Exhaustive University Study Guide: Principles of Microeconomics and Macroeconomics

The Foundation of Economics: Definitions and Methodology

• Etymology and Definition

  • Greek Origin: The word "Economics" originates from the Greek word "Oikonomos", meaning a steward. It consists of two parts: "Oikos" (a house) and "nomos" (a manager).

  • Alfred Marshall's Definition: He defined it as the "Study of man in the ordinary business of life," though this is often criticized as being too vague.

  • Paul Samuelson's Definition: "The study of how people and society choose to employ scarce resources that could have alternative uses in order to produce various commodities and to distribute them for consumption, now or in future amongst various persons and groups in society."

  • General Scientific Definition: The social science concerned with the allocation of scarce resources to provide goods and services which meet the needs and wants of consumers.

• Scarcity and Choice

  • Scarcity: In economics, scarcity means that resources are not enough to fill everyone's wants to the point of satiety. Resources are limited in both rich and poor countries.

  • Wants: A materialistic desire for an activity or an item. Human wants are considered infinite.

  • Economic Choice: Because resources are limited, people must choose alternatives. It is assumed that "Economic Man" chooses the alternative yielding the greatest satisfaction. Every choice involves a sacrifice.

  • Opportunity Cost: The cost of an item measured in terms of the alternative forgone.

• Scope and Characteristics of Economic Problems

  • Economic problems arise only when four characteristics coexist:

    1. Human ends (wants) are without limit.

    2. These ends are of varying importance.

    3. The means (time, energy, materials) for achieving ends are limited.

    4. The means have alternative uses.

• Methodology and Scientific Method

  • Empiricism: Testing ideas based on observed evidence.

  • The Scientific Method: Begins with formulating a theory, followed by a hypothesis, then testing against behavior.

  • Ceteris Paribus: A Latin expression meaning "all other things remaining constant." It is an essential component of the scientific method used to isolate the item under investigation.

• Economic Description and Analysis

  • Positive Economics: Concerned with objective, factual statements about what does or will happen. These statements are verifiable by facts (e.g., how a tax affects usage).

  • Normative Economics: Involves subjective value judgments and personal views. It focuses on what "ought to be" and is settled by political choice rather than science (e.g., whether taxation should "soak the rich").

• General Economic Goals

  • Control of inflation.

  • Reduction of unemployment.

  • Promotion of economic growth.

  • Attainment of a favorable balance of payments.

Economic Systems: Market, Command, and Mixed Economies

• The Three Fundamental Questions

  1. What commodities shall be produced and in what quantities?

  2. How shall goods be produced (what combination of land, labour, and capital)?

  3. For whom shall goods be produced (who enjoys the national product)?

• The Free Economy (Price System/Enterprise)

  • Definition: Decisions are the outcome of millions of individual choices by consumers, producers, and owners of services reflecting private preferences.

  • Consumer Sovereignty: Consumers are the "dictators" of the kind and quantity of commodities produced by bidding up prices for desired goods.

  • Key Features:

    • Private ownership of the means of production.

    • Freedom of choice and enterprise.

    • Self-interest as the dominating motive (profit/satisfaction maximization).

    • Reliance on the price mechanism (supply and demand determine market prices).

    • Competition involving many buyers and sellers.

    • Limited government role (provision of defense, police, and infrastructure).

  • Advantages: High incentives to accumulate wealth; consumer choice; efficiency driven by competition; flexibility to changes.

  • Disadvantages (Market Failures): Unequal distribution of wealth; under-provision of public goods (defense, health); negative externalities (pollution); hardship through unemployment; wasted resources in advertising or restricted competition.

• Planned Economies (Command System)

  • Definition: All major economic decisions—allocation, price levels, and distribution—are determined by a government ministry or planning organization.

  • Advantages: Potentially full use of factors of production (no unemployment); economies of scale through mass production; efficient provision of natural monopolies; focus on basic services rather than luxuries.

  • Disadvantages: Lack of consumer choice; little incentive for innovation or hard work; massive, potentially inefficient bureaucracy; high cost of maintenance for planning committees.

• Mixed Economy

  • Definition: Contains elements of both market and planned systems. The government controls the public sector (health, education, police) while the private sector is influenced by market forces but regulated by laws (safety, pollution).

  • Advantages: Provision of necessary non-profit services; retention of private sector incentives; price control via competition.

  • Disadvantages: Possibility of large private monopolies; significant bureaucracy and "red tape."

Specialisation, Division of Labour, and Exchange

• Specialisation: Concentrating on one specific activity or type of production.

• Division of Labour: Splitting the production process into a large number of individual operations, with each task assigned to a specific worker.

• Stages of Development:

  1. Specialisation by craft.

  2. Specialisation by process.

  3. Regional specialisation.

  4. International division of labour.

• Benefits:

  • Greater skill and task performance becomes automatic.

  • Saving of time between operations.

  • Employment of specialists suited for specific aptitudes.

  • Enables the use of specialized tools and machinery.

• Disadvantages:

  • Monotony leading to boredom and inefficiency.

  • Decline of craftsmanship and innovation.

  • Increased risk of unemployment if the specific skill is no longer needed.

  • Increased interdependency; inefficiency in one part can halt the whole system.

• Barter and Money: Specialisation requires exchange. Barter is the exchange of goods for goods. Modern economies use money as a medium of exchange to handle surpluses.

Demand Analysis and Market Dynamics

• Economic Dramatis Personae

  • Households: Demand goods, supply factor services (labour, land, etc.), aim to maximize utility.

  • Firms: Use factors to produce commodities, aim to maximize profits.

  • Central Authorities: Public agencies that exert control over markets and individual decisions.

• The Law of Demand

  • Ceteris paribus, more of a commodity is bought at a lower price than a higher price. The demand curve is downward-sloping.

  • Individual Demand Schedule: A plan of quantities demanded at different prices by one person.

  • Market Demand Schedule: The summation of all individual demand schedules for a given commodity.

• Factors Influencing Demand

  • Own Price: The primary determinant; inverse relationship with quantity demanded.

  • Prices of Related Goods:

    1. Complements: Goods used together (e.g., cars and petrol). If price of A rises, demand for B falls.

    2. Substitutes: Goods used in place of each other (e.g., butter and margarine). If price of A rises, demand for B rises.

  • Income: As income rises, demand for "normal goods" increases. For "necessities," demand remains constant. For "inferior goods," demand falls.

  • Taste and Preferences: Influenced by fashion, religion, and environment.

  • Population: Size and structure (ageing vs. young populations).

• Types of Demand

  • Competitive Demand: Between substitutes for consumer income.

  • Joint/Complementary Demand: Goods consumed together (cars and fuel).

  • Derived Demand: Demand for a factor of production derived from the final good (e.g., wood for furniture).

  • Composite Demand: A commodity with several different uses (e.g., wood for tables, beds, and windows).

• Exceptional Demand Curves (Reverse/Abnormal)

  • Giffen Goods: Highly inferior goods where demand rises as price rises (e.g., cheap necessary foodstuffs).

  • Articles of Ostentation: Snob appeal/conspicuous consumption; goods desirable only if expensive (perfumes, jewellery).

  • Speculative Demand: Buying more when prices rise due to fear of further increases.

Elasticity of Demand and Supply

• Price Elasticity of Demand (Ped)

  • Ratio of proportionate change in quantity demanded to proportionate change in price.

  • $Ped = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}}$

  • Point Elasticity Formula: $Ped = \frac{\Delta Q}{Q} \times \frac{P}{\Delta P}$

  • Arc Elasticity Formula: Uses the average of the two points.

  • Degrees of Ped:

    • Perfectly Inelastic: $Ped = 0$ (absolute necessity like insulin).

    • Inelastic: $Ped < 1$ (habit-forming goods).

    • Unit Elasticity: $Ped = 1$

    • Elastic: $Ped > 1$ (luxuries).

    • Perfectly Elastic: $Ped = \infty$ (perfect competition).

• Income Elasticity of Demand (EY)

  • $EY = \frac{\Delta Q}{Q} \times \frac{Y}{\Delta Y}$

  • Positive EY: Normal or luxury goods.

  • Negative EY: Inferior goods.

  • Zero EY: Absolute necessities.

• Cross Elasticity of Demand (Ex)

  • Refers to responsiveness of good B's quantity to good A's price.

  • Positive Ex: Substitutes.

  • Negative Ex: Complements.

• Price Elasticity of Supply (Es)

  • $Es = \frac{\text{Percentage change in quantity supplied}}{\text{Percentage change in price}}$

  • Factors affecting Es: Time (supply is more elastic in the long run), availability of resources, number of producers, ease of storing stocks, technology, and cost of production.

Market Equilibrium and Price Controls

• Equilibrium Price: The market price where quantity demanded equals quantity supplied.

• Mathematical Approach to Equilibrium

  • Linear Model:

    • $Qd = a - bP$

    • $Qs = -c + dP$

    • At equilibrium: $a - bP = -c + dP$

    • Equilibrium Price: $P = \frac{a + c}{b + d}$

  • Quadratic Model: Involves squared variables, yielding two solutions. Only the positive price is considered.

• Stable vs. Unstable Equilibrium

  • Stable: Forces push the market toward equilibrium if it diverges.

  • Unstable (Knife Edge): Divergence sets up forces that push the price further away.

• Price Controls

  • Price Floors (Minimum Prices): Set above equilibrium to assist producers. Often results in excess supply/surplus (e.g., agriculture price supports).

  • Price Ceilings (Maximum Prices): Set below equilibrium to assist consumers. Results in excess demand/shortages (e.g., energy crisis rationing).

• Agriculture Price Fluctuations

  • Caused by factors beyond producer control (weather, pests).

  • Cobweb Theorem: A dynamic model where adaptive expectations lead to perpetual price oscillations.

  • Buffer Stocks: Government buys surplus to store and sells during shortages to stabilize prices.

Theory of Consumer Behaviour

• Cardinal Utility Approach

  • Assumes utility is measurable in "utils."

  • Law of Diminishing Marginal Utility (DMU): As consumption increases, the marginal utility (extra satisfaction) of each successive unit decreases.

  • Equi-marginal Principle: Consumer maximizes utility when the marginal utility per shilling spent is equal across all goods:

    • $\frac{MU_x}{P_x} = \frac{MU_y}{P_y} = \frac{MU_z}{P_z}$

  • Consumer Surplus: The difference between what a consumer is willing to pay and the market price.

• Ordinal Approach (Indifference Curve Analysis)

  • Assumes consumers rank preferences rather than measuring utility.

  • Indifference Curve: Shows combinations of two goods providing the same satisfaction. Curves are convex to the origin and do not cross.

  • Budget Line: Shows combinations of two goods reachable with a given income and prices.

    • Slope: Represents the relative prices of the two goods.

  • Consumer Equilibrium Point: Where the budget line is tangent to the highest possible indifference curve.

• Income and Substitution Effects

  • Substitution Effect: Response to changes in relative prices with real income constant. Always leads to buying more of the cheaper good.

  • Income Effect: Response to the change in real income (purchasing power).

  • Inferior Good: Negative income effect is smaller than the substitution effect.

  • Giffen Good: Negative income effect is larger than the substitution effect; a fall in price results in a fall in quantity demanded.

  • Engel Curve: Describes how the purchase of a good varies with total income.

Theory of Production and Factors of Production

• Four Factors of Production

  1. Land: All natural resources; fixed in supply and has no production cost to society.

  2. Capital: Stock of wealth used for further wealth production. Divided into fixed capital (buildings) and working capital (raw materials).

  3. Labour: Human physical/mental effort for reward. Supply determined by population size, age structure, and wage rates.

  4. Enterprise: The entrepreneur who bears uncertainty and manages control.

• Production in the Short Run

  • At least one factor (usually land/capital) is fixed.

  • Total Physical Product (TPP): Total output realized.

  • Average Physical Product (APP): $APP = \frac{TPP}{L}$

  • Marginal Physical Product (MPP): Change in TPP from one extra unit of variable input.

  • Law of Diminishing Returns: Successive increments of a variable factor applied to a fixed factor will eventually result in a declining marginal product.

    • Stage I: Increasing returns.

    • Stage II: Diminishing returns (optimal stage for firm operation).

    • Stage III: Negative returns.

• Production in the Long Run

  • All factors are variable.

  • Returns to Scale:

    1. Increasing Returns to Scale: Output increases by a greater proportion than inputs.

    2. Constant Returns to Scale: Output increases in same proportion as inputs.

    3. Decreasing Returns to Scale: Output increases by a smaller proportion than inputs.

  • Isoquant: A curve showing combinations of two factors that produce the same level of output.

  • Isocost Line: Represents a given level of total cost.

  • Expansion Path: The locus of least-cost combinations of factors for different output levels.

Theory of Costs and Economies of Scale

• Short Run Cost Concepts

  • Fixed Costs (FC): Do not vary with output (rent, insurance).

  • Variable Costs (VC): Vary with output (labour, fuel).

  • Total Cost (TC): $TC = FC + VC$

  • Marginal Cost (MC): Increase in TC from producing one extra unit.

  • Lowest Point of AC: MC always intersects ATC at its minimum.

• Internal Economies of Scale

  • Technical: Indivisibilities, increased dimensions (e.g., bus vs. matatu), linked processes.

  • Marketing: Buying/selling in bulk, specialized advertising.

  • Financial: Better access to lower-interest loans.

  • Risk-bearing: Diversification reduces impact of failure in one area.

• External Economies of Scale

  • Concentration: Skilled labour pool in the area, infrastructure development.

  • Information: Specialist journals and research facilities.

  • Disintegration: Subcontracting specialized processes.

• Diseconomies of Scale

  • Bureaucracy: Slower decision making and loss of flexibility.

  • Loss of Control: Difficulty monitoring large workforces.

Market Structures: Perfect Competition to Oligopoly

• Perfect Competition

  • Assumptions: Many buyers/sellers (price takers), homogenous products, free entry/exit, perfect knowledge, profit maximization.

  • Short Run: Firm can make super-normal profits but price must cover Average Variable Cost.

  • Long Run: Freedom of entry ensures all firms make only "normal profits" (where $P = AC_{min}$).

• Monopoly

  • Definition: A sole seller in a market. A price maker.

  • Sources: Patent rights, natural monopoly (AC falls with output), exclusive control of inputs, market franchise.

  • Price Discrimination: Charging different prices for the same good based on segment price elasticity of demand (requires market identification and prevention of resale).

• Monopolistic Competition

  • Many producers selling differentiated substitutes.

  • Product Differentiation: Achieved through branding, packaging, after-sales service.

  • Excess Capacity Theorem: In the long run, firms produce at a level less than that which minimizes average cost.

• Oligopoly

  • Few large firms; highly interdependent decisions.

  • Collusive Oligopoly: Cartels (formal agreements like OPEC) or Price Leadership (informal agreement where one firm sets price).

  • Non-Collusive Oligopoly (Kinked Demand Curve): Suggests price rigidity. Raising price leads to massive loss of customers (elastic portion); lowering price leads to a price war (inelastic portion).

National Income Accounting and Macroeconomics

• Key Concepts

  • Gross Domestic Product (GDP): Value of output produced within the country borders.

  • Gross National Product (GNP): GDP plus net property income from abroad.

  • Net National Product (NNP): GNP minus depreciation (capital consumption).

  • Real GNP: GNP deflated for price changes using a price index.

• Measurement Approaches

  1. Expenditure Approach: $Y = C + I + G + (X - M)$

  2. Income Approach: Summing wages, rent, interest, and profits.

  3. Output Approach: Also called the "Value Added" approach to avoid double counting.

• The Keynesian Multiplier and Accelerator

  • Multiplier (k): The ratio relating a change in GDP to the initial autonomous increase in expenditure.

    • $k = \frac{1}{MPS} = \frac{1}{1 - MPC}$

  • Accelerator (\beta): The ratio of induced investment to the increase in income.

  • Business Cycles: Fluctuations in output around the long-term trend (Slump, Recovery, Boom, Recession).

Money and Banking

• Functions of Money

  • Medium of exchange.

  • Unit of account.

  • Store of wealth/value.

  • Standard of deferred payment.

• The Banking System

  • Commercial Banks: Accept deposits, advance loans, and provide clearing services.

  • Credit Creation: Banks create money by lending out a portion of their deposits. The Deposit Multiplier is $1/r$ (where r is the cash ratio).

  • Central Bank Roles: Government's banker, banker's bank (clearing house), issuer of currency, lender of last resort, manager of national debt.

• Monetary Policy Instruments

  • Open Market Operations (selling/buying securities).

  • Discount Rate (Bank Rate).

  • Variable Reserve Requirements (Cash/Liquidity ratios).

  • Moral Suasion and Selective Credit Control.

Inflation, Unemployment, and Trade

• Inflation

  • Types: Demand-pull (demand > supply at full employment); Cost-push (rising wage costs/import prices).

  • Effects: Money loses value; income distribution worsens; can lead to balance of payments deficits.

• Unemployment

  • Types: Transitional (job seekers moving), Structural (industrial/technological shifts), Cyclical (depression), Urban (migration), Disguised (apparent employment with zero marginal productivity).

  • Phillips Curve: Illustrates the inverse relationship between the rate of inflation and the unemployment rate.

• International Trade

  • Theory of Absolute Advantage: A country specializes in goods it produces more efficiently than others.

  • Theory of Comparative Advantage: Focuses on lower opportunity costs. Trade is beneficial even if one country is more efficient in everything, provided the relative efficiencies differ.

  • Balance of Payments (BOP): Record of all transactions between residents and foreigners. Divided into Current Account, Capital Account, and Monetary Account.

• Structural Adjustment Programmes (SAPs)

  • IMF/World Bank policies for LDCs including currency devaluation, privatization, and cuts in social spending. Often criticized for hurting the poor while attempting to manage debt.

Questions & Discussion

1. Write short notes on: Scarcity and choice, Opportunity cost, Production possibility frontier, Positive and normative economics.

2. Specialisation benefits & limitations: Discuss the impact of specialization on productivity versus worker monotony and craftsmanship.

3. Define cross-price elasticity: Explain values for substitutes and complements.

4. Factors of production: What determines the supply and demand for identified factors?

5. Monopoly comparison: In what ways does a perfect market differ from a monopoly, oligopoly, and monopolistic competition?

6. Price Control: Discuss the short and long-term implications of decontrolled prices.

7. National Income: List the different methods of estimating national income and state problems experienced in computation.