CPA SECTION 2
CCP SECTION 2
CIFA SECTION 2
CS SECTION 2
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her to apply the fundamental principles of economics in decision making
4.0 LEARNING OUTCOMES
A candidate who passes this paper should be able to:
- Apply basic mathematical and graphical techniques to analyse economic relationships and interpret the results
- Apply the knowledge of economics in decision making
- Analyse economic problems and suggest possible policy related recommendations
- Apply knowledge of economics in international trade and finance
- Apply economic principles in the development and implementation of policies in agriculture and industry
- Demonstrate an understanding of emerging economic issues.
4.1.1 Introduction to economics
- Definition of economics
- Micro and macro economics
- The methodology of economics and its basic concepts
- Economic descriptions and analysis
- Scarcity, choice, opportunity cost and production possibility frontiers and curves
- Economic systems: free economy, planned economy and mixed economy
- Specialisation and exchange
4.1.2 Demand, supply and determination of equilibrium
18.104.22.168 Demand analysis
- Individual demand versus market demand
- Factors influencing demand
- Exceptional demand curves
- Types of demand
- Movement along and shifts of demand curves
- Elasticity of demand
- Types of elasticity: price, income and cross elasticity
- Measurement of elasticity; point and arc elasticity
- Factors influencing elasticity of demand
- Application of elasticity of demand in management and economic policy decision making
22.214.171.124 Supply analysis
- Individual versus market supply
- Factors influencing supply
- Movements along and shifts of supply curves
- Definition of elasticity of supply
- Price elasticity of supply
- Factors influencing elasticity of supply
- Application of elasticity of supply in management and economic policy decision making
126.96.36.199 Determination of equilibrium
- Interaction of supply and demand, equilibrium price and quantity
- Mathematical approach to equilibrium analysis
- Stable versus unstable equilibrium
- Effects of shifts in demand and supply on market equilibrium
- Price controls
- Reasons for price fluctuations in agriculture
4.1.3 The theory of consumer behaviour
- Approaches to the theory of the consumer- cardinal versus ordinal approach
- Utility analysis, marginal utility (MU), law of diminishing marginal utility (DMU)
- Limitations of cardinal approach
- Indifference curve analysis
- Budget line
- Consumer equilibrium; effects of changes in prices and incomes on consumer equilibrium
- Derivation of a demand curve
- Applications of indifference curve analysis: substitution effect and income effect for a normal good, inferior good and a giffen good; derivation of the Engels curve
- Consumer surplus
4.1.4 The theory of a firm
188.8.131.52 The theory of production
- Factors of production
- Mobility of factors of production
- Production function analysis
- Short run analysis
- Total product, average and marginal products
- Stages in production and the law of variable proportions/ the law of diminishing returns
- Long run analysis
- Isoquant and isocost lines
- The concept of producer equilibrium and firm’s expansion curve
- Law of returns to scale
- Demand and supply of factors of production
- Wage determination theories
- Trade unions: functions and challenges
- Producer surplus/economic rent
184.108.40.206 The theory of costs
- Short run costs analysis and size of the firm’s total cost, fixed cost, average cost, variable costs and marginal cost
- Long run costs analysis
- Optimal size of a firm
- Economies and diseconomies of scale
4.1.5 Market structures
- Definition of a market
- Necessary and sufficient conditions for profit maximisation
- Mathematical approach to profit maximisation
- Output, prices and efficiency of: perfect competition, monopoly, monopolistic competition, oligopolistic competition
4.2.1 National income
- Definition of national income
- Circular flow of income
- Approaches to measuring national income
- Concepts of national income: gross domestic product (GDP), gross national product (GNP) and net national product (NNP), net national income (NNI) at market price and factor cost, disposable income
- Problems of measurement; uses of national income statistics and their limitations
- Analysis of consumption, saving and investment and their interaction in a simple economic model
- Determination of equilibrium national income
- Inflationary and deflationary gaps
- The multiplier and accelerator concepts
- Business cycles/cyclical fluctuations
4.2.2 Economic growth, economic development and economic planning
- The differences between economic growth and economic development
- Actual and potential growth
- The benefits and costs of economic growth
- Determinants of economic development
- Common characteristics of developing countries
- Role of agriculture and industry in economic development
- Obstacles to economic development
- The need for development planning
- Short term; medium term and long term planning tools
- Limitation of planning in developing countries
4.2.3. Money and banking 220.127.116.11 Money
- The nature and functions of money
- Demand and supply of money
- Theories of demand for money: The quantity theory, the Keynesian liquidity preference theory
18.104.22.168 The banking system
- Definition of commercial banks
- The role of commercial banks and non-banking financial institutions in the economy
- Credit creation
- Definition of central bank
- The role of the central bank; traditional and changing role in a liberalised economy, such as financial sector reform, exchange rate reform
- Monetary policy, definition, objectives, instruments and limitations
- Determination of interest rates and their effects on the level of investment, output, inflation and employment
- Harmonisation of fiscal and monetary policies
- Simple IS -LM Model
- Partial equilibrium and general equilibrium
4.2.4 Inflation and unemployment
- Definition and types of inflation
- Causes of inflation: cost push and demand pull
- Effects of inflation
- Measures to control inflation
- Definition of unemployment
- Types and causes of unemployment
- Control measures of unemployment
- Relationship between unemployment and inflation: the Phillips curve
4.2.5 International trade and finance
- Definition of International trade
- Theory of absolute advantage and comparative advantage
- World trade organisation (WTO) and concerns of developing countries
- Protection in international trade
- Regional integration organisations, commodity agreements and the relevance to less developed countries (LDCs)
- Terms of trade, balance of trade, balance of payments (causes and methods of correcting deficits in balance of payments), exchange rates types of foreign exchange regimes, factors influencing exchange rate foreign exchange reserves
- International financial institutions: International Monetary Fund (IMF) and World Bank
- National debt management: causes and interventions
- Structural Adjustment Programmes (SAPs) and their impacts on the LDCs
4.2.6 Current developments
- Factors affecting economic development: Informal credit market, development index, growth of market structures, voting behaviour technology transfer, democracy and development, environmental concerns.
- Introduction to economics……………………………………………………….7
- Demand, supply and determination of equilibrium……………………22
- The theory of consumer behaviour…………………………………………..60
- The theory of a firm……………………………………………………………….80
- Market structures……………………………………………………………..…..115
- National income………………………………………………………………………..136
- Economic growth, economic development and economic planning….170
- Money and banking…………………………………………………………….………194
- Inflation and unemployment…………………………………………………….….222
- International trade and finance……………………………………………………232
- Current developments………………………………………………………….…….269
INTRODUCTION TO ECONOMICS
DEFINITION OF ECONOMICS
The modern word “Economics” has its origin in the Greek word “Oikonomos” meaning a steward. The two parts of this word “Oikos”, a house and “nomos”, a manager sum up what economics is all about. How do we manage our house, what account of stewardship can we render to our families, to the nation, to all our descendants?
There is an economic aspect to almost any topic we care to mention – education, employment, housing, transport, defence etc. Economics is a comprehensive theory of how the society works. But as such, it is difficult to define. The great classical economist Alfred Marshal defined economics as the “Study of man in the ordinary business of life“.
DEMAND, SUPPLY AND DETERMINATION OF EQUILIBRIUM
In any economy there are millions of individuals and institutions and to reduce things to a manageable proportion they are consolidated into three important groups; namely
- Central Authorities
These are the dramatis personae of the economic theory and the stage on which much of their play is acted is called the MARKET (see lesson three for definition of market).
This refers to all the people who live under one roof and who make or are subject to others making for them, joint financial decisions. The household decisions are assumed to be consistent, aimed at maximizing utility and they are the principal owners of the factors of production. In return for the factors or services of production supplied, they get or receive their income e.g.
- Labour – wages and salaries
- Capital – interest
- Land – rent
- Enterprise – profit
THEORY OF THE CONSUMER BEHAVIOUR
APPROACHES TO THE THEORY OF THE CONSUMER
CARDINAL VERSUS ORDINAL APPROACH
Through the study of theory of consumer behaviour we can be able to explain why consumers buy more at a lower price than at a higher price or put differently why individuals or households spend their money as they do. We shall assume that the consumer is rational and aims at maximising his satisfaction, so given his income he consumes that basket of goods and services which produces maximum satisfaction. Two major theories explain the behaviour of the consumer, neither presents a totally complete picture. The first approach is the marginal utility, or cardinalist approach. The second approach centres on the indifference curve analysis or the ordinalist approach.
CARDINAL UTILITY APPROACH
The downward sloping nature of the demand curve can be explained by using the law of diminishing marginal utility. For instance, consider a consumer who ahs to choose between two goods, X and Y, which have prices Px and Py respectively. Assume that the individual is rational and so wishes to maximise total utility subject to the size of the income.
The consumer will be maximising total utility when his or her income has been allocated in such way that utility to be derived from the consumption of one extra shillings worth of X is equal to the utility to be derived from the consumption of one extra shillings worth of Y. In other words, when the marginal utility per shilling of X is equal to the marginal utility per shilling of Y. Only when this is true will it not be possible to increase total utility by switching expenditure from one good to another. This condition for consumer equilibrium can be written as follows:
Where MUx and MUy are the marginal utilities of X and Y respectively and Px and Py are the prices (in shillings) of X and Y respectively.
Any number of commodities may then be added to the equation. The table below gives
hypothetical marginal utility figures for a consumer who wishes to distribute expenditure of K£44 between three commodities X, Y and Z.
THE THEORY OF PRODUCTION
FACTORS OF PRODUCTION
The sum total of the economic resources which we have in order to provide for our economic wants are termed as factors of production. Traditionally economists have classified these under four headings. They are:
The first two are termed primary factors since they are not the result of the economic process; they are, so to speak, what we have to start with. The secondary factors, however are a consequences of an economic system.
- i) Land
The term land is used in the widest sense to include all the free gifts of nature; farmlands, minerals wealth such as coal mines, fishing grounds, forests, rivers and lakes.
In practise it may be very difficult to separate land from other factors of production such ascapital but, theoretically, it has two unique features which distinguish it.
Firstly, it is fixed in supply. As land includes the sea in definition, then we are thus talking about the whole planet, and it is obvious that we cannot acquire more land in this sense.
Secondly, land has no cost of production. The individual who is trying to rent a piece of land may have to pay a great deal of money but it never cost society as a whole anything to produce land.
DEFINITION OF A MARKET
A Market may be defined as an area over which buyers and sellers meet to negotiate the exchange of a well-defined commodity. Markets may also mean the extent of the sale for a commodity as in the phrase, “there is a wide market for this or that commodity”. In a monetary economy, market means the business of buying and selling of goods and services of some kind.
Concepts to know:
Average Revenue (AR): This is the revenue per unit of the commodity sold. It is obtained by dividing Total Revenue by total quantity sold. For a firm in a perfectly competitive market, the AR is the same as price. Therefore, if price is denoted by P, then we can say:
P = AR
Because of this, the demand curve which relates prices to quantities demanded at those prices is also called Average Revenue Curve. In economic theory, the demand curve or price line is often referred to as the revenue curve.
Marginal Revenue (MR): This is the increase in Total Revenue resulting from the sale of an extra unit of output. Thus, if TRn-1 is Total Revenue from the sale of (n-1) units and
TR n is total revenue from the sale of n units, then the marginal revenue of the nth unit is given as:
dTR = P(1 – 1/Ed) or TRn – TRn – 1
Total Revenue: The money value of the total amount sold and is obtained by multiplying the price by the total quantity sold.
DEFINITION OF NATIONAL INCOME
National Income is a measure of the money value of goods and services becominng 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.
THE CIRCULAR FLOW OF INCOME AND EXPENDITURE
This is an economic model illustrating the flow of payments and receipts between domestic firms and domestic households. The hoouseholds supply factor services to the firms. In return, they get factor incomes. With factor incoomes, they buy goods and services from the fir ms. These flows can be illustrated diagrammatically as follows:
ECONOMIC GROWTH, ECONOMIC DEVELOPMENT AND ECONOMIC PLANNING
THE DIFFERENCE BETWEEN ECONOMIC GROWTH AND ECONOMIC DEVELOPMENT
Economic Growth is a narrower concept than economic development .It is an increase in a country’s real level of national output which can be caused by an increase in the quality of resources (by education etc.), increase in the quantity of resources & improvements in technology or in another way an increase in the value of goods and services produced by every sector of the economy. Economic Growth can be measured by an increase in a country’s GDP (gross domestic product).
Economic development is a normative concept i.e. it applies in the context of people’s sense of morality (right and wrong, good and bad). The definition of economic development given by Michael Todaro is an increase in living standards, improvement in self-esteem needs and freedom from oppression as well as a greater choice. The most accurate method of measuring development is the Human Development Index which takes into account the literacy rates & life expectancy which affects productivity and could lead to Economic Growth. It also leads to the creation of more opportunities in the sectors of education, healthcare, employment and the conservation of the environment.It implies an increase in the per capita income of every citizen.
MONEY AND BANKING
THE NATURE AND FUNCTIONS OF MONEY
The development of money was necessitated by specialization and exchange. Money was needed to overcome the shortcomings and frustrations of the barter system which is system where goods and services are exchanged for other goods and services.
Disadvantages of Barter Trade
- It is impossible to barter unless A has what B wants, and A wants what B has. This is called double coincidence of wants and is difficult to fulfill in practice.
- Even when each party wants what the other has, it does not follow they can agree on a fair exchange. A good deal of time can be wasted sorting out equations of value.
- The indivisibility of large items is another problem. For instance if a cow is worth two sacks of wheat, what is one sack of wheat worth? Once again we may need to carry over part of the transaction to a later period of time.
- It is possible to confuse the use value and exchange value of goods and services in a barter economy. Such a confusion precludes a rational allocation of resources and promotion of economic efficiency.
- When exchange takes place over time in an economy, it is necessary to store goods for future exchange. If such goods are perishable by nature, then the system will break down.
- The development of industrial economies usually depends on a division of labour, specialization and allocation of resources on the basis of choices and preferences.
INFLATION AND UNEMPLOYMENT
DEFINITION AND TYPES OF INFLATION
The word inflation has at least four meanings.
- A persistent rise in the general level of prices, or alternatively a persistent falls in the value of money.
- Any increase in the quantity of money, however small can be regarded as inflationary.
- Inflation can also be regarded to refer to a situation where the volume of purchasing power is persistently running ahead of the output of goods and services, so that there is a continuous tendency of prices – both of commodities and factors of production – to rise because the supply of goods and services and factors of production fails to keep pace with demand for them. This type of inflation can, therefore, be described as persistent/creeping inflation.
- Finally inflation can also mean runaway inflation or hyper-inflation or galloping inflation where a persistent inflation gets out of control and the value of money declines rapidly to a tiny fraction of its former value and eventually to almost nothing, so that a new currency has to be adopted.
Demand-pull inflation is when aggregate demand exceeds the value of output (measured in constant prices) at full employment. The excess demand of goods and services cannot be met in real terms and therefore is met by rises in the prices of goods. Demand-pull inflation could be caused by:
INTERNATIONAL TRADE AND FINANCE
DEFINITION OF INTERNATIONAL TRADE
It is the exchange of goods and services between one country and another.
International Trade can be in goods, termed visibles or in services, termed invisibles e.g. trade in services such as tourism, shipping and insurance.
Reasons for the Development of International Trade
- Some goods cannot be produced by the country at all. The country may simply not possess the raw materials that it requires; thus it has to buy them from other countries. The same would apply to many foodstuffs, where a different climate prevents their cultivation.
- Some goods cannot be produced as efficiently as elsewhere. In many cases, a country could produce a particular good, but it would be much less efficient at it than another country.
- It may be better for the country to give up the production of a good (and import it instead) in order to specialize in something else. This is in line with the principle of comparative
- In a free market economy, a consumer is free to choose which goods to buy. A foreign good may be more to his or her liking. This is in line with the principle of competitive forces and the exercise of choice.
- Shortages: At a time of high domestic demand for a particular good, production may not meet this demand. In such a situation, imports tend to be bought to overcome the shortage.
FACTORS AFFECTING ECONOMIC DEVELOPMENT
Inflation affects both consumers and producers in the market, and poses a threat to the market stability. Throughout history, inflation has played a major role in the economy of nations. For example, after World War I, the German government printed a vast amount of money, which gave rise to major inflation in the economy of Germany. When people had money, but scarcity of products, the price of the products went sky high, as the value of money had gone down. Having plenty of money made the price go so high that people had to pay a large amount of money to by a simple loaf of bread. Currently, many nations of the world are facing similar financial crisis and economic downward trend, giving rise to a credit crunch.
When inflation affects the economy of a nation, you have to pay more money to maintain the same standards of living, and to purchase the same amount of goods and services, due to a rise in prices.
Interest rates can have a major impact on the growth of economy, especially for industries such as real estate, automobiles, and cruise companies. A larger interest rate would discourage customers from burrowing money and purchasing these products or services. It also discourages companies form making expansions, investing in new areas, making new capital investments, and starting new businesses.