primary and the artificial resources by the capital-secondary, and the human resource by labor-primary and the entrepreneur-secondary.

  1. land


  • It is used to refer to all the natural resources below or above the earth’s surface that are needed to support production. They are sometimes referred to as gift of nature because they occur naturally
  • A basic factor of production
  • lacks geographical mobility(immobile)
  • quality is not homogenous
  • Can be put in various uses.
  • Supply of land is fixed, however some resources can get depleted egforests,lakes etc
  • Quality can be improved for better use
  • Reward is rent
  • Human being can increase the productivity of land using greater units of labor capital, application of fertilizers, gabions, mixed farming, intercropping, afforestation, crop rotation, controlling soil erosion, giving land sometime to gain fertility.
  • Subject to law of diminishing marginal returns.



This refers to all the artificial resources used for production of goods and services. Capital can either be fixed or circulating.


  • Its manmade
  • A basic factor of production
  • Reward is interest
  • Its subject to depreciation/decreasing value
  • Usually not consumed in its production process.


This is the mental (doctors and teachers) or physical (farm workers) human effort exercise in the production process for a reward.


  • A basic factor of production
  • Can’t be separated from the provider.
  • A laborer sells his/her labor and not himself.
  • Mobile geographically and occupationally.
  • Productivity can be increased by motivating workers.
  • Reward is salary (fixe amount), wage (temporary) or commissions, fees (usually a pre-determined amount) earned to professionals for services rendered to clients in their private practice e.g. doctors, lawyers, accountants and architects.
  • Can be skilled or semi-skilled


This is the person who comes up with a business idea.


  • Basic factor of production
  • Brings all the required resources together in a bid to start and operate a business with a view of earning profit.
  • Reward is profit.
  • A distinct factor of production which must be distinguished from specialized labor.
  • Entrepreneurs differ in ranges of self-employed(kiosk owners),opportunistic(hire others),inventors(mpesa,I pads),pattern multipliers(supermarkets + petrol stations),economies of scale exploiters(hawkers sell at discount so as to increase turn over),acquirers(uchumi),buy-sell artist,speculators,artisans/craft man(beautician/mechanic),intrapreneurs(James mwangi,bob collymore,michael joseph)


Division of labor and specialization occurs when the production process is split into many stages or operations. Each stage is the special task of one worker or a group of workers. The people working in each stage are then said to be specialized in their respective activities. The principle of division of labor is commonly applied in various manufacturing processes. When one worker performs certain tasks of a job. It is referred to as specialization. This process creates interdependence among the parts involved. This concept has some advantages and disadvantages.


  1. Workers skills are enhanced because of performing repetitive tasks.
  2. The worker suffers less fatigue as they concentrate on doing one task in one place.
  3. There is a likelihood of new talents developing and also new inventions
  4. The rate at which work is done increases leading to faster or quicker results.
  5. The goods and services produced are usually of high quality since they are produced by specialists.
  6. Use of machines is made possible, which leads to standardization of commodities and lower production costs which may lead to higher profits
  7. The overall output increases because the work is done at a faster rate.
  8. Planning and management of work becomes easy which enhances efficiency in the organization.
  9. Less time is spent on movements from one site of work to another since the worker performs only a specific task.


  1. The workers suffer from boredom due to the monotony of doing the same task or job repeatedly
  2. Because of the splitting of the production tasks where each worker performs only a specific task, a problem at one stage can affect the whole production process, leading to loss of time, reduction in output and possible loses.
  3. Since a worker performs only a small part of the whole process, there is lack of motivation as it is difficult for the individual workers to identify themselves with the final product.
  4. In case of a fall in demand in the jobs that the specialized workers are engaged, they find it difficult to enter into new jobs. This is due to specialization in a particular field only.
  5. Specialized firms may become dominant in the market and therefore they may increase the prices of their products at will
  6. The interdependence between countries or firms created by specialization may lead to shortages of goods and services at certain times e.g. during conflicts of war leading to shortages in other regions.
  7. Use of machines not only reduces employment opportunities but it also denies people the opportunity to apply their skills.


THIs refers to ease with which a factor can be transferred from one use or location to another. If easy to transfer factor from one use or location to another, the factor is said to be mobile and if it is not it is said to be immobile. There are two aspects to the mobility to factors of production

  1. Mobility from one employment to another. This is called occupational
  2. Mobility from one place to another otherwise called geographical mobility


Physically, land is immobile. Thus can’t be moved from one place to another. Therefore geographically, land is not mobile. Occupationally; land is mobile since it can be used to produce different products.


Generally, capital is mobile both geographically and occupationally. This is because most types of capital such as vehicles can be moved from one place to another and put to different uses. However infrastructure such as roads, railway, networks and heavy machinery are immobile.


It’s probably the most mobile factor of production. This is partly because the basic functions of the entrepreneur are common to all industries. The entrepreneur is also able to move to any region and work there


Its relatively mobile geographically but less mobile occupationally. Thus, while labor can move from one area to another, it is more difficult for people to change occupations, especially if they are highly specialized or skilled.


  1. Specificity of the factor-a factor is said to be specific then it is specialized. Specific factors are immobile.
  2. Time taken to modify a factor-it refers to time it takes to acquire new skills, to retain or to modify a specific factor. If it takes a very long time, the factor will be immobile but if it takes a short time, it will be fairly mobile.
  3. The reward offered in new location or occupation. If it is substantially better than what the factor is currently earning, it is likely to be mobile. However if the reward is less, the factor the factor will be immobile.
  4. The duration a factor has been in the present occupation. After being in an occupation for a long time there is a tendency especially for labor to get used to and prefer the current occupation.
  5. Security of job and fringe benefits offered .this condition particularly applies to labor.
  6. The general state of applies to the location of new job.
  7. The nature of the factor
  8. Cost of living
  9. Social, cultural and political differences
  10. Age


It refers to number of laborers/employees which a firm is willing and able to hire at given wage rate over a specified period of time. It’s a derived demand since it arises from the demand of goods and services

Determinants of demand for labor

  • Demand for goods and services the firm is producing. As demand for goods increase, demand for labor increases.
  • Productivity of labor. If labor is more productive compared to other factors, the demand for labor increases.
  • Changes in the prices of other factors of production. Comparing price of labor and capital, if price of capital increases relative to that of labor, then the demand for labor increases.
  • The wage rate. The higher the wage rate the lower the demand


This refers to the number of workers willing and able to work (or man-hours available for work) at a given wage rate and over given period of time.


Labour is no doubt the most important of all factor or production, for the efficiency of any production will to a large extent depend on the efficiency and supply of the labour working in the process. Besides labour is also the end for which all production is undertaken.


Supply of labour refers to the number of workers (or, more generally, the number of labour hours) available to an economy. The supply of labour will be determined by:

  1. Population Size-In any given economy, the population size determines the upper limit of labour supply. Clearly there cannot be more labour than there is population.

2.Age Structure –The population is divided into three age groups. These are:

  • The young age group usually below the age of 18, which is considered to be the minimum age of adulthood. People below this age are not in the labour supply, i.e. they are not supposed to be working or looking for work.
  • The working age group, usually between 18 and 60, although the upper age limit for this group varies from country to country. In Kenya for example, for public servants, it is 55 years. It is the size of this group which determines the labour supply.
  • The old age group, i.e. above 60 years are not in the labour force.
  1. The Working Population- Not everybody in the working age group will be in the labour force. What is called the working population refers to the people who are in the working group, and are either working or are actively looking for work, I.e. would take up work if work was offered to them. These are sometimes called the actively active people. Hence this group excludes the sick, the aged, the disabled and (full time) housewives, as well as students. These are people who are working and are not willing or are not in a position to take up work was given to them.
  2. Education System and training-If the children are kept in school longer, then this will affect the size of the labour force of the country.
  3. Length of the Working Week-This determines labour supply in terms of Man-hours. Hence the fewer the holidays there are, the higher will be the labour supply. This does not, however mean that if the number of working hours in the week are reduced, productivity if there is a high degree of automation.

6Remuneration/wage rate.-The preceding five factors affect the supply of labour in totality. Remuneration affects the supply of labour to a particular industry. Thus, an industry which offers higher wages than other industries will attract labour from those other industries.

7.The Extent to Barriers to Entry into a Particular Occupation-If there are strong barriers to the occupation mobility of labour into a particular occupation, e.g. special talents required or long periods of training, the supply of labour to that occupation will be limited.

8.Retirement age policy of the government.

9.Technology – means of product


Efficiency of labour refers to the ability to achieve a greater output in a shorter time without any falling off in the quality of the work – that is to say, increase productivity per man employed. The efficiency of a country’s labour force depends on a number of influences.

  1. Climate-This can be an important influence on willingness to work, for extremes of temperatures or high, humidity are not conducive to concentration even on congenial tasks.

ii.Education and training –Education and training produce skills and therefore efficient labour. Education has three aspects: general education, technical education and training within industry. A high standard of general education is essential for developing intelligence and providing a foundation upon which more specialized vocational training can be based. Technical training provided in the universities, colleges and by industry itself. Training within industry is given by each firm to its employees.

iii.Working Conditions-Research has shown that if working conditions are safe and hygienic, the efficiency of labour will be higher than if the conditions were unsafe or unhygienic.

  1. Health of the worker-The efficiency of the worker is closely related to his state of health which depends on his being adequately fed, clothed, and housed.

v.Peace of Mind-Anxiety is detrimental to efficiency. People (workers) may be tempted to overwork themselves to save at the expense of health to provide for contingencies like times of sickness, unemployment and old age. Others may be worried about their work or their private problems.

vi.Efficiency of the Factors-The productivity of labour will be increased if the quality of the factors is high. The more fertile the land, the greater will be the output per mass, other things being equal. Similarly, the greater the amount and the better the quality of the capital employed, the greater will be the productivity of the labour.

Efficiency of the organisation is even more important since this determines whether the best use is being made of factors of production.

vii.Motivating factors-These are factors which boost the morale of the workers and hence increase the efficiency. They include such things as free or subsidised housing, free medical benefits, paid sick leave, allowing workers to buy shares in the company and incorporating workers’ representatives in the decision-making of the firm, In this way the workers feel that they are part and parcel of the organisation and are not being used.

viii.The Extent of Specialisation and Division of Labour-The greater the amount of specialisation, the greater will be the output per man, Division of labour increases the efficiency of labour.

ixThe Entrepreneur-Land, capital and labour are of no economic importance unless they are organised for production. The entrepreneur is responsible not only for deciding what method of production shall be adopted but for organising the work of others. He has to make many other important decisions such as what to produce and how much to produce.


This refers to the extent of complexity of business organizations. It means the potential or capacity of a business firm to produce output.

The size of any business organization depends on:

  1. Capital employed.
  2. Quality of capital employed.
  3. The number of workers employed.
  4. The amount of raw material employed.
  5. The number of departments it has.
  6. The amount and quality of energy employed.


This refers to the technical relationship between input requirements and output of a firm.

If a firm requires land, labor and capital the firms production function is:

Qx = f (N, K, L)

Where Qx = Output, L= labor, K = capital and N = land.

In the short run some of these factors are fixed and labor in most cases is a more variable factor.

Short run effects of changes in a variable input are given by the returns to scale in production.

Graphical representation of production labor


Assuming labor is the only variable factor, it is possible to describe the average product of labor and marginal product of labor.

Average product of labor (APL) = Total product per unit of labor

APL = TPL /L e.g. 200 / 10 = 20.

This defines the level of efficiency of labor.

Marginal product of labor (MPL)

Refers to change in the total product due to change in labor.


Suppose a firm uses labor in the production of its output, the table below gives the total products of the corresponding labor units. Use the table to establish the relationship between total product, average products and marginal products


Labor (L) TPL (‘000’ kg) APL MPL
0 0 _ _
1 3 3 3
2 8 4 5
3 12 4 4
4 15 3.75 3
5 17 3.4 2
6 17 2.833333 0
7 16 2.285714 -1
8 13 1.625 -3




  1. When APL is rising MPL>APL
  2. When APL is falling, MPL <APL
  3. When APL is at maximum MPL = APL
  4. When TPL is at maximum, MPL = 0

Both graphs initially increase, reach a maximum before finally declining. This is because of the law of diminishing returns

Long run refers to a period of time in which all variables are able to settle at their equilibrium and all economic processes have time to work in full Average product (AP) is the output per unit of the variable factors and it‟s given by: AP = Total product (TP) Number unit of variable factors E.g. the average product of workers and capital are given by: AP = TP; AP = TP L K Marginal products it is changes in the total product brought about by varying the employment of the variable factors by one unit e.g. increasing employment by 1 person. MP = Change in total product Change in quality of labour employment = ΔTP ΔL

Fixed Costs are costs that do not change as output varies. They are associated with fixed factors of production and include; rent rates, insurance, interest on loans and depreciation. Fixed costs remain the same whether output is one unit or output is 1,000 units. Fixed costs are also referred to as overhead costs or unavoidable costs.

Depreciation, especially in capital intensive industries usually constitute a major item in fixed costs since the life of capital tends to be measured in economic rather than technical terms and machinery, for example, depreciates even when not in use. Variable Costs- are costs that are related directly to output and include the wages of labour, the costs of raw materials, fuel and power. Variable costs are alternatively known as direct or prime costs. Total Costs represent the sum of fixed costs (FC) and variable costs (VC). TC = FC+VC When output is equal to zero, total costs will be equal fixed costs since variable costs will be zero. When production begins to increase total costs will continue to rise as variable costs increase since output expands.

Law of Diminishing Marginal Returns/Law of Variable Proportions

 It states that holding other factors constant as additional unit of a variable factor are added to a given quantity of a fixed factors, the total product and the marginal product will initially increase at an increasing rate but beyond a certain level of output it will increase at a decreasing rate and eventually fall.

Law of diminishing marginal returns

As the units of a variable input are added to a fixed factor, its marginal/additional production initially increases at an increasing rate, then increases at a decreasing rate before finally declining.

The law of diminishing marginal returns on scale

It states that   as more and more factors of production are added to fixed factors, additional/marginal output initially increases at an increasing rate until the optimum point beyond which it starts to decline.

This explains the three stages of production namely:

  1. The increasing returns.
  2. Constant returns /decreasing rate and
  3. Decreasing/declining returns.

One factor is fixed and the rest are variable.

  1. All units of the variable are similar or alike.
  2. Prices of the factors of production remain constant.
  3. Production is continuous.
  4. Technology remains constant.
  5. Only during the short-term period.

Weaknesses of the law

  1. It’s a theory of static situations which cannot be realistic in current scientifically dynamic world.
  2. It’s assumed that land is a natural resource and man has nothing to do to increase its supply which isn’t true.
  3. It’s possible to improve the industrial machinery and other equipment’s so that extra people on land can move to industry bringing down the diminishing returns.



Decisions on what goods and services to produce.

  1. What to produce
  2. How production is to take place e.g. what raw materials and machinery should be utilized
  3. Where a production plant is to be located
  4. When to produce
  5. The scale of production e.g. how big should the factory be.
  6. When and where to invest.
  7. How production can be improved and controlled
  8. What type of business unit to engage in?

Factors that influence decisions on what goods and services to produce.

  1. Whether the firm is product or market oriented-firms that produce products are meant to meet consumers’ needs are said to be market oriented firms ie cars came first; they were unique and novelty. Over time, car producing firms realized need to develop cars that meet consumer needs.
  2. Level of competition come up with products consumers will prefer.
  3. Level of technology-new inventions and innovations often result in new products/improved mobile phones which can cope up with the existing technology.
  4. Management role-senior management has a role to play. A wrong decision ruins rather than build the enterprise.
  5. Financial viability-cost of production and expected returns should be considered funds may only be approved for the product that promises long term benefits to the firm. If benefits of product outweigh the costs, then such product will be developed and if not so, it will be dropped.

Determining the size of the firm.

The following are some of the ways in which the size of a firm may be determined.

  1. The numbers of employees-large firms are usually within employment of large number of workers. The larger the firm the range of functions that will be carried out by one individual.
  2. Volume of output-a firm with a high output is considered to be large.
  • Floor area covered by premises.
  1. Capital invested
  2. Production methods-specialization and division of labor is usually associated with big firms. When using this criterion, to determine size of a firm, technology levels should be taken into account.
  3. Market served-i.e. a firm having many branches all over the country can be said to be the big.
  • Sales volume-amount of sales of a firm makes within a given period of time.


Existence of small firms in an economy.

The advantages enjoyed by large scale firms do not make them necessarily dominant in economy. Small scale firms exist hand in hand with large-scale firms even when there is direct competition. Reasons

  1. Size of the market-in a situation when demand for a product is not high, large scale production may not be justified and it’s only appropriate for such a market to be served by small scale firms.
  2. Nature of the product-this makes it sometimes impossible to produce it in large quantities e.g. in a situation when one is offering personal services e.g. painting or nursing, such a product can only be produced by an individual or a small firm.
  3. Simplicity of organization-small firms has the considerable advantage of simplicity in organization. They avoid bureaucracy, wastage and managerial complexity associated with large scale organization.
  4. Flexibility of small firms-it is more adaptable to changing circumstances .a sole trader can easily switch overnight to publishing newspapers. When an owner of a business wishes to maintain flexibility so as to take advantage of any new opportunity, he/she may have to maintain small firms
  5. Quick decision making-less consultations are made
  6. Belief that small firms are more manageable.
  7. Rising costs of production-in situations where production cost rise too fast such that diseconomies of scale set in very early, firm has to remain small.
  8. Need to retain control-to retain control and independence, owners of firm may wish to keep it small.
  9. Legal constraints-in some situations, laws may restrict growth of a firm therefore in such circumstances existing firms remain small.

Location of a firm

This means the selection of a place where the proposed firm would be established. This selection of location is one of the problems facing management and as such an appropriate decision has to be made. This is so because a good location would lead to success while bad location would lead to failure of business enterprise. The factors influencing location of firms include;

  1. Raw materials-this is usually the case where raw materials are heavy and bulky such that costs of transporting them to far distances would be too high e.g. nature of raw materials determines/influences the location of a firm and this explains why sugar mills and textile industries are located in those areas where sugar cane and raw cotton are produced. Firms that use perishable raw materials ought to be located near the source of raw materials e.g. tea factories are located near the farms.
  2. Market-a firm may be located near market for its products to avoid costs involved in transportation of finished brick-making firms may be located near market because bricks are bulky and it would be very expensive to transport them.

A firm that deals in perishable/fragile products needs to be located near market to avoid breakages/spoilage as those commodities are transported for long distances to market

E.g. bread and milk usually go bad very quickly and therefore need to be consumed immediately they are produced.

Glass breaks very easily and therefore their transportation need to be avoided as much as possible.

  1. Human resources(labor).-can be classified into either skilled, semiskilled and unskilled labour.labour intensive firms must be located in areas where there is not only abundant labor force but also an appropriate in Kenya, firms requiring labor of any kind may be located in urban centers because in such areas labor is in plentiful supply.
  2. Transport and communication-firms require constant supplies of raw materials, often in large quantities from different sources, and finished goods have to be distribute to various destinations.therefore,good transport network is another very important locational factor to be considered when establishing firms. When communication network is poor, business people will not be able to give or get information in time.
  3. Power and water supply-power is needed for running the industrial machines while water is required for cleaning, cooling and even as a raw material. Firms that require a lot of power and water need to be located where there is adequate supply of these webuye paper mills is located near source of water because paper mills require a lot of clean water.
  4. Government policies-government can encourage development of firms by offering special concessions to industries such as;
  • Offering free or cheap land.
  • Reduction of taxes
  • Offering subsidies
  • Offering direct financial assistance
  • Improvement of infrastructure.

Some of the reasons why government can influence location of industries could be to populate its empty lands, provide jobs in areas of persistent employment in order to reduce imbalance in regional development.

Other factors include.

  1. Availability of auxiliary services e.g. banking and insurance
  2. Rooms for expansion
  • Effects of firm on environment
  1. Security
  2. Terrain of land



This means the concentration of similar firms in one particular area or region. The factors which encourage localization of firms include;

  1. A well-developed infrastructure in an area attracts firms into that area.
  2. Availability of large population which may provide both labor and market.
  • Interdependence among various firms in areas such as training of personnel.
  1. Government policy requiring firms to be located in a certain area.
  2. Availability of raw materials in certain areas.


  1. Encourages establishment of support business enterprises e.g. many firms are located in one region, institutions e.g. banks,insurance,companies and distributors are likely to set up businesses in the area to offer services required.
  2. Encourages creation of a pool of labor force. This is because when industries are concentrated in one area, people tend to migrate to that region in search of employment. This enables firms to meet their labor force requirements.
  3. Localized firms are likely to attract others which use the finished goods of the established firms as raw materials thereby creating a market for localized firms.
  4. Localized firms are able to easily dispose off their waste by either selling them to other firms for recycling or by jointly undertaking waste disposal projects.
  5. Concentration of firms in one area encourages creation of employment opportunities in the region.
  6. Concentration of firms in one area encourages development of the necessary infrastructure e.g. water systems, roads, communication network, health and education facilities in the region.


  1. Concentration of firms in one region may have negative impact on environment in the region e.g. emissions from factories may cause both air and water pollution.
  2. May lead to regional imbalance in development e.g. areas of industrial concentration tend to enjoy provision of social amenities e.g. roads, schools, hospitals etc.
  3. Concentration of firms in one region contributes to rural-urban migration. Such movements are undesirable because they may cause open unemployment in town while in rural areas they may cause labor deficiency.
  4. Increased population in areas of industrial concentration may spark off a series of problems e.g. congestion, increased rate of crime, immorality, spread of diseases e.g. hiv/aids and housing problem.
  5. Localization of firms may be undesirable because terrorism activities or war can destroy country’s industrial base.
  6. A fall in demand of products produced by localized firms would result into a widespread unemployment in the affected area.

Delocalization of firms.

This refers to establishment of firms in different parts of country as opposed to localization where firms are concentrated in one area. The government may encourage delocalization in order to achieve various objectives by using various methods such as giving free land, tax benefits and offering subsidies.


  1. Reduces effects caused by occurrence of war, terrorism attacks or earthquakes.
  2. Provides employment opportunities to people living in rural areas.
  3. Reduce rural-urban migration
  4. Encourage balanced regional development
  5. Provide a market for locally produced raw material.
  6. Local communities are able to get the produced goods without necessarily travelling very far.


  1. Spread of pollution to various parts of the country
  2. Skilled manpower may not be readily available in rural areas.
  3. Security may be a problem in some areas.
  4. Service industries e.g. banks may not be available in rural areas.
  5. Incentives offered by government are an added burden to tax payer.
  6. Continued protection from foreign competition by government may make the firm to continue producing substandard products.


Refers to a unit of production known as producer or its equivalent entity. It is made up of plants and its size depends on the economies and diseconomies of scale.

The optimum firm

This refers to s firm which has reached the most efficient size where costs of production per unit output are minimal. It’s the best / ideal point of a firm.

Conditions necessary for optimum

  1. Factors of production must be combined in their most efficient manner.
  2. The firm must be enjoying internal economies of scale.
  3. The firm must have no motive to expand or contract.
  4. The firm must be incurring lowest average cost.
  5. The firm must be enjoying returns to scale.
  6. The entrepreneur must be rational.

Optimum size of the firm

This is the most efficient size of the firm, at which its costs of production per unit of output will be at a minimum, so that it has no motive either to expand or reduce its scale of production.  Thus, as a firm expands towards the optimum size it will enjoy economies of scale, but if it goes beyond the optimum diseconomies will set in.


Short run and long run costs

Short run refers to that period of production time in which at least one factor input is fixed (cannot be varied). On the other hand long run refers to that period of production time in which the input of all factors of production can be varied.

The actual length of production time does not correspond precisely to any particular period but varies from industry to industry.

Short run costs in production

Short run costs can be classified as follows:

  1. Fixed costs (FC)

This refers costs which do not change with changes in the output. For example  Land.

  1. Variable costs (VC)

Refers to costs which change with change in output.

The above are combined to form the formula.

Total Costs (TC) = Fixed Costs (FC) + Variable Costs (VC)

TC = FC + VC

Other costs

  1. Average Fixed Cost (AFC)

Refers to average fixed cost per unit of output.


  1. Average Variable Cost (AVC)

Refers to total variable cost per unit of output.


  1. Average Total Costs (ATC) = TC / Q or AFC + AVC
  2. Marginal Costs (MC)

Refer to change in total cost due to change in output.


A firm produces good x using labor as the only variable factor. It’s fixed cost is five dollars. The table below therefore shows the firms total cost at the corresponding output levels. Calculate: TVC, AFC, AVC, ATC and MC

5 0 _ _ _ _ _
9 1 4 5 4 9 4
12.5 2 7.5 2.5 3.75 6.25 3.5
15.8 3 10.8 1.7 3.6 5.27 3.3
18.8 4 13.8 1.25 3.45 4.7 3
22 5 17 1 3.4 4.4 3.2
25.5 6 20.5 0.83 3.42 4.25 3.5
29.3 7 24.5 0.71 3.5 4.19 3.8
33.6 8 28.6 0.63 3.56 4.2 4.3
38.5 9 33.5 0.56 3.72 4.27 4.9
44 10 39 0.5 3.9 4.4 5.5



AVC reaches the lowest point at a lower level of output Q1 compared with ATC. This is because ATC includes both AFC and AVC.


Long run costs

In the long run, the firm varies its output as well as is plant capacity to expand therefore all costs is variable. Therefore the firms long run average cost curve can be derived assuming that the firm can build an infinite number of plants of different sizes. This curve shows the lowest possible costs of producing different output levels given the firm production and factor prices.

Revenue Function

Revenue is the receipt from the sales of a good or service Total revenue is given by the price x quantity sold TR = PQ Where TR- total revenue, PQ- price x quantity Average Revenue is given by; AR = TR refers to revenue per unit sold on average Q Marginal revenue it is the increase in revenue brought about on extra unit sold. MR = ΔTR ΔQ


These are the benefits / advantages that accrue to affirm by virtue of its large size. Economies are either internal or external.


These are advantages which come from within and reduce the cost of operation.

They include:

  1. Technical economies- Indivisibilities: These may occur when a large firm is able to take advantage of an industrial process which cannot be reproduced on a small scale, for example, a blast furnace which cannot be reproduced on a small scale while retaining its efficiency.

Increased Dimensions:  These occur when it is possible to increase the size of the firm’s equipment and hence realize a higher volume of output without necessarily increasing the costs at the same rate.  For example, a matatu and a bus each require one driver and conductor.  The output from the bus is much higher than that from the matatu in any given period of time, and although the bus driver and conductor will earn more than their matatu counterparts, they will not earn by as many times as the bus output exceeds the matatu output, i.e. if the bus output is 3 times that of the matatu counterparts.

Economies of Linked Processes:  Technical economies are also sometimes gained by linking processes together, e.g. in the iron and steel industry, where iron and steel production is carried out in the same plant, thus saving both transport and fuel costs.

Specialisation:  Specialisation of labour and machinery can lead to the production of better quality output and higher volume of output.

Research:  A large firm will be in a better financial position to devote funds to research and improvement of its product than a small firm.

  1. Managerial / administrative economies.
  2. Marketing economies of scale- The buying advantage: A large-scale organisation may buy its materials in bulk and therefore get preferential treatment and buy at a discount more easily than a small firm.
  3. The packaging advantage: It is easier to pack in bulk than in small quantities and although for a large firm the packaging costs will be higher than for small firms, they will be spread over a large volume of output and the cost per unit will be lower.
  4. The selling advantage: A large-scale organisation may be able to make fuller use of sales and distribution facilities than a small-scale one. For example, a company with a large transport fleet will probably be able to ensure that they transport mainly full loads, whereas small business may have to hire transport or dispatch part loads.
  5. Financial economies of scale-: A large firm will have more assets than a small firm. Hence, it will find it cheaper and easier to borrow money from financial institutions like commercial banks than a small firm.

5 Research and developmental economies.

6 Welfare economies.

7 Risk bearing economies.


These are savings that come from without because a firm is located near others.They include:

  1. Ready markets-I.e. availability of commercial facilities.
  2. Development of good transport and communication.
  3. Development of financial institutions.
  4. Development of training institutions.
  5. Research through pool of capital resources.
  6. Development of trading associations
  7. Creation of labor force which is skilled in various techniques.


These are disadvantages / problems that accrue to a large firm as it expands in size. It can be both internal and external.


  1. Managerial diseconomies-This mainly arises due to management difficulties and rising prices of inputs such as labour.Increase in development makes coordination tasks become more difficult. The firms are big so communication is problematic. Maintenance of morale is also more difficult. Control as well as implementation is extremely difficult in practice.
  2. Selling / marking diseconomies
  3. Labor diseconomies


They accrue due to concentration of firms in the same place / area and they increase the cost of production.

  1. Traffic congestion.
  2. Shortage of accommodation.
  3. Air, water pollutions.
  4. Increased price on land.
  5. Increase in crime.
  6. Development of slums.
  7. Shortage of food.





This refers to factors such as the number of firms in the market , the ease at which firms enter or leave the market, the size of the firm, etc which determine the behavior and performance of firms selling products in that market.

A market in economics refers to a situation/context where potential sellers of a commodity are brought into contact with potential buyers and a means of exchange is available.there does need to be a physical entity corresponding to a market thus for example,a market may be created over telephone or market.


  • Presence of commodities
  • Presence of buyers
  • An area/region must exist.
  • Interaction between buyers and sellers.
  • Existence of sellers
  • A medium of exchange unless barter system is being applied.


The market may be wider or limited depending on area covered on selling commodities.the extent depends on;

  1. Nature of commodity-if the commodity is durable and valuable,the market will be wider and vice versa is true.
  2. Extent of demand-commodities with greater demand translates to wider market and the vice versa is true.
  3. Peace and security-during peace and security,commodities will be sold in large areas hence the market will be wider and vice versa is true.
  4. Means of transport and communication-if they are developed,it will be possible to move commodities from one place to another.
  5. Policies of the government which can either promote or restrict movement of goods.
  6. If the banking and monetary system of a county is more stable,there will be a wider market due to the facilitation made.


  • To facilitate transactions by providing the opportunities of buying and selling goods
  • It serves as an outlet of goods and services for various goods produced
  • It is a source of supply to a society
  • Facilitates contact between buyers and sellers
  • Helps in determination of prices to be charged in amarket through demand and supply forces in the market
  • Influences increase or decrease in production depending on market demand of a product.



These are categorized according to market structures:

  1. Perfect competitive market
  2. Pure monopoly single supplier for the market
  3. Monopolistic competition market with firms producing differentiated products
  4. Oligopoly a few interdependent firms dominate themarket
  5. Duopoly


It’s a market having many buyers and sellers selling homogeneous/ identical products. Its common in the agricultural sector e.g. maize, egg



  1. It’s a market which has many buyers and sellers such that no single person can influence the market price and output.
  2. Products sold are homogeneous.
  3. There are no barriers to entry and exit of market.
  4. No government control e.g. no price control.
  5. Demand curve facing the firm is perfectly elastic. For example a small price increase in one firm causes a big decrease in demand.
  6. Both buyers and sellers are price takers- no one can influence the market.
  7. Both buyers and sellers have perfect knowledge about the market. They know product price and quantity.
  8. There is perfect mobility of factors of production. Factors of production are free to move from none profitable activities to profitable activities.


Prices in this market are determined by the market forces of demand and supply. This is where demand and supply curve meet.

There are many sellers such that no single sellers can influence the market price such that each seller must sell the product at market price.

In this case the market price is the individual firm price and the market demand curve is the individual firm represented by a horizontal straight line.



A firm maximizes profits or is at equilibrium when it produces the level of output at a point where MR = MC and as long as MC cuts MR from below. It is possible for a PC firm to make losses, abnormal profits or normal profits in the short run depending on the position of the AC curve. Firms in this market make normal profits in the long run.


The abnormal profits are shown by the colored part


The firm makes losses when it produces the level of output at point where MR = MC  and AC is above MR and thus produces output Qe.

The firm is at equilibrium when it produces the level of output at point at X where MR = MC and produces output Qe.

At point X, AR = AC meaning TR = TC; TR – TC = O (normal profits)


Why normal profits are generated in the long run in perfect competitive market


Firms in this market at first make abnormal profits attracting many firms since entry is free. Supply increases and prices start decreasing and now firms start making losses.

Losses force some firms to exit the market since exit is also free. This consequently reduces supply and prices start increasing such that in the long run firms are at equilibrium when they make normal profits.

Normal profits are experienced when TR = TC meaning TR – TC = 0 (normal profits). At this point existing firms cannot quit the market and new firms cannot enter the market.



  1. Consumers have choice in terms of many sellers to choose from
  2. No monopolies who may overcharge consumers by overcharging
  3. Entry is free
  4. Exit is free
  5. Competition among seller’s leads to production of high quality products enjoyed by consumers
  6. No wasteful competition.



  1. Consumers lack variety of products because products are homogeneous.
  2. Stiff competition among firms causes weak firms to close down.
  3. Closing down of weak firms causes unemployment in the country.
  4. Firms make only normal profits in the long run.
  5. There is no room to produce public goods to benefit the public since the aim of the firm is to make profits.
  6. Since firms aim at making profits, they might not account for externalities. E.g. pollution.



This market which does not satisfy perfect competition market conditions. For example a monopsony market which is a market structure characterized by a single buyer e.g. KPLC which buys electric power from Kengen

This is a market having many buyers and one seller selling a product which has no close substitute and there are barriers to entry preventing other firms from entering the market.



  1. Many buyers.
  2. One seller.
  3. There are barriers to entry. For example trade licenses.
  4. There is no direct competition from sellers since there is only one seller.
  5. Total control of essential resources or strategic resources.
  6. The government confers exclusive rights through issuance of ownership rights and especially through innovation / discovery.
  7. The firm experiences economies of scale.
  8. The government can grant one firm the exclusive right to operate – legal monopoly. E.g. water and electricity
  9. The firm is the price maker.



  1. Absolute ownership of raw material.
  2. Control over the marketing channel.
  3. Economies of low operating costs
  4. Government licensing to only some firms to supply some commodities KPLC
  5. High initial costs of starting the firm / industry. SAFARICOM
  6. Patent rights issued as a result of innovations.MICROSOFT
  7. Ownership of the rights of a well known brand.OMO BLUEBAND
  8. Elasticity of market demand – Inelastic demand promotes monopoly
  9. Number of firms – monopoly decreases as no of firms increase
  10. Interaction among firms – Aggressive interactions promotes monopoly for some firms
  11. Legal barriers
  12. Possession of knowledge or techniques


Monopoly demand curve

Since there is only one seller or the good, the firms demand curve is in effect to the industry’s demand curve. For example the monopolistic demand curve is the market demand curve which is normally downward sloping. Therefore the monopolistic is not a price taker he will charge different prices at different l

Because he faces a downward  sloping Qd curve ( AR curve), the monopolistic has to reduce the prices of all units sold in order to sell an extra unit of output. This implies that the MR must be less than the price.


Short run equilibrium

The aim of the monopoly is to maximize profits and this will be achieved when his


During the short run period, the market demand and costs of production will dictate how much a monopolistic will produce. At equilibrium a monopolistic will produce at a point where the short run marginal cost equals marginal revenue.


The monopolist misallocates resources because he adheres to the principle of MR = MC. but restricts output and charges more price than a perfectly competitive market. He also does not produce at the lowest point of ATC therefore does not gain productive efficiency. Also the monopoly does not have a supply curve because the same quantity is sold at market at different prices.


The long run equilibrium

In the long run, the monopolistic has enough time to adjust output with change price. He can do this by building another plant or a smaller one depending on price and demand.

At the long run a monopolistic will produce at a point where long run marginal cost  is equal to long run marginal revenue.

If the total demand for the product does not change, the demand for any product of the firm will fall. This shifts the demand curve shifts to the left until the abnormal profits are eliminated and this point there are no incentives for new firms to enter the market.



  • There is stability of output and prices than under competitive conditions.
  • Enables the monopolist to spend on research and development.the invention of new techniques of production becomes possible.
  • It is helpful to provide some services more smoothly and efficiently e.g. the network of electricity or water supply demands monopoly organisations.
  • The establishment of monopoly is helpful to obtain the economies of scale
  • The firm can reduce costs by standardizing his/her product and avoiding advertising expenses.



  1. There is no optimal allocation of resources-e.g. kplc hence lack of competition.
  2. Consumers are likely to be overcharged in many cases because they lack any option.
  3. There is dead weight loss
  4. Price discrimination-ability of monopoly to charge different prices for the same good.
  5. A problem of quality of goods ie poor quality and issues of efficiency are compromised.
  6. The level of output is too results in decrease in production and increase in unemployment.
  7. The monopolist can use his powers to restrict the entry of new firms and discourage the fair competition.
  8. There is usually no freedom of choice as consumers are forced to get the product from producer and therefore have no freedom of choice.

Price discrimination under monopoly

A monopoly might charge different prices to different customer of similar goods and services in different markets in order to increase his profit levels and where price differences are not justified by cost differences.



  1. Airline companies/ trains charging different price to classes.
  2. Electricity utilities.
  3. International trade.


Conditions for price discrimination

  1. The seller must posses some degree of power in ability to control out put and price.
  2. The monopoly must segment the market into distinct classes and charge different prices to each class.
  3. The monopolistic must be aware of the willingness of the customers to pay for the products.
  4. The monopolistic must be able to protect resale of the product by buyers.

The price to charge in each market is dependent on the price elasticity of demand. In the first market where demand is price inelastic, he charges a higher price while selling lower quantity. In the second market where demand is price elastic, the price is lower and the quantity sold is higher.

Perfectly discriminating monopolistic (1st degree monopolistic)

The seller in this case charge the customer the highest price he or she is willing to pay.

The monopolistic demand and MR curves coincide because the monopolistic does not cut price on preceding units to sell more output. The most profitable output is at Q1 where MR = MC   but it is greater than that of nondiscrimination monopolistic.


  • Perfect price discrimination results in greater profit and greater output than is the case of single price monopolistic.
  • Some consumers pay more than the single price but others pay less.
  • Perfect price discrimination and price competition are equally efficient.

Most markets have neither the single seller required to meet the definition of a pure monopolist nor the large number of small sellers and undifferentiated product necessary to qualify as perfectly competitive.

Monopolistic competition is a market where there are many firms producing similar but differentiated products with each firm having a limited degree of price control.  E.g. designers,food industry(colgate ,aquafresh etc).Monopolistic competition is a form of market in which there are many sellers of a heterogeneous or differentiated product and entry into and exit from the industry are rather eas’;y in the long run. Because of the differences among their products, firms in this market have some control over their price but it is usually small, because the products are close substitutes. The demand curve of a monopolistic competitive firm is highly elastic, but not perfectly elastic as in the case of perfect competition.

Monopolistic competition is most common in the retail and service sectors of an economy. Clothing, hair dressing, detergents and food processing are some of the industries that come close to monopolistic competition at the national level. At local level we can think of fast food outlets, beauty salons all located in close proximity to one another.

Short run price and output determination under monopolistic competition

The figure below shows the price and output determination under monopolistic competition. Since a monopolistically competitive firm produces a differentiated product that has close substitutes, the demand curve it faces is negatively sloped but highly price elastic. As in the case of monopoly, since the demand curve facing a monopolistic competitor is negatively sloped and linear, the corresponding marginal revenue curve is below it.

The best level of output of the monopolistically competitive firm in the short run is given by the one at which MR=MC. This is shown by point E1 on figure a. The optimal output is Q1 while optimal price is P1. The monopolistically competitive firm earns an economic profit presented by P1CVA in the figure a  below

Short run and Long Run Price and Output Determination under monopolistic Competition


If firms in a monopolistic competition earn economic profits in the short run, more firms will enter the market in the long run. This shifts the demand curve facing each monopolistic competitor to the left (as its market share decreases) until it becomes tangent to the firm’s LAC curve.  Thus in the long run all monopolistically competitive firms break even (earn normal profit) and produce on the negatively sloped portion of their LAC curve (rather than at the lowest point, as in the case of perfect competition). This is shown in figure b above. The condition to be satisfied for profit maximization in the long run is MR=MC and P=AC.


Product differentiation

Refers to a strategy designed to capture and retain particular market segments by producing a range of related products.  The products may be differentiated by packaging, design, content, chemical composition, advertising and other applicable forms.

Perfect differentiation leads to a relatively elastic demand. Chamberlin argued that the demand for these products is affected by services associated with the product


The firm maximizes profit by equating MC with MR hence selling at O P1.

The firm makes supernormal profits equal to ABCP1.  The firm then retains or increases these profit levels by engaging in non price competition e.g. advertisements and repackaging to make its products attractive to buyers.


Long run equilibrium

As long as the firm continues to make supernormal profits, new firms are induced to enter the industry. This leads to a fall in the demand of a single firm’s demand hence shifting the demand curve to the left until the supernormal profits are eliminated. At this point there are no incentives for other firms to enter the market.

Profit maximizing behavior of firms

 Firms seek to maximize profits under normal circumstances.


Profits (π) = TR – TC


Conditions for profit maximization

  1. Requires that the firms marginal revenue (MR) equal its Marginal cost (MC).




  1. Total Cost (TC)

Refers to all costs incurred in production process. They can be fixed or variable costs.

  1. Average Cost (AC)

AC is the cost per unit output produced

  1. Fixed Cost. (FC)

FC is cost incurred independent of output produced.  It is constant and does not change with output.

  1. Variable Cost (VC)

VC is cost that varies with output produced.



This refers to the market structure dominates by large few firms. The number of sellers (firms) is small enough for other sellers to take account of each other i.e. if one seller changes his prices or uses non- price strategies his/her rivals would react. This is called oligopolistic dependency. Examples of this firms are,oil,motorvehicles and cigarette industries.Characteristics

  1. Contains few firms who produce goods that are substitute but need to be perfect substitutes.

2 Lies somewhere between extreme of perfect competition are monopoly.

3 There are barriers to the entry.

4 Decision of the firms are strictly interdependent

5 Sellers agrees on the price or the market share


Forms of oligopoly

(i) Duopoly where market is dominated by two firms

(ii) Pure oligopoly where the products of the few sellers are identical.

(iii) Differentiated oligopoly where products are differentiated in term of quality packaging etc.

(iv) Collusive oligopoly where the few sellers in the market come together and make decisions to control the prices, quality and quantity to be produced.

(v) Non collusive oligopoly where the few sellers determine their prices, quality and quantity without colluding.


Kinked Demand Curve The interdependence in oligopolistic firms explains the price rigidity among the firms. The theory of kinked demanded curve suggests that firms in oligopoly face two sets of demand curves.

(i) Price increase

(ii) Price reduction which is slightly inelastic

For price increases the firm is an elastic demand curve dd. For price decreases it is on the inelastic demand curve DD. This means the actual demand curve for firms is represented by dED. The demand is said to have a kink at point E associated with the price P1 and quantity Q1. All firms in the industry are assumed to be in a similar position which implies that if a firm raises its prices and its competitor fails to follow suits then, it will loss large sales of revenue. This firms is on the elastic portion of the demand curve If one firm reduces prices then, its competitors will have to reduce their price by at least a much or even more to retain the market share. When the price is lower each firm has the same market share which implies that the firms are on the inelastic portion of the demand curve. Collusion will take the form of agreeing the prices for each market share. This is done in order for the oligopolistic firms to maximize their joint profits and reduce uncertainty. A form of open collision is known as a cartel whereby firms produce differently but act like determinants of price and output. Figure 5.8 shows the Equilibrium of an oligopolistic firm facing kinked demand curve. The marginal revenue is discontinuous at the output level where there is a kink in the demand curve. The kink in the demand curve explains the nature of the marginal revenue curve. Where at point E and output Q the marginal revenue curve falls vertically since at the higher price the marginal revenue curve correspond to less elastic demand curve. The firm maximizes its profit where the marginal cost is equal to marginal revenue. Its is very likely that the marginal cost curve will cut the marginal revenue curve between point X and Y which corresponds to the discontinuous part of marginal revenue curve.



  • Through equitable distribution of resources where rich are taxed more than the poor.
  • Through government regulations which limit expansion of some firms
  • Through use of marketable permits that prevents competition.
  • Protection from competition through giving specific firms patent rights
  • Protection through giving firms copyrights
  • Through giving subsidies by government to specific firms to promote their production.


  • To ensure consumers are not exploited through over pricing.
  • To ensure goods are up to standards.
  • To ensure that people involved in business comply with the law ie paying business permits,tax etc.
  • To prevent overexploitation of resources due to low prices.
  • To facilitate healthy competition.




National Income is a measure of the money value of goods and services becoming available to a nation from economic activities. It can also be defined as the total money value of all final goods and services produced by the nationals of a country during some specific period of time – usually a year – and to the total of all incomes earned over the same period of time by the nationals.



  • Gross Domestic Product-The money value of all goods and services produced within the country but excluding net income from abroad.
  • Gross National Product.-The sum of the values of all final goods and services produced by the nationals or citizens of a country during the year, both within and outside the country.
  • Net National Product.-The money value of the total volume of production (that is, the gross national product) after allowance has been made for depreciation (capital consumption allowance).NNP=GNP-D
  • Nominal Gross National Product.-The value, at current market prices, of all final goods and services produced within some period by a nation without any deduction for depreciation of capital goods.
  • Real Gross National Product-This is the national output valued in constant prices during some base year or nominal GNP corrected for inflation.An inflational deduction called stock appropriation is done.
  • Net national income.-This is the income received from productive activities after subtracting indirect taxes and adding subsidies ie NNI=national income at factor cost-indirect taxes+subsidies.
  • Personal income-this is the sum of all incomes received by the residents of a country during a excludes undistributed profits,corporation taxes and social security contributions eg the NSSF but it includes transfer payments ie personal income=nni-undistributed profits-corporation taxes-social security contributions +transfer payments.
  • Disposable personal income-this is the income that an individual /resident of a country receives after paying direct taxes to the government eg income tax
  • Per capita income
  • Refers to national income divided by the population of that particular country


The compilation of national income statistics is a very laborious task.  The total wealth of a nation has to be added up and there are millions of nationals.  Moreover, in order to double check and triple check the statistics, the national income statistician has to work out the figures out in three different ways, each way being based on a different aspect.  The three aspects are:

  1. THE NATIONAL OUTPUT: – The creation of wealth by the nation’s industries. This is valued at factor cost, so it must be the same as b) below.
  2. THE NATIONAL INCOME: – The incomes of all the citizens.
  • THE NATIONAL EXPENDITURE because whatever we receive we spend, or lend to the banks to invest it, so that the addition of all the expenditure should come to the same as the other two figures.

Put in its simplest form we can express this as an identity:

National output º National Income º National Expenditure.




In this method value of output of all the firms in the economy is added together to arrive at national income figure.

To aid in this the economy is divided into different productive sectors eg farming, fishing, mining etc.  It is a useful method where a census of production of the economy is required.

It is important that only the value added at each stage of production or by each firm is counted in order to avoid double counting.

The term value added of the firm may be defined as the difference between the total value at each stage and the value of the previous stage.

For example:  Consider a case of wheat bread production shown below;

Kshs.                           Value Added

Farmer                                                100,000                       100,000

Miller                                                  150,000                         50,000

Bakers                                                 180,000                         30,000

Retailers large / wholesalers              190,000                         10,000

Retailers                                             200,000                         10,000

820,000                       200,000

To avoid double counting we use value added only or the other approach is to add the final product only.  Imports if and only if included in the total output should be excluded and exports if excluded should be included.

The figure obtained is further adjusted by adding net factor income from abroad.

This is the most direct method of calculating national income.



  • Stock appreciation-subtracted.
  • Residual errors-subtracted.
  • Net factor income from abroad-added if positive and subtracted if negative.
  • depreciation



Income method approach is from the distribution side.In this approach national income is got by adding together all the rewards earned by all factors of production for a given period.  We include only those particular income flows that originate with the production of goods and services whose total we seek to estimate.

Only then will the total income flows equal the total of the goods and services.

In an economy income is earned as follows;-

  1. Land receives rent (R)
  2. Labour receives wages (w)
  3. Capital receives interest (r)
  4. Enterprenuer receives profit (π)

So that Y = R + W + r + π, however the following also should be taken into account:

  1. Retained earnings – (re) that part of profit retained by firms should be taken into account
  2. Subsistence income (sy) – this occurs in a case where income is not paid but services are rendered eg services of housewives, self provided services etc



  1. Transferred payment (tp) – Payment made without satisfying ‘Quid Pro Quo’ criteria ie income for which the recipient provides no good or service.
  2. We should exclude income received from people who sell building, automobiles or things produced in a previous period, because what they receive in payment is ‘not income’ in the sense of something generated in the cause of producing the output of the current period (py)
  3. Anything for which neither a good or a service is supplied in exchange and for which there is therefore no corresponding for example receipts of people who sell bonds and debentures (SB)

Therefore National Income will be expressed as follows:-

Y =  R + W + r + Re +  π + Sy – tp – Py – SB

Y = C + S + T + Rpf



In this approach we add together all types of spending on finished goods and services in an economy.  It involves counting each unit produced at the time of purchase and valuing it at the actual purchase price.  If we add up total expenditure on goods and services, we will have (subject to a number of qualifications).  The total we seek and also a total in which each unit of  output is valued at what appears to be the best available indicator of the value of that unit to the society ie the price actually paid for it.

Different types of spending in an economy are identified and added together:-

  1. Personal consumption expenditure (C)

Spending in food items, services, durable goods by households.

  1. Private domestic investment (Gross) (I)

This includes all purchases of machinery, tools and equipment, all construction whether residential as commercial and changes in inventory.

Inventory changes as investments are produced and not sold or sold when not produced in the present period.  If at the end of the year firms have more stock on the shelves than at the end of the year it means that the economy has produced more than it has consumed.  Therefore positive changes should be added when GNP is determined.  For inventory decline we subtract from GNP since GNP is a measure of the current year’s output and we must omit anything produced in past or previous years.A fall in inventory means that the economy consumed more than it produced in a given year, thus consuming previous years production.

  1. The Government (G)

All government spending on final goods and services should be included but exclude spending on transferred payments as well as subdsidies.

  1. Exports and Imports

Spending by foreigners on goods and services produced in a country should be included.

Export is symbolized by (X)

Imports is spending on foreign goods and services produced in other countries.  It is symbolized by (M).

Net export (Xn) is the amount by which foreign spending on our goods and services exceed the amount of spending on goods and services exceed the amount of spending on goods and services produced by foreigners.

Therefore, GNP =  C + I + G + X – M also measures aggregate demand of an economy.



The desired total measures the amount of output produced by an economy in a specified period of time.  Thus it must clearly indicate only expenditures on the purchase of goods and services produced in that period.

The exclusions include:-

  • Any part of billion of shillings spent during that period on goods produced in earlier periods. All expenditures of this kind merely reflect changes in the ownership of pre-existing output.  As such they are not part of the total of expenditure that measures the values of total output.
  • It must exclude all expenditures of things that are neither goods nor services and therefore do not reflect production at all either current or past. For example spending on stocks and bonds.  There is no production or output of goods and services corresponding to expenditure on mere pieces of paper.
  • All expenditure by central and local government for which the government does not receive a good or services in exchange eg transfer of payments.
  • Spending on intermediate products so as to avoid double counting.



National Income Accounting is beset with several difficulties. These are

  • Making decisions on what goods and services to include

Although the general principle is to take into account only those products which change hands for money, the application of this principle involves some arbitrary decisions and distortions. For example, unpaid services such as those performed by a housewife are not included but the same services if provided by a paid housekeeper imputed value is usually assigned to this income. Many durable consumer goods render services over a period of time. It would be impossible to estimate this value and hence these goods are included when they are first bought and subsequent services ignored.  Furthermore, there are a number of governmental services such as medical care and education, which are provided either ‘free’ or for a small charge. The solution is that all unpaid services are excluded.

  • Danger of Double Counting

The problem of double counting arises because of the inter-relationships between industries and sectors. Thus we find that the output of one sector is the input of another. If the values of the outputs of all the sectors were added, some would be added more than once, giving an erroneously large figure of national income. This may be avoided either by only including the value of the final product or alternatively by summing the values added at each stage which will give the same result.Some incomes such as social security benefits are received without any corresponding contribution to production. These are transfer payments from the taxpayer to the recipient and are not included. Taxes and subsidies on goods will distort the true value of goods. To give the correct figure, the former should not be counted as an increase in national income for it does not represent any growth in real output.

  • Inadequate Information

The sources from which information is obtained are not designed specifically to enable national income to be calculated.

  • It is easy to value the goods that are sold in market but those which aren’t sold in market have no price attached to them.
  • Activities that are considered illegal eg making illicit brews are also not included when measuring national output although they involve echange of money.
  • The value to put on goods that have been ket as stock becomes has to decide whether to use the cost of goods /the price to be paid for them.price is different from cost of similar goods being produced due to a rise /fall in the production costs.
  • Prices of some resources keep fluctuating in markets
  • It is difficult to measure the cost of wear and tear or depreciation of equipment inorder to arrive at net national income


The size of  a nation’s income depends upon  the quantity and quality of the factor endowments at its disposal. A nation will be rich if its endowments of natural resources are large, its people are skilled, and it has a useful accumulation of capital assets.  The following points are of interest:

  1. Natural Resources

These include the minerals of the earth; the timber, shrubs and pasturage available; the agricultural potential (fertile soil,  regular  rainfall, temperature or tropical climate); the fauna and flora; the fish; crustaceaetc of the rivers and sea; the energy resources, including oil, gas, hydro-electric, geothermal, wind and wave power.

  1. Human Resources(labour supply).

A country is likely to prosper if it has a large population; literate and numerate sophisticated and knowledgeable about wealth creating processes.  It should be well educated and skilled, with a nice mixture of theory and practice.  It should show enterprise, being inventive, energetic and determined in the pursuit of a better standard of living.

  1. Capital Resources

A nation must create and then conserve capital resources.  This includes not only tools, plant and machinery, factories, mines, domestic dwellings, schools, colleges, etc, but a widespread infrastructure of roads, railways, airports and ports.  Transport creates the utility of space.  It makes remote resources accessible and high-cost goods into low-cost goods by opening up remote areas and bringing them into production.a country that uses modern equipments eg tractors in ploughing would be able to produce more than a county using simple jembes.

  1. Self-sufficiency

A nation cannot enjoy a large national income if its citizens are not mainly self-supporting.  If the majority of the enterprises are foreign –owned there will be a withdrawal of wealth in the form of profits or goods transferred to the investing nation.

  1. Political Stability-the government that maintains conducive political atmosphere may attract both local and foreign investors who in turn contribute to increasing size of national income.Inorder to plan and execute production plans,firms require a stable political environment.
  2. Level of technology-this refers to the techniques in production of goods and services determining quality and quantity of goods and services provided.the higher the level of technology used in production prcess,the higher its output and hence higher national income.
  3. Entrepreneurship-availability of entrepreneurs who have the ability to organise the factors of production will have a bearing on countys national income.
  4. Land-a country with abundant resources is likely to have a high national income relative to a country without.
  5. The quantity and quality of factors of production.



  1. We need national income statistics to measure the size of the “National cake’ of goods and services available for competing uses of private consumers, government, capital formation and exports (less imports).
  2. National Income statistics are also used in comparing the standard of living of a country over time
  3. And also the standards of living between countries.
  4. National Income Statistics assists in investment decisions and this is possible because the data from this statistics may show the sectors which are declining and those growing.investors would save in growing sectors to save him/her time and cost of conducting market research.
  5. If National Income Statistics are disaggregated it would enable us to assess the relative importance of the various sectors in the economy. This is done by considering the contribution of the various sectors to Gross National Product over time. Such information is crucial for planning purposes for it reveals to planners where constraints to economic development lie. It therefore becomes possible to design a development strategy that eventually would overcome these problems. This central contribution could be in the form of employment or the production of goods and services.
  6. By assessing exports and imports as a percentage of Gross national Product i.e. using national statistics, it is possible to determine the extent to which a country depends on external trade.
  7. Provides a breakdown of consumer expenditure, government expenditure,levels of investment and total taxes paid to the government. This helps the government to plan for development activities using taxes collected e.g. social amenities provision helps government when making policies regarding investment.
  8. To provide information on the relative sizes of the various sectors of the economy and their contribution e.g. agriculture and manufacturing. This will be determined by the share of each sector in relation to total national output.
  9. Provide information on performance of the economy over a given period of time and this forms a basis of comparison between different periods.
  10. Provide information which is used in making economic policies, preparing annual budgets and preparing development plans.
  11. This statistics provide information on the distribution of income which helps the government to address income disparities e.g. through subsidies and tax relief.
  12. G.D.P is a measure of economic growth. If G.D.P goes up it indicates that the economy is growing.
  13. Provides information on the types of factor incomes within the economy and this can be an indicator of shrinking/growing sectors of the economy.
  14. Used as a measure of standard of living of people in a country.
  15. Assists in comparing standards of living,although this method has a number of drawbacks ie different currencies are used and conversion may be tedious,definition of goods and services used in computing national income may also differ in different countries,disparity in income distribution and different needs and taste of citizens.


By National Income is meant the value of outputs produced within a year.  Income per capita is simply the National Income divided by the population of the country in a year.

INCOME PER CAPITA     = National Income


It shows the standard of living a country can afford for its people.  The level of income per capita is determined by the size of a country’s population.  The higher is the rate of growth of population, the lower is the rate of growth of income per capita.

Per capita income is a theoretical rather than a factual concept.  It shows what the share of each individual’s National Income would be if all citizens were treated as equal.  In a real world situation there exists considerable inequality in the distribution of income especially in the third world countries


Standard of living refers to the quantity of goods and services enjoyed by a person. These goods may be provided publicly, such as in the case of health care or education or they may be acquired by direct purchase. It also includes the less easily quantifiable aspects of living such as terms and conditions of employment and general living environment.

National Income figures can be used to measure the standard of living at a particular point of time and over time. This is done by working out the per capita income of the country. By per capita income we mean: the value of goods and services received by the average man. Per capita income is obtained by dividing the National Income by the Total population. If the per capita income is high, it can be deduced that the standard of living is high.



  • The composition of output may change. e.g. more defence-related goods may be produced and less spent on social services, more producer goods may be made and less consumer goods, and there may be a surplus of exports over imports representing investment overseas. Standards of living depend on the quantity of consumer goods enjoyed.
  • Over time prices will change. The index of retail prices may be used to express the GNP in real terms but there are well known problems in the use of such methods.
  • National Income may grow but this says nothing about the distribution of that income. A small group may be much better off. Other groups may have a static standard of living or be worse off.
  • Any increase in GNP per capita may be accompanied by a decline in the general quality of life. Working conditions may have deteriorated. The environment may have suffered from various forms of pollution. These non-monetary aspects are not taken into account in the estimates of the GNP.
  • Finally the national income increases when people pay for services which they previously carried out themselves. If a housewife takes an office job and pays someone to do her housework, national income will increase to the extent of both persons’ wages. Similarly a reduction in national income would occur if a man painted his house rather than paying a professional painter to do the same. Changes of the above type mean that changes in the GNP per capita will only imperfectly reflect changes in the standard of living.


Per capita income figures can also be used to compare the standards of living of different countries. Thus if the per capita income of one country is higher than that of another country, the living standard in the first country can be said to be higher. Such comparisons are made by aid giving international agencies like the United Nations and they indicate the relevant aid requirements of different countries.

But there are major problems in using real income per head (per capita income) to measure the standard of living in different countries. First there is the whole set of statistical problems and, secondly, there are a number of difficult conceptual problems or problems of



  1. Inaccurate estimates of population: The first statistical problem in calculating income per head particularly in less developed countries is that we do not have very accurate population figures with which to divide total income.
  2. Specific items which are difficult to estimate: Another data problem, as already mentioned, is that data for depreciation and for net factor income from abroad are generally unreliable.  Hence although we should prefer figures for “the’ national income, we are likely to fall back on GDP, which is much less meaningful figure for measuring income per head.  Inventory investment and work-in-progress are also difficult items to calculate.
  3. Non-marketed subsistence output and output of government: some output like subsistence farming and output of government are not sold in the market.  These are measured by taking the cost of the inputs.  In one country, however, salary of doctors for instance, might be higher and their quality low compared to another country.  Although the medical wage bill will be high, the “real consumption” of medical care in the former might be lower.  Since  “public consumption” is an important element in national income, this could affect comparisons considerably.Also in making international comparisons it is assumed that the complied national income figures of the countries being compared are equally accurate.  This is not necessarily the case. If, for example, in one country there is a large subsistence sector, a lot of estimates have to be made for self-provided commodities.  The national figures of such a country will, therefore, be less accurate than those of a country whose economy is largely monetary or cash economy.
  4. Different degrees of income distribution: large population may be contributing a small proportion of national output while a few contribute a higher percentage.the many people who share only a small proportion will have a low standard of living.
  5. Different Types of Production: If one country devotes a large proportion of its resources in producing non-consumer goods e.g. military hardware, its per capita income may be higher than that of another country producing largely consumer goods, but the standard of living of its people will not necessarily be higher.
  6. Different forms of Published National Income figures: The per capita income figures used in international comparisons are calculated using the published figures of national income and population by each country. For meaningful comparisons, both sets of national income figures should be in the same form i.e. both in real terms or both in money terms, the latter may give higher per capita income figures due to inflation, and thus give the wrong picture of a higher living standard.  On the other hand, if both sets are in money terms the countries being compared should have the same level of inflation.   In practice, this is not necessarily the case.
  7. Exchange Rates: Every country records its national income figures in its own currency.  To make international comparisons, therefore, the national income figures of different countries must have been converted into one uniform currency.   Using the official exchange rates does this. Strictly speaking, these apply to internationally traded commodities, which normally form a small proportion of the national production.  The difficulty is that these values may not be equivalent in terms of the goods they buy in their respective commodities i.e. the purchasing power of the currencies may not be the same as those reflected in the exchange rate.
  8. Difference in Price Structures: Differences in the relative prices of different kinds of goods, due to differences in their availability, mean that people can increase their welfare if they are willing to alter their consumption in the direction of cheaper goods.  The people in poor countries probably are not nearly as badly off as national income statistics would suggest, because the basic foodstuffs, which form an important part of their total consumption, are actually priced very low.
  9. Income in relation to Effort: increased gross national output  may have resulted from an increase in the number of hours worked.G.N.P is a measure of production and consumption not necessarily indicating an improvement in peoples welfare.the citizens may be working in unhealthy conditions and leisure time denial thus G.N.P does not take into account peoples welfare.
  10. Differences in size: A problem which is both conceptual and statistical is due to the transport factor.  If two countries are of different sizes, the large country may devote a large proportion of its resources in developing transport and communication facilities to connect the different parts of the country.  This will be reflected in its national income, but the standard of living of its people will not necessarily be higher than that of smaller country, which does not need these facilities to the same extent.
  11. Differences in Taste: Another formidable difficulty is that tastes are not the same in all countries.  Also in different countries the society and the culture may be completely different thus complicating comparisons of material welfare in two countries.  Expensive tastes are to some extent artificial and their absence in poor countries need not mean a corresponding lack of welfare.  Tastes also differ as regards the emphasis on leisure as against the employment of the fruit of labour:
  12. Different climatic zones: If one country is in a cold climate, it will devote a substantial proportion of its resources to providing warming facilities, e.g. warm clothing and central heating.  These will be reflected in its national income, but this does not necessarily mean that its people are better off than those in a country with a warm climate.
  13. Income per head as index of economic welfare: We cannot measure material welfare on an arithmetic scale in the same way as we measure real income per head.  For instance, if per capita income increases, material welfare will increase; but we cannot say by how much it has increased, and certainly that it has increased in proportion.
  14. It does not take into consideration the effects of production activities on environment eg environmental degradation and pollution.
  15. It just measures economic growth as opposed to economic development .
  16. Quality of Life

National income figures do not reflect the quality of life.  An increase in national income may be the result of linger working houses, inferior working condition, increase in housewives (which means less comfort).  Generally national income has no provision for leisure time.




Money is any asset that is generally acceptable as a means of payment to settle transactions as well as a medium of is anything that is generally acceptable for payment of debts. Stages in development of money

Historically, the development of money in the present form has evolved through the following stage;


  1. Commodity money

This is the money that has a value apart from its use as money. In primitive agricultural stages, domestic animal like cattle, goat, horses, cow etc were used as money. These commodities lacked the essentials of durability; homogeneity etc so could be used any more. Later, there was the use of precious metals of gold, silver and copper i.e. metallic money. The uncoined metals as a medium of exchange further created difficulties. People were unable to know the eight and value of pieces of bullion at sight. This led to the replacement of the unstandardized metal ingots with a standardized coinage. The metallic coin had a quarantined weight of value by a competent authority. Thereafter, the coins also proved a failure as a good medium of exchange. They were clipped, abraded and melted down. Efforts were then made to find out a better unit o account.


  1. Convertible paper money

This was the second stage where paper was used to substitute commodity at rate specified on the currency. Before 1914, the bulk of bank notes were convertible into gold. The bank had to pay the bearer a specific amount of gold on demand. In today’s economy the paper notes are convertible notes. They are neither fully or fractional convertible into gold.


  1. Deposit money.

This consists of deposit at bank and financial institution which are subject to withdrawals by Cheques are a safe way of transferring the ownership of deposit in financial institutions.


For a commodity to perfom as money it has to have the following characteristics.

  • Acceptability-money must be acceptable to everyone for it to be used as a medium of exchange
  • Durability-should be able to last for a long time without getting torn,defaced or losing its shape and texture.the material used to make money should therefore be of a quality that resists wear and tear.
  • Divisibility-should be easily divisible into smaller denominations but still maintain its value.this enables the buyer to purchase various quantities of goods and services.
  • Cognizability-should be made of a special material that is easily recognizable to minimize risk of forgery and printing of fake notes and mint coins.this cognizability of money enables people to differentiate various denominations of the currency.
  • Homogeneity-should be made using a similar material so that it appears identical e.g. 500 notes should be printed using the same material and have identical security features to eliminate risk of confusion and forgeries.all notes of the same denomination should be identical.
  • Portability-should be convenient to carry even if it has a high face should neither be too bulky to carry around as this would hamper should be light.
  • Stability in value-should last for a long time without changing in value so that it maintains credibility and that fluctuates in value makes people want to hold their wealth in form of goods.
  • Liquidity-should be easy to convert into other forms of should be able to quickly convert money into properties or other forms of assets.
  • Scarcity-should be relatively scarce in supply.if money was abundant in supply then it would lose value.
  • Malleability-the material used to make currency coins should be easy to cast into required shapes.


  • Medium of exchange-money is generally acceptable by everybody in exchange for goods and therefore enables trade to be carried out conveniently hence reducing drawbacks of barter trade
  • Measure of value-when commodities are valued in terms of money,a problem of fixing exchange rate is solved.this is because money provides a common denominator in which the values of various goods and services are expressed.
  • A unit of account-money can be held for no other purpose than is a unit by which goods and services are valued.
  • Store of value-this is because it is easily convertible into other forms of can also be kept as savings for future transactions since it is durable and relatively stable in value.
  • Standard of deferred payment-a debt incurred today can be paid at a later date using used to settle future payments.
  • Transfer of immovable properties-using money,we are able to transfer the value of a commodity from one person or place to a piece of land in Mombasa can be sold and the money received used to acquire a piece of land of an equivalent value in another province.
  • Measure of wealth-wealth can be measured in monetary terms.



This refers to exchange of goods and services for goods and services.this trade has several drawbacks.

  1. It is difficult to estimate the value of one good with another
  2. It depended on double coincidence o wants between traders.
  • Perishability of some commodities tomatoes,fruits and milkcould go bad very easily hence could not be stored.
  1. Divisibility aspect was a problem ie it wasn’t easy to divide some commodities into smaller goods.
  2. Portability-it was difficult to transport goods since some were heavy and bulky.


  1. Buyers and sellers are able to get the goods and services they require immediately after the exchange.
  2. A country/person is able to dispose off the surplus.
  3. Promotes social relations among the trading communities,through negotiations
  4. Promotes specialization in the production of goods and services ie concentrate on what you can offer best.


Demand for money refers to the tendancy or desire by an individual or general public to hold onto money instead of spending is also known as liquidity can be hold by individuals in various forms and these include;currency notes and coins,securities e.g. treasury bills and bonds,demand deposits held in current accounts of banks,time deposits held in fixed deposit accounts.


  1. The transaction motive-here one holds money with a motive of meeting normal daily expenses e.g. buying food,entertainment ,paying wages,postage,travelling,buying raw materials etc
  2. The precautionary motive-this is where people tend to hold money to meet expenses that might occur unexpectedly or emergencies e.g. sickness,accident,or loss of property through is obvious that optimistic and risk takers  will keep less money while pessimistic /risk averse will keep more money.
  3. The speculative may be held to be used in future especially when people anticipate that the prices of goods and services will be lower than they are presently and one plans to invest in opportunities that will bring more gains/returns. such money is said to be held in a speculative held for this purpose depends on levels of income and how optimistic/pessimistic people are about future happenings.


This refers to the stock of monetary items that are in circulation in an economy at a particular point in time.these items basically consists of;total currency ie notes and coins issued by central bank and the total demand deposits.the following variables affects money supply;

  • Policies of commercial banks-if more loans are ooffered to individuals and firms,money money is released in economy and the vice versa is true.
  • Increase in national income-this increases economic activities resulting to money level in economy to increase and vice versa is true.
  • Increase in foreign exchange-increased export earnings arising from increased export trade leads to an increase in money supply in an economy and the vice versa is true.
  • Coins and notes offered by commercial banks
  • Central bank guidelines to commercial bank on cash reserve requirements.
  • Government policies ie can be geared towards expenditure,borrowing which increases money supply,
  • Open market operations activities.
  • Intrest rate policies
  • Special deposits requirement by CBK.
  • A change in the public desired cash holdings.
  • Balance of payment equilibrium or disequilibrium-disequilibrium transalates to a net outflow of currency which leads to a reduced money supply.

Money supply is best understood through the concept of MONETARY POLICY.this can be defined as a deliberate move by government through the central bank to manipulate the supply ,availability and cost of money inorder to achieve the desired economic levels.The following are the various instruments /tools that commercial banks use in conjuction with the centaral bank to regulate the level of money supply/Methods of credit control.

  • The bank rate policy/bank intrest rates.
  • During inflation the Central Bank increases the commercial bank lending rates on loans making borrowing expensive ;translating to reduced money supply and during deflation the rates are lowered thus promoting borrowing.
  • Increased rates decrease the amount of currency in circulation while a decrease in rates increase the amount of money in circulation as in individuals are charged low intrest rates
  • Open market operation:
  • This refers to sale and purchase of securities in the stock market. During inflation the central bank sells government securities (treasury bills and bonds)to withdraw an amount of money from the general public and during deflation it buys back the securities to increase currency in circulation.
  • Reserve requirements/cash/liquidiy ratio requirement.
  • Central bank requires commercial banks to hold a certain proportion of total deposits in cash form to meet the needs of those customers who may wish to withdraw ratio=cash held/total deposit.if the central bank lowers this ratio then more money will be available for lending and the vice versa is true.This is meant to decrease or increase money in the commercial bank reserves.
  • Rationing of credit:
  • This is based on the size of loans a commercial bank is allowed by the central bank.
  • Margin requirements:
  • The margin refers to the difference between a loan and a collateral security.
  • If the margin is big, loans will be expensive thus the public will shy away from borrowing loans thus money supply will reduce and if the margin is small the loans will be cheap thus many people will be more willing to borrow loans,increasing money supply in the economy.
  • Restricting terms of hire purchase agreement and credit sales
  • Here the Central bank may encourage or discourage the purchase of commodities on installments. To discourage it, the payment period is decreased and deposit fraction raised to discourage buyers from buying on credit thus releasing some lump some of money which they could be holding,and the vice versa is true.
  • Direct action, requests ,Moral persuasion and publicity:
  • CBK Directs the commercial banks to advance loans to a given amount. Directs the commercial banks to behave in a defined way ie expand or contract credit creation activities.  Reports on financial matters related to commercial banks encourage banks to change their policies.
  • Compulsory deposit requirements-CBK may require commercial banks to maintain certain amounts of deposits with it in special accounts whose money would stay frozen.this act has effect of reducing amount of money available to commercial banks for lending which implies a reduction in money supply.if the CBK wishes to increase supply of money,it may reduce/release the deposits to commercial banks.
  • Selective credit control-CBK may give special instructions to commercial banks and other money lending instructions as to the type of sectors to give credit to and ones which credit should be restricted to.
  • Loans to banks and discount window-this allows eligible institutions to borrow money money from central bank usually to meet short term liquidity needs.
  • Gentlemens agreements-these are voluntary agreements between cental bank and banks aimed at improving monetary conditions in Tanzania,such agreements have been used between central bank and the largest commercial bank in an effort to lower spread on intrest rates.


  1. Commercial banks do not cooperate fully within the central bank
  2. A government monetary system may be reduced or increased in size and controlled tightly without deleterious effects on its performance,however monetary system contains commercial banks that are in business for profit.
  3. The system may create problems for monetary authorities .this controls may weaken profit and capital positions of banking system and this may in turn make commercial banks less responsive to policies of monetary authorities.
  4. Omos are not quite virtually effective in controlling money supply due to less developed money and capital markets and limited range of financial assets(securities) held by C.M.A.
  5. On reserve requirement,some commercial banks have access to external lines of credit from partners/their parent companies.
  6. Funding-may be effective in controlling liquidity.however since the rate of intrest on long term debt is usually much-higher than on short-term loans.



Banking  refers to all the activities carried out by financial institutions involving money.this financial institutions include:central bank,commercial banks and non banking financial institutions e.g. industrial and commercial development corporation(I.C.D.C). Some important terms in banking.


  • Bank statements: This is a list of all transactions made by the bank with or on behalf of the customers of the account holder.  It is issued at the end of each month to current account holders.  It enlists all deposits made by the account holder, all cheques paid by the bank out of his account holder, all cheques paid by the bank out of his account and any charges made by the bank.
  • Credit transfers: This is the process where an account holder draws a cheque carrying a wholesome amount to be paid to various people and attaches it to a list of names of the people to be paid.  The cheques and the list are presented to the bank and the bank takes up the responsibility of transferring payments to payees who must be account holders.
  • Standing orders: its an arrangement between the account holder and his bank to pay a specific amount to a named party at a regular or specific intervals for a given period of time until the agreement is cancelled by the drawer.  The system serves best in payment of salaries, rent and rates insurances.  A fee is charged by the bank for these services.
  • Travelers cheque: Issued to a person after paying for them in advance they are in fixed denominations.  It is important to businessmen always on transit.
  • Credit cards: mainly issued  by banks.  It gives authority to the holder to buy goods and services up to an agreed amount.  The selling party then presents the card to the issuing organization for payment.
  • Cheque guaranteed card: its issued by banks to reliable current accounts.  The guarantee card if attached to a personal cheque it guarantees payment against the personal cheque.  In other wards it cannot be dishonored.
  • Clearing house: it’s a central place where different banks meets to settle amounts that become payable to each other as a result of their clients transactions.  The transfer of payments is done by the central bank since it holds all commercial banks accounts.


There are various categories of banks ie


1.COMMERCIAL BANKS-they are financial institutions that carry out commercial services,accept deposits from the public and advance loans.they are formed with the aim of making profit hence are trading businesses like any other.


  • Accepting deposits-they play a vital role in economy by mobilizing domestic savings and enabling efficiency and convenience in transactions by accepting deposits ie cash items,warrants,E.F.Ts,night safes etc in three main accounts ie
  1. Current accounts.


  • Deposits of any amount can be made at any time.
  • here the deposits may earn intrest and the account holder is expected to pay some fee to the bank for services provided e.g. account maintenance.
  • Money deposited in this account is withdrawable on demand by means of cheque.
  • Money can be withdrawn from this account at any time during working hours so long as the account has sufficient funds.
  • No minimum cash balance is required to be maintained.
  • Does not earn intrest but instead the bank charges ledger fees for services rendered.
  • The banks may allow customers to withdraw more money than they have in their current accounts and this is known as bank overdraft that carries interest at an agreed rate.
  • This are accounts operated by people who have the intentions of saving money(small savers).
  • The balance on the account above a certain minimum earns intrest.
  • Funds are not withdrawn by use of cheques.
  • Overdrafts are not usually allowed.
  • In most cases one is required to maintain a certain amount in account.
  • Withdrawal of money exceeding a certain maximum amount might require a notice to be given by the customer of the intended withdrwal.
  • Ordinarily withdrwals can only be made by the account holders themselves.
  • Banks don’t use this money as compared with fixed deposit accounts.
  1. Do not allow withdrwal/addition of money into the account before the end of a fixed pre-detrmined period.
  2. They are appropriate for people who have money that they have no immediate use for
  3. Earns intrest at an agreed rate and the rate of intrest depends on the amount deposit as well as the period taken by the deposit.usually higher than savings account .
  4. There is usually a minimum amount that can be allowed for this type of account
  5. On expiry of deposit period,the account holder can withdraw all the money together with intrest or even renew the contract for another similar different term.
  6. If the account holder withdraws the money before the expiry date of the agreed deposit period he/she not only loses the accrued intrest but might also be charged for breach of contract.
  7. There are no bank charges to the account holders.
  8. The money held in fixed deposits can be used as security for getting a loan.
  9. Lending money/provide loan facilities –this can also be offered even in form of overdraft.others are short term,medium term or long term.
  10. Safekeeping of valuable items-e.g. title deeds,share certificates,jewellery and wills for safe keeping for their customers and they provide safety  vaults and lockers  and a nominal fee is charged.
  11. Provides money transfer facilities-money can be transferred from Nairobi to London via commercial banks.some employees have their salaries transferred to their accounts from employers accounts.this arises mainly through standing orders,credit transfers,telegraphic transfers,cheques,bank overdrafts,letters of credit,credit cards and travellers cheques.
  12. Provision of foreign exchange/effect foreign exchange payments-a person with foreign currency can convert it into local currency.
  13. Provide financial information ie giving advice on investment and management of funds –ie best shares;saving in a fixed deposit account as well as information on how to engage in foreign trade.
  14. Provide trusteeship(trustee services)-banks act as managers on behalf of their clients.the bank also act as a trustee on behalf of a client who dies and there is no person to manage his/her business affairs effectively.also takes into account property estate
  15. Act as guarantors and referees-this usually happens to clients whowish to engage in credit transactions to secure loans from other financial institutions or get goods on credit from new suppliers.
  16. Act as intermediary between savers and borrowers-a link is created between savers and borrowers of money and through such a link,economic activities are facilitated.
  17. Discounts bills of exchange-banks discount bills of exchange and accept promissory notes from their trusted clients.discounting a bill means that the bank accepts a bill from its customer and exchanges it for less cash than the amount on the bill because the bill has not yet matured.
  18. Provides safer means of payment-commercial banks provide safe and reliable means of payment ie cheques,bank overdrafts,credit transfers and other means that are used to make payments
  19. Credit creation-this refers to the process of creating money from the deposits in the customers accounts.
  20. Helps in financing international trade-ie offering mediums of exchanges , promissory notes and letters of credit.


This is an institution established by the government of that country to manage and control the supply of and demand for money in a countrys economy.

It can also be defined as the highest institution in a countrys banking system which regulates and controls the economy financial activity to ensure stability and prosperity.


  • Facilitate rapid and steady economic growth.
  • Create full
  • Stabilize prices of commodities
  • Ensure balanced development.
  • Enhance equilibrium in balance of payments.
  • Foreign Exchange rate stability.
  • Moop out excess liquidity
  • Control business cycles.
  • Intrest rate stability.
  • Financial market stability.



  1. Issuance of currency-this is usually in notes and coins,in correct amounts to check on inflation.
  2. Acts as governments banks-ie keeps overnments accounts,mangages overnment borrowing as well as a financial advisor to the government.
  3. Bankers to commercial banks(banks banker)-
  • Acts as a custodian of the reserves held by commercial banks.
  • Supervises the operations of commercial banks.
  • Advises commercial banks on financial matters.
  • Offers a central clearing house-this is where banks settle debts due to each one of them which arise from their daily operations.
  • Statutory management during financial crisis.
  • Licensing operations of commercial banks.
  • Repatriation of excess foreign currency/profits on behalf of commercial banks.
  • Acts as a lender of last resort

4.Controlling commercial banks-central bank controls commercial banks and other financial institutions by giving instructions to them on lending procedures and proper banking practices to prevent over-exploitation of clients.

5.Lender of last resort-this means that commercial banks may obtain loans from the central bank to meet their daily financial obligations when need arises.

6.Exchange control(maintaining stability in exchange)-it is responsible for maintaining a suitable exchange rate between the local currency and foreign official agent to  government dealings.

7.Act as link bank to external financial institutions-this facilitates international financial relationships as well as linking financial institutions e.g. the I.M.F with the World Bank.

8.Facilitates clearing of cheques-it facilitates clearing of cheques between different commercial banks through its clearing house.

9.Administering public debt-it is responsible for management and repayment of the debt(internally or externally)when it matures.

10.Implementation of monetary system/policy-this is so as to regulate the economy by using several instruments of monetary policy to either expand economic activities or depress them ie. O.M.Os,bank rates,cash ratio,margins,deposits,selective credit control and directives.

11.Credit control-the amount of credit given out by by commercial banks affects the quantity of money in circulation and this at the end determines money supply in an economy.this is so sensitive due to the aspect of  inflation or deflation.


  1. Spurring economic growth and development-investments being made by savings made by clients and others offered to businesses and individuals as loans.
  2. Currency and economic stability-it ensures that the value of a countrys currency is stable in relation to other countries currencies.
  • Smooth operation of the money market-ie short term finances required by businesses by buying or selling securities and bonds
  1. Equitable development-it ensures that credit is available to all the sectors of the economy.
  2. Regulating and financing banks and other financial institutions-this ensures stability in the countrys economic environment.
  3. Regulating money supply-it plays an important role in ensuring that adequate money is available in the economy to ensure expansion of economic activities.


This are institutions that address themselves to the financial needs of particular sectors of the economy which commercial banks have not been able to cater for adequately.the examples include;

  1. Development finance institutions-primary goal is to promote and aid growth and development of commerce and industry in an K.I.E-Kenya Industrial Estates,D.F.C.K.I.D.B-Industrial Development Bank.S.E.F.C-Small Enterprise Finance Company.
  2. Housing finance companies/building societies-mainly involved in financing housing activities and may either put up houses which they sell to individuals and organisations or provide mortgage finance to qualified people who wish to put up their own H.F.C.K-Housing Finance Company of Kenya.E.A.B.S-East African Building Society.
  • Savings and credit co-ooperatives societies(saccos)-they are formed mainly to enable members save and also obtain loans most conveniently and at favourable conditions.usually formed by people who are engaged in similar activities or are under one Mwalimu Savings and Credit Cooperative Society,Afya Savings and credit society,Harambee Savings and credit cooperative society.
  1. Insurance companies and pension funds -they provide finance to commercial organisations as well as to individuals and also assist in creating confidence and a sense of security to their clients. eg Kenya National Assurance, N.S.S.F.
  2. Long term finance companies eg I.C.D.C. I.D.G., A.F.C. Finance house and hire purchase firms eg D.F.C.K-development finance company of Kenya.


  • They stimulate competition with commercial banks over deposit and other credit markets hence stimulate efficiency in terms of improved services to borrowers in the financial market.
  • They have enhanced the development of financial market through the introduction of great variety of financial instruments e.g. investment deposit account,mortgages deposit account.
  • Offer services beyond the scope of the commercial banks
  • Through its expansion,it has created an additional vehicle for the more effective execution of the government monetary policy.
  • Helps in purchasing of durable consumer and capital goods through hire-purchase houses.
  • They provide financial advice to their client.
  • Offer credit facilities to risky borrowers at higher rate of interest.
  • Offers financial advice to various individuals and institutions in an economy.
  • Increase employment facilities which leads to full employment due to the increased demand.


  • Commercial banks provide current accounts,savings and fixed accounts but NBFIs mainly operate savings and fixed deposit accounts.
  • Commercial banks normally provide short and medium term finance while NBFIs provide medium and long term finance.
  • Commercial banks provide finance that is not restricted to any particular activity while NBFIs provide finance for specified purpose
  • Commercial banks provide foreign exchange transactions to their customers while NBFIs do not.
  • Commercial banks are the key participants in money market of an economy-a market for short term loans,bank overdrafts and government treasury bills whereas NBFIs are key participants in capital market-a market dealing with long term finances e.g. bonds and mortgages.
  • Commercial banks are members of clearing house operated by the central bank where banks exchanges cheques drawn against them by their clients whereas NBFIs do not provide cheques to their customers for use in transactions.
  • Commercial banks are usually involved in credit creation activities while NBFIs are not involved in this activities.
  • Commercial banks are used by the central bank to regulate the quantity of money supply in the economy while NBFIs are not under the direct control of central  bank and cant be used to regulate money supply in an economy.
  • Commercial banks operate bank account with the central bank of Kenya which is the bankers bank whereas NBFIs intermediaries do not have this facilities


  • Credit cards usully enables the holder to obtain goods and services on credit from specified suppliers.
  • They also enable the holder to obtain money from specific banks and other specified financial institutions.
  • They are available to adults of approved credit worthiness locally and internationally.
  • The companies offering this cards include;Barclays card,American express,access card and visa card.


  1. Enables the holder to get goods and services from specified sellers without paying immediately.
  2. Usually convenient to carry around.
  3. Enables the holder to get money from specified banks.
  4. Increases credit rating of an individual.
  5. It is safer to carry the card around than to carry cash.
  6. Some are internationally acceptable.


  1. To acquire the card the applicant is required to have an established credit record.
  2. The holder is charged high interest rate by card company.
  3. It is prone to abuse through fraud.
  4. The interest is charged if there is delay in repayment.
  5. A minimum age of 18 years is required for one to become a holder.
  6. The holder may be tempted to overspend
  7. Their use is limited to only specific areas(urban areas).
  8. Faces competition from other means of payment e.g. cheques,money orders and postal orders.
  9. Only few businesses accept cards.
  10. Long procedures are involved in getting the card.
  11. The cards can only be afforded by people with high income.


Economists of various countries usually strive so as to ensure that the economy follows export promotion(this are deliberate attempts by government to encourage the export sector) motives as opposed to import substitution motive( a trade option policy entailing an attempt to replace commodities that are being imported,usually manufactured goods,with domestic sources of production and supply and have been criticized in recent years as foreign firms are always the beneficiaries).


Public finance can be defined as the collection of revenue by the central government and local government and all the expenditure(spending) of revenue in the provision of public utilities.According to Findlay Shirras (year) public finance is the study of the principals underlying the spending and raising of fund by public authorities.

 Sources of public Finance

There are two main sources of public finance namely:-

  1. a) Public revenue
  2. b) Public debt-government borrowing.
  3. a) Public Revenue

This refers to the income that the government gets from its citizens. The government can raise its revenues through taxation or non tax activities. This gives rise to tax revenue and non tax revenue.


Taxation is considered the most important source of public revenue. A tax is a compulsory payment made to the government without any direct benefit to the individual or firm. Revenue raised through taxation is used for the benefit of everyone in the society. Taxes can be classified as either direct or indirect taxes. Examples of direct tax are income tax, corporation tax, capital gains tax, estate duty/inheritance tax. Examples of indirect tax are custom duties, exercise duties,sales tax and value added tax. In the year 2005/2006 88% of the government revenue was from taxes while only 12 % was from other sources. Income tax contributes the highest percent, followed by customs and excise, and then VAT.

Non Tax Revenues

(i) Surpluses from public corporations-A public corporation is an organization in which the government has a stake in its ownership.Public corporation normally provides essential services at a fee to the members of the society.E.g. Kenya Pipeline Company, KBC, KB Standards, etc. When the revenue earned from thesupply of these services is more than the expense incurred, the surplus is paid to the government.

(ii) Fines and penalties.-The judicial system in the country is made of courts and tribunals which impose fines and penalties on individuals, firms and corporations that break the laws of the land. The money raised from the fines and penalties becomes public revenue.

(iii) Fees-The government renders some direct services to its citizens such as licensing of marriages,issuing birth certificates, permits, issuing and renewal of driving licenses. For such services a small fee is usually charged. Such fees are a source of public revenue.

(iv) Income from properties.-The government owns many properties. These include homes for which rent is charged, land for which rates are charged and game parks where entry fees are charged. This also is a source of public revenue.

(v) Interest earned from loan repayments-The government charges interest on loans borrowed by the public through its corporations e.g.Agricultural Finance Corporation, Kenya Industrial Estate (K.I.E) etc. This interest collected constitutes part of the public revenue.

(vi) Sale of real assets-The government may sell assets that belong to its parastatals and other state corporations as well as local authority assets. This may take the form of privatization of state corporations, sale of council assets and direct sale of government properties (e.g. vehicles, Grand Regency etc

(vii) Royalties-These are payments to the government arising from the use of natural resources by companies and individuals e.g. in the use of mines and forests.

  1. Dividends and profits earned from government direct investments
  2. Escheats; if a person dies without a proper will and has no legal heirs,properties of such a person revert to state and may constitute part of public revenue.
  3. b) Public debt covered later in detail


Prof. Dalton divides the scope of public finance into four categories namely:-

  • Public income/ revenue
  • Public expenditure
  • Public debt
  • Financial administration
  1. a) Public income/revenue-This refers to government income collected from various sources. The main sources of public revenue include taxes, fees, fines and penalties, income from properties, interest from loans repayment, sale of real assets and royalties.
  2. b) Public expenditure-This refers to spending by the government. Public expenditure covers the canons or the principals which govern it and its effects on production, employment, income distribution,stability and growth. It also includes reasons for increase in public expenditure and changes in the pattern.
  3. c) Public debt-When public revenue falls short of public expenditure, the government borrows to meet the gap.This is the public debt. Therefore public debt includes reasons, methods and sources of public debts, its effects on production, consumption, income distribution and economy, the burden of public debt and methods of debt redemption.

d)Financial administration-The aim of financial administration is to control processes and operations of public revenue,public expenditure and public debt. The scope of financial administration includes the collection,custody and disbursement of public money, the coordination of expenditure according to a wellformulated plan, the management of public debt and the general control of the financial operations of the state. It also includes the preparation of the budget, its execution and auditing of the state.


  1. To ensure redistribution of wealth to all persons in the society ie both the rich and the poor are taxed and poor are given inform of of housing,health care ,education and other amenities
  2. To control the consumption of harmful products.heavy taxes are levied on commodities e.g. alcoholic beverages and cigarettes.
  3. Provision of public goods and services.this include police protection,maintenance of law and order,public health care,disaster management and public infrastructure.this all is aided by public finance through the government.
  4. It ensures collection of revenue where the government uses revenue to finance its activities
  5. It also promotes equitable regional development.the government tries to attain balanced regional development throughout the country.this is done through equitable resources allocation achieved through public finance.
  6. To promote government investment.the government invests in particular projects e.g. electric power generation and distribution,construction of infrastructure and establishing industries.such investments help to spur economic activities leading to economic growth and development throughout the country.
  7. Promoting economic stability.the government adopts suitable policies aiming at spurring economic activities.
  8. Can reduce inflation ie the government can impose high taxes to reduce the high money in the economy.


Taxation is considered the most important source of public revenue. A tax is a compulsory payment made to the government without any direct benefit to the individual or firm. Revenue raised through taxation is used for the benefit of everyone in the society


  1. Compulsory contribution to state.
  2. Imposes personal obligation on tax payer
  • Contributions received from tax payer may not be incurred for their benefit but for general and common benefit
  1. Taxes are not imposed because an individual has received benefits from state or state has rendered any service to him.
  2. Revenues generated through taxation are used for the common benefit of all persons in society.
  3. Leads to a reduction in wealth of an individual/firm ie involves a sacrifice.


  • Complsory contribution
  • Imposed by government only.
  • Element of sacrifice is involved.
  • Benefit is not the condition for tax payment.
  • Tax has no relation with cost of service the government renders to an individual.
  • Tax may be imposed on individual or property but are actually paid by individuals.
  • It’s a legal collection.

Taxes are sometimes levied by government. They are not levied in isolation,but are part of a comprehensive system known as the tax system.Tax avoidance refers to a situation where the tax payer exploits the loopholes within the tax system in order to pay less tax.Tax evasion refers to a situation where tax payer deliberately tries to evade tax.


  1. Raising revenue which is used by government in providing goods and services
  2. Discouraging consumption of certain products e.g. beer/cigarettes.
  3. Discouraging importation of certain products e.g. sugar in order to protect local industries ie heavy taxes on impots.when export duties are lowered,export trade increases.
  4. Reducing inequality in income distribution by taxing the rich and using finances realized to finance activities that benefit the poor
  5. Controlling inflation/maintaining economic stability-during times of prosperity,the government may raise tax levels to control unplanned expenditure by people.execessive expenditure may raise inflation in the society.during tough economic times,tax rates may be reduce making goods relatively cheaper and thus encouraging consumption in the economy.
  6. Helps in location of businesses.high tax on businesses located in urban areas would make entrepreneurs locate their businesses in rural areas where tax is less.this assists in solving localiosation and deocalisation.
  7. Protection of local industries.heavy taxation makes imported goods more expensive than local ones.individuals therefore prefer relatively cheaper locally manufactured goods.local industries therefore have already market for their goods and are able to compete favourably with foreign firms.
  8. Helps in correction of balance of payments .high tax on imported products discourage importation,thereby increasing balance of payments.

Adam Smith was the first economist who laid down four important canons of taxation which are the efficiency principals/canons of taxation to which were added few more by subsequent economists.This are conditions/guidelines which a good tax system ought to fulfill.


  1. The canon of equality

The canon of equality, equity or justice is the most important canon of taxation. Smith explained it thus: “The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue which the respectively enjoy under the protection of the State.” It means that every person should pay the tax according to his ability and not the same amount. It also means that everybody should not pay at the same rate. Rather, every taxpayer should pay the tax in proportion to his income. The rich should pay more and at a higher rate than the other person whose income is less. Thus this canon implies equality of sacrifice or ability to pay the tax n proportion to the income of the taxpayer.

  1. The canon of certainty

According to smith, there should be certainty in taxation because uncertainty breeds corruption. By the canon of certainty he means that “the tax which each individual is bound to pay ought to be certain, and quantity to be paid ought all to be clear and plain to the contributor and to every other person.” Thus this canon requires that there should be no element of arbitrariness in a tax. It should be clear to every taxpayer as to what, when, and where the tax is to be paid. Nothing should be left to the direction of the income tax department. Certainly also means that the state should also be certain about the amount of tax revenue and the time when it is expected to flow in the exchequer.

  1. 3. The canon of convenience

This canon lays down that both the time an manner of payment should be convenient to the taxpayer. In the words of smith, “Every tax ought to be levied at the time or in the manner in which it is most likely to be convenient for the contributor to pay.” In India, the payment of land revenue is in keeping with this canon because it is to be paid after harvesting. Similarly, the payment of sales tax and excise duty by the consumer is also convenient because he pays these taxes when he buys commodities and at a time when he has the means to buy. The manner of payment is very convenient to him because these taxes are included in the prices of commodities.

  1. The canon of economy

Every tax should satisfy the canon of economy in two ways. First, it should be economical for the state to collect it. if the cost of collection in the form of salaries of tax officials is more than what the tax brings as revenue, such a tax is uneconomical, and hence it should not be levied. Second, it should be economical to the taxpayer. It means that he should have sufficient money left with him after paying the tax. A very heavy tax on incomes will discourage saving and investment, and thus adversely affect the productive capacity of the community. Smith states this canon in these words: “Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state.”

  1. The canon of productivity

According to this canon, a tax should be productive in the sense that it should bring large revenue which should be adequate for the government. But it does not mean that in its efforts to raise more revenue, the government should tax the people heavily. Such an effort would adversely affect the productive capacity of the economy. Further, this canon implies that one tax which brings large revenue is better than a number of taxes which bring small revenue. Many taxes may not be productive. They may also be uneconomical

  1. 6. The canon of elasticity

This canon is closely related to that of productivity. The canon of elasticity requires that the government should be able to raise the rates of axes when it is in need of more revenue. In other words, taxes should be elastic. The best example is excise duties. They can be levied on any number of commodities and their rates can be increased every  year in order to raise more revenue. But care has to be taken that the rates of excise duties should not be so raised that they may encourage inflationary pressures in the economy.

  1. The canon of flexibility

Flexibility in taxation is different from elasticity. Flexibility means that there should be no rigidity in taxation. The tax system can be changed to meet the revenue requirements of the state. On the other hand, elasticity in taxation means that the revenues can be increased under the prevailing tax system. But there cannot be any elasticity in taxation without flexibility because some change is required in the rates and structure of taxes if the state wants to increase revenue.

  1. The canon of simplicity

The tax system should be simple, plain and intelligible to the common taxpayer. The tax system should not be complicated. It should be simple to understand as to how is it to be calculated and how much is it to be paid. The form/forms to be filled up for calculation and payment of a tax should be simple and intelligible to the taxpayer. This canon is essential in order to avoid ambiguity,corruption and oppression on the part of the tax department.

  1. The canon of diversity

There should be diversity or variety in taxation. A single or a few taxes would neither meet the revenue requirements of the state nor satisfy the canon of equity. There should, therefore, be a variety of taxes so that all citizens should contribute towards the state revenues according to their ability to pay. There should be a variety of direct and indirect taxes. But a large multiplicity of taxes will be difficult to administer and hence uneconomical.

10.The canon of expediency.

This implies that possibility of imposing tax  should be taken into account from different angles ie reaction upon tax payers should also be taken into one should do what is convenient rather than what is morally right.

11.The canon of coordination.

In democratic countries taxes are imposed by state,central state and local government and it is therefore desirable that there must be desirable coordination between different taxes imposed by different taxing is very much needed considering the intrest of tax payer and government especially in democratic countries.


  1. Maximum social benefit thus reducing inequalities.
  2. Just distribution of tax burden.
  • Universal application of taxes ie each person should pay tax according to his ability to pay and individuals possessing same ability should contribute same amount by way of taxes.
  1. Revenues should increase with increase in national income.
  2. Tax should be balanced.
  3. Tax structure should facilitate use of fiscal policy.


The person on whom tax is initially imposed may either bear the whole of it or pass part or the whole of it to someone else. The burden on the initial person is known as the impact of tax. The final resting place of tax burden is known as the incidence of tax.


  1. Based on impact of tax/impact on tax payer.
  2. Direct taxes-occurs when impact and incidence of tax are on the same is not possible for such an individual to shift any part of tax to anybody else. The examples include;personal income tax(PAYE),death duty,profits and property of individual,corporation tax,stamp duty(tax paid in areas e.g. conveyancing of land or securities transfer from one person to another),wealth tax which is levied on personal wealth that goes beyond a certain limit ie on land,houses,accumulated profits,savings and all realizable assets ,motor vehicle licence fees,fuel levies paid by motorists companies capital transfer tax and capital gains tax.


  • Economical in collection
  • Enhances equality and fairness because payment is based on size of citizens income.
  • Tax revenue is certain as the government can compile income categories as well as contributors in each category from annual returns made by tax contributors.the tax payer also knows how much to pay.
  • The society is conscious(civic conscious) as the tax payer feels the pinch of paying tax and is therefore keen in examining expenditure ensuring the government uses correctly what it collects.
  • There are no leakages as the taxes are mostly paid directy to tax authorities and not collected by middlemen.
  • Elasticity is enabled as they can be expanded to cover as many areas as periods of decreased economic stability tax rates are reduced to ensure people have money to spend.
  • Does not affect price of goods and services as this tax is not inflationary as it only affects consumers disposable incomes and not the price of goods and services.
  • Brings redistribution of wealth and this is mainly seen in progressive tax system where wealthier members are taxed more than poorer.the finances obtained from wealthier members are used to finance services that benefit poor members of community.
  • Usually simple to understand by both the contributor and collector.
  • Desirable as it only affects people who fall witin the jurisdiction of income tax and corporation tax.
  • Flexible as this tax is elastic ie can be raised or reduced according to needs of the society.


  • Possible tax evasion by either falsifying information or just ignoring payments
  • Unpopular with citizens as the burden of tax is borne by tax payer directly.
  • No consultations are made of tax payers
  • In most developing countries most people have low incomes and the government of these countries rely on direct taxes as the main source of revenue
  • It is not imposed on all citizens ie low income earners outside tax brackets are exempted and this makes them not contribute anything to state and they are therefore not interested in scrutinizing government expenditure to ensure proper use of resources.
  • It is a deterrent to saving as high taxation on peoples income would reduce their ability to save as it leaves them with less disposable income.
  • Encourages capital flight because direct taxes like corporation taxes encourage capital flight from the country.this is because the high taxes in country force foreign investors to withdraw their investments and transfer them to countries with lower taxes.
  • Inconvenience as the tax payer has to submit statement of his total income along with the sources of income from which it is derived which is generally subject to complications.
  • Possibility of injustice as it is difficult to accesss income of all classes accurately.hence,it may not fall with equal weight on all classes.moreover direct taxes are arbitrary fixed by the government and they may not be delt on basis of ability to pay.

This is a type of tax whereby the person on whom it is initially imposed may not shoulder the whole tax burden but may shift either the whole or part of it to someone is usually based on consumption of goods and services.examples include;VAT,import duty,export duty(discourages exports) etc.


  • Coverage .the government raises high amounts because taxes are levied on a wide range of essential commodities and every member of community will be taxed.
  • Convenient because it is not paid in lumpsome but in small bits as one buys the commodity and the pinch is not experienced and tax is hidden in price of commodity and therefore the payer may not be aware of it.
  • Difficult to evade because all those who buy the taxed commodity have to pay the tax.
  • Ease of collection.indirect taxes are collected by manufacturers and sellers of goods and services and then remitted in lumpsome payment to tax authorities.
  • Promotes social welfare e.g. harmful products like cigarettes and alcoholic drinks may be taxed heavily to discourage their consumption.
  • Can be used selectively to achieve a given objective like price ie high tax is likely to increase product price.
  • Promotes equality as this tax is charged at fixed rates to all the people in the society.
  • Its flexible/elastic as it enables the government to either raise or reduce tax rate to suit the prevailing economic situation in the country.any slight increase in tax rate greatly increases the revenue.
  • Tax payment is voluntary e.g. if one doesn’t want to pay tax,he/she would only need to avoid the taxed commodity ie those who do not take beer don’t pay tax on it.
  • Stimulates effort as increase in this tax is likely to stimulate effort as people struggle to maintain their current standards of living.


  • Uncertainity in revenue yield as one may not predict the amount of revenue as it is not easy to forecast sales.
  • Expensive to administer as the state has to employ many tax inspectors who ensure that the correct amount of taxes are being collected and remitted to tax authorities.
  • Regressive/less equitable as the burden falls more heavily on consumers with low incomes compared to high income earners
  • May fuel inflation/increase price of commodities
  • Encourages falsification of records as revenues depends on the sales recorded by traders so as to pay less.
  • Lacks contributors awareness thus tax payers do not take an active intrest in government spending.
  • Leads to low savings due to increasing tax and the extra income consumers could have saved and invested decreases as consumers pay more for goods and services.
  • Impartial/can be avoided as it usually targets few sets of goods e.g. cigarettes,alcoholic beverages and motor vehicles and consumers of these goods are heavily penalized.
  • Absence of civic consciousness.
  1. Classification based on rates of tax/structure.

Taxes are classified according to the relationship between amount paid as tax and income of the tax payer.

  1. Regressive tax-takes a higher proportion of low income earners as compared to high income earners
  2. Proportional tax-tax payers pay a fixed percentage of their income as tax.
  3. Digressive tax- combines progressive and proportional tax systems. The tax rate keeps rising up to a maximum limit.
  4. Progressive tax-amount paid increases proportionally.


  • Helps in reduction of income inequalities. The higher income earners pay relatively more tax.
  • Reduced collection of tax as the revenue yielded is high but collection cost remains the same.
  • Motivation to work if rates are high as consumers will work harder to maintain their living standards.
  • Enhances distribution of resources as the rich are taxed more which reduces the gap between the rich and poor. The revenue raised from high income earners is used to improve welfare of poor.
  • Economical because the administrative tax do not rise with increase in tax rates.
  • Easily elastic can be helpful in curbing inflation.


  • Discourages savings as those who work hard and earn more income are taxed heavily.their savings are also taxed at increasing rates.
  • Encourages tax evasion as high incomes attracts high taxes.people will try to conceal some some of their incomes.
  • Oppressive as the tax impair savings and thus hurt the levels of investment
  • Makes some assumption ie progressive taxes assumes that persons earning the same income derive the same benefits from that income and this is not always true.
  • Deterrent to work as high tax rate may deter people from working harder e.g. a progressive tax on personal income would make an individual to opt for leisure instead of working overtime to get extra income.
  • Inconvenient because taxation inconviniences tax-payer who has to comply with complicated formalities relating to sources of income as well as expenses incurred while generating it.
  • Deterrent to investment as heavy taxation deter entrepreneurs from investing in highly risky but profitable areas.


This is a statement of estimates /proposals of the way the government plans to raise finances and how such finances are to be spent in a given financial year.


  1. Deficit-budgeted revenue is less than budgeted expenditure.
  2. Balanced-budgeted expenditure equals the budgeted revenue.
  • Surplus-budgeted revenue is more than the budgeted expenditure.

The raising of government revenue and expenditure of the revenue so raised inorder to achieve the desired objectives is known as the fiscal policy.Budgetary policies enable the government to realize its budget objectives and the ultimate goal is to ensure economic stability prevails in the country.


  1. Outlines all the government expenditure.
  2. Outlines government revenue.
  3. Enables government planning of programmes that lead to economic growth and development in a country.
  4. Introducing changes in taxation.all changes are contained in annual budget.
  5. Regulating money ,monetary policy instruments are used.
  6. Assists in stimulating economic activity.when the level of economic activity is low,budget can be used to increase government expenditure in the economy.


The taxable capacity of a country depends on the following factors.

Size of national income. Taxable capacity depends on the size of national income or wealth or natural resources of a country and the extent to which they are developed. The higher the national income, the higher the taxable capacity of a country, and vice versa.

Distribution of national income. In a country where there is inequality of income, taxable capacity is high because the few rich can be taxed heavily. On the other hand, if there is equality of income, the taxable capacity is relatively low because the government expenditure to uplift the poor will be less.

Stability of income. In developed countries, the incomes of individuals are stable, the taxable capacity is high. But where incomes are subject to fluctuations and are unstable, as in underdeveloped countries, the taxable capacity is low.

Size and growth of population. If the size and growth rate of population are high, the per capita income will be low. So the taxable capacity will also be low, and vice versa.

Standard of living. If the standard of living of the people is high, it means that people are spending more on comforts and luxuries. So their capacity to pay taxes is also high, and vice versa.

Tax system. The type of tax system affects the taxable capacity. A progressive tax system has a higher taxable capacity because it falls on higher income groups, as in the case of direct taxes on incomes. On the other hand, regressive indirect taxes which fall heavily on low income groups have low taxable capacity.

Sources of Revenue. Taxable capacity depends on the number of sources of revenue available to the government. The greater the number of revenue sources that are productive, the higher the taxable capacity, and vice versa.

Public expenditure. If public expenditure is meant to increase the welfare of the people, people do not mind paying taxes. If the government spends money on unnecessary and unproductive projects, people will not be willing to pay taxes. Thus taxable capacity is high for productive public expenditure which increases national income, and vice versa.

Taxing and spending income. Taxable capacity depends on the manner and timing of both taxing and spending income by the government. This involves compensatory spending and compensatory taxation. Compensatory spending compensates for the fall in private investment and increases output, employment and income. Compensatory taxation compensates for the fall in private expenditure, compensates for the fall in private expenditure, saving or investment by taxing the people. Both tend to increase economic activity and national income thereby raising the taxable capacity.

Price situation. Taxable capacity is determined by the price situation in the country. If prices are rising, the real income of the people falls and their taxable capacity declines. The converse is the case when prices are falling.

Organization of the economy. If the economy s primarily agricultural, the taxable capacity will be low because the income from agricultural operations is uncertain. On the other hand, an industrial economy has high taxable capacity because the industrial sector generates larger income than the agricultural sector.

Psychology of the people. Taxable capacity also depends upon the psychology of the people.People are prepared to more pay taxes honestly and willingly during a war and natural calamities like floods, earthquakes, etc. As pointed out by Findlay Shirras, “the psychology of the people has much to do with the extent of taxable capacity. People are often willing to bear heavier taxation on patriotic or sentimental grounds. On the other hand, adverse psychology of the people has much to do with the extent of taxable capacity. People are often willing to bear heavier taxation patriotic or sentimental grounds. On the other hand, adverse psychology of the people towards the payment of the taxes lowers down the taxable capacity.

Political conditions. What should be the level of taxation is a political factor these days. A country with has political stability, its taxable capacity will be high if there is political instability or the government is unsympathetic and repressive, the taxable capacity will be low.


This refers to spending by government of finances it has raised.


  1. Capital /development expenditure-This refers to government spending on projects aimed at facilitating economic development in a country e.g. road construction,water provision,electrification of rural areas etc.
  2. Recurrent/consumption expenditure-Refers to government spending that takes place on a regular basis. Every financial year the government has to allocate funds to meet such expenditure e.g. payment of salaries to civil servants,provision of drugs in public hospitals and fuelling government vehicles and protecting the country from external invasion.
  • Transfer payments-The government makes transfer payments to recipients who do not directly contribute to a country national income. This transfer payments include amount spent by the gove on disaster management e.g. famine relief,grants to educational institutions and pension to retirees.


This are considerations to be taken into account before the government incurs any expenditure and they are also known as canons of government expenditure.

  1. Maximum social benefit-any public expenditure must be incurred in such a way that majority of people are able to reap maximum benefit out of it.
  2. Economy-public expenditure must be incurred in the most economical way by avoiding any possible waste or not spend more than what has been raised.
  3. Sanctions-before public expenditure is incurred,it must be sanctioned/approved by relevant authority e.g. parliament in Kenya.this ensures that public authorities do not abuse their powers and spend public funds
  4. Elasticity/flexibility- expenditure policies should be able to change .this is so as to meet the prevailing economic situations e.g. war times; during drought,public expenditure should be incurred to avert hunger disaster.when drought is not there,expenditure should be incurred on development projects.
  5. Equity/equitable distribution-public expenditure should be carried out with the aim of reducing income and wealth inequalities in the society.expenditure should be distributed favourably to all sectors in the economy.
  6. Proper financial management-public funds should be well managed.this should be facilitated by maintenance of proper accounting records which should be audited as required
  7. Productivity-this ensures production is increased and efficiency enhanced ie a small proportion should be spent on non-development projects and a major proportion spent on development projects.
  8. Surplus-the principle requires that government incurs current expenses based on its current revenue projections.
  9. Canon of benefit-expenditure to provide maximum benefit to the society as a whole.


Effects of Public Expenditure on Production

According to Dalton, production and employment in a country depend on three factors:

(a)Ability of the people to work, save, and invest;

(b)Willingness to work, save and invest’

(c)Diversion of economic resources as between different uses and localities.

Public expenditure influences these factors in a number of ways and thus helps in increasing production and employment within the country. The ability and Willingness to work, save and invest depend on the nature of expenditure. The former increase with the increase in the efficiency of workers which, in turn, raises production and employment.

On Social Insurance. Public expenditure on social insurance benefits such as unemployment, sickness, maternity, old age pensions, etc. tends to increase the purchasing power of workers indirectly. When these facilities are provided by the state to the workers indirectly. When these facilities are provided by the state, the workers are not required to spend on them, thereby increase their real purchasing power. The money so saved is spent by them on other articles. It means an increase in their standard of living which raises their efficiency and production.If, on the other hand, the workers spend the money so saved on gambling, drinking, etc. their ability and willingness to save fall which adversely affect their ability and willingness to save fall which adversely affect their ability to work, thereby reducing production.

On Basic Facilities. Public expenditure on basic facilities also tends to raise efficiency and ability to work. When the state provides such basic facilities as cheap ration, low-rent houses, mid-day meals to children, cheap milk, etc. the ability to save increases. This, in turn, tends to raise their ability to work, thereby increasing production.

On Education and Public Health. Public expenditure on education and public health has direct welfare effects on society. Expenditure on education is regarded as investment in human capital because it helps in skill formation and thus raises the ability to work and produce core. Similarly, public health is also another form of investment in human capital. Healthy workers, who are free from diseases, work more and raise production.

On Economic Overheads, Basic Industries, etc. Public expenditure on economic overheads, basic industries, etc also helps in increasing the productive capacity of the economy. Public expenditure on power, transport, communications, irrigation, soil erosion. Land reclamation, etc tends to increase the supply of resources for production over a long period. Moreover, expenditure on roads, railways, and other means of transport also affects the mobility of men and materials, which, in turn help in increasing the productive capacity. Further, the development of basic industries like iron and steel, engineering, heavy chemicals, fertilizers, etc. is very helpful in the development of other industries. Again, public expenditure on river valley projects helps in providing larger employment opportunities. It provides protection against floods ad drought, thereby avoiding loss of resources.

On Credit and Banking Facilities. Public expenditure in providing credit and baking facilities also helps in increasing the productive capacity of the economy. It is through bank nationalization and/or through state and cooperative banks and opening of a network of branches throughout the country that the state can provide cheap and better credit and banking facilities to agriculture,industry and trade, and thus help in increasing their productivity.

On Backward Regions and Areas. Public expenditure on the development of backward regions and depressed areas helps in providing employment through basic facilities. The private enterprise is shy to invest in these areas. It is only the state which by providing all types of basic facilities like roads, railways, power, industries, etc develops such areas whereby the people get jobs and the production power of the area increases.

In the Form of Grants and Subsidies. Public expenditure in the form of grants and subsidies to farmers, firms and industries is highly productive. When there is a bumper crop, the prices of farm products fall considerably. The state can save them from disaster through price support. It can purchase their surplus stocks at fixed minimum prices. In order to encourage higher production, the state can provide such inputs as fertilizers, seeds, pump sets, etc at subsidized prices. Similarly, the state can help develop industries by providing them subsidies. Some of the industries have high costs in the initial stage of production. As a result. The prices of their products are high and they are not in a position to compete in the market, and thus they meet an early death. To save such industries, public expenditure in the form of subsidies may enable them to develop without charging high process from its customers.

On Information. Public expenditure on providing information in the form of such publicity media as TV, commercial broadcast, etc helps private and public enterprises in getting their products publicized. As a result, their sales and production increase. Similarly, public expenditure on employment news, bureaux and exchanges helps in placing the right man at the right job and in this way provides larger employment opportunities and tends to increase productivity.

Effects of Public Expenditure on Diversion of Resources

Public expenditure affects the pattern of production through the diversion of resources from existing uses to more productive uses. In fact, government expenditure in itself is a diversion of resources from private to public uses. Public expenditure induces people to divert their resources to more productive uses in the following ways:

  1. On Infrastructure. Public expenditure on the development of roads and railways helps in diverting resources to more productive uses when the market for products becomes large.Again, public expenditure on generation of power supply and irrigation facilities helps in the diversion of resources to large industries and agriculture. Further, public expenditure on providing research technical education, etc tends to divert economic resources in order to create conditions of economic stability. Further, when public expenditure is made on such long-run infrastructural facilities as roads, railways, power, irrigation, etc it is trying to divert resources from their present to future uses which are more productive.
  2. On Backward Areas. Public expenditure on the development of backward regions or areas brings diversion of resources from more developed to less developed areas. Such diversion takes place when the government incurs more expenditure in the form of transport, power,and on the establishment of public enterprises in a backward region. Grants made by the government for the development o such areas helps in diverting natural and human resources from the developed to backward areas.
  3. To private enterprise. Public expenditure in the form of loans and subsidies to private enterprise helps in the diversion of resources into productive channels. Sometimes loans and subsidies are made conditional. They are dependent on the quality of the product. In such cases, diversion of resources leads to the production of better quality product. In such cases, diversion of resources leads to the production of better quality products as against inferior goods.
  4. On defence. Public expenditure on defence or war leads to the greatest diversion of resource. Such expenditure diverts resources from peaceful uses to war uses. It is normally regarded as the wastage of human and material resources which can otherwise be used for social benefits. But to defend a country s the foremost duty of government. It provides security to life and property and saves the nation from foreign domination. All expenditure on defence is not wasteful rather it is productive indirectly. Defence expenditure on the construction of roads, bridges, aerodromes, shipyards, and on other means of transport and communications help in building infrastructure in the country which are ultimately used by the civilian population. It also provides employment to people engaged in their construction.Moreover. Public expenditure incurred in maintaining the armed forces in the form of supplies of food, clothing and other materials increases their demand and production and helps in increasing employment opportunities manifold. No doubt, when resources are diverted from their private uses to war, their supplies to the masses are reduced which adversely affect their standard of living. But this is only a temporary phase so long as the war continues.

Effects of public expenditure on income distribution.

Public expenditure by increasing social welfare helps in reducing inequalities of income and wealth. According to Dalton, it is only progressive expenditure that tends to reduce inequalities.A progressive expenditure is one when a person with lower income receives larger benefits as compared to a person with higher income. Public expenditure for purposes of income distribution is of two types: transfer expenditure and exhaustive expenditure. In the case of transfer expenditure, low income groups are given cash benefits in the form of unemployment,sickness, disablement, dependents, and maternity benefits, and old age pensions. All such expenditures by the state help the poor and middle income groups in raising their incomes indirectly. Exhaustive public expenditure also tends to reduce income in equalities and it is in the form of free and cheap services of commodities, such as free education, free medical facilities, free milk or meals to school children, free transport for school children and for workers subsidized rations, subsidized lunch to workers, rent – free quarters, etc. There are also intangible benefits such as providing rent and recreation centres, public parks reading rooms and libraries etc. Which tend to raise the efficiency of workers indirectly. Such non-monetary benefits increase the real income and standard of living of the workers and masses. Public expenditure of both transfer and exhaustive types helps in the redistribution of income. On the other hand, if such benefits reduce the desire to work and save, they will tend to reduce the incomes of the beneficiaries. Consequently, the inequalities are not reduced. To conclude with Dalton, “that system of public expenditure is best which has the strongest tendency to reduce the inequalities of incomes.

 Effects of public expenditure on economic stability

Increase in public expenditure tends to raise national income, employment output, and prices.An increase in public expenditure during deflation increases the aggregate demand for goods and services and leads to a large increase in income via the multiplier process. It has the effect of raising disposable income thereby increasing consumption and investment expenditure of the people. The public expenditure includes expenditure on such public works as roads, canals,dams, parks, schools, hospitals and other buildings, etc. And on such relief measures as unemployment insurance, pensions, etc. Expenditure on public works creates demand for the products of private construction industries and helps in reviving them, while expenditure on relief measures stimulates the demand for consumer goods industries. But the effectiveness of public expenditure primarily depends upon the public work programme, its importance in the economic system, the volume and nature of public works and their planning and timing.

 Effects of public expenditure on economic development

The effects of public expenditure on economic development lie in increasing the growth rate of the economy. But investment in the capital goods sector may increase production in the long run. Therefore, public expenditure should also be directed towards meeting the immediate needs of the economy, so as to raise agricultural and industrial production, and to increase the production of essential consumer goods.

Rise in growth rate of the economy. Public expenditure on the establishment of heavy and basic goods industries in the initial periods increases the growth rate of the economy. But investment in the capital goods sector may increase production in the long run. Therefore, public expenditure should also be directed towards meeting the immediate needs of the economy, so as to raise agricultural and industrial production, and to increase the production of essential consumer goods.

Increase in employment, income and production. Public expenditure on economic and social overheads provides larger employment opportunities, raises incomes and, above all, the productive capacity of the economy.

Increase in revenue and profit. To increase the production of certain essentials commodities, to end private monopoly in various spheres, and to control the “commanding heights” of the economy, the state starts public enterprises. These bring revenue to the government and profits.

Reduction in inequalities. Public expenditure tends to lessen inequalities of income and wealth by raising the earning capacity of the people. This is done by providing educational facilities and through skill formation

Help to private enterprise. Public expenditure helps in encouraging private enterprise by establishing state-owned financial and banking institutions to provide cheap credit.

Regional balance. Public expenditure helps in bringing about regional balance in the economy by diversifying industries in backward and less developed areas of the country. Thus public expenditure is one of the important instruments for economic development.


There has been a phenomenal increase in public (centres, state and civic bodies) expenditure over the years. The following reasons are given for this.

Expansion of state activities. Adolph Wagner, a German economist, writing in 1883 propounded the law of Ever-increasing state activity. According to Wagner, public expenditure increases in response to the law of increasing expansion of public activities. He maintained that there is a persistent tendency both toward an intensive and  expensive increase of state functions and activities. New duties are being continuously undertaken and old ones are being performed on a large scale. As a result, public expenditure is increasing steadily.

Internal security. Wagner also referred to the maintenance of internal security as an important factor for the increase in government expenditure. Enforcement of law and order for maintaining peace and security has led to the expansion of legal and administrative systems and police force.These have led to the increase in public expenditure.

Defence. Every country pays greater attention to its defence preparedness against foreign attacks. As a result, public expenditure on equipping its armed forces with the latest armaments has increased. As Adam Smith said long ago, Defence is better than opulence.” So public expenditure on defence is essential.

Welfare activities. Wagner wrote about the increase is public expenditure due to the expansion of cultural and welfare activities of the state. Modern states are welfare sates which provide free education, medical facilities, and social security measures, maintain historical monuments, museums and public libraries, and encourage cultural, sports and health programmes.Consequently, public expenditure has tended to increase.

Population increase. The increase in population on account of better health and medical facilities leading to reduction in death rates has resulted in increasing public expenditure on the people. The state has to spend more on roads, railways, schools, colleges, houses, etc.

Urbanization. With the growth of population, there is migration of population form rural to urban areas in search of employment. Existing cities expand and new cities come up. These require huge public expenditure in schools, parks, zoos, houses, etc. Simultaneously, the expenditure on civic administration also increases.

Price Rise. In modern times, prices have a tendency to rise continuously with the increase in the growth rate of the economy. As a result, the government expenditure on goods and services increase. The rise in the cost of living further increases government expenditure by way of higher salaries and enhanced D.A. to its employees in various civil and military departments.

Economic Development. Modern governments are engaged in the development of their economies. They spend large sums on infrastructural facilities, on research and development in various fields, on the development agriculture and industry, on the development of public sector,etc. This has led to the increase in public expenditure.

 Public Debt. The state borrows both internally and externally to meet its eve increasing public  expenditure. This further raises public expenditure in the form of repayment of loans and interest charges.

Burden of democracy. Modern governments are democratic in nature. Countries are run on a multi-party system with elections after four or five years.Often governments fail due to lack of majority in the parliament. This necessitates frequent elections. This tends to increase public expenditure. Further, there are “pressure groups'” and”interest groups” within the parliament which want allocation of government funds for providing public services in their constituencies. Moreover, according to the World Bank, wide spread corruption in democratic countries has increased public expenditure manifold.


Development expenditure refers to public (government) expenditure of developing the economy.The development expenditure of modern developing economies consists of expenditure on:

Social services. Like education, health, social security and others;

Economic services like agriculture, industries, minerals fuel and power, transport and communication and others

Community services such as roads and bridges, sanitation and others.

On the other hand, the non-development expenditure of modern developing economies includes.

Expenditure on general services such as defence, justice, police and general administration;

Expenditure on unallocable and other purposes such as interest on public debt.

But in these countries, these two types of expenditure cannot be placed in water-tight compartments. This is because without expenditure on defence, police etc., it is not possible to keep up the pace of development if there is aggression from outside an unrest from within the country. Unless there is peace on the boarders and protection of life and property within the country, economic development is not possible. Similarly, interest on public debt may also be regarded as development expenditure. This is because governments of developing counties borrow both internally and externally mainly for development purpose.


The role of development expenditure in a country lies in increasing the growth rate of the economy, providing more employment opportunities, raising incomes and standard of living,reducing inequalities of income and wealth, encouraging private initiative and enterprise, and bringing about regional balance in the economy.

  1. a) Heavy and basic goods industries.

Development expenditure on the establishment of heavy and basic goods industries in the initial period increases the growth rate of the economy. But investment in the capital goods sector increases production in the long run.

  1. b) Consumer goods and raw materials.

To meet the immediate needs of the economy, development expenditure should be directed towards increasing agricultural productivity to meet the growing demand for goods and raw materials, and increasing the supply of consumer goods by encouraging establishment and expansion of the small industries sector which may also provide sufficient employment opportunities. The growth rate of the economy can be increased only when public expenditure fulfills the short-term and long-term objectives of the development plan. Moreover, to prevent inflationary tendencies within the economy, the public expenditure should secure a balance between demand and supply of goods.

  1. c) Economic overheads.

Economic overheads are such public works as roads, railways, canals, power project, etc. When the government spends on such project, it provides employment to millions of an employment people in underdeveloped countries. The provision for such services helps to increase production, trade an commerce. As a results, employment and incomes increase.

  1. d) Social overheads.

Development expenditure on social overheads like education, public health, cheap housing, etc,makes the people healthier and efficient. It is the state which can create the “critical skills” needed for rapid development by investing in human capital.

  1. e) Allocation of resources.

Development expenditure helps in improving the allocation of resources towards desired channels. In order to remove scarcities of food product, the state opens fair price shops and may even subsidise food for the working classes to maintain their health and efficiency. It may fix minimum prices for food grins, and through state trading and creation of buffer stocks encourage farmers to produce more.

  1. f) Public enterprises.

To increase the production of certain essential commodities to and private monopoly in various spheres of production, and to supplement private enterprise, the sate may start public enterprises.the services, to developed and conserve natural resources, to establish basic and key industries like heavy electrical, chemicals, fertilizers, machine tools, defence production, etc, to undertake state trading, etc.

  1. g) To stimulate private enterprise.

Development expenditure helps in stimulating private enterprise through the establishment of state-owned financial and banking institutions t provide chap credit of farmers, small and large industries, traders, etc, development expenditure also encourages the agricultural and industrial sectors of the economy by means of grants, subsidies, tax   exemptions, etc. Moreover, when the state spends on the creation of economic and social overheads like power, transport, education,etc., they pave the ay for the establishment and expansion of the private sector. The creation of the infrastructure leads to external economies that are reaped by the private sector.

  1. h) To remove inequalities.

Developing counties are characterized by extreme inequalities of income and wealth.Development expenditure tends to lessen them. Expenditure on education, public health and medical facilities helps n human capital formation. As a result, the earning power of he working populating is enhanced. As economic development proceeds rapidly through rising public expenditure, the barriers to upward mobility are removed. Occupations expand and spread,providing more jobs to the people. With acquisition of skills, the level of wages tends to rise within the economy. Moreover, industrialization increases the share of wages and decreases the share of profits in national income in the long run, and the gap between higher and lower incomes is narrowed.

  1. i) To remove regional imbalance.

Development expenditure helps to remove regional imbalance in the economy. if things were left to market forces, commerce, banking, industries and almost all the main activities would be localized in a few selected regions, and the rest of the economy may be in a state of perpetual backwardness, as was the case developed areas and backward regions can be developed by staring a certain projects like building a dam, digging a canal, starting new industries, etc. Such project will not only promote but also secure larger employment opportunities, thereby increasing per capita output and income of such areas in developing countries.


National debts are debts which a state owes to its own subjects or to the nationals of other countries. Public debt is a source of government revenue. In the case of public debt the government has to pay interests and repay the principal to the public.NB Nothing is required to be paid by the government in respect to all other sources of revenue.


There are two major sources of public borrowings namely internal and external

Internal sources:

Internally the government borrows from individuals, corporations, non-banking financial institutions, commercial banks or from the central bank.These lend to the government through buying of treasury bills or government bonds. The treasury bills and bonds sold by the government are relatively safe.

External sources:

Externally, the government borrows in the form of foreign capital which can enter a country as private capital and/or public capital.Private foreign capital may take the form of direct or indirect investments in the borrowing country. Public foreign capital may consist of bilateral hard loans e.g. giving of loans by the British government in Sterling Pounds to Kenyan government, bilateral soft loans and multilateral loans (e.g loans from IMF, World Bank, UNDP) and Intergovernmental grants.

Internal debt +external debt =national debt.

 Classification/ Types of public /national debt

Public debts are of various kinds and include:

  1. a) Voluntary debt and compulsory debt.

Voluntary Debt is that debt which is taken by the government without any force or coercion.People lend it to the government voluntarily. Actually all public debts are voluntarily.However, sometimes the government compels the people to buy governments bonds. e.g. incase of a war or a national emergency. These are the compulsory debts.

  1. b) Funded debts and unfunded debts

Funded debt is a long term debt for a definite period. The interest rate to be paid, with terms and conditions of repayment are clearly stated in the debt instrument (certificate). In order to repay the debt, a debt fund is created in which some money is deposited every year by the government.The debt is repaid out of this fund on maturity.

Unfunded debt is for a short period of less than a year. The government does not create any separate fund to repay the debt. Such a debt is repaid out of its current receipts often by floating additional bonds in the market. Thus it is also called a floating debt.

  1. c) Productive debt and unproductive debt.

Productive/ reproductive loans are debts/ which are fully covered by assets of equal or greater value and the source of the interest is the income from the ownership of these, such as railways,oil pipeline e.t.c. Thus a debt is productive when its amount is spent to finance a project which in long run brings revenue to the government, out of which interest is paid on the debt.Unproductive debt does not increase the productive capacity of the economy because it is not backed by any existing assets e.g. loans taken by the government for covering the budget deficit or to help during war, famine, earthquake and flood victims e.t.c. These do not bring any revenue to the government and are therefore called dead weight debts.

  1. d) Redeemable debt and irredeemable debt

Redeemable debt is that which is repayable by the government after a fixed period of time. The interest on this loan is paid by the government regularly, half yearly or annually. When the debt matures, the government pays back the principal amount to the lenders.For the repayment of the principal either the government creates a fund in which a fixed amount is deposited every year or it raises the amount through taxation

Irredeemable debt is that whose principal amount is not refunded by the government. However,interest is paid regularly on such a debt for the period of its duration.Debt incurred during a war may be non-redeemable by the government.

  1. e) Internal debt and external debt

Internal debt is that debt which is raised by the government from individuals, institutions e.t.c.within the country while external debt is a debt that is raised by the government from person or institution outside the country such as IMF, World Bank e.t.c.


Deficit budget-The government borrows when it has a deficit budget. The deficit budget can be met by raising the tax rates or levying new taxes. However tax collection takes a long time. By giving a particular date for the subscription of a loan, the government can meet its requirements immediately. That is why government prefers debt to other sources of revenue.

War-The government borrows from the public when it is involved in a war. During a war, the government’s expenditure increases many times on armaments and forces. This can be met by raising public loans on a large scale rather than through taxation.

Natural calamities-Natural calamities like earthquakes, floods, famine e.t.c. tend to increase government expenditure in order to provide relief to the victims. This necessitates large public borrowing by the government.

Economic development-Both developed and developing countries borrow for their economic development. Developing countries do not have sufficient resources to finance their development plans because they are poor. Developing countries borrow for the development of agriculture, industry, power,transport, communication e.t.c. Developed countries also borrow to modernize their infrastructure like roads, railways, powers, e.t.c.

Public enterprise and utilities-Every country whether a socialist, capitalist or mixed economy runs certain public enterprises and utilities such as railways, power works, postal services e.t.c. which requires large funds. The government can meet them through public borrowing rather than taxation.

Economic stability-The government also borrows to stabilize the economy. To control inflationary conditions, the government borrows to take away excess money supply from the public.Since public borrowing is voluntarily, this is a better method than raising taxes because loans from the public do not increase the costs of production. Public borrowing also helps to lift the economy from a depression. During a depression, idle funds are lying with the banks which the government borrows in order to spend on public work programmes.


Public debt is required to be paid back along with interest from whom the government borrows.This is done by levying taxes on people. This involves hardship on tax payers which is the burden of the public debt .The debt may be internal or external The burden of debt may be:

  1. Direct money burden
  2. Indirect money burden
  3. Direct real burden
  4. Indirect real burden

The burden of public debt can be examined from the point of view of internal debt or external debt

Burden of internal debt


  1. Direct money burden

The direct money burden of an external debt is the amount which a debtor country pays to the foreign creditor country in the form of interest and principal. The repayment of loan and payment of the interest to the foreign country is made in foreign currency. This imposes a direct money burden to the borrower country.

  1. Direct real burden

This is the loss of economic welfare of the people of the debtor country when they make payments to foreign creditor. In order to pay the interest and the loan, the debtor Country exports more to earn foreign exchange or pays the debt to the external creditor in the form of exports of goods and services. This is the real burden of external debt.

  1. Indirect money burden

If the external burden is utilized for productive purpose such as building roads, channels, power projects e.t.c. and establishing industries, this will increase employment, income and production.Its monetary burden will not be heavy because the payment of the principal and interest will be more than compensated by the benefits flowing from productive projects.

  1. Indirect real burden

The imposition of more direct taxes on commodities in order to pay interest and principal on external loans puts heavy burden on the people. This is because their capacity to work and save declines. This leads to a fall in production. If interest on external debt consumes a large part of national income, the government is forced to reduce social and development expenditure. The burden of debt will be more. The indirect real burden is also very heavy if the external loans are used in unproductive channel like a war since it will be a dead weight debt on the people.


Some economists argue that when the government incurs long term debt it burdens future generation with the cost of its present policies. Cost here means the sacrifice undergone by the people. They argue that when the government finances development projects by public borrowing, the present generation escapes the cost. The burden of debt is shifted to the future generations which pay the principal and also benefit from projects.Other economists argue that the real burden is borne in the period in which the government expenditure is incurred. Therefore, when the government borrows, it diverts private savings into public use. The payment of interest on bonds is made through taxation and therefore they argue there is no burden to the future generations.However, the situation is different when the debt is incurred to finance a war. People who live during the war bear the heaviest burden by sacrificing consumption of goods. Therefore, the burden is on the current generation. During war, the nation may be starved of capital goods and this will be an indirect burden to future generation.


Debt management refers to all actions of the government, including both the treasury and the central bank which affect the composition and retirement of the debt held by the public.


The main ones are:-

  1. To minimize the interest cost of servicing the debt to the tax payer.
  2. To employ it contra cyclically as stabilization weapon to supplement monetary and fiscal policy.


They include:

1) Lowering the interest cost.

2 Changing the maturity structure.

3 Advance refunding.

4 Co-ordination with monetary and fiscal policies.


This means the payment of interest and repayment of principal by the government.

The method of debt redemption includes:

1 Out of revenues – generally, the government pays the debts out of its revenue though a surplus budget. It makes a provision in the budget as the amount to be paid during the year.

2) Sinking fund – under this method, the government creates a fund for the repayment of the debts known as sinking fund and deposits a fixed sum of money out of its revenue each year for the period of the loan.

3) Serial bond redemption – according to this method, whenever debt is floated, the, date of maturity of certain bonds is fixed beforehand on the basis of their serial numbers. When the time for maturity comes, bonds bearing the serial numbers are paid back.

4) Lottery method – according to this method, bonds which are to mature in a particular period time are drawn on the basis of the lottery system. Only the bond holders whose bond numbers have come out are paid back while the payments of others are deferred to the other lottery dates. Such a method creates uncertainty among the bond holders.

5) Debt conversion – in this method, the debt with the highest interest rate is converted into a new debt when the market rate of interest falls. The government borrows at low rate of interest and repays the past debt even before it matures. The lender is free to take his money back or get his loan converted into a fresh one.

6) Capital Levy – this is a once for all tax to redeem a public debt. It is levied on capital assets on a progressive scale just after a war or an emergency when the burden of the debt is very heavy.

7) Date repudiation – this means canceling of all debt all together. The government refuses to repay the debt. This method of debt redemption is not practicable because the government’s reputation may be at stake. Its very existence may be endangered. However, Russia did it in 1917


When government borrows, it transfers money from one type of people to another. Money flows from the people to the government and further to those on whom government spends the borrowed money. This leads to expenditure effects of public debt.When the government pays the interest and repays the loan, money is again transferred from those who are taxed (by the government in order to pay the interest and principal), to those who hold government’s bonds. This leads to revenue effects of public debt. These transfers of money from one set of people to another through public debt affects consumption, production, distribution and the business activity in general. Therefore public debt has the following effects:

  •  Effects of public debts on consumption
  •  Effects of public debt on production
  •  Effects of public debt on distribution
  •  Effects of public debts on prices or economic activity
  •  Effects of public debt on private sector


Economic development may be defined as the increase in the standards of living of a nation’s population with sustained growth from a simple low income economy to a modern high income economy. Its scope includes the process and policies by which a nation improves the economic, social well-being of its people.

Public debt plays an important role in economic development of a country in the following ways:

  •  Capital formation
  •  Anti inflationary measure
  •  Compulsory savings
  • Capital formation

Borrowing from the public can be another source of capital formation in undeveloped countries.This device is better that taxation. Taxation means forced saving, borrowing in voluntarily. The tax payer is never happy in paying tax for he doesn’t expect to get his money back. A lender, on the other hand, gives his money on loan of his own accord to receive it back along with interest after a stipulated period. Unlike taxation, borrowing does not adversely affect incentives to save and invest. The lure of interest is always there to increase the incentives instead.

  1. Anti- inflationary.

Public borrowing acts as an anti-inflationary measure by mobilizing surplus money in the hands of the people in a developing country. A successful public borrowing programme can be a useful tool of economic development by diverting resources from unproductive channels. Public borrowing is resorted to for specific development projects like power generation, irrigation works, road, railway, e.t.c. Thus it is a useful way of financing development projects.

  1. Compulsory savings

If sufficient funds are not forthcoming in the form of voluntary loans, the government may have to resort to compulsory borrowing for the mobilization of resources for capital formation.Compulsory public borrowing is therefore justified in those undeveloped countries where taxation and voluntary borrowing fail to bring adequate funds for development to the exchequer.Certain sectors of the society who waste a large portion of their income in unproductive channels or derive special benefits from particular development projects may be forced to subscribe to government bond. However, it is not advisable for any underdeveloped country to rely on this method of forced savings except for specific development projects and for a short period.Ultimately, governments will have to depend on voluntary borrowings.


Fiscal policy is the management of public finance by the government so as to influence the economy in the desired direction. It is the conduct by the government of its financial operations in the pursuit of economic stabilization. The government must frame its taxation, expenditure and public debt policy so as to secure economic stability with growth.


Both aim at regulating the level of aggregate demand for domestic goods and services or the output of the economy.

Fiscal policy is formulated and enforced by the government directly. While monetary policy is formulated and enforced by the Central Bank. However, there is nowhere in the world where the Central Bank is thoroughly independent of the government. It functions under the governor, in Kenya under the Ministry of Finance.

Fiscal policy is government revenue, expenditure and debt management with a view to have a direct impact on the economy i.e. so as to manage the allocation of resources and the flow of funds in order to affect the level of income, prices, employment and output. Monetary policy on the other hand is government policy in relation to money supply to achieve the same policies as those of taxation.


Until the great depression of 1930, monetary policy had been the main instrument of economic stabilization. The great depression saw the failure of free enterprise economy. During this period, under monetary policy economies failed completely. The prices went down men and machines were thrown out of work. Demand contracted and workers had no purchasing power to buy goods and services. Investment failed to peak up even a 1% rate of interest failed to attract the demand for investment. Capital and the capitalist system collapsed suggesting monetary policy could no longer click. It was against this background of universal despair that Keynes in his general theory (1936) gave an insight into the determinants of national income and the role of government in making capitalist economies to work.


The objectives of fiscal policy are the same as monetary policy objectives these are,

  • a) Stabilization of the economy
  • b) Price stability
  • c) Economic growth
  • d) Full employment
  • e) Redistribution of income and wealth
  • f) Equilibrium in balance of payments


The fundamental objects of the fiscal policy are to find revenue for the government to finance its growing expenditure. Fiscal policy seeks to achieve its objectives through 3 major ways.

  1. a) Taxation
  2. b) Public expenditure
  3. c) Public debt management.



This is a persistent and generalized increase in price levels making the consumers to have a low purchasing power.It is a process in which price levels are rising at a rapid rate and money is losing value.It is also defined as general level of prices in a basket of goods(consumed by every one e.g. sugar,milk,unga,keroseneetc).The problem of inflation is that it reduces the value of money.Inflation is measured using consumer price index.CPI.

Deflation on the other hand refers to a situation where there is a trend for general prices of goods and services to fall.


  1. Creeping /mild/moderate inflation-prices rise at a rate of less than 10% per annum.This inflation is not harmful to economy and it is desirable to induce more investment thus promoting growth and it is of benefit to debtors-ie they buy goods at current price and pay for them in future at the same old price and not the high price commodity would be selling at that time, and business people i.e entrepreneurs are encouraged in economic times when prices are high since they will supply more goods and profit margins will be high,and still they buy goods when prices are low and sell them later when prices have risen.


  1. Rapid inflation- This is inflation rate around 6%.It is harmful to the economy
  2. Galloping inflation-General price levels are increasing is in tens or hundreds.
  3. Run away/hyper inflation-Prices are extremely high .people usually lose confidence in money as a medium of exchange and store of value ie consumers use a lot of money to buy few goods and services. In such a situation consumers use a lot of money to buy few goods and services. This type of inflation would appear unlikely to happen. It however happened in Germany in 1923 and the country had to do away with its currency system to restore its monetary confidence.
  4. Stagflation-this is derived from stagnation and inflation ie it combines elements of stagnation and inflation in an is a condition of high inflation in a period of high unemployment/ arises due to an increase in production costs e.g. wages causing firms to reduce employment of labour and other resources which in turn lower production reducing goods supply in economy.



1.Consumer price index-This is an index number of the prices of measures the realative changes in the prices of a specified set of consumer goods which would be bought by the average house hold on a regular basis.the basket may consist of commodities e.g. food and beverages,housing,transportation,medical care and so on.The weights in the index are based on the survey by government of family expenditure to ensure that it relates to present day buying patterns.commodities representing a larger proportion of expenditure will be given more significant weights in the index.

in Kenya inflation is considered by income groups and by categories of goods and services.the CPI is a fairly reliable measure of the cost of living.however since it is a fixed weight index it does not allow for substitution effects whereby consumers may for example select a substitute good whose price has experienced a relatively smaller increase.quality of goods changes such that a price increase may reflect improved quality rather than inflation.the CPI may sometimes overstate price increases.the CPI is measured using two methods;


  • Month-on-month inflation-this is inflation over a period of 12 months.
  • Average –annual inflation-this refers to the average of the month-on month inflation over the last 12 months.
  • Three months annualized inflation-this refers to month-on month inflation that would be generated if generation in last 3 months were to be maintained throughout the year.
  • Underlying inflation-this refers to change in the general price level that includes changes in prices of food and any other once and for all price change.


The types of inflation forms a basis of categorizing inflation in an economy.

  • Suppressed inflation-this inflation has been prevented from taking effect using deliberate measures taken by government e.g. price controls and it is not measurable
  • Inertial/built-in inflation- this is a condition of rising prices at a steady rate over time.
  • Balanced inflation-it has no effect on output,employment or income distribution because prices remain relatively the same even though high.
  • Unbalanced inflation-it causes changes in the relative prices of commodities in economy.
  • Anticipated inflation-people expect and are prepared for it.
  • Unanticipated inflation-people did not expect it and hence were unprepared for it.


They are two main causes of inflation ie;

Cost push inflation-this refers to increase in cost of production of goods and services.This reduces supply ie higher costs reduces the aggregate supply.Diagramatically,x axis we have the income/output and y axis the price levels and the supply curve is contractionally.


Types of cost-push inflation.

  1. Wage push inflation-this results from an increase in labour costs/wages as a result of labour unions demanding higher wages without a corresponding increase in productivity.the business will reduce the amount of labour employed causing production to fall.the fall in supply causes prices to rise since demand has remained at the same level
  2. Profit push inflation-it develops when firms exercise their market influence to raise prices to higher levels than necessary and retain their profit margin.
  3. Supply-shock inflation-this arises as a result of impact of unforeseen disturbances called supply shocks. Ie extreme crop failure will cause prices of agricultural produce to rise rapidly because the buffer stocks may not be enough to take care of resulting shortage.if crude oil rises abruptly in international market,the impact is that there is an increase in the cost of production of firms that use oil as fuel.


  • Rise in wages and salaries-this may increase the cost of labourie brought about by pressure from workers and trade unions for better pay.the increased cost of labour may be reflected in the increased prices of commodities which in turn would cause inflation.
  • Increase in taxes-increase in direct taxes e.g. VAT can increase costs of production and cause firm to raise their prices.
  • Drive for higher profit margins-this increase in prices will increase the general price level in economy causing inflationary conditions.
  • Unforeseen disturbances-they arise and the country can do little to stop them.when such things as the rapid increase in crude oil prices/crop failure occur prices in domestic economy rise,creating inflationary conditions.
  • Increase in prices of inputs-this includes raw materials e.g. fuel,electricity and transport costs.this pushes costs of production up pushing up goods and services costs.
  • Reduction in subsides-the producer will therefore meet part of cost which government was paying through subsidsation and this would be eventually be reflected in increase in price of commodity.
  • Imported inflation-this results from trading with foreigners.the overall domestic price level is composed of average prices of domestically produced goods and domestic prices of imported goods.this arises due to rise in prices of foreign goods as well as well as dependence on imported goods.

This type of inflation comes about where there is excessive demand for goods and services in the economy causing a rise in prices.  The rise in demand pulls prices upwards, hence the term “demand pull:.  In this situation, there is: too much money chasing too few goods: diagramatically,x axis we have GDP and on y axis we have prices,and it is a contractionally one.


The following are some of the factors that cause demand pull

  • Increase in government expenditure

The government finances its activities from the revenue it collects mainly from taxes, levies and fines.  In situation where the government is not able to raise enough money from its main sources, it can resort to borrowing from the central Bank or in the very extreme cases, it may print more money.When the government spends the money, it in effect makes more money available to people thus increasing aggregate demand, which in turn may lead to upward pressure on the prices of goods and current debt stands at 900 billion

  • Effects of credit creation by the commercial banks

Credit creation is the process through which banks lend out money to individuals and businesses.  Through this process, commercial banks can lend out more money that the deposits they hold.  This process increases the money supply, which in turn leads to an increase in consumers purchasing ability.  The increased consumer’s ability to purchase more goods and services increases the aggregate demand which eventually leads to inflation.

  • Increase in money incomes

If money incomes increase due to reasons such an increase in export earnings, or increase in wage earnings, the people’s purchasing power will increase.  This will have upward pressure on prices as demands for goods and services increase.

  • General shortages of goods and services

Shortages of commodities supplied may bring about demand pull inflation in that the demand would be higher than supply.  The high demand hence pulls the prices of the commodities upwards.  Shortages may be caused by factors such as, adverse climatic conditions, hoarding-introduce goodswhen prices are high, and smuggling-no taxes are paid, withdrawal of firms from the industry and decline in levels of technology.

  • Increase in population
  • Changesin tastes and preferences of consumerswich is positive.
  • A fall in the level of savings.
  • Expectations of price increases.
  • Decreased taxation on personal salary
  • Long gestation period.
  • Inadequate infrastructural facilities-goods don’t reach market.

Effects of Inflation in an Economy

Inflation has a number of have on businesses, demand and consumer confidence.  These effects can either be positive or negative as discussed below:

  • Positive effects of inflation
    • Benefit to debtors

Inflation may benefit debtors’ in that they end up paying less in real terms.  This is because the debtors pay for the commodities in the future at the old low prices and not at the high prices which the commodity would be selling.

  • Benefit to the sellers

Sellers may benefit from inflation in that they buy commodities when prices are low and sell them later when prices are high thereby making more profits.

  • Motivation to work

Inflation may have some motivating effect to work as people try to cope with effects of inflation by working harder.  As prices of commodities go up people may find that they are not able to buy the amount of commodities they were buying before the inflation set in.  In an effort to maintain their standards of living, they may work harder in order to earn more.

  • Using the Philips curve concept it reduces unemployment at a considerable level.


  • Negative effects of Inflation
  • Reduction in profits

A rise in prices of commodities may lead to reduced sales volume for firms.  This in turn may reduce the firm’s profits.

  • One uses more of time

Inflation can be wasteful in that individuals and firms may waste a lot of time shopping around for reasonable prices.  The time so wasted can be an extra cost to the individual or firm.  Similarly, firms may waster a lot of time adjusting their price list to reflect new prices.

  • Increases in wages and salaries

During inflation, firms are usually pressurized by employees and trade unions to raise employees’ wages and salaries to cope with inflation.  A conflict may arise between the parties concerned, regarding the level of increase that is adequate and may result to strikes.

  • Decline in standards of living

During inflation, consumers’ purchasing power decreases.  This is so especially for people who earn fixed incomes such as pensioners.  The reduction in purchasing power brings about a decrease in standard of living.

  • Loss to creditors

Creditors lend out when the value of money is high.  At the time of payment, the creditors receive less in real money terms. Since its value has been eroded by inflation.

  • Retardation of economic growth

Inflation may create a situation where business people are not willing to take risks, invest in new ventures, expand production or hire more workers.  This would be more than the exports resulting into unfavorable balance of payment.

  • Adverse effects on the balance of payments

Inflation may have adverse effects on the balance of payments.  If inflation is high in the domestic economy, exports become more expensive leading to a fall in their demand.

On the other hand, the imports from countries not experiencing inflation become relatively cheap thus increasing their demand.  This implies that the imports would be more than the exports resulting into unfavorable balance of payment.

  • Loss of confidence in the monetary system

High levels of inflation may lead to loss of confidence in money both as a medium of exchange and a store of value.  This may lead to a collapse of the monetary system.

  1. A rise in unemployment will engineer.
  2. Reduced savings and investments-more money is spent on purchasing items.
  3. Social and political instability prevails due to strikes and unbearable life to citizens.
  • Widens the gap between the poor and the rich.
  • Leads to unfair distribution of incomes


Controlling Inflation (Anti-inflationary measures)

Inflation is not desirable and for this reason the government may adopt policies meant to reduce or control it to a manageable level.  The anti- inflationary policies are divided into three categories:

  • Monetary policies
  • Fiscal policies.
  • Non- monetary policies
  1. Monetary policies (Control of Money Supply)

In most cases inflation will occur when the amount of money in circulation is greater that the available goods and services.  The government should ensure that increase in money supply is matched with increase in goods and services.  Monetary policy influences the economy through changes in the money supply and available credit. The central bank uses the following monetary policy instruments to control money supply/ to remove inflation:

  1. Bank rate policy. During inflation, the bank rate is raised. In view of this commercial banks also increase the interest rates/lending rates thus discouraging borrowing hence a reduction in the amount of money in circulation.
  2. Open market operation. During inflation, the central bank sells government securities such as treasury bills and government bonds through open market operations (OMO). This reduces the excess money in circulation.
  3. Reserve requirements. During inflation, the central bank increases the reserve requirements. This reduces the amount of money at the disposal of commercial banks for lending purposes. This helps to control the amount of money in circulation
  4. Rationing of credit. All commercial banks get loans from the central bank up to aspecific limit. During inflation, this limit is reduced.
  5. Margin requirements. Margin requirement is the difference between the value of the security and the amount of the loan advanced against that security. During inflation, the margin requirement is raised.
  6. Consumers selective credit control. Here the central bank discourages the purchase of commodities on instalment basis to check inflation.
  7. Restricting terms of hire purchase agreement and credit sales in order to reduce demand for commodities sold. This can be done by:
    • Increasing the rate of interest.
    • Reducing the repayment period.
    • Increasing the amount required as down payment.

8 Moral persuasions.

9 Selective credit control-the central bank here discourages offering credit to certain sectors that are likely to spur inflation and offer to those sectors that do not transmit inflation.

  1. Fiscal policies.

Fiscal policy refers to the deliberate change in either government spending or taxes to stimulate or slow down the economy. It is the budgetary of the government relating to taxes, public expenditure, public borrowing and deficit financing. Fiscal policy is based on demand management i.e raising or lowering the level of aggregate demand by controlling government expenditure, consumption expenditure and investment expenditure. The main fiscal policy measures are:

  1. Public expenditure. During inflation the government reduces its expenditure leading to a reduction in the amount of money in circulation and a fall in prices.
  2. Changes in taxation. Changes in tax rates can help in the stabilization of the economy. For example, a decrease in tax rates increases disposable income in relation to national income. Hence consumption rises at every level of national income. With increase in aggregate demand for goods, employment increases. A rise in tax rates causes a decrease in disposable income, creates a larger budget deficit and reduces inflation. Also high inflation reduces individual’s purchasing power and a fall in prices.
  3. Changes in government expenditure. If inflation is at or above the level of full employment in the economy, the government can reduce prices by restricting its own unproductive expenditure.
  4. Public borrowing. Public borrowing reduces aggregate demand for goods hence reducing the price level. If the government borrows money from individuals and spends it on more productive purposes, the production of goods increases and prices tend to fall.
  5. Balanced budget changes. A balanced budget decrease has a mild contractionary effect on national income and hence bringing down the price level.
  6. Control of deficit financing. If the government resorts to deficit financing e.g bank borrowing and printing of notes to finance the budget deficit, money supply in the country increases and this pushes prices upwards. Deficit financing should be avoided.
  7. Non-monetary measures
  8. Wage Adjustment. Wages must be raised at regular intervals to enable the individuals to maintain their purchasing power at the same level.
  9. Output Adjustment. The government must take steps to increase the production of goods, so that the rise in price level is checked.
  10. Price control. The government fixes prices or imposes direct controls on prices of essential/basic commodities.
  11. Rationing. Here the purchase of specific commodities is controlled. The individuals can purchase a specific quantity only during a specific period.

There other methodologies that can be used to control the level of inflation ie;

  • Control of the Level of demand

The solution to demand-pull inflation is to reduce the level of demand in the economy as whole.  The government can achieve this by using the following two fiscal policies:

  • Changing in taxation-An increase in tax such a income tax would reduce consumer demands for goods and services.
  • Reducing government spending-Government spending is an injection into the economy. If it is restricted the amount of money in circulation would reduce thereby reducing demand to commodities.
  • Cost controls

Cost push inflation can be controlled by controlling the factors that contribute to rise in cost.  These factors include:

  • Increase in wages and salaries-To curb inflation brought by increase in wages and salaries the government may restrict such increase. Alternatively, if unions are believed to be pushing for excessive pay increase, then direct attempts can be made to curb their powers.
  • Reducing taxes- taxes such as VAT are believed to be behind the cost-push inflation, the government cab reduce such taxes in order to control inflation.
  • Restricting imports-Where inflation is caused by increase in prices of imports, the importing country can control the inflation by reducing the quantities of such imports. This can be done by looking for alternative sources of supply.
  • Bureaucratic obstacles/complicated procedures.


Deflation is a situation where there is a fall in the general level of prices and as a result thereof, the value of money increases. It is that state of the economy where the value of money is rising or prices are falling. Deflation, in fact is a situation where falling prices are accompanied by falling levels of employment, output and income.

Causes of deflation

  • A fall in private investment
  • A persistent unfavourable balance of payments
  • Continued government budgetary surpluses
  • A sudden increase in total output
  • Action of the central bank to raise the interest rate.
  • Action of the central bank by selling securities such as treasury bills and government bonds

Effect of deflation on different sections of the society

  1. Over production. When prices are falling, the producers buy materials and other inputs at higher prices and are forced to sell the products at lower prices. This results in over production of commodities.
  2. Traders lose. During deflation, the traders purchase their goods at higher prices and have to sell them later at lower prices due to the deflationary trend.
  3. Investing class. During deflation, the equity holders lose and debenture holders gain when prices fall.
  4. Fixed income groups. During deflation, the pensioners, wage earners gain as the wages and pensions do not decrease with the fall in prices.
  5. Consumers. When prices of commodities fall, the consumers whose income is fixed, gain.
  6. Creditors and debtors. During deflation, the creditors to gain and the debtors tend to lose.
  7. Tax payers. The tax payers lose during deflation as the value of money rises.
  8. Private sector units. The private sector units when the prices of their goods fall.
  9. Industrial unrest. During deflation, there are industrial disputes and unrests in the industrial sector.
  10. Pace of economic growth. During deflation, the pace of economic growth slows down. The reduction in output and increase in unemployment retards economic growth



This is trade between countries. It refers to trade carried out outside boundaries of a country hence it involves two or more may involve bilateral or multilateral trade and it is therefore categorized into exports and involves people in different countries who have different mostly involves countries with different monetary units


  1. Countries can import those commodities they cannot produce e.g. cars ,aero planes mobile phones televisions ,clothes etc are manufactured by few countries.
  2. Enables a country to earn foreign income by exporting in surplus productionand the income is used to import the goods that it can produce e.g. medicines,machinery and food
  3. It expands market for the countrys products,hence consumers usually have a wide choice of goods(variety of products).
  4. Enables countries to would make no sense for a country to specialize if there is no market,thus the resources are fully utilized and they also produce high quality goods
  5. It improves social and cultural ties with different countries by doing business with them
  6. It strengthens international peace-political links and world peace is promoted.
  7. It stimulates economic growth and economic development-foreign income comes frostering trade and the income got can be used to develop infrastructure as well as markets due to the foreign investments that are made abroad to countries experiencing enabling environment.
  8. Enables a country to import the necessities of life e.g. food,basic needs etc.
  9. Low prices-since international trade promotes specialization and hence mass production unit cost of output is low and consumers benefit from consequent low economies of scale benefits.
  10. Technology-international trade is an important channel for flow of technology from one nation to another.with international trade, countries producing consumer goods can exchange them for capital goods and therefore enhance their production capabilities.ideas are also exchanged.
  11. Competition-international trade increases competition thereby promoting efficiency in production. Inefficient firms which can only sell at high prices would be driven by efficient prices which can sell at low prices.
  12. Sometimes it enables a country to obtain goods more cheaply than it can produce them ie where a country has comparative advantage in producing the commodities.
  13. Enables countries specialize in production of goods and services for which they have comparative advantage in terms of resource endowment thus efficient utilization of resources.
  14. Enables government to earn revenue through taxation.
  15. Enables a country to dispose off its surplus.
  16. Facilitates mobility of factors of production e.g. labour and capital from one county to another.
  17. Promotes employment creation.


  1. Military self sufficiency-this argument is used to defend tariffs imposed to protect domestic industries producing goods and services essential for defence and war.
  2. Increased domestic employment-to raise the Gross National Product,we would have to reduce imports.increased G.N.P implies increased domestic employment,thus imports are highly discouraged.if demand for domestic goods are increased,production of domestic goods will go up and so will be employment.
  3. Diverstification of stability(self sufficiency).countries dont rely on imports for development.this promotes reduction reliance on few imported goods or services.
  4. Infant industries argument-protective tariffs (government tax on imported goods)are needed to allow new domestic industries to establish themselves as cheap imports usually drives off young industries away from the market.
  5. Cheap foreign labour argument-developed countries need to keep away products which are cheap mainly because they are made using cheap labour(it is a threat to us undeveloped ie low salary,cheap  labour).if allowed this cheap product will force domestic product out of market and producers will be forced to lower domestic wages thereby lowering standards of living in those developed countries.
  6. Economic integration-countries intending to create common market/economic union may be forced to erect tariffs to keep products of non-member countries out of market.
  7. Can lead to importation of harmful products.
  8. Over depending on imported commodities e.g. the essential ones could lead to a country becoming a slave of other and could compromise sovereignity ie developing countries always owe developed countries some money leading to unfavourable balance of trade.
  9. May lead to exhaustion of resources usually got in raw form.
  10. A country that relies on imported products may face problems of supply during the times of emergency.
  11. May lead to a country experiencing import inflation.this erodes importing power of people in importing country as they can afford to buy fewer commodities.
  12. High levels of specialization may lead to problems which occur when demand for commodity being produced falls as it may lead to massive unemployment at sectors of economy affected by fall in demand and lay off workers to cut down production costs.
  13. It enhances interactions and through this people of a given country end up acquiring bad cultural values from their trading partners.



The earliest advocate of international trade was the so called father of economics Adam Smith.according to smith,labour costs determines efficiency in production and nations should concentrate their efforts in producing goods they could make more cheaply. Nowadays we know labour cost  labour cost are not necessarily the dominant cost of production.however,this does not contradict Adams theory.indeed,we still believe in advantages of specialization both at macro and micro suggesting that nations secialise in producings goods that they can produce more cheaply than anybody else.smith was obviously advocating for international trade either at personal/national level.specialisation generates surplus output which has to be traded for what is scarce.if nations were to specialize in line with absolute advantage,then total output would increase thereby raising welfare of both consumers and producers.increased output would generate more revenue to producers while consumers  would be assured of adequate supply at reasonable prices.Assume the following output for a given resource of 100 workers or 100 man hours.

  Wheat cars
kenya 400 100
Japan 500 300
World production 900 400

Assume specialization in line with degree of absolute advantage.

  wheat cars
Kenya 0 0
Japan 1000 600
Worlds production 1000 600

Worlds production of wheat increases to 1000 and that of cars increases to 600.according to smith,it is unlikely that cost of production and would be uniform across countries. Some would produce more efficiently than others due to the reasons below;

  • Natural advantage ie Gods given resources e.g. oil.
  • Acquired advantages e.g. special skills acquired through training or high level of technology and investment in capital goods


The theory of absolute advantage failed to discuss fully the economic implications if a country had absolute advantage .if a country had  three products or six products,should that country be the only country in the world producing these goods?. Where would the other countries get commodities or money to exchange for goods produced by the advantaged address this problem,david  ricardo  developed the theory of comparative advantage. According to the theory of comparative advantage,the  country which has absolute advantage in production of all goods should specialize in production of goods where its absolute advantage is greatest.a country with no absolute advantage should specialize in producing the goods where its absolute advantage is least(.assume the following output for a given resource of 100 man power/workers.

Analysis of opportunity costs.

First scenario.

  Wheat Cars
Kenya 400 100
Britain 500 300
Worlds production 900 400

Total production 1300.

Britain has absolute advantage in production of both wheat  and cars.neverthless Britain has te largest comparitve advantage in production of cars.suppose they specialize in accordance with ricardos theory ie Kenya –produce wheat and Britain-produce cars ie ratio of cars is 3 times ie1:3 compared to wheat ratio 4:5.after specialization;

Second scenario.

  wheat Cars
Kenya 800 0
Britain 0 600
Worlds production 800 600

If the opportunity cost of producing 400 wheat is 100 cars,it means if Kenya produced 0 cars,it could double production of wheat to 800 units.likewise,Britain could double production of cars if she forfeited wheat production.we now have increased world production of cars by 200 units while production of wheat has gone down by 100 the worlds now better of?.it all depends on world exchange rate between cars and wheat.suppose two units of wheat,one would get 1 car.if Kenya wanted 200 cars then it would have to give 400 units of wheat ie

1 car=              2 wheat.

200 cars=        ? Wheat.

Third scenario;

  wheat cars
Kenya 400 200
Britain 400 400
Worlds production 800 600

Total production 1400.

Comparing first scenario with the last one,Kenya seems to have benefited more in trade than Britain.

Using the first scenario,the opportunity costs can be realized. Britain should specialize in cars production while Kenya should specialize in wheat production because the opportunity costs are lower.

Compairing the first scenario with the last one Kenya seems to have benefited more in trade than Britain  but Britain is not badly off. Before trade,opportunity cost of 1 car was 5/3 through the market she can exchange 1 car for 2 units of wheat!.

Before trade Kenya would have given 4 units of wheat to get one car with trade,she only needs to give 2 units of wheat!.due to the gains alluded to it,it is obvious that countries need not to be self sufficient.there are other gains from international trade but what a country brings home from international trade depends on value of exports relative to value of imports or the international prices. Needless to say,the prices of imports and exports will be determined by forces of demand and supply:a situation which is complicated further by factors determining supply or demand.


  1. It assumes that labour is the only factor of production.
  2. Assumes perfect mobility of factors of production ie factors of production can be switched from one production to another.this is not easy.
  3. Assumes no transport costs.if they are considered,what appeared to be a comparative advantage can translate to a loss.
  4. Assumes that products are homogenous-in a modern economy,homogenous(similar in every respect) products are rare as firms strive to differentiate products inorder to outbid each other in the market.
  5. Free market economy-both Adam Smith  and Ricardo  advocated for free trade.clearly their theories would have no substancein absence of free trade and freemarket economy.
  6. Assumes constant cost-even when a country switches from one product to another and increases production of that other good in which it has comparative advantage,costs remain constant.


Terms of trade refer to the rate at which a country’s exports are exchanged for her is computed as export price index/import price index.


  1. Nature of commodity being exported-normally prices of primary products tend to be lower compared to those of manufactured goods.a country whose main export is raw materials such as unprocessed  agricultural products is likely to experience unfavourable terms of trade.a country that exports finished products e.g. manufactured goods is likely to experience favorable terms of trade.
  2. Nature of commodity being imported-manufactured goods command higher prices compared to others in world market.a country that imports such expensive goods may experience adverse terms of trade while one that imports cheap raw materials may experience favourable terms of trade
  3. Demand for a countrys exports-an increase in demand for a countrys export in the world market ,such a country is likely to experience favourable terms of trade.if demand for a countrys export decline,she may experience unfavourable terms of trade.
  4. Existing world economic order-due to their strong bargaining power,industrialised countries tend to dominate decision making in international prices therefore tend to favour products from these a result,they may have favourable terms of trade while the less developed countries may have deteriorating terms of trade.
  5. Total quantity supplied-this may depress price into the world market.a country relying on exportation of such a product may therefore experience unfavourable terms of trade.a country that relies on exportation of a commodity that is in short supply in world market may experience favourable terms of trade.

Balance of Trade.

This refers to the difference between the values of visible imports and visible exports of a country within a defined period of time; usually one financial year.Visible trade is trade in tangible goods e.g. Tea,oil,chemicals,fertilizers,machinery,vehiclescoffee, tools and etc. on the other hand invisible trade refers to trade in services e.g. Tourism services offered by expatriate’s ,freight,insurance,banking charges,foreign loans and aids,expenses on foreign education,training and political delegates,expenses by foreign embassies and expenditure of a country in her foreign missions and repartriated profits and dividends.

If during a given period the value of imports is greater than that of exports, the balance of trade is said to be unfavorableable(deficit) and the vice versa favourable(surplus).  If the value is equal then it is at equilibrium or zero or (neutral).

Factor that may cause an adverse balance of trade.

  • Low exports
  • Increase in imports
  • Unfavorable terms of trade.
  • Shortage of capital
  • Climatic situation.
  • Devaluation policy by other countries.
  • The flow of capital goods.
  • Structural disequilibrium resulting from fundamental changes in growth of a country.

Balance Of Payment.

This refers to the differences between due receipts from other countries and due payments to other countries in the year ie it is the difference between inflows and outflows of foreign currency in a given economy for a given year. Bop will further be defined as the economic transactions of one country with the rest of the is the difference between visible and invisible exports versus visible and invisible imports. The bop will be surplus if total receipts are greater than total payments and therefore it is said to be favourable.on the other hand bop will be in deficit if total payments are greater than the total receipts. This deficit must be financed from overseas or by borrowing from overseas or the such a situation bop is said to be unfavourable and it will be at equilibrium position if total receipts and total payments are equal.


They are usually divided into two;

  1. Capital Account.

The capital account is maintained by the central bank. It involves long term payments either inward or outward. This includes foreign loans and shows the balance between receipts and payments regarding foreign loans ,donations reserves,investments and is also known as financial account.

DEBIT                                                                         CREDIT

Donations-given out Donations received
Loans-advanced Loans received
Fixed assets purchased ie financial (shares,stocks,bonds and government bills)and non-financial assets(factories,land,buildings). Fixed assets sold to foreigners
Securities and bonds purchased by Kenyans Investments(securities),shares purchased by foreigners
Repatriated dividends Dividends received
Grants given out Grants received
Foreign aid given out Foreign aid received.


  1. Current account.

It shows the balance between exports and imports of visible and invisible items during a particular year. It should be noted that on debit side we record payments(cash,foreign exchange outflows,shipping charges paid,bank charges paid,tourism overseas by kenyans) and on the credit side we record receipts(cash,foreign exchange inflows,tourism income,remmitances from diaspora,banking income received).

Unfavorable balance of payment is a macro economic problem because it;

  • Causes unemployment.
  • Leads to a fall in in exchange rate.
  • Leads to collapse of infant industries.
  • Causes capital flight
  • Results in low economic growth and development.


Surplus or deficit can denote disequilibrium of bop where the international receipt and payments are not equal.however,under normal circumstances,disequilibrium refers  to deficit in bop where  payments are greater than receipts.

In such a situation,balance of payments is said to be unfavourable.most of the less developed countries face unfavourable bop while developed countries face favourable bop ie surplus in their bop.the following are the main causes of the disequilibrium.

  1. Reliance on few export commodities-the exports of most developing countries consist of mainly one or two primary products like copper,coffee,tea,cocoa,groundnuts,cotton etc.the demand for such products is not very high and their demand in international market is more elastic.this leads to low earnings of of foreign exchange leading to deficits in bop.
  2. Increase in imports-the imports of most developing countries are too high and mostly constitute capital goods ie machinery .this is partly because less developed countries are technologically backward and cant produce these goods locally.the prices of such import import goods are quite high and this leads to unfavourable balance of payments.
  3. Unfavourable terms of trade-they areunfavourable.countries xperiencing this get very low prices for their exports but pay exorbitant prices for the imports of manufactured and capital goods.
  4. Shortage of capital-most less developed countries are producers of primary commodities and cant process some of mineral and agricultural resources they produce into finished goods due to lack of capital and necessary technology.
  5. Too much reliance on foreign borrowing-most developing countries face macro-economic problems such as unfavourable bop because of relying too much on foreign borrowing either from world bank and imf or other friendly countries.some of the loans they obtain are paid back with huge intrest rates and this leads to unfavourable bop.this countries become so much indebted.
  6. Natural calamities-this usually interfers with the production of some commodities.agricultural production is very vulnerable to changes in climatic conditions and its production is affected adversely if these weather conditions are not favourable.this leads to unfavorable bop especially to countries which rely on one or two agricultural commodities as their main source of foreign exchange earning.
  7. Flow of capital-when outflow of capital is high/when inflow of capital is low,this will lead to unfavorable bop.
  8. Taste and preference towards foreign goods-in some countries,citizens prefer consuming foreign goods as opposed to locally produced goods. This will increase imports resulting into unfavourable bop.
  9. Foreign trade orientation-this refers to a situation whereby developed countries buy raw materials from developing countries at a cheaper price,process them into final goods(as they have the requisite technology) and then sell them to developing countries at a high price.this causes deficit in bop.
  10. Devaluation policy by a trading partner-sometimes devaluation policy adopted by countries may result in bop deficit in other coffee is the main export of both Kenya and Uganda.if Uganda decides to devalue her currency,then her coffee will become cheaper in international market.this means Uganda will increase her coffee export and this may lower demand for kenyas coffee in the global a result,kenyas export of coffee will decline leading to unfavourable bop.
  11. Changes in trade cycles ie boom,recession and depression.
  12. Over valuation of a domestic currency-valuation refers to putting new values to local over valued domestic currency is likely to discourage exportation while encouraging imports because  countrys exports become more expensive compared to imports.this results into a country earning less from exports while paying more for imports thereby causing disequilibrium in bop.


  1. Export promotion-this can be adopted by encouraging producers to produce goods for exports.if volume of export of goods and services is increased balance of payment deficits can be removed.
  2. Import restriction.
  3. Devaluation-here,exports become cheaper to foreigners and imports expensive to residents.this helps to correct unfavourable balance of trade as volume of exports may increase.
  4. Diverstification of exports –it will increase developing countries volume of export correcting unfavourable bop.
  5. Increase in production-of goods and services.this will lead to increased volume of exports and it might also lower goods that are being imported from other countries and therefore correcting unfavourable bop.
  6. External soft loans-the government can seek soft loans from world bank ,imf and other friendly countries to correct her unfavourable bop.
  7. Deflation-this is a situation whereby government can deliberately decide to reduce the price of domestic goods.this may be adopted with a view of encouraging consumption of domestic goods and discouraging consumption of foreign or imported goods and this help to correct unfavorable bop if domestic goods possess higher elasticity of demand.
  8. Receiving gifts and donations from other rich friendly countries.
  9. Selling foreign assets and investing money in domestic market.
  10. Persuading/pleading with foreign countries to trade with us including marketing ourselves
  11. Drawing upon our gold many countries central bank keep the gold,which belongs to a country. This gold can act as a security that will enable country to borrow loan from IMF and world bank.


  • Borrowing from another country.
  • Receiving gifts and donations.
  • Deferring payment through the IMF.
  • Selling foreign investments.
  • Using foreign exchange reserves.
  • Devaluing an own currency.
  • Importing on credit.


  • Expansion of exports
  • Restriction of imports
  • Tight monetary policy.
  • Contractionary fiscal policy.
  • Imposition of quotas/quantities imported.


This is defined as the price of a countrys currency expressed in terms of another countrys currency.generally,the exchange rate is expressed as amount of the local currency per unit of the foreign rate is usually of great importance because it determines the price of exports,determines price of imports and has a direct effect on exports and imports of a country.generally ,there are two main exchange systems/regimes ie


The monetary authorities e.g. central bank  here fix their own currency value against some common standards e.g. 1 dollar= 80 kshs.Countries like china fix their exchange rates.


  1. Encourages long term capital flows because there is no uncertainity or risk.
  2. There is no fear of fluctuations ie there is no rapid appreciation or depreciation.
  • It has no adverse effects on speculation.
  1. It is the best for small countries because small countries suffer when depreciation occurs.
  2. It is less inflationary because of stability of currency.
  3. There is certainity of foreign payment(exporters and importers knows what they will get).


  1. A country will be required to maintain a huge foreign exchange reserve in order to defend the chosen rate of exchange.
  2. Tends to depend on international institutions e.g. imf to help them solve problems of adverse depreciation.
  • It is usually complex and needs highly skilled administration.
  1. There is a sustained balance of payment disequilibrium.
  2. Defending a currency may involve raising intrest rates,which can be both damaging and costly to domestic economy.
  3. There is always reluctance to change the exchange rate and this could lead to a country persisting with an over-valued exchange rate inorder to avoid devaluation.
  • It becomes appropriate at a time of high and differential rates of inflation between countries.
  • If a revaluation/devaluation is expected speculation may build up as great gains will be made or losses avoided.

The price/exchange rate is determined by forces of demand and when  we have more supply of dollars in Kenya,the usage of Kenya shillings will be minimal because the dollar will be easily affordable by many due to the law of demand and supply.


  1. It is simple to operate because it is determined through the market.
  2. Enhances smoother adjustment of balance of payment as it leads to automatic stabilization.
  • It is the best when it comes to solving differences between supply and demand.
  1. Monetary policy is very effective in solving these problems.
  2. Promotes international trade because forces of demand and supply have better market adjustments.
  3. It leads to freeing of internal policy since where a country has a floating exchange rate,a bop deficit can be rectified by a change in external price of currency.this leaves the government to pursue into the internal policy objectives such as growth and full employment without external constraints.
  • Provides an indication of a relative scarcity of a currency,which leads to better allocation and eliminates possibility of over valuation of the currencies that are common in many developing countries under a fixed exchange rate system.
  • Provides that there is a need to maintain a low reserve of foreign currency or a higher one to defend the local currency against either too much depreciation or too much appreciation.
  1. Prevents rapid inflation since if a country is experiencing inflation its local currency will automatically depreciate against the hard foreign currencies.


  1. Uncertainity-this arises since exchange rate can fluctuate in value from day to day and such can adversely affect trade,capital flows and forward planning.
  2. Day to day change in exchange rate-this may encourage speculative movement of hot money from one country to another and thus worsening changes with exchange rate.
  • Lack of discipline-lack of discipline in economy since problems such as inflation may be ignored until they have reached a crisis level.
  1. It impedes the movement of long term capital ie compromise on long term capital.
  2. It is more nflationary ie if exchange rate increases,import prices increases also thus rapidly increasing inflation.
  3. Official intervention cannot always be ruled out i.e. in some cases the financial bodies are forced to intervene.


This are the factors affecting demand and supply of currency and includes;

  1. Balance of payment-bop deficit exerts downward pressure (depreciation) on a country’s currency whereas bop surpluses exert an upward pressure (appreciation) on a country’s local currency.
  2. Relative level of interest rate-if domestic real interest rates increases relative to those of other contries,nationals of other countries will find the domestic economy an attractive place to invest.this will increase demand for domestic financial assets and would mean an increase in supply of foreign currencies. Thus an increase in interest rates tend to exert an upward pressure(appreciation on a country’s currency) while a decline in interest rate would lead to depreciation of local currency.
  3. The level of inflation-if the general level of prices increases rapidly in one country this can cause depreciation of its domestic currency. During demand-pull inflation, there may be too much supply of local currency leading to its depreciation.similary if an economy is suffering from cost-push inflation,cost of production of goods meant for export will be high and this will affect the volume of export leading to deficit in bop and hence depreciation of domestic currency.also if an economy is suffering from inflation,many countries avoid trading with it inoder to avoid imported inflation.
  4. Speculation-a belief by a speculator that a particular currency will appreciate will lead the holders of that currency to attempt to convert other currency in that currency because they will gain after depreciation.if they speculate that a certain currency will depreciate,they will set it at a current high price to avoid future losses.
  5. Government policy-if a particular government is involved in persistent devaluation,there may be loss of confidence in its expectation of increased taxation of foreign income/confistigation of assets by government may also lead to loss of confidence with consequences in depreciation of local currency.
  6. Political atmosphere-political upheavals may lead to loss of confidence on a countrys domestic currency.



This refers to where two or more countries in same region join up and co-operate with each other for their mutual economic also refers to economic cooperation within a region.

It means abolition of discrimination within an also means any type of arrangement in which countries agree to coordinate their trade, fiscal and or monetary policies.

In a region where complete economic integration is in practice implies that there is:

  • Free trade in all goods and services.
  • Free flow of capital.
  • Freedom of migration.
  • Freedom of establishment of business.
  • Free flow of information and ideas
  • No difference in taxation.
  • No national difference in rules governing competitors and monopoly.
  • No differences in environmental regulations
  • A single currency in use.

This type of integration is beneficial to member countries as they are able to develop faster than if they were to carry their economic activities individually.


They are  categorized depending on their degree of integration.

1.PREFERENTIAL TRADE AGREEMENT.(preferred treatment).

This is the weakest form of economic,countries would offer tariff reductions and not eliminations,to a set of partners countries in some product categories.


This is a group of two or more custom authorities in which duties and other restrictive territories regulations of commerce are, tariffs between the member countries are abolished but each country retains its own tariffs against non-members ie member countries apply uniform tariff rates to each other but separate individual tariffs to the remaining countries.

3.Customs union.

It allows no tariffs /other trade barriers between member countries as in free trade areas but the difference  is that it harmonizes trade policies of member countries with those of the rest of world e.g. member countries setting common tariffs according to the rest of world.

4.Common market.

It goes beyond thecustoms union and in addition to eliminating trade barriers among member countries and sharing trade policies,free movement of labour and capital among member nations is allowed e.g. EAC where one can work and establish business in any part in the region.

5.Economic union

It will typically maintain free trade in goods and services,set common external tariffs among members,allow the free mobility of capital and labour and will also relegate some fiscal spending responsibilities to a supra-national agency.An example is of the European union common agriculture policy(CAP)

6.Monetary union.

It establishes a common currency among a group of countries.this involves the formation of a central monetary authority which will determine monetary policy for the entire group as well as using common public services e.g. Railway and communication network e.g. European Union (E.U) which has adopted Euro as their common currency.

7.Multilateralism versus regionalism.

The main objective here is on trade liberalization.The logic here is that the larger the regional trade area,relative to the size of the world market,the larger will be that regions market power in trade.the more market power,the higher would be the regions optimal tariffs and export taxes.

8.Duty free zones/free economic zones.

This are set up to attract foreign investment by allowing raw materials and intermediate products to be imported duty free.


  1. Enables countries to specialize in production of those commodities where they have comparative advantage thus trading surplus commodities.
  2. Enables a country to exploit economies of scale as it provides wider market for goods and services and therefore promotes employment in the countries involved.
  3. Encourages peace,free flow of information and  better relations both economically and politically as the countries involved depends on each other.
  4. Encourages foreign investment because the possibility of making large profits in a more enabling economic environment.
  5. Trade stability is enhanced in cases where there is use of a common currency e.g. the Euro in the European Monetary Union.
  6. Regional unemployment differences are reduced in where  regional integration involves permitting free movement of factors between factors.
  7. It fosters a great degree of competition thus promoting economic efficiency and consumer sovereignity through a wider variety of goods and services.
  8. It leads to redistribution of income in favour of low income areas through low cost production in such areas and exporting to areas where prices are higher.
  9. Availability of market/extension of locally produced goods-a wider market for a countrys products is created.
  10. Creation of industries-this is so as to cater for the increased demand.
  11. Extension of research-to cater for large markets ,research institutions are established to enhance efficiency in production as well as production of quality products.
  12. There is higher bargaining power in the world market and this helps the countries to get better prices for their goods.
  13. Flow of resources-member states which might be disadvantaged in terms of technical and human resource capabilities benefit from those which are more advanced. E.g. Kenya being more advanced than her neighbours will benefit from the big pool of human and technical resources in Kenya as there will be a free flow of resources among the countries.


  1. Political instability within the countries and political aggression between the various countries failing the integration efforts.
  2. Production of similar products thus limiting scope of trade.
  3. Unequal distribution of the benefits of regional integration where industrialised countries tend to grow more as they already enjoy certain economies of scale.
  4. It leads to trade diversions where trade leads to of sources of commodities from low to high cost produce.
  5. Since it involves reduction of tariff barriers between member countries,it leads to loss of revenue which implies that the government has less money to spend on developing projects.
  6. In cases where there is sharing of common services such as railway and ports it may be difficult to allocate the benefits and costs of such sharing.
  7. Inefficient industries may be killed off by imports from other member states,which is likely to result in increased unemployment in countries where industries have to close down.


  • European common market.


  • Common market for eastern and southern Africa.
  • The south African development community.
  • The economic community for west Africa states.
  • T.A (Preferential Trade Area) The market has 21 members countries.


  • To eliminate tariffs on certain products and to reduce on certain others in order to facilitate easy trade in members countries.
  • To enable member country’s citizens to interact and exchange ideas that can be beneficial to all.
  • To reduce the problem of limited market.
  • To enable members country bargaining power in the world market. That is in all matters relevant to commerce and matual interest.
  • It facilitates infrastructure on inter state transport and communication among members countries.

Others are:

  • E.C. ( European Economic Community ) Aimed at facilitating and promotion trade relations between European members countries.
  • P.E.C. (Organization of Oil Exporting Countries.) The organization caters for interest of the member oil producing nations.
  • F.T.A ( European Free Trade Area)
  • A.T.T. (General Agreement on Trade and Tariffs) This is aimed at reducing tariffs as an aim of increasing international trade. Over thirty developing nations including Kenya are signatories to the agreement. Its headquarters is in Geneva.
  • C.O.W.A.S. (Economic Community of West Africa, Caribbean and the pacific. The major aim is to negotiate for better terms with the industrialized nations, in trade. This is necessary since the members countries are basically producers of raw materials.

There exists two main effects of a trading bloc

  1. Trade creation-this basically means creation of intensive trading activities.
  2. Trade diversion-when the removal of barriers inside the bloc results in trade being switched from a more efficient producer outside the union to a less efficient one inside.

Free trade.

  • In free trade importers and exporters do not need the government consent.basically it refers to movement of goods and services into and out of a country without any government interference.


  1. Promotes production.
  2. Expands trade among members countries.
  • Establish uniform custom policy in members countries.
  1. Help members countries to raise their standard of living-Through specialization in particular countries, which it produces best and most efficiently,costs of production are reduced. This means that consumers pay less for quality goods and services.
  2. Help to achieve full employment level because there is efficient allocation of resources i.e. residents of a country are free to migrate to any area where their services are needed.
  3. Helps to develop for a greater variety of goods and services.
  • Creates economies of scale, more supply in member’s country
  • Market help to reduce prices.
  1. Enhances of specialization-it allows international division of labour which leads to specialization.countries engage in production of commodities which they can produce most economically resulting in lower production costs leading to favourable prices of goods and services.
  2. Leads to quality and cheaper products.
  3. Leads to international peace and understanding.
  • Promotion of industrial growth-wide markets encourages new firms while the existing ones are forced to increase their production capacity to cater for the increased demand.
  • Helps to dispose off the surplus

Negative effects;

  1. It reduces efficiency in production of different commodities.
  2. Country involved remains less developed since more industries are not established.
  • The major disadvantage is that it gives way to inferior goods to enter the market and may pave way to monopolies.
  1. Unfair competition-the less developed countries suffer due to stiff competition from the economically advanced countries which have better production techniques and adequate finances.
  2. Slow economic development-a country may stagnate in other areas due to over-specialisation.there may also be no need to establish new industries as all needs are being met through trade.
  3. Injurious and harmful products to social well-being of the citizens may get into the local market.
  • Dumping-sale of goods in an export market at a price below price charged in local economy.the motive may be to dispose off any surplus stock in the exporting country or an attempt to penetrate the local market unfairly.
  • Bad cultures are likely to find their way into the market.
  1. Infant industries are usually killed.
  2. Leads to exhaustion of natural resources.

Reasons why a country may find it necessary to control its international trade:

  • To protect infant and key industries against foreign competitions.
  • To avoid entry of harmful commodities in the country.
  • To avoid dependency in other countries.
  • To eliminate dumping of foreign goods, which may jeopardize the local market.
  • To create the employment opportunities through economic growth.
  • To correct the balance of payment deficit.
  • To determine the necessary and unnecessary goods and services.
  • To fight against possible monopoly by super firms.
  • To raise revenues for government projects in the country.


The theory of comparative advantage advocates the gains from free trade and practice however,many governments impose barriers to trade.this now refers to the implementation of policies which restrict free flow of goods and services internationally.

It also refers to imposition of measures aimed at restricting trade among countries.


  1. By imposing tariffs: these are taxes charged on imports to make them expensive hence discouraging consumption in the local market.

-The tariffs can be in form of custom duties (import duties). This is a source of revenue to the government although it is used to discourage imports.

-A specific tariff is levied on commodities according to quantities purchased ie a fixed tax per unit of goods,compound tariff is fixed tax combining both the advolerm and specific tariff,while Advalorem tariff is charged on goods according to their value.

2.Non tariff barriers-this are more problematic.this are measures designed to restrict imports or artificially boost exports.these barriers may take the following forms;

  1. Quotas-this are quantitative limits placed on importation of specified commodities.they may be set on value/volume of imports.under quota system,any increase in domestic demand is expected to be satsisfied by increasing production locally a good example is of embargo where we have zero quota.
  2. Foreign exchange control-the government can therefore make acquisition of foreign exchange more difficult to restrict international trade.
  • Voluntary export restrains(VERS)-this are voluntary imposed limits by a government of an exporting country on the exports of a certain commodity aimed at forestalling official protective action on part of the importing japan has entered into a number of VERS with the USA and EU countries relating to the export of its cars.
  1. Bureaucratic export procedures-this involves imposition of complex and time consuming bureaucratic procedures for goods entering a country which may increase the difficulty and cost of exporting.
  2. Product standard specifications-imports can be restricted on basis that they have not met quality and safety regulations can be used to limit imports on standard goods.
  3. Subsidies-this is an indirect measure providing protection from overseas producers by making domestic products more attractive relative to imports.
  • Moral persuasion-the government appeals to importers and exporters to willfully restrict importation/exportation of a certain commodity.
  • Embargoes-this is an official order that forbids buying/selling of a is usualy established for political rather than for economic reasons.


  1. Revenue argument-it is a source of revenue for state mainly through tariffs.
  2. Infant industy argument-they are protected in the short run.
  3. Declining industy argument-without dealing with this ,industries might collapse leading to sudden mass unemployment.
  4. The dumping argument/discourage dumping-this is the practice of selling abroad at a price lower than charged for same product in domestic has a short term benefits for countries receiving the cheaper commodities,the longer term consequences may be a reduction in domestic output and employment.this is because it kills small industries in the less developed countries where the cheap goods have been dumped by the developed nations because the consumers will automatically buy this cheap products.most developing countries therefore impose high tariffs meant to discourage dumping.
  5. Balance of payment argument-tariffs and quotas may therefore be used in an attempt to restrict imports and improve balance of payment position.
  6. The strategic industy argument-this is a non –economic argument stating that industries produce goods and services which are of strategic importance in times of crises or armed conflict.this industries need to be protected since they are very strategic to a country e.g. food production is very important to a country.incase of a war,a country has to be in a position to ensure there is enough food in country and this explains why some countries protect their agricultural sectors.
  7. To avoid the dangers of specialization-specialisation may lead to diseconomies of scale e.g. agricultural specialization may contribute to monoculture,which can  in turn lead to soil erosion,vulnerability to pests and falling agricultural yields in future.over specialization can cause a country to be completely vulnerable to certain changes in  demand or to costs and availability of imported raw materials or energy or new inventions,which eliminate its  comparative advantage.
  8. Economic sanctions-a measure taken in respect of some economic activity which has the effect of damaging another countrys economy ie weaken a political economy.
  9. Creation and protection of employment-by imposing trade restrictions,imports are discouraged encouraging establishment of local industries to provide commodities that would otherwise have been imported.existing industries continue to thrive thereby ensuring that employed remain in employment.
  10. To preserve morals and culture- people of different nations interact to carry out trade and people may end up borrowing cultural values of other country.the government ban foreign goods which are likely to interfere with culture,moral and health standards of its people e.g. films and literature may erode cultural practices of society.
  11. To expand domestic market-buying imported goods expand s market for foreign goods.government may reverse this by introducing protective masures with the aim of encouraging citizens to consume locally produced goods and this will expand market for domestic products due to an increase in demand.demand may further stimulate investment.
  12. To facilitate economic recovery-where an economy is facing a recession/depression,the government may adopt protective measures which will stimulate investment.this is aimed at achieving economic recovery.


  1. Production of low quality products-the protected local industries may end up producing low quality commodities due to lack of competition. The local consumer is therefore denied the chance of enjoying high quality goods which might have otherwise come from the other country.
  2. Overprotection of infant industries-they should be protected to a given period of time and then exposed to competition. Overprotection reduces their competitiveness and the international market is also limited.
  3. Raising the prices of goods-the protected local industries may not enjoy economies of large scale due to their small sizes and they therefore incur high production costs for their products leading to increase in prices of commodities.
  4. Reduction in volume of international trade-free trade facilitates specialization and thus one country will engage in production of the commodities it can produce economically. Protectionism reduces volume of international trade since countries tend to produce everything they need.
  5. Possible emergence of monopolies-protection gives domestic firms monopoly power. Monopolies are notorious for exploiting consumers by charging high prices.
  6. Possible retaliation by other countries-when a country imposes restrictions on imports from another country,the other country can react by similary imposing restrictions on imports from former country. This would be detrimental to both countries.
  7. Less consumer choice-trade restrictions implies that there would be few goods and services that consumers can chose from. This in turn leads to low standards of living for such consumers.


  1. The I.M.F. ( International Monetary Funds)

It was established in 1944 aimed at restructuring international trade transactions.The major objectives were;

  • To case debt payment among member countries.
  • To settle trade imbalances and advances.
  • To provide short term loans to member countries.
  • M.F. uses special drawing rights (SDR) to assist members  countries to settle their deficits, and short terms loans. Its done out of the  members pooled funds. Each member country is required to subscribe a define amount and is expected to maintain the sum in order to qualify for short term loans in need be.
  • Maintenance of stable exchange rates.
  • Promotion of consultation and cooperation among member countries.
  • Promote economic stability and prevent crisis
  • To help resolve crises when they occur.
  • Promote growth and alleviate poverty.
  • Provision of sufficient international liquidity.
  • It uses concessional lending and non-concessional lending.
  • Concessional imf facilities-uses the poverty reduction and growth facility(PRGF) where interest on loans is 0.5%;loan repayment being 5.5-10 years.
  • Non-concessional imf facilities-they are subject to imf market related interest rate based on SDR intrest rate.they include;
  • Stand-by arrangements-SBA-they are designed to deal with short term bop problems and is the most widely used imf facility.
  • Extended fund facility-EFF-it aims on helping countries to address protracted bop problems that were rooted in structure of economy.
  • Supplementary reserve facility-SRF-The aim is to meet a need for very short term financing on a large scale.
  • Contigent credit lines-C.C.L-it aims to helping members countries to prevent crises.
  • Compensatory financing facility-CFF-it was established with the aim of helping countries that were experiencing a sudden shortfall in export earnings or an increase in cost of imports caused by fluctuating world commodity prices
  • Emergency assistance- this is mainly to countries that have experienced a natural disaster or are emerging from a conflict situation.


  • World Bank. ( International Bank of reconstruction and development) I.B.R.D. all members of world bank (I.B.R.D) must be members of I.M.F.the world bank encompasses all the five institutions namely,
  • I.B.R.D-it aims to reduce poverty by promoting sustainable development in middle income and creditworthy poorer countries by means of loans,guarantees and non lending which includes analytical and advisory services.
  • IDA-the international development association.-helps poorest countries to reduce their levels of poverty by providing intrest-free credits with a 10 year grace period and maturities of 35-40 years.
  • Ifc-international finance corporation.the mandate is to further economic development through private sector.
  • Miga-the multilateral investment guarantee agency-it aims at promoting foreign direct investment into emerging economies inorder to improve peoples lives and to reduce poverty.
  • Icsid-the international centre for settlmement of investment dispute.aims at encouraging foreign investment by the provision of international facilities for reconciliation and arbitration of investment disputes.


The mandate is to oversee the international monetary system and promotes international monetary cooperation Mandate is to promote economic development and structural reform
Assists members in temporaly bop difficulties by providing short to medium term financing thus providing them with the opportunity to correct  maladjustments in bop Assists developing countries by providing long term financing of development projects and programmes
Sources of finance differ;draws its financial resources principally from quota subscriptions of its members Acquires most of its financial resources by borrowing on international bond market.


The principal functions includes;

  • Provide funds for capital development
  • Give loans to be paid back within a period of 5 to 25 years.
  • Encourage free trade and international cooperative through investment.
  • Assist in reconstruction and development by facilitating investment of capital for productive purposes.
  • To promote foreign private investment by guarantee of or through participation in loans.
  • To provide loans for productive purposes out of its resources or out of funds borrowed by it facilitating economic development of member countries.
  • To promote the long-range growth of international trade.

c)U.N.C.T.A.D. –United Nations Conference on Trade and Development. It advocates for developing countries international trade benefits . e.g. Price stability, reduction of tariffs

d)The general agreement on tariffs and trade (GATT)-It was established in 1947 as a multilateral treaty to provide a code of conduct governing international trading relationships and a framework for progressive trade liberalization.the major objectives were;

  • Help member countries raise their standards of living.
  • Achieve full employment level.
  • Develop resources of the world.
  • Expand production and exchange of goods
  • Promote economic development

e)African development bank(ADB).-it provides development finance on concesssional terms (interest on loans is 0.5%;loan repayment 5.5-10 years to low income to member countries who are unable to borrow on the non-concessional terms of the bank.the principle functions include;

  • Provide loans and equity investment for economic and social advancement of member countries.
  • To provide technical assistance in order to strengthen capacity for members to prepare and execute development project and programmes.
  • To promote investment of public and private capital for development purposes.
  • To assist in coordinating development policies and plans
  • To stimulate economic cooperation between African countries.
  • To assist member countries to improve the utilization of their resources
  • To cooperate with national, regional and sub-regional economic institutions in Africa as well as with other outside agencies that aim to support.
  1. f) International commodity organization-the main purpose is to stabilize prices of primary commodities.
  2. g) International labor organization-Ilo.
  3. h) The world trade organization-WTO-this is the only global international organization which deals with rules of trade between nations.



Population refers to the number of human beings living in a particular region at a particular time. Population data of a country is mainly obtained through a census. The characteristics of the information collected include;age,religion,gender,marital status and education level.


Population is never static but keeps on changing with time. These changes may be associated with the concepts below.

  1. Population growth rate-this refers to the rate at which the size of population changes over a given period of time usually one year. The population growth rate varies from region to region


  1. Birth rate-this is the number of live births in a year per 1000 people over a given period of time usually one year. It is also called crude birth rate.

Crude birth rate=number of births/total population X100.

Fertility has an effect on birth rate. It refers to productivity of a country’s population ie average number of children per woman that women in the child-bearing age are likely to give birth many African societies, fertility rate are determined by socio-economic ,political and cultural factors.


  • The age and sex structure of the population.
  • The incidence of barrenness.
  • Social/cultural attitudes towards child bearing before marriage.
  • The marriage rate among people in the productive age bracket.
  • Social/significance of children to parents
  • Technological progress-Children have ceased to be economically important with industrialization.Mechanisation can now be applied in almost all sectors in economy reducing need for labor intensive techniques e.g. in agriculture.
  • Famine epidemics and war-they disrupt normal family life reducing the likelihood of women to conceive.
  • Government policies-this is through specific policies and programs. A policy like provision of family planning services and education benefits of having manageable family sizes.
  • Health and education-With improved medical care,child survival has improved eliminating need for having many children. Women who are educated get married at a later stage contributing to falling fertility rates.
  • Socio-economic considerations-some discourage people getting many children leading to a decline in fertility rate.
  • Ignorance-No planning in families thus high fertility rate.
  • Some religions do not encourage family planning.

This refers to the number of deaths within a given area/group over a given period of time.This is the rate for every 1000 people in is also known as attrition rate and is calculated as;

MR=number of deaths/total populationX100.


  • Infant mortality rate-refers to the number of deaths in the first year of life per 1000 live births.
  • Child mortality rate-refers to the number of deaths of children aged between 1-5 years per 1000 live births.
  • Adult mortality rate-refers to the number of adults dying per 1000 of population.

Life expectancy is the average age at death of the inhabitants of a given area. Information on mortality is useful as it helps decision makers in making projections and also in planning for health provision. The mortality rate in Kenya has been declining due to the reasons below.

  • Improved diets.
  • Better health care
  • Probability of contamination and infection has greatly been reduced by advances in environmental sanitation and personal hygiene.
  • Internal conflicts and wars which plagued pre-industrial societies have been eliminated with powerful and stable governments being established.
  • Technological advances and improved standards of living.


  • Some cultural practices taking children as security during old age-this case may create desire to have many children.
  • Early marriages prolonging the woman’s reproductive life.
  • People wanting to have many children in areas of high mortality rate so that if some die others will be left.
  • Children being seen as a source of cheap labor.
  • Where people are ignorant or are oppressing family planning methods.
  • Religious beliefs which are encouraging large families.


  • Delayed marriages due to such things as staying in school for long periods.
  • Craving for high standards of living leading to people having few children.
  • Desire to give children better lives than parents has made some people want to have few children.
  • Where a small family is considered fashionable.
  • Due to a decline in mortality rate, people have the confidence that few children would all survive.
  • Availability of viable retirement benefit schemes that have made people stop viewing children as security in old age.
  • Family planning.

This refers to population movement from one place to another leading to change in residence in which a recognized boundary is crossed.

Immigration refers to the movement of people into a given area.

Emigration/out-migration refers to movement of people out of a given area.

Migrants-tend to be young and have little attachment to any given area/community.



  • Change in status/role.
  • Entering the labour force.
  • Graduation from school
  • Marriage
  • Divorce

The difference between immigration and emigration is known as net immigration.


This refers to the rate at which the population of a country is increasing per year ie birth rate-death rate+netmigration.Using graphical representation x axis-Poppulation and y axis output per capita

  • Optimum poppulaion-This is a population where the number of people is in balance with the existing is not static but dynamic.Once optimum level is reached a further increase of people would decrease output.

This kind of population depicts that,

  • It is the population that can generate he highest living standards  given the available resources and state of technology.
  • Population size that can lead to the most efficient use of resources while maximizing output per capita.
  • A decrease in a countries population would lead to higher standards of living
  • An increase in population would lead to lower living standards.
  • Under population-this is where there is insufficient labour compared to other factors of production ie capital and occurs when available resources in a country are greater than size of population in a is usually not in numerical figure but the population in relation to a countrys resources.


  1. There is under utilization of resources.
  2. High transportation costs because people are thinly distributed hindering internal trade. Inhabitants engage in subsistence production and specialization is absent leading to economic development not realized.
  3. Small market-under population does not stimulate development of industries since the size of market is too small to support large production from industries
  4. Lack of social amenities-it becomes uneconomical to build them because of low capital per head used to construct roads,dams,schools,hospitals and other social amenities.
  5. Slow economic development-lack of pressure on resources reduces creativity due to limited competition. This makes people more comfortable thereby slowing down economic development.

3)Over population-this exists when a country’s population is large compared to its resources such that the resources are over is a social and economic problem associated with unemployment, high dependency ratio, insufficient housing, insufficient medical facilities, insufficient educational facilities, declining living standards and output per person falls with every increase in population.


  • Market-a large population can support large productions from industries as it offers aalarge market.
  • Labour-a large population increases the supply of labour for large scale production and also makes it possible for labour to move to areas where it is required.
  • It has a high consumption level ie there is a high demand for goods and services and this stimulates investment in production of various commodities.
  • There is better utilization of resources.
  • Technological improvement is likely to be prevalent due to ideas combination due to competition and pressure of population on resources which may lead to high efficiency and inspire people to look for new methods of productivity improvement.


  1. Poor standards of living
  2. High levels of unemployment.
  3. Strain on social amenities
  4. High dependency on a small working population
  5. Imbalance in demand and supply.
  6. Immoral activities are usually rampant.
  7. Pollution is also experienced.
  8. Savings and investments levels are likely to decline.

4)Ageing population-This refers to population which has a high propotion of old people ie above 65 years.It is as a result of decrease in fertility rate and decrease in old age mortality rate.This kind is not economically desirable because it leaves the country with insufficient labour force for resource exploitation.Provision of pension and medical facilities pose heavy financial burdens to them.


  1. They tend to provide less mobile labour force.
  2. Low labour supply is likely.
  3. Reduced revenues from income taxes.
  4. High dependence of old on working population.
  5. The society becomes less productive as it lacks input of the energetic youth.
  6. May result to unemployment due to fall in demand for goods and services required by the youth.
  7. Adaptation problems-it is usually difficult for old people to change with the world trends as they are conservative in ideas,taste and attitudes.
  8. Education and training problems-it is normally difficult for old people to acquire new skills and techniques of production as they can’t fit in new production activities.
  9. Increased pension and commodities for the old-the burden of retirement is felt by the working population because most of the resources are spent on consumption rather than production.

5) Young population-majority is comprised of young people compared to old people. This population is considered un economically active and has to be supported by those who are gainfully employed. Large share of public resources must be devoted to needs of dependents e.g. health and education.

6) Declining population-this is as a result of a higher death rate than birth rate.



  1. Smaller  markets-leads to less investment and also unemployment.
  2. Less pressure on land and other resources.
  3. Reduced expenditure on social services-the government save money that was previously  spent in providing services.such money is now used for development purposes.
  4. Shortage of labour supply.



  1. Dependency burden  raises.
  2. Low living standards due to savings declining sine more income is sent in provision of basic necessities.
  3. Unemployment-most sectors of economy will be unable to provide employment opportunities since they are not growing.
  4. Social problems-overcrowding in residential areas and social problems such as housing,crime,pollution and traffic jams are experienced.
  5. Food shortages-this occurs when policies aimed at increased food production are not formulated
  6. Strain in social amenities.


This  refers to the composition of population in terms of education levels,morbidity,age,gender and the number of working people.



  1. Increased market demand.
  2. Enough labour supply.
  3. Technological advancement-due to competition and pressure of population on resources may lead to high efficiency and inspire people to look for new methods of productivity improvement.
  4. Export promotion-talents may be many and coupled with technology advancement will not supply superior quality goods but also enough quantity for home consumption and export.


  1. Effect on per capita income-increases at an increasing rate and then starts to fall.
  2. Increased dependency ratio-high birth rate
  3. Effects on savings and investments
  4. Effects on employment-in over populated country.
  5. Effects on provision of social amenities-government finds it difficult to provide them in adequate.
  6. Effects on distribution of income-
  7. Effects on environment-over exploitation of natural resources and environmental degradation and restoration by the government means spending money which would have been used for other purposes.


Rapid  population growth-high dependency ratio-low incomes per capita-low savings-low investment-poverty.


Employment- Refers to the engagement in any type of productive income generating activity. It includes public and private wage employment and personal employment such as farming. It can also be defined as the engagement of a person to some productive work or to some legal income generating activity.

Full employment refers to a situation where all people who are willing and able to work are employed. This concept does not however exist in real life world.

Unemployment-This refers to a situation where people are willing and capable to work at the existing wage rates but cannot secure jobs.

Unemployment rate = Total unemployed(working ages)

Total  population

Unemployment is that situation of a country when a greater proportion of such people who are able to work and willing to work are unemployed.  Those people who are not willing to work or unable to work are known as unemployable.

Unemployment is the condition of not being put to productive use, and and is usually applied to people without jobs or” gainful employment”.  Not having a job when a person needs one can make it difficult to meet financial obligations such as purchasing food to feed oneself and one’s family, and paying one’s bills; failure to make mortgage payments or to pay rent may lead to homelessness through eviction.

The unemployment problem is harmful for economic, social and political stability of any country. In economics, unemployment refers to the condition and extent of joblessness within an economy and is measured in terms of the unemployment workers divided by the total civilian labour force.  Unemployment in an economic sense has proved a surprisingly difficult thing to define as there is some controversy about what exactly is meant by “unemployment”.

The terms unemployment and unemployed are sometimes used to refer to other inputs to production that are not being fully used-for example, unemployed capital goods.

The unemployment problem is of concern to the government because it means that a scarce factor of production (i.e. labour) is lying idle and being wasted.  Unemployment can also lead to social problems such as crime as well as being a cause of social and personal distress.

Impact/effects of unemployment on society

  1. Lacking a job often means lacking social contact with fellow employees, lack of self-esteem, mental stress and illness and of course the inability to pay bills and to purchase both necessities and luxuries. The latter is especially serious for those with family obligations, debts, and /or medical costs, where the availability of health insurance is often linked to holding a job. Rising unemployment increases the crime rate, the suicide rate, and causes a decline in healthiness.
  2. The combination of unemployment, lack of financial resources and social responsibilities may push unemployment workers to take jobs that do not fit their skills or allow them to use their talents i.e unemployment can cause underemployment. For example, in Kenya it’s common to find university graduates working as watchmen or other lowly paid jobs.
  3. Rise in crime and other anti-social activities.
  4. Low economic growth
  5. Low standards of living due to high levels of poverty.

Measuring unemployment/Types of unemployment

1.Transitional Unemployment

Transitional unemployment is that situation which prevails due to some temporary reasons.

2.Turnover Unemployment

Turnover unemployment-occurs when a person resigns or leave their present job to look for another. He will be temporary unemployed in the meantime

3.Casual Unemployment

Casual workers are employed for a specific job and when that job is completed, these workers become unemployed.  For example, workers employed by shipping or building construction companies are employed on casual basis.

4.Seasonal Unemployment

This is a type of unemployment experienced where demand for goods and services is seasonal. Some industries have seasonal demand and the products of such industries are manufactured for a specific period of the year.  The workers of such industries remain unemployed for a few months.

5.Structural Unemployment

Structural unemployment is that situation which prevails due to some structural change e.g improvement in technology.

6.Cyclical Unemployment

Cyclical unemployment is caused by economic factors leading to poor performance by the economy. It is associated with the trade cycle.  During a slump (business cycle recession), prices are too low and profit margin disappears.  In this case, investment decreases and unemployment increases as there is not enough aggregate demand for the labour.

7.Technological Unemployment

Due to technological development, capital intensive techniques have been invented.  The use of latest technology does not require a large number of labourers because most of the work is completed by machines.  This decrease in demand for workers is known as technological unemployment. 

8.Industrial Change

The establishment of new industries decreases the demand for the products of old industries.  For example, the rapid increase in the demand for the products of Japan’s industries is one reason for greater unemployment in some European countries.

9.Keynesian Unemployment

According to Keynesian theory of income and employment, unemployment occurs due to lack of effective demand i.e. a decrease in demand for a product, which causes reduction in its production and workers are laid off. If effective demand is less, then production of goods and services will fall which will further result in unemployment of labor force.  Another feature of Keynesian unemployment is that unemployment of labor is associated with unemployed capital as plant and machinery become idle during the period of depression.

10.Urban Unemployment

Due to availability of more facilities in urban areas, more and more people tend to move to urban areas.  The employment opportunities are not enough to absorb all those people who come to settle in urban areas.  This situation creates urban unemployment.


Disguised unemployment is that situation when some people are employed apparently, but if they are withdrawn from this job, total production remains the same. It is also called underemployment In under-developed countries, there is 20 to 30% disguised unemployment in the agriculture sector.  If there is disguised unemployment, measures should be taken to employ these people in other sectors of the economy.

12.Frictional unemployment/search unemployment.

This is a type of unemployment caused by industrial upheavals such as power shortages, immobility labor, machinery breakdown e.t.c It occurs when a person may have been made unemployed in a certain area but vacancies exist in the same occupation in another area.

13.Voluntary unemployment or real wage unemployment.

This is a type of unemployment where a person is able to work, work is available ,but he is unwilling to work.  Some degree of unemployment will always exist because some people do not want to find work due to idleness or their chosen way of life.

14.Residual unemployment

There will always be a category of unemployment consisting of people who, because of physical or mental disabilities find it very difficult to find work.  Some firms attempt to employ a certain number of workers from this group but not opportunities exist.

15.Hidden unemployment

Hidden (or covered) unemployment is the employment that is not reflected in official unemployment statistic, due to the way the statistics are collected.  Because of hidden unemployment, official statistics often underestimate unemployment rates. Thus, it is almost impossible to have a situation of 100% employment (full employment).  In consequence, full employment is taken to mean an acceptable percentage of unemployment is taken to mean an acceptable percentage of unemployment (between 2 and 3%).

16.Involuntary unemployment.

This occurs when people are actively looking for jobs at the existing wage rate but can not get the job.


  1. Lack of capital

The shortage of capital is the hindrance in the establishment of more industries and due to this reason, more employment opportunities are not created.

  1. Lack of education and training facilities

Sometimes, employment opportunities are available for skilled and trained persons.  The lack of education and training facilities may be another reason for employment.

  1. Rapid population growth

The rapid increase in population compared to the overall growth of the economy and the available resources leads to unemployment.  In many countries, the employment opportunities are not increasing at the rate of increase in labour supply.

  1. Inadequate co-operant factors of production
  2. Use of inappropriate technology in developing countries.

Most developing countries use capital intensive techniques of production i.e techniques that make use of more machines and less labour which displaces human labour and reduces chances of other people getting jobs.

  1. Seasonality of jobs.

This is especially important in developing countries where the agricultural sector is dominant. Changes in weather leads to seasonality in agricultural production which causes seasonal unemployment. Seasonality of jobs also affects the tourism sector whereby unemployment tends to be high during off-peak seasons

  1. Job selection
  2. Rural to urban migration

The massive movement of the young and energetic people from the rural to urban areas leads to urban unemployment owing to the limited job creation capacity in the urban areas

  1. Lack of product market
  2. Inappropriate education system

The education systems in most developing countries were adopted from developed countries. These education systems are geared towards white collar jobs and this does not conform to realities in developing countries most of which have high populations and low rates of white collar job creation in the formal sector.

  1. Poor planning and mismanagement
  2. Poor government policy on informal sector
  3. Unfair competition leading to closure of
  4. Low demand for goods and services.
  5. Minimum wage laws-some people do not mind working for lower wages than minimum levels set by the government. These laws do not ease the problem of unemployment instead they cause more people to be laid off by firms that cant afford to pay them


  1. Use of appropriate technology

The Government should adopt pricing policies that encourage the use of appropriate technology. This can guide investments towards labor intensive technologies in different sectors which are appropriate to labor surplus economies of many less developed contries. Labor-intensive techniques must be adopted in such countries in order to absorb more china,Indonesia and tyland are the leaders in the clothing sector.

  1. Decentralization of Industries and markets

Industries must be established in different regions of a country.  The establishment of industries in various parts of the country will provide employment opportunities to greater number of people.  It will also induce people not to migrate to other areas of the country.

  1. Diversification of economic activities

The diversification of agricultural and industrial production can be also agricultural and industrial goods are produced then there will demand for more workers.  As a result, creation of alternative employment opportunities will increase. This reduces seasonal unemployment in areas that over depend on tourism and agricultural activities.

  1. Greater use of natural resources

Greater use of natural resources can also increase the employment opportunities.  In most of the countries including Kenya, there are uncultivated lands.  If these lands are brought under cultivation then more and more people can be employed.

  1. Use of fiscal and monetary Policies

The Government can use fiscal and monetary policies to create more employment opportunities.  Central bank can encourage advancing more loans to those projects which can provide employment to greater number of people. Similarly, the expansion of public work programmes can solve the problem of unemployment to a greater extent.

  1. Adopting relevant education system and training facilities

Sometimes, there is greater demand for skilled and educated people.  The education and training facilities should be provided to the individuals to enable them to increase their knowledge and technical skill.

  1. Control of population growth

The rapid increase in population is the main cause of unemployment in less-developed countries.  The Government should take some steps such as encouraging family planning and educating the population on the need for small familiesto control the population growth in an effort to solve the unemployment problem in the long run.

  1. Employment offices

The Government should establish employment offices to various parts of the country.  These offices can co-ordinate between employers and jobseekers.

  1. Encouraging employment creation in the private sector

Government policy can support private sector development by creating an enabling environment for the private sector to develop. This includes providing incentives such as micro financing to offer capital to small and medium term enterprises, developing infrastructure, provision of cheap land, lowering the tax rates on profits, offering subsidies e.t.c

  1. Encouraging foreign direct investment.
  2. This can be achieved by providing a conducive political and economic environment to encourage the inflow of foreign capital.
  3.  Encouraging the use of domestic goods

This tends to create employment domestically. Considerable use of foreign inputs and goods should be reduced since such usage generates employment abroad and not domestically.

  1. Intensive rural development by the government.


  • Providing appropriate education and training that provides relevant skills & knowledge
  • Delocalization of firms to reduce urban unemployment which is brought about by rural-urban migration
  • Ensure there is political stability to boost foreign investors’ confidence
  • Protect local industries from unfair foreign competition
  • Promote the informal sector
  1. Increasing government expenditure on projects that can create more jobs.
  2. Development of the informal sector.
  3. Favorable government policies i.e. raising money through taxes, training programs to the unemployed on how they can raise their skills
  4. Marketing and research (information).-this leads to better prices that encourages producers or investors to expand production scale and creates need for labor reducing unemployment.





  • Economic growth is an increase in activity in an economy. It refers only to the quantity of goods and services produced; it says nothing about the way in which they are produced.
  • Refers to a steady physical increase in a country’s productive capacity which is identifiable by a sustained increase in a country’s real output of goods and services or real national income over time.
  • It is a quantitative concept and may not be accompanied by an increase in the quality of life.
  • It does not necessarily mean economic development.


  • This is a more comprehensive concept as compared to economic growth, as it is a qualitative approach.
  • It refers to an increase in per capita income which is equitable associated with an improvement in the indicators of the quality of life (literacy, infant mortality, life expectancy and population per doctor).
  • For it to arise, absolute number of poor in a given country should not be increasing, and this means that there is increased employment opportunities
  • It implies fundamental changes in economic and social structure of a country.
  • It implies changes in the composition of output and allocation of inputs by sectors ie.Positive changes in technical ,structural(infrastructure)and institutional(health education ,financial) arrangements.
  • It is associated with decline in share of agricultural sector and a corresponding increase in value of the manufacturing and service sectors.
  • It considers underlying determinants of economic growth; thus a more comprehensive than economic growth i.e. encompasses a broader scope.
  • To measure it, one needs to adopt a broader measure of economic welfare than gross national product per capita.


  • Improved economic performance as measured by GDP(gross domestic product)-this is the total value of final goods and services produced within a country divided by the total population.
  • Improved standards of living characterized by high income,equality,good health and adequate education.
  • Improvement in levels of technology being used.
  • Changes in levels of personal,political and institutional freedoms
  • High levels of productivity low population growth and dependence.
  • Numerous international trade benefits
  • Efficiency and effectiveness of domestic economic institutions.
  • Stability and flexibility of political social institutions.
  • Numerous entrepreneurial, scientific and technological research and development capabilities.
  • Higher life expectancy-This could be as a result of increased food supply,minimal war prevalence’s as well as low incidences of diseases.
  • Higher literacy levels-According to U.N;adult literacy is arrived by checking the percentage of those aged 15 years and more in a region and are able to write a short,simple sentence as part of their every day life.
  • Lower levels of poverty levels ie absolute-one has barely enough to survive fom day to day and relative poverty-poorness in relation to another person.
  • Demographic indicators which are positive ie populational characteristics,marital status,gender,age,literacy levels.
  • Disease indicators-countries suffering high losses from diseases and epidemics are termed as developing and those with fewer losses are termed as developed.
  • Improved productivity of factors of production thereby achieving more output per unit of a factor.
  • Shift from agricultural to manufacturing sector.
  • Increased industrialization hence chances of unemployment are minimal.
  • Improved infrastructure(roads and electrification).
  • Reduction of gap between the poor and rich.


  1. Increase in per capita income-this should be higher as compared to the overall population
  2. Alleviation of poverty ie those who struggle to get basic needs i.e. simple clothing,shelter and food.
  3. Reduction of income inequality
  4. Reduction of unemployment
  5. Reduction of regional disparities.
  6. Maintenance of environment. Efforts have been made for there to be sustainable development which will last without damaging the environment. Development is therefore judged by how productive activities are controlled in order to conserve the environment e.g. planting trees.
  7. Industrialization-this involves transforming the economy from agricultural to an industrial one.
  8. To ensure there is improved social services ie health,education to eliminate the effect of disease and ignorance.


  1. Degradation of environment-this occurs due to industrial development which might destroy the natural habitats of wildlife polluting air and water and the government may be forced to spend a lot of money in protecting or conserving the environment.
  2. Overcrowding in slums-provision of basic social services becomes difficult in slums thereby resulting in low standards of people
  3. Rendering knowledge and skills obsolete-this is mainly through technical advancement thus affecting job opportunities of many people.
  4. Creating social tensions-creating social tensions-this may occur due to income distribution among individuals and regions. Political instability may also occur due to unsatisfied expectations from some groups of people.


  1. Lack of inducement to invest.
  2. Lack of social infrastructure.
  3. Inadequate capital.
  4. Inability to save.
  5. Rapid population growth-due to low per capita income realized.
  6. Low natural resource endowment.
  7. Poor technology been used.
  8. Attitude and beliefs of a society and how they perceive things that do not incorporate change.
  9. Poor human resource endowment.
  10. Unfavourable domestic environment
  11. Indivisibility of capital-leads to slow development.Some machines can not be bought due to their large sizes and price.
  12. Dependence from other countries.
  13. Political instability.


  1. Human resource-countries must be concerned with the quality of their human resource.planners trying to hasten economic development emphasize on;control of diseases and improved health and nutrition as well as improved education,reduced illiteracy as well as trained workers.
  2. Natural resources-land is the most important available land productivity can be increased by adding fertilizers and adopting the latest methods of tillage.
  3. Capital-in advanced economies 10-20% of income may go into capital contrast the poorest countries are often able to save 5% of national income.Moreover much of the low level saving goes to provide the growing population with housing and simple tools and little is left over for development.
  4. Technology-economic development relies on japan a country which joined the industrial race at the end of 19 th century sent students abroad to learn western technology.Relying and adopting of foreign technologies has made japan to move into its position today as the world second largest industrial economy.this example has shown how countries can thrive by adapting foreign science and technology to local market conditions.
  5. Less burden debt-when debts are paid off,neo-colonialism is also done away with giving a county even more political independence and stability.
  6. Increased exportation and decreased importation-this translates to a surplus budget as well as favourable balance of trade as well as balance of payment account.

Basically, an economy can experience actual or potential growth ie.

  1. Actual economic growth-refers to the annual percentage increase in national output which typically fluctuates in accordance with the phases of trade cycle(aspect of inflation).
  2. Potential economic growth-this is the rate at which the economy would grow if all the  resources e.g. human beings and machinery were fully utilized.


  1. Contributes to a higher standard of living-provided economic growth results in a higher real income per capita,this should imply that a greater quantity of better quality commodities is made available to each person to consume.
  2. Economic growth can help to reduce poverty-in many developing countries a considerable proportion of people live in absolute poverty which implies that they cant satisfy their basic needs.Economic growth may provide a greater access to commodities e.g. food,housing and clothing that enable the poor to satisfy their basic needs more adequately.
  3. It can redistribute income without making anyone worse off.Although economic growth does not necessarily improve the income distribution,in situations where economic growth is taking place,it may be possible to change the distribution of income so as to achieve greater greater equity without making anyone worse off.
  4. Increases chances of creation of employment.
  5. Possibility of increased investments is also evident.
  6. There is reduction of dependency as economy becomes self sufficient.


  1. It implies a faster use of natural resources which in turn contributes to depletion of these resources.Despite new discoveries being made,resources such as petroleum are likely to eventually run out and this will eventually impose a limit on economic growth.
  2. It is often associated with an opportunity may entail an investment in capital goods whose opportunity cost is the current consumption which is foregone. The higher rate of economic growth aimed at,the higher the sacrifice of present consumption which is necessary.
  3. It may contribute to technological unemployment-technological progress may create new jobs;it may also make some jobs obsolete and therefore some individuals rendered redundant;this may for example contribute to significant retraining costs for the affected individuals.
  4. Economic growth may be associated with negative externalities e.g. pollution  and noise and still it can lead to exhaustion of some non-renewable resources.

Economic development can be measured using the following variables;

  • International monetary fund-this usually divides countries into categories of industrial countries,developing countries and transitional economies.
  • United nations and world bank build on these categories by further subdividing countries into high income,middle-income and low –income countries.these categories are primarily based on the measure of income per capita.
  • A unique categorization is provided by the united nations human development index.the index is based on the notion that countries can only claim to be developed when certain basic needs e.g. wide spread access to education,health,food and employment are fulfilled.Countries are then ranked on basis of this index.the united nations has also developed human poverty index based on proportion of people in a given country who do not reach certain minimum standards in terms of aspects e.g. access to health services and education.
  • D.P-gross domestic product.
  • Genuine Progress Indicator (GPI) –GPI is a concept in welfare economics that has been suggested to replace gross domestic product (GDP) as a metric of economic growth. GPI is an attempt to measure whether a country’s growth, increased production of goods, and expanding services have actually resulted in the improvement of the welfare (or well-being) of the people in the country. GPI advocates claim that it can more reliably measure economic progress, as it distinguishes between worthwhile growth and uneconomic growth.


  1. Low per capita income
  2. Heavy dependence on agricultural sector-subsistence farming.
  3. Considerable dependence on a narrow range of products-usually primary products to generate a substantial proportion of their export revenues.
  4. Inadequate infrastructure and social services i.e roads , sewerage systems,health and education are strained.
  5. Low-capital-labour rates/ratios-this limits their ability to use modern production methods and this leads to a vicious circle of poverty in many developing countries
  6. Illiteracy levels are high.
  7. High population growth rate is experienced.
  8. Poverty levels are high;ie one has cash but cant meet his/her needs and wants.
  9. They have foreign debt in developed countries.
  10. There exists classes ie low,middle and upper brought up by different purchasing powers.
  11. Political instability;public scandals;elections and hardships are the talk of the day.
  12. High proportion of labor force engaged in agriculture.
  13. Low level of technology being used in production.
  14. Foreign trade orientation/dependence on developed countries. Such countries earn less from their export trade and spend more on imports.
  15. Disparity in income distribution ie  less than 20% rich people compared to over 90% poor people in these economies.
  16. Low level of savings and investments
  17. Problems of unemployment.
  18. Under utilization of natural resources.


  1. The vicious circle/cycle of poverty-this refers to a self-reinforcing situation whereby certain factors exist that tend to perpetuate an undesirable developing countries the vicious circle of poverty can be viewed from the demand side and supply side.demand side implies that low levels of income lead to low levels of demand which in turn lead to low rates of investment and a corresponding deficiency of capital,low productivity and low income.From a supply side perspective low productivity implies low real income which in turn implies low saving and low level of investment that contributes to deficiency of capital.The deficiency of capital contributes to a low level of  productivity and low income as shown below diagrammatically;lack of capital-low savings-low investments-low productivity-low income.
  2. Human resource constraints-individuals lack key skills and knowledge reuired for economic development.lack of adequate skilled human  lead to low productivity,factor immobility and limited occupational specialization.underdeveloped human resources imply that there is a low level of knowledge about alternative production techniques,natural resources,existing market conditions and opportunities.
  3. A low level of capital formation-poverty can be considered as both a cause and a consequence of a countrys low rate of capital is an important accompanying factor of production.labour as an input is more productive when it has more machinery to work with.
  4. Socio-cultural constraints-this constitutes a formidable obstacle to development in many developing countries.Economic development is profoundly influenced by social attitudes e.g. attitudes may be influenced by ethnic distinctions and regional loyalties which may inhibit geographical mobility.
  5. Foreign exchange constraints-this countries have experienced  limited gains from trade compared to developed countries.This is because they are usually dependant on primary exports  subject to long term declining terms of trade compared to manufactured products.Primary products are also subject to greater price fluctuations compared to manufactured goods.
  6. Lack of entrepreneurial skills vital in development process-entrepreneurs can be considered as playing the role of combining existing factors of production in new and more efficient ways.
  7. Corruption and resource management-public funds meant for development projects sometimes are diverted to private use.donor funds aimed at economic development have been mismanaged and consequently their impact in areas such as poverty alleviation has often been limited.
  8. Inappropriate policies have sometimes been applied in developing countries ie the inappropriate strategy of import substitution which generally proved to be ineffective.Appropriate policies have not been implemented or are partially implemented.
  9. Developing countries have also been particulary vulnerable to health epidemics e.g. AIDS-this is partly because of inadequate health facilities;loss of life and reduced productivity.


Development planning is a process through which one focuses on the future and it involves resource allocation,resource accumulation and resource management.the development plans are classified on basis of;

  1. Degree of coverage-ie comprehensive or partial
  2. Degree of government control-ie directive(it outlines the economic targets to be achieved) ,indicative (they are broad and outlines of intended economic purpose)or transformational(outlines strategies for securing a complete change in an economy) plans.
  3. Time dimension-long term,medium term or short term plans.


  1. Markets do not operate efficiently in developing countriesdue to un appropriate and inefficient allocation of resources,subsistence sector,commodity and factor markets are badly organized.
  2. Market failure argument-trade-off between efficiency and equity failure leads to gross disparities between social and private valuations of alternative investment projects.
  3. The foreign aid argument/bargain-to persuade donors that money will be used as an essential ingredient in a well conceived and internally consistent plan of action.
  4. Resource mobilization and allocation argument(coordinating investments)-development planning is assumed to help modify the restraining influence of limited resources by recognizing existence of particular constraints and by choosing and coordinating investment projects so as to channel these scarce factors into their most productive outlets.
  5. The attitudinal/psychological argument-development planning helps to put/rally people behind the government cutting  across class,caste(dividing people in classes),race,religions and  tribal factors  in a national campgain to eliminate poverty,ignorance and disease.
  6. Project evaluation/ranking projects- a pre-detrmined criteria is used and when there are deviations they are noted and corrective measures taken before it is too late.
  7. Stimulation of effort-a well laid out development plan may help the government stimulate efforts of people in the desired showing possible achievement the government may persuade its people to invest with greater confidence,put greater efforts towards fulfillment of planned objectives and to see the need for making sacrifices in order to achieve the required level of domestic savings.
  8. Sectorial forecasts-planning provides the government with a long term view of the various sectors of the economy ie agricultural,manufacturing or service industries.
  9. To ensure long term decision making
  10. Avoiding duplication-this may occur when industries are located in different parts of the country.over emphasis on one area and leaving the other one is thus minimized.
  11. Promoting balance in regional development.


  1. Establishment of a planning body-Here we have economists,statisticians and engineers.
  2. Availability of statistical data-for use by the planners.
  • Fixing of realistic targets and priorities-Targets should be SMART,consistent and realistic so as to attain a predetermined growth rate in economy.
  1. Maintenance of proper balance in the economy ie public,private,agriculture and industrial sector.
  2. Incorruptible and efficient administration.
  3. Strong education base-a firm education base is essential for strong administration.
  • Proper development policy arrived though scientific and market research
  • Non interference by politicians-without public support the plan is bound to fail.


  1. Insufficient and unreliable data-such data greatly diminishes the accuracy and internal consistency of economy-wide quantitative plans.
  2. General lack of appropriately qualified and experienced personnel-plans made by foreign experts.formulation and carrying out a comprehensive and detailed plan is likely to be in Kenya most students are the ones that assist patients in hospitals.
  3. Lack of necessary technical facilities and resources e.g. powerful computers-this limits ability to develop accurate and comprehensive economic models.
  4. A limited range and effectiveness of policy instruments because many individuals in developing countries put many of people out of reach of planners
  5. The high levels of illiteracy in developing countries put many of people out of reach of planners.
  6. Unanticipated economic disturbances-these may be external or internal-most developing countries have “open economies”with considerable dependence on the vicissitudes of international trade,aid and private foreign involvement.
  7. Institutional weaknesses-e.g.lack of coordination between say planners and administrators,excessive buraeaucratic procedures  which makesthe process of planning difficult as the decision making process is unnecessary too long and political bureaucratic corruption is also evident.
  8. Deficiencies in plans and their implementation-this tend to be over-ambitious and vague on specified policies for achieving stated objectives.there exists a large formulation and implementation gap.
  9. Lack of political will-lack of commitment and political will on part of many developing countries leaders and high level decision makers.
  10. High costs are incurred and this affects the countrys total budget.
  11. Rigidity –economic plans are usually rigid and may not be easily or readily adaptable to changing economic conditions.
  12. Existence of large subsistence sector making planning unrealistic.
  13. Problem of private sector-an economy with  the public and private sector may give incentives to the private sector may require to give incentives to private sector hoping that it will operate in the desired direction.this sometimes may not be possible as those in the private sector may be pursuing very different objectives from those of planners.
  14. Transfer of inappropriate development plans from developed countries which may end up failing in developing countries
  15. Lack of clear policies to guide the planners.
  16. Reliance on donor funding’s from developed countries and if this is not realized implementation of this projects becomes difficult.
  17. Failure to involve local people in planning.
  18. Natural calamities-plans are frustrated directly or indirectly if funds meant for a particular project would be diverted from planned purpose to be used in combatting calamity.
  19. Over ambitious plans-some plans especially those meant to impress donors so that they release foreign aid may be unrealistic and the plans finally become difficult to implement.
  20. Lack of cooperation among the executing parties-i.e. among the experts e.g. a conflict between ministry of finance and planning agencies. The plan may not take off.
  21. Inflation-if prices are rising too rapidly the resultant change in planned resource costs may negatively affect its implementation.



This refers to new issues that are coming up as far as economic issues are concerned.

  • Use of advanced technology-computers which have come up with new changes ranging from less paper work and many people are unemployed.
  • Emergence of automatic teller machines.
  • Emergence of mobile banks.
  • Emergence of customer care services department to handle financial matters only.
  • Emergence of m banking
  • Globalization-this is a process whereby different systems and parts of a related trade, function as a closely-knit system at the international level. Communication and transport have vastly improved and affects many aspects of economics from competition policy to monetary policy and agricultural policy.
  • Mergers and joint ventures of institutions so as to increase the institutions capital base.
  • Hiv aids and drug abuse menace.
  • Pollution-air, water, noise and solid waste due to drastic economic changes.
  • Environmental Corruption .
  • Depletion of natural resources.
  • Rogue economics-recent credit crisis shows how financial deregulation and globalization has contributed to many new problems which leave economies vulnerable to financial speculation.
  • Pressure on commodities-the world is used to dealing with a situation of abundant supply of raw materials, but diminishing supply and growing demand threatens to change that. Oil prices are rising due to speculation and due to fact demand is simply rising faster than supply.
  • Shifting balance of global economy-in post war period, US economy was dominant. The old phrase when America sneezes, the rest of the world catches a cold was very much appropriate. Sleeping giants have risen.
  • Dealing with commodity shortages there is the introduction of government quotas,tariffs,protectionism etc.
  • Growth of china economies.
  • HIV aids menace.
  • Emergence of consumerism movements-this is an organized movement of citizens and government agencies to improve the rights and power of buyers in relation to sellers
  • Destruction of environment e.g. lumbering, desertification etc.
  • Emergence of fraudsters who produce counter fake products.
  • Emergence of environmentalism movement-this is an organized movement of concerned citizens and government agencies to protect and improve people’s current and future living environment.
  • Liberalization-this is removal of trade barriers-i.e. free trade.
  • Regional economic integration- e.g. EAC, COMESA,PTA boundaries become irrelevant.
  • Emergence of export processing zones-this are areas set aside by government where industries can set up firms to process goods for export at little or no charge.
  • Enactment of new government policies ranging from quotas,rules,regulations and law enactment e.g. media bill,mututho bill and tobacco bill.



  1. Restriction of lending capacity of money to citizens,challenge-increases money supply in economy.
  2. Huge taxation-challenge-increased demand of level of goods.
  3. Control imports-challenge-imported inflation.
  4. Rationing of foreign exchange-challenge-imported inflation.
  5. Control exports-challenge-shortage of domestic market product.




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