ECONOMICS STUDY TEXT

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1 ECONOMICS STUDY TEXT Page 1

2 GENERAL OBJECTIVES 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. CONTENT 4.1 Microeconomics 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 Demand, supply and determination of equilibrium Demand analysis - Definition - Individual demand versus market demand - Factors influencing demand - Exceptional demand curves - Types of demand

3 - 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 Supply analysis - Definition - 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 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 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 4.1.4 The theory of a Firm 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 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 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 Macroeconomics 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

5 - 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 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 Money and banking 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 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

6 4.2.4 Inflation and unemployment Inflation - Definition and types of inflation - Causes of inflation: cost push and demand pull - Effects of inflation - Measures to control inflation Unemployment - Definition of unemployment - Types and causes of unemployment - Control measures of unemployment - Relationship between unemployment and inflation: the Phillips curve 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 Current developments - Factors affecting economic development: Informal credit market, development index, growth of market structures, voting behaviour technology transfer, democracy and development, environmental concerns Emerging issues and trends CHAPTER 1 INTRODUCTION TO ECONOMICS

7 Introductions to Economics When you hear of the term economics, what comes up in your mind? Most people relate economics with money only. Yet economic discipline is very big and deals with more than money. Let s explore and understand the basics of economics. We can better appreciate the definition of economics by examining different definitions of economics which can be classified into: 1. Science of Wealth Early economist understood Economics as study of wealth. Adam Smiths laid foundation of Economics as a study and emphasized the need to increase society`s wealth as the subject matter of economics. 2. Science of Material Well Being Towards the end of 19 th Century, writers explained economics as a science which studied economic goods or wealth in their relation to man. We can therefore say that economics involves management of society resources since they are scarce. You can also say that economics is the study of how society manages its scarce resources. Economist s studies how people interact with each other. They analyze forces and trends that affect the economy e.g. unemployed population and inflation. Scope of Economics On the other hand we need understand the scope of economics to understand the subject better. The scope of economics can be described by proper understanding of its subject matter and its nature as a science. To understand it better, let s understand the following concepts; Subject Matter of Economics Adam Smith the father of Economics considered economics as a science of wealth. Alfred Marshal made it the study of material welfare. Hence economics studies how many uses the material requisites for his wellbeing.

8 Activity Would you consider Adam smith definition of economics or Alfred Marshal`s definition? Discuss. Economic Problem What do you think economics helps you to achieve? How does it help you? You can only understand the concept by analyzing the concept of economic problem. Economic problem concerns the ends to be achieved and the means to achieve these ends. Therefore any typical economic problem e.g. a drought in Kenya, lack of enough hydropower is addressed by the following: 1) What to produce. 2) How to produce. 3) For who to produce. 4) Problem of economic efficiency. Nature of Economics Would you consider economics as an art or a science? It s generally accepted that economics is a social science which deals with human behaviour in solving economic problems arising from multiplicity of wants and scarcity of means. But is it a positive science or normative science? Positive science describes things as they are. Normative science describes things as of what they ought to be. We can say that positive science studies existing facts but does not comment on whether they are desirable. Normative science comments on the desirability or observed facts in the context of being ethical Activity Would you consider legalizing of drug trafficking as application of positive or normative economics? Methodology of Microeconomics You are now familiar with economics as a subject. Let s now examine the subject matter of our course which is microeconomics. Microeconomics is a study of economics which deals with

9 small and individual units of an economy. It s the study of particular firms, particular households, individual prices, wages, income, individual industries and particular commodities. It s observing the economy through a microscopic view to find out the working of markets, for individual commodities and the behaviour consumers and producers. Distinction between Micro Economics and Microeconomics Microeconomics studies the behaviour units, the households, firms etc Macroeconomics deals with economic affairs in large and overall dimensions of economics life such as employment, determination of output and income, fluctuations of income, trade cycles, growth and international trade. Microeconomics is based on independence of individual units. Macroeconomic theory considers interdependence among the individual units. Economic models The study of economics involves understanding various building of models to increase our understanding of the real world economic models. You will analyze very many economic problems using the models. But what are they? An Economic model is an organized set of relationship that describes the functioning of an economic identity under a set of assumptions from which a set of conclusions is logically derived (Economic identity means households, industry, a region or an economy). Economic model is a set of economic relations expressed through a set of mathematical equations. A model is built for two main purposes; 1. Analysis (explanation) Prediction How would you build and test an economic model To define the problem Formulate assumptions Collect data Derive logical deductions

10 To Test the Model Empirically. To accept project or revise the model Let s illustrate a sample model by considering the Production Possibility curve model. One popular model in economics is the Production Possibility Curve model. Let s see what it analyzes and how. Production Possibility Curve model Production possibility curve is an analytical tool used to illustrate and explain the problem of choice. Assumptions 1. Only two goods X (consumer goods) and Y (Capital goods) are produced in different proportions in the economy. 2. The same resources can be used to produce either or both goods and can be shifted freely between them. 3. The supplies of factors are fixed. But can be reallocated for the production of goods within limits. 4. Production techniques are given and constant. 5. The economy s resources are fully employed and technically efficient. 6. The time period is short. Explaining the Production Possibility schedule /Curve Possibilities Quantity of X Quantity of Y P B C D P P and P1 are possibilities in which the economy can produce both 250 units of Y and 250 units X with given.

11 2. The PP schedule shows that when the economy produces more units of X it produces less units of Y successively. 3. In other words, the economy withdraws the given quantities of factors from production Y and uses them in production of more of X. Activity Can you now draw the Production Possibility Curve from the above schedule? The Concept of Equilibrium You already have heard of the term equilibrium. What do you think the term means? An equilibrium is a position of rest characterized by absence of change. There is complete agreement of economic plans of the various market participants. All decisions by the participants in the market are in unity with each other. Partial Equilibrium analysis We can now examine the significance of partial equilibrium having seen what equilibrium is. It s the study of an individual, a firm, an industry or a group of industries viewed in isolation to understand the equilibrium. Economic Systems Have you ever come across people comparing how market dynamics such as pricing, distribution of goods and services, ownership etc work from one country to another? In some countries, financial systems and the way people work have some similarities. In others, things are completely different. Why do we have these differences? Some of them can be explained by the economic systems that we have. Economic Systems refers to the way economic elements, individual workers, firms, government agencies are linked together to form an organic whole. In the recent past there has been criticism of capitalist system which is being blamed for the current economic crises in USA. It s seen to be the origin of global financial crisis. We can now study it to understand the system.

12 Capitalism It is a system in which consumers or producer of resources are engaged in economic activities with a large measure of economic freedom. Features Private property. Profit motive is a paramount goal. Price mechanisms are not controlled by central authorities. Role of state was confined to maintenance of law and order. Competition implies large number of buyers and sellers. Socialism It is an economic organization in which land, labour, organization and capital are owned and regulated by the state. There is collective ownership and regulation by the government. We generally have the following features: a) Public ownership of means of production and distribution. b) Central planning of the economy. c) Equality of income distribution. The prices are controlled by and regulated by central planning authority This is a SAMPLE (Few pages have been extracted from the complete notes:-it s meant to show you

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