managerial economics
TRANSCRIPT
MANAGERIAL ECONOMICS MODULE
Managerial Economics is about making decisions. Specifically managerial economics is
defined as the integration of economic theory and methodology with analytical tools for
application to decision making about the allocation of scarce resources in public and
private institutions (Seo and Winger 1979). We study Managerial Economics because it
helps us to make better decisions.
The basis, however, of studying Managerial Economics is by way of looking at the
Economic Theory with its two branches which are:
1. Microeconomic Theory which deals with decision making within individual units
such as households
business firms and
public institutions
2. Macroeconomic Theory which is concerned with the overall level of economic
activities and the economic cyclical behaviour. The macroeconomic theory deals
with the interaction of broad economic aggregates such as:-
- consumption
- spending
- investment
- inflation
- employment
- fiscal and monetary policies
THE DECISION MAKERS’ OBJECTIVES
The assumption in general is that any organization’s goal is to maximize benefits
provided by the organization’s operations in relation to its cost i.e. to maximize the
benefit-cost margin.
Different Economic Systems
Managerial Economics is practised in every economic system. The common economic
systems are:
1. Free enterprise (capitalism).
2. Centrally planned (communism and socialist)
3. Mixed Economy
CAPITALISM
It is an economic system in which the means of production are owned and operated by
individual owners or capitalists. It is also referred to as free enterprise. This type of an
economy is based on Adam Smith’s philosophy of the invincible hand where he describes
how competition in free markets would influence production in ways that would increase
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public well-being. Under such circumstances, production is directed mainly by what
consumers want. Free Enterprise is mainly practised in the United States of America and
has the following characteristics:
1. Private ownership of capital or means of production.
2. Free enterprise which means the ability to start or dissolve any business
operations
3. Free markets, which means a competitive market place which determines supply
and demand of goods and services
4. Freedom of choice for people to buy what they please and to work where they
wish.
5. Individualism which means that the groups, the society and the government are
necessary, but are less important than the individuals’ self-determination.
6. Limited Role of Government. In capitalist societies, the people dislike
excessive government interference in their personal and business lives.
CENTRALLY PLANNED ECONOMY
Both communism and socialism are discussed under centrally planned economies which
some authors refer to as command economies or collectivism. Centrally planned
economies are characterized by the following.
1. Government ownership of the means of production and control of all economic
activities.
2. Central Planning which means that the government drafts a master plan of, what it
wants to accomplish and directly manage the economy to achieve the planned
goals
3. The planners determine the following:-
- what will be produced
- how it will be produced
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- how much will be produced
- how the products and services will be distributed.
Collectivism is mainly practised in China, Cuba, Sweden, Denmark.
MIXED ECONOMY
The economy is characterised by both private and public ownership of the means of
production.
The mixed economy is what we usually experience the world over. Individual buyers
and sellers will not be in a position to arrange for the production of such things as roads
and bridges, educational opportunities for all, equipment for national defence and public
buildings.
ECONOMIC GOALS
Naturally, every economic system has economic goals it would want to achieve given the
limited resources. The economic goals are as follows:-
1. Full Employment by having useful jobs for all those who are willing and able to
work . Although difficult to achieve full employment is an important goal to
achieve for basically two reasons.
a. the greater the employment, the greater is the economy’s aggregate output
b. the greater the unemployment the more must the employed share their income
with the unemployed through mechanisms like free health, free education etc.
(Chisholm and McCarty (1978)
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As such achievement of full employment makes everyone better off.
2. To promote Economic Growth by increasing the amount of goods and services
available to the citizens. Growth is made possible through increased productivity
of labour and capital.
Labour becomes more productive through increased education and training, and capital
becomes more productive through technological improvements and more intensive use.
Both processes require shifting of resources away from current consumption to
investment i.e. to say, people will be saving more and consuming less so that funds will
be available for investment.
This saving investment process is helped by an efficient financial sector.
3. To promote a Rising Standard of Living which is basically achieved by
producing more quality goods and services.
4. To promote Price Stability in order to prevent inflation and deflation in the
values of the national currency.
5. To promote stability in the Balance of Payment and Foreign Exchange Rates.
The BOP is a record of all transactions between one country and all other
countries. The record shows whether for example Zimbabwe is buying more or
less from other countries than the other countries buy from us. If it buys more
than it sells to those countries it will have a unfavourable balance of payment. If
the above is the situation then Zimbabwe may either have to lower the price
(exchange rate) at which it sells its products so that it can sell more. If the
exchange rate is lowered, the costs of imports increase.
6. The goal of efficiency : Efficiency is defined as the degree to which an economic
system uses its resources to produce the maximum amount of wanted or needed
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goods. An efficient system would minimize waste. Efficiency is closely related
to productivity and growth.
FACTORS OF PRODUCTION
For any economy to achieve the economic goals it has to use the factors of production
efficiently. By combining the factors of production the output realized in the form of
goods and services. The factors of production are as follows:-
1. Land: Land as a factor of production consists all of the original and irreplaceable
resources of nature. It includes such things as minerals, timber etc. Land is a
fixed resource and the reward or price paid for its use is rent. Land together with
labour, capital and entrepreneurship, are combined to produce valued goods and
services. Otherwise it will be valueless.
2. Labour: Labour is both the unskilled and skilled efforts directed towards the
creation of goods and services. It includes manual work, brain work and creative
work. The quality of labour improves with better health and education.
Unskilled labour is generally, in abundance while highly skilled labour is often scarce in
areas where it is most needed.
In Zimbabwe our employment market is flooded with unskilled labour, and this has
resulted in our dependance on imported labour (expatriates) in the short-run.
The price of labour is wages and its directly linked to the price of products produced. If
the price of labour goes up i.e. if wages go up, the price of goods and services will go up
in turn. This is so because wages are part of the variable costs incurred by a producer
during the production process. That cost is in turn passed onto the consumer as high
prices of the products.
Besides wages, labour also recieves other benefits such as sick leave maternity leave etc,
labour also receives a salary. A salary is different from a wage in the sense that the
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person who gets a salary takes part in the organising and management of business. Again
a salary remains fixed over a period of time and is paid on a monthly basis whereas
wages are often paid on a weekly or by weekly basis.
3. Capital: Capital as a factor of production is composed of machinery, equipment,
buildings. Capital is also referred to as a produced means of production simply because it
consists of goods we have produced, but are kept aside to produce other goods and
services.
The function of capital goods is to assist labour in the production process. In other
words, capital goods assist labour to increase production of goods or services. The price
of capital is interest.
4. Entrepreneurship: Entrepreneurship encompasses initiative and willingness to take the
risks involved in managing a business operation. This factor of production is viewed as
the most important one which involves the bringing together of the other factors into a
creative and productive way, by the entrepreneur.
The entrepreneur assumes the risk of organising and managing the other factors of
production with the hope of making some profit, which is the reward for
entrepreneurship. Profit is the motivating factor, to the entrepreneur, for bringing the
factors of production together.
What is business? All profit-directed economic activities that are organised directed to
provide product and services.
PRODUCTION POSSIBILITIES
Our wants are unlimited, but the resources, with which to satisfy them are very scarce.
This is the Fundamental Economic Problem with its two sides-scarce resources and
unlimited wants especially as societies become more affuluent. Scarcity is not the same
as poverty. In other words we have to prioritize our needs within the limits of our
resources. Given such a situation, it requires that we make a choice amongst a number of
alternatives – alternatives such as choosing to produce more capital goods or more
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consumer goods. This also calls for an efficient use of the resources and the technology
available when making the choice of goods and services to be produced.
Every time we make a decision to produce something we choose to forego the alternative
which we could have produced, the cost of this foregone alternative is known as the
OPPORTUNITY COST, (Neil Fuller) Foundation Economics 1987.
An efficient use of the resources and the technology available demands that a nation
prioritises its needs and wants. In other words given the fact that human wants are
unlimited, but resources are limited a nation should consider producing those products
and services that give the population highest utilities and those alternatives with a high
opportunity cost.
Making choices based on Opportunity Cost
Wants are arranged according to priorities and priorities that have large opportunity costs
have to be dealt with first. The changing pattern of opportunity costs is called the law of
increasing costs.
For example, a nation may be faced with a problem of creating more jobs for those
citizens who are able and willing to work, like here in Zimbabwe. At the same time the
nation may be faced with problems of building civic centres where citizens may hold
different functions. Faced with such a problem, a nation has to identify the more
important issue of the two and the one with the high opportunity cost and allocate
resources accordingly. If the resources are very limited a nation may consider to allocate
those limited resources to creating more jobs which programme will benefit more
citizens, and will contribute towards the raising of the standard of living.
At any time, a nation has a number of wants to satisfy and at the same time it has a
number of alternatives from which list it draws its priorities. How choices are made are
influenced by a unique combination of resources in a most efficient manner. For example
an abundance in capital goods would lead to capital intensive production.
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In most cases, at the top of the list, would be the most urgent wants with high opportunity
costs and further down the list would be wants of lower priority with smaller opportunity
costs. But whatever combination of goods a nation chooses to produce there should be
no under-utilization of resources and the opportunity cost should be considered.
Going back to our example of choosing between building a civic centre and investing the
resources into creating more jobs for the citizens, we will find out that the opportunity
cost of not creating more jobs for those citizens who are able and willing to work is much
higher than that of not building a civic centre. In such a case, more jobs for citizens will
be at the top of the priority list.
When a nation chooses to produce a combination of products, it should consider how best
the resources can be utilized so as to avoid increasing costs or diminishing returns. For
whom to produce in a free market economy is determined by the value the system places
on the contribution, to the economy, of each sector of society.
Table 1
Production Possibilities per Year
WHEAT (IN TONNES) MOTOR CARS
Combination 1
Combination 2
Combination 3
Combination 4
Combination 5
10 000
9 000
7 000
5 000
0
0
1 000
2 000
3 000
4 000
Wheat
Production
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In 000s of Tons 14
12
10
8
6
C
4 D
2
0 1 2 3 4 5
Production of cars in 000s
Figure 2/1 shows the combination of wheat and cars that could be produced by a country
without under-utilizing its resources, and all the possible combinations lie on the curve.
If a country produces a combination of wheat and cars that falls out of the curve, at point
D, it means that it is under-utilizing its resources and technology. Point C is also out of
the productivity curve and it means that a nation can not possibly produce such a
combination because it does not have enough resources or adequate and appropriate
technology to produce such an output.
The proceeding discussion is a theoractical explanation of how people make choices as to
what to produce given the limited resources. As a choice is made something has to be
given up and the fore-gone cost of the alternative choice is called the opportunity cost.
For example, as society chooses to produce 10 000 tons of wheat, it produces zero cars.
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Then when it chooses to produce a thousand cars it foregoes the production of 1 000 tons
of wheat.
LAW OF INCREASING COSTS OR LAW OF DIMINISHING RETURNS
To begin with, lets assume that a government in making choices of what to produce, has
chosen to allocate resources for the production of a combination of wheat and cars. If the
government wants to increase the production of wheat, it removes some of the workers
from the car factory to come and work in the wheat field.
If the government wants to increase car production, it may do so by transferring workers
from the wheat field to the car factory in the short run. As more workers are transferred
to the wheat field, it becomes more expensive to increase the workers because the wheat
field will get to be too small to have all workers on it.
In fact, each additional worker unit applied to the land produces less and less output per
unit than earlier units. At the same time if workers are moved to car factories each
additional worker has less machinery to work with, some will stand idle but will still be
paid thereby increasing the costs.
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PART II
BUSINESS CYCLES AND THE OVERALL ECONOMY
As a nation strives to achieve the goal of economic growth especially, a number of people
are involved. It is common sense that in achieving growth and economic stability politics
play a major role. The same people who make economic decisions also make political
decisions.
The politicians as they run a nation are mainly interested in maintaining economic
stability because with economic stability the nation is at least guaranteed of achieving
three goals which are:-
1. it would grow steadily over the years
2. give a job to everyone who wanted one
3. maintain a stable price level.
However, as much as government would want to achieve the above goals it is so hard to
control economic stability because a number of different forces are at work in each and
every economy. The forces sometimes work at cross purpose. For example, the forces
that maintain high employment are the same forces that tend to give us higher prices.
The fluctuations of the economy are referred to as the business cycles. Those
fluctuations happen every now and then and affect economic growth. The economic
fluctuations tend to be cyclical. Inflation and Price stability, unemployment and full
employment, growth and declining output, all tend to recurr periodically in some related
fashions.
As the economy goes through the fluctuations the economic activities are measured to see
how well the economy is performing. That economic output is measured as Gross
National Product (GNP). It is the measurement of the total output of all the production
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by a national economy. In fact it is the market value of all goods and services
produced during a given period of time (normally a year) “Market Value” here means
the actual prices at which the goods and services are sold, and are measured in a
country’s local currency.
What is measured under Gross National Product?
1. Goods and services purchased by individuals.
2. Investments by both businesses and individuals
3. Government Expenditures
4. Export of goods and services
GOODS AND SERVICES PURCHASED BY INDIVIDUALS
This category includes the total value of all goods and services bought by individuals for
their own use, and also those purchase made by non-profit institutions such as churches
and schools. The goods bought are divided into two categories, durable and non durable
goods respectively.
The durable goods do not quickly wear out. They have a relatively long life. These
include cars, refrigerators, television sets, and furniture. There are also some durable
services such as the medical bills, lawyers bills and education bills. The non durable
goods are those with a very short life, such as petrol, clothing and food.
INVESTMENTS
This is the amount of money spent during a particular year on capital goods such as new
machinery, equipment, office buildings, factories, and warehouses. Every year
businesses replace some of their old machines and the money they spend in doing so
becomes part of their investments. Furthermore, business inventories which comprise of
raw materials, goods in process and finished goods are also part of investment.
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GOVERNMENT PURCHASE OF GOODS AND SERVICES
Government is one of the nation’s biggest buyers of goods and services. Millions of
dollars are spent each year on national defence, and for the operations of the
government’s many branches and agencies, large amounts of money are also spent on
constructing roads, bridges, schools and hospitals.
EXPORT OF GOODS AND SERVICES
A country imports (buys) and exports (sells) goods and services to the world at large. If
it exports more than it imports then the net export figure can be shown as a plus on the
GNP and that denotes a favourable balance of trade. If it imports more than it exports,
there will be a negative figure on GNP which denotes an unfavourable balance of trade.
BUSINESS CYCLES
GNP is strongly influenced by the up and downswings of the economy. These
fluctuations which are regular and last for a period of 3-12 years are referred to as
business cycles.
The business cycles come in different forms.
The drought of 1981-84 was a business cycle which resulted in low GNP. All the major
determinants of GNP were seriously affected by the drought. Individuals had to control
their spending power and buy just the necessities of life, because the future was
unpredictable. Besides, their disposable income was reduced when government
introduced a surcharge tax of 2.5% on top of the already stipulated income taxes they had
to pay. The 2.5% was taxed on both individuals and companies and the money was put
aside as drought relief fund. Companies’ investments process was also affected.
Currently workers in Zimbabwe are contributing 3% of their salaries towards the Aids
Levy and that has, a negative effect on the workers’ disposable income.
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Presently our GNP is affected by the shortage of Foreign Currency. Both the private and
public sectors cannot expand their factories’ production output and buildings because
they do not have enough foreign currency to buy new machinery or raw materials.
A Typical Business Cycle and the Phases it Goes Through
Peak
Slowdown
GNP
In
$ Trendline
Recession
Expansion
Recovery
Depression
Time
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Expansion
At this stage the output of goods and services is increasing rapidly. Unemployed
resources are being put to use. People’s income and consumption increase as they
(people) get employed and cause firms to increase the output of goods and services. The
investors consider the business climate favourable and are inclined to expand their firms.
At this stage interest rates increase. This is bad for those who want to borrow funds, but
good for those seeking to lend their savings. Prices may begin to rise due to rising
consumption patterns which may result into demand pull inflation.
Peak
The next stage is the peak or boom or prosperity. At this stage the economy will be
producing as much as possible. Almost all available resources will be employed
especially present plant capacity and labour.
Incomes are quite high and people are willing to spend. Investors try to expand their
operations to take advantage of the consumption which is on the rise. Interest rates are
high and prices may now begin to rise rapidly to inflationary levels. Most people are
pleased with the way the economy is performing. But this does not remain like that
forever.
Slow down and decline
At the peak stage the prices are inflationary and people begin to find it difficult to spend
their money on the costly goods. As that happens, sales of goods and services go down.
Inventories begin to build up, and that results into cutting down on production thus laying
off some workers. Idle capacity will start to be realized in the different sectors of the
economy. Prices may not decline but there will not be much of a tendency for them to
rise either. Interest rates will fall since people will not be inclined to borrow more
money in the face of an uncertain economic future. If the decline persists it culminates
into recession.
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Recession
At this stage output of goods and services has seriously dropped and if this continues
unabated it culminates into depression.
In most cases the nation would not sit and watch the economy getting into depression.
Normally government intervenes at recession stage using its economic tools such as the
fiscal policy or monetary policy.
Depression
This is the bottom of the cycle. Unemployment will be high and consumption is
seriously reduced. People just buy the basic necessities of life. Old equipment is not
replaced. Machines and buildings may lie idle because there is no demand for goods and
services.
The economy cannot perform any worse than the depression stage. Instead it recovers
and begins to expand as government implements the fiscal and monetary policies.
Recovery
After the depression stage the economy bounces back into recovery. This might be as a
result of low interest rates which lure investors into borrowing money and start producing
goods and services. Government normally play a leading role by spending on public
sector investment programmes. As it invests in building bridges, schools etc, people get
employed and start to buy more goods and services. Then the next stage will be
expansion.
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Causes of Business Cycles
A closer look at the business cycle will help bring up the things that make business cycles
happen. The causes of the business Cycle include:
changes in the demand of goods and services by both individuals and the
government,
changes in money supply, changes in business investments,
population changes and
normal psychological factors.
1. Changes in Demand of Goods and Services
Changes in demand of goods and services by individuals, businesses and
government do cause a business cycle. If individuals start to spend more money
because they have more income, maybe because the government has cut down
income taxes, the economy will improve. At the same time if the government
spends more money on its various programmes, such as defence, construction of
bridges, hospitals etc, the economy will improve. On the other hand, if
individuals and the government reduce their spending, the economy will slow
down.
2. Changes in the Money Supply
Government can either slow or increase economic growth through the supply of
money thereby implementing a monetary policy. If the economy is growing too
rapidly, and the prices are sky rocketing, the government may choose to follow a
contractionary monetary policy, whereby it cuts down the supply of money.
When that happens, borrowing of money becomes difficult. Those businesses
that depend on borrowed funds will be forced to cut down on production because
of the scarcity of money. By the same token government may stimulate the
economic growth by manipulating money supply.
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3. Changes in Business Investments
Business investments play a major role in increasing or decreasing economic
growth. If business firms increase their investments either because there is more
money supply or because individuals have more to spend on goods and services,
the economy will improve. If there is little demand for their products the
businesses will slow down on production.
4. Population Changes
Business cycles may also be caused by population changes, and this is directly
linked to changes in demand of goods and services. As the number of people
increases, naturally, the demand for goods and services also increases thereby
tempting business firms to produce more.
5. Psychological Factors
In some cases, both individuals and business firms’ anticipations may cause
business cycles. For example if people believe that the economy is strong, they
are likely to buy more, and they even buy some goods on credit with the hope to
pay for them with future income. At the same time they feel comfortable enough
to borrow money from financial institutions.
On the other hand if they anticipate a decline in economic activities, they
(individuals) will reduce their spending and in turn business activities will
decline.
In Zimbabwe, since independence, industry has been hesitant to increase
investment; particularly foreign firms for political fears. At the same time those
in the real estate business have been investing in new buildings or acquiring old
ones for resale and the real estate business has been brisk in Zimbabwe.
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6. Other exogenous factors such as drought, political situation or politics of the
nation. In Zimbabwe ever since 1982 when the country experienced the first
severe drought after independence, the country has been experiencing more
severe droughts at intervals of 10 years; and they have negatively affected the
output of the economy.
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PART III
THE ECONOMY AND THE FIRM
A firm refers to a complete business organization or enterprise which is involved in
administration of human and non-human long range resources, planning, production and
sales. Thus a firm is part of an industry. For example, Astra Paints is part of the Paint
Industry. The industries in turn belong to sectors such as the Manufacturing Sector,
Mining Sector etc.
The business firms are organized in different ways. Basically there are three types of
business ownership which are single proprietorships, partnerships and corporations. In
Zimbabwe, the co-operative type of ownership is also featuring.
TYPES OF BUSINESS ENTERPRISES AND THEIR SOCIAL
RESPONSIBILITIES
1. SOLE PROPRIETORSHIP
It is the type of business organized and owned by one person, the proprietor. The sole
proprietor is normally the manager of the business firm and he bears all the risk involved
in running a business, and his reward is the profit he hopes to make from the business
operations.
His/her initial capital is limited and his liabilities are not limited. Should he/she become
insolvent the debtors can sell the proprietor’s personal belongings to get their money
back.
Advantages
Simple to start
Proprietor owns all profits
Personal satisfaction
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Sole decision maker
No tax on business as distinct from owner
Easy to dissolve
Disadvantages
Unlimited financial liability
Hard to raise funds for expansion
Often has no one to share management burden
2. PARTNERSHIP
Two or more people may share the ownership of a business firm and co-operate in the
management. The partnership arrangement enables the owner to raise more capital than
the sole proprietor. In addition to capital, they also combine their skills together. A
Partnership can either be limited or unlimited. With the limited partnership, the owners’
personal possession are protected in case the business fails to pay its debts. The debtors
can only take what partners will have contributed towards the business.
The unlimited partnership is vulnerable. Should the business become insolvent, the
debtors will sell the partner’s business and personal possession to get their money back.
Lawyers, accountants, doctors often form partnerships.
Advantages
Few restrictions on starting
Pooling of funds, talents, and borrowing power
More chance to specialize than Sole proprietorship
Personal satisfaction
No tax on business as distinct from owners
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Disadvantages
Unlimited and joint financial liability
Potential for personal disagreements
Relative impermanence
Frozen investment
A joint venture is a special type of partnership set up by individuals or firms to
accomplish a specific task or project. The task or project often is short-term. Once it has
been accomplished, the joint venture ends.
3. THE CORPORATION
To avoid the inconvenience created by the other two types of business ownership, a
corporation my be formed. A corporation is an artificial being, invisible, intangible and
existing only in contemplation of law. (Musselman and Hughs, Introduction to modern
Business). In other words, a corporation is a separate and legal entity apart from its
owners. A corporation is based on the principle of limited liability, which means that the
owners are liable for the debts of the corporation only to the extent of their stock
holdings.
Legally as an artificial being, the corporation can sue and be sued and what happens to it
in the courts has no bearing on the lives of the owners and managers unless they
themselves have done something illegal. The owners are the stock holders who invest
their money in return for a share of the profits made.
Advantages
Separate legal entity
Limited financial liability of owners
Long life
Easy transfer of ownership
Greater financial capability
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Disadvantages
Special and double taxation
Complex and costly to form
Government regulation and public disclosure requirements
4. CO-OPERATIVE
According to the former Ministry of Co-operatives, cooperatives are economic
enterprises carrying out economic objectives aimed at improving human living standards.
A co-operative can also be defined as a business owned by and operated for the benefit of
its user-members, each of whom has one and only one vote in elections.
In this section, the business firm is going to be the center of discussion. As stated before,
a business firm is involved in the Administration of human and non-human resources
through its personnel department. To qualify to be called a business firm, it must be
involved in some production of goods or services.
FRANCHISING
It is a situation where a firm called a franchisor, licences others (franchisees) to use the
idea, name and procedures an to sell its products or services in return for royalty and
other types of payments.
The franchisee is the firm that is licensed to use the franchisor’s business idea and
procedures and is often granted and exclusive right to sell the franchisor’s products or
services in a specified territory.
The franchisor and the franchisees are related to each other through the franchising
agreement. The agreement is a contract between a franchisor and a franchisee that spells
out the rights and obligations of each party. The agreement creates a franchise, a
frachising system, a franchisor and a franchisee [Reinecke, Dessler, Schoell 1989].
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Advantages
1. Frachisee Recognition – identified with the parent firm.
2. Management Training and Assistance many franchisors operate training
schools for franchisees where they are taught business skills like record keeping,
purchasing, marketing customer relations and quality control.
3. Economies in Buying
A franchisor can make or buy ingriedients or supplies in large volume which are
resold to franchisees at lower prices.
4. Financial Assistance
Usually, a franchisee puts up a certain percentage of initial costs to cover the cost
of land, buildings, equipment and promotion. The franchisor helps with the rest
in the form of a loan. The franchisor also sells supplies to franchisees on credit.
Drawback to Franchising
1. Unscrupulous franchise promotors might be selling franchises that have
little merit
2. Monthly payments must be made to the franchisor even if profits are low
3. There is little room to be creative because product and operations are
uniform
4. There is less independence than you might expect, since the franchise
might specify the products you sell, your business hours and your record
keeping procedures
5. Other franchisees might start in nearby areas thereby saturating the
market.
6. The franchisor might be unable to live up to commitments in the
franchising agreement
7. Poor performance by some of the franchisor’s other franchisees might
harm your business’s image
8. Franchisors often make policy decisions without consulting their
franchisees.
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BUSINESS SOCIAL RESPONSIBILTIES
Business firms do not operate in a vacuum. Their operations are influenced by different
environment such as the natural/physical environment, social, political and legal
environment. As business firms operate in these different environments they also have to
meet some social responsibilities.
Business firms are responsible to different people in different ways. A business firm is
responsible to the following people:-
1. owners
2. customers
3. creditors/suppliers
4. employees
5. government
OWNER CUSTOMER
COMMUNITY BUSINESS FIRM CREDITORS
GOVERNMENT EMPLOYEES
Businesses’ Social responsibilities
1. OWNERS : The firm is responsible to the stockholders or owners by making sure that
the business is viable – that is protecting their investment. Normally the viability of the
business is achieved through making profits and growth and that will allow owners to
earn some interest on their investment. When the business expands, it can enter into new
markets and provide more goods and services, and with growth normally, increased
profits are realized.
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2. CUSTOMERS : The ultimate success or failure of every business rests with the
customer says R HODGETS. If customers buy the business’ goods or services, it
will survive. If they do not then it will collapse. Different firms or businesses
have adopted different slogans as a way of identifying themselves with the
customers. For example JAZZ STORES where the customer is king and Sales
House, the People’s Store. OK Bazaar where the Nation shops and serves. New
up to date devices are used to keep the customer satisfied. For example in the
banks, there are computers used to speed up the services given to the customers so
as to keep them satisfied. When they get satisfied normally they will keep on
coming back.
3. CREDITORS : These are the people to whom the business owes some money.
They may have provided the firm with supplies or materials or even loaned funds
to the firm. The firm’s responsibility to these people is to repay the debts as they
fall due.
4. EMPLOYEES : Employees produce goods and services sold by the firms. The
social responsibility of the firm to the employees is to provide good salaries, good
working conditions, job security and satisfying work.
5. GOVERNMENT : Business has a social responsibility to abide by the law in all
its operations. The operations refer to the actual buying and selling of goods and
also the hiring of employees. The business should not discriminate on the basis of
race, sex or age. A business should render proper tax returns, observe proper
wages, overtime and implement pension schemes etc.
6. COMMUNITY : Business has a social responsibility to make the community a
better place in which to live. Business must play an active role in trying to solve
common community social problems like alcoholism and drug abuse amongst
teenagers. At the same time firms have an obligation to keep the environment
clean.
Besides the above mentioned social responsibilities, business is faced with more current
challenges such as:-
equal opportunity in employment
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protection of environment (ecology)
better and safer products (consumerism
Equal opportunity in employment means that people who are able and willing to work
should not be discriminated against because of race, age, sex, or religion. In Zimbabwe,
we probably could tie this up with the Black Advancement Policy advocated by the
Ministry of Labour Manpower Planning and Social Welfare in 1984.
Protection of the environment as discussed above means that the business firm has an
obligation to keep the environment clean. The business firms must see to it that they do
not pollute the water we drink with the chemical waste they discharge.
They must see to it that they do not pollute the air we breathe with the dark clouds of
smoke they release every day and society must also be safeguarded against the noise
pollution it is exposed to.
Consumerism is the most interesting of the three social challenges in that it directly
affects the customer. In fact, according to V.A MUSSELMAN and E.H HUGHES in
their book, Introduction to Modern Business, Consumerism is defined as a movement to
inform consumers and protect them from business mal-practices.
Consumers are becoming more aware of their rights. They want information about what
they are buying. In fact, the movement focuses on inferior and dangerous merchandise,
unfair business practices and false or misleading advertising. In Zimbabwe, we have the
Consumer Council of Zimbabwe which is advocating the consumer rights.
Basically, there are four consumer rights which in 1962 President J.F KENNEDY of the
United States of America outlined and he wanted them guaranteed by law. These are the
basic consumer rights we still adhere to even today.
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1. The right to safety – to be protected against the marketing of goods which are
hazardous to health or life.
2. The right to be informed – to be protected against fraudent, deceitful businesses.
3. The right to choose – have access to a variety of products and services
4. The right to be heard.
BASIC MARKET MODELS OR STRUCTURES
Business firms operate in a competitive environment naturally, but the degree of
competition depends on the firm’s size and the industry it is in. To understand the degree
of competition involved, the whole market is divided into four market models, which are
as follows:-
1. Pure competition
2. Pure monopoly
3. Monopolistic competition
4. Oligopoly
PURE OR PERFECT COMPETITION:
Features of Perfect Competition
a) There must be many small buyers and sellers in the market. The law of supply and
demand must prevail.
b) The products of the industry must be all alike – must be homogenous or identical.
For example, at the Farmer’s Market Musika at Mbare, there are many small sellers
and buyers and the products are homogenous. The sellers bring tomatoes, potatoes,
carrots, cabbages, fruits etc.
c) The buyers and sellers must have complete knowledge of MARKET conditions
In other words, buyers must understand what products are available how they are to be
used and what their prices are throughout the market. Knowledge of market conditions
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will allow consumers to buy the most wanted goods in the markets where they are most
plentiful and selling at the lowest prices. Sellers must also have complete information
about prices and production costs throughout the market so as to enable them to supply
goods and services to markets where they are scarce and selling at the highest prices.
Furthermore, sellers or producers must have complete information about how each and
every producer is making the products. This however, does not work out that way
because of too much competition among companies. In fact, there are records of
companies who have hired spies to find out what their competitors are doing.
Fortunately, companies are protected by patent laws which entitle the inventors to a
monopoly on the use of the new processes or products for a period of time, ensuring an
advantage over competitors.
d) Buyers and sellers must be mobile and react quickly to news of MARKET
Conditions.
Buyers must move to areas where goods are in abundance and prices are low, while
sellers move to areas of scarcity where prices are high.
PURE MONOPOLY:
The monopoly market structure illustrates one extreme example – that of one seller who
supplies the industry’s entire output. The single seller may achieve its monopoly position
through providing a unique service. Maybe by having information that is not available to
other firms or by taking advantage of the lack of mobility of other sellers.
FEATURES OF A PURE MONOPOLY MARKET STRUCTURE
a) The presence of a unique good or service which only that firm, in the whole industry
can provide. Consumers cannot buy the product anywhere else, and with such
strength, the monopoly firm has the power to set a price anywhere on its demand
curve.
b) Information barrier. The monopoly may have information that is not readily available
to other firms wanting to enter the industry.
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c) Lack of mobility. Other firms which want to enter the industry might not be mobile.
Mobility here encompasses availability of large capital investment to begin an operation.
On the other hand, the existing monopoly may enjoy economic of scale – that means that
it spreads its capital costs over a large volume of output thereby keeping unit costs low,
whereas a new firm entering the market will be experiencing increasing economies of
scale – having higher production costs. Furthermore, the new firm may not be in a
position to meet the high expenditure necessary to advertise the new product.
Monopolies do exist in every economic system. In Zimbabwe, the parastatals we have
such as National Railways of Zimbabwe, Air Zimbabwe, Post and Telecommunications,
etc can be equated to monopolies and companies like Leyland and Dahmer Coach
Builders.
A monopoly normally sets its own prices, and high prices too. It does not follow the law
of supply and demand. In most cases the government will have to step in to regulate the
price.
MONOPOLISTIC COMPETITION
We have discussed the tow extreme market structures – pure competition and pure
monopoly. In between the two extremes, there are two other market structures. These
are the monopolistic structure and oligopoly. The two market models contain some
elements of both perfect competition and pure monopoly and they reflect more on the
conditions of actual markets.
Monopolistic competition is more or less pure competition in that there are small buyers
and sellers, and in a way it is also similar to pure monopoly in the sense that the goods on
the market are homogenous yet it can never be like a pure monopoly because capital
requirements are generally so low that many small firms can enter the industry. Most of
the shops we have such as dry cleaners,restaurants, department stores or supermarkets fall
under monopolistic competition. Each shop tries to distinguish its products from those of
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its competitors, through product differentiation. This is a way of attracting customers.
Product differentiation allows a firm to establish some monopoly control over price.
Prices may go up and buyers still buy the product because they are loyal to a particular
brand. For example, some people will always prefer Tanganda Tea to any other brand
even if the price of Tanganda Tea were to go up.
Another characteristic of monopolistic competition is that due to the large number
of firms on the market, output for each firm is less than maximum, resulting in
higher unit costs. The prices charged are higher than under pure competition due
to product differentiation. There is also heavy use of resources to maintain
product differentiation through advertising.
OLIGOPOLY: The oligopoly market structure has fewer firms. They maybe as few as
three or as many as thirty with just two or three dominant firms. Their production is
carried out on a large scale and they tend to grow through mergers. Examples we have in
Zimbabwe will be the Lonrho Group of Companies, TA Holdings, Apex Corporation and
Delta Corporation to mention a few. Small firms combine to enlarge their market share
or they are absorbed by bigger firms which become the holding companies.
Oligopoly firms have high overhead costs for plant equipment, advertising and executive
salaries, but their great volume in output permits the large firms to spread their costs over
a larger number of units thereby enjoying economies of scale. The few firms have
market power due to their small numbers and that enables them to keep prices higher than
the production costs
The firms know each other well and they react to each other’s challenges quickly. They
tend to work together when changing prices. Non price methods of competition like
aggressive personal selling and advertising play an important role with oligopoly firms.
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Common Exit Barriers Include the Following:
1. Investments in plant and equipment that have no alternative uses and
cannot be sold off. Therefore, if the company wishes to leave the industry,
it has to write off the book value of these assets.
2. High fixed costs of exit, such as severance pay to workers who are being
redundant
3. Emotional attachments to an industry, such as when a company is
unwilling to exit from its original industry for sentimental reasons.
4. Strategic relationships between business units. For example, within a
multi-industry company, a low-return business unit may provide vital
inputs for a high-return business unit based in another industry. Thus the
company may be unwilling to exit from the low-return business.
5. Economic dependency on the industry, as when a company is not
diversified and so relies on the industry for its income.
ENTRY BARRIERS
1. Economies of scale
2. Product differentiation done by firms to promote their products
3. Capital requirements to enter a market limit the number of potential entrants
4. Access to distribution channels may be limited
5. Absolute cost advantage – buying supplies in large quantities that allows
discounts
6. Government policy
7. Threat and retaliation.
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PART IV
SUPPLY AND DEMAND
How much to produce and for whom to produce are questions that are easily answered by
the market system. Households and business firms interact and it is through that
interaction that some indications are seen as to what households want produced by firms.
As households buy goods and services they are in fact voting for the kinds of goods and
service they prefer.
The market system is also called the price system or supply and demand system, and it
determines what prices to charge for a product. Prices perform two basic functions on the
market which are:-
1. a rationing function
2. an incentive function
By using prices, the available goods and services are rationed out among buyers
according to their purchasing strengths. Those who have more money and are willing to
spend it will buy more goods and services.
Prices also function as an incentive for producers to produce more. Normally, where
demand is high, price will rise. For example, there is a strong demand for residential
houses in Zimbabwe for the present time and the prices offered are quite high. These
high prices are seen as an incentive to the people in real estate business and to those in
the building industry as a whole.
Theoretically when demand falls prices normally fall too. Under such circumstances,
firms will cut back on production releasing resources for use in other industries where
there is more demand for the products and services.
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Prices, as can be deduced from the preceeding explanations, determine how we should
employ our scarce resources to provide for our unlimited wants. In other words price
determines what to produce. As discussed before, people show their support for a
product or service by the price they pay for it (the product). The production depends on
the relative prices of the resources involved. Normally, the most plentiful resources have
the lowest prices but as resources become scarce, prices rise and discourage their use. At
the same time, advances in technology may lead to production of cheaper products.
THE LAW OF DEMAND
The law of demand states that consumers normally choose to buy fewer units of a good at
high prices and more units at low prices. (Chisolm and Mccarty, Principles of Economics
1978). Consumers find the low prices as an incentive to buy more.
Theoratically, lets look at the behaviour of buyers of tomatoes as depicted by the
schedule below:-
DEMAND FOR TOMATOES
PRICES/KG QUANTITY IN KGs
$1000 20
750 40
500 70
250 90
100 100
The demand schedule above shows the quantity of a good (in our case tomatoes) that a
particular consumer would buy at various price levels. The same combination of quantity
demanded and the price levels can be shown in a graphical way.
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DEMAND CURVE
Price 1000
800
600
400
200
020 40 60 80 100
Quantity
When the points are connected with a line they produce what is known as a demand curve
and a characteristic that is true of all normal curves is that they are downward sloping
(from left to right).
The downward sloping is due to the fact that at high prices, consumers demand less of the
good and at low prices, they demand more of the good. Demand for any goods and
services can change any time due to several factors, some of which we have discussed
under Business Cycles. So besides price, demand for goods and services can change
because of the following:-
1. a change in consumer’s income (money supply)
2. a change in consumer’s taste or preferences
3. change in the number of consumers in the market for a given product (population
changes)
4. the prices of other goods consumers may choose to buy instead of the particular
product.
5. What consumers expect to happen to the economy, or to the part of it that
concerns them (psychological factors).
A change in any of the above mentioned factors will change the demand for a particular
product.
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TASTES
Tastes give rise to fashion changes, if people’s tastes did not change, there probably
would be no changes in fashions. Dresses that were bought like hot cakes last year may
not be selling well this year because people’s tastes have changed. For example when the
Georgette type of dress came into fashion, many women went crazy about it, songs were
composed of women who complained that their men/husband’s love was not meaningful
because they had not bought them Georgette dresses. The fashion was popular but now
its a thing of the past.
When taste change the demand curve shifts to the right if the demand for the product
increases or to the left if demand decreases.
Price
D2 D1
Quantity
INCOME
Changes in consumers’ income also affect demand for goods and services. When people
earn more money they are likely to buy more goods and services, particularly things they
have not been able to afford before. For example if a family’s income increases, the
family can afford to have a family doctor for consultations instead of just going to the
clinic. Another concrete example, is that when Zimbabwe became independent, the
minimum wage was introduced which meant that the majority of the working people
began to earn more money. With such an increase in peoples’ income, there was a
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scramble for houses in law density areas. The demand for houses increased, pushing the
demand curve to the right, which pattern it is still maintaining. With changes in their
income, consumers will also demand some of the luxury goods such as cars, television
sets and expensive furniture.
PRICES OF RELATED GOODS
Demand for a good may be affected by a change in the price of another good. For
example, if the price of beef increases, people switch to eating more chicken, pork or fish
if that is less expensive; and switch back to beef when it becomes affordable again.
An increase in the price of margarine is likely to increase the demand for butter. These
are called substitute goods where one may be replaced by the other. On the other hand
there are complimentary goods like fuel and automobiles. An increase in fuel may result
in a low demand for motor cars.
NUMBER OF BUYERS
This is closely related to population changes. An increase in the number of consumers in
the market will obviously increase the demand for a product. The increase may be as a
result of large families, resettlement, or better transportation methods, which can
transport the goods to a greater number of customers.
EXPECTATIONS
Expectations are the same as psychological factors in business cycles. This simply means
that if consumers expect their incomes to increase in the near future, they are likely to
buy more expensive items than if they expect the incomes to decline. Much of the credit
buying of such goods as TV sets, stereo sets, and expensive clothes is done with the
expectation of paying for them out of future income.
If customers expect the prices of goods to rise, they may be induced to buy them for
storage and if they anticipate shortages, they may buy in panic.
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The consequence of such kind of buying is a great demand for the product so much that it
may be unavailable in the short run.
On the other hand, if people are not secure because of some external forces such as
drought, or banditry activities, they are likely to postpone many purchases so as to keep
money for more hard times. For example, during the drought period of 1982/84 there
was a drop in sales of many consumer goods such as TV sets, cars and furniture. People
were concerned mainly with the basics of life such as food and clothes.
CHANGE IN DEMAND VS CHANGES IN QUANTITY DEMANDED
There is a difference between a change in demand and changes in quantity demanded.
Each of the proceeding factors can cause a change in demand and make the demand
curve either shift to the right if there is an increase or to the left if there is a decrease in
demand. In other words, a change of any of those factors, leads to a different level of
sales at every price. Changes in demand cause the demand curve to shift to the right (if
demand increases) or to the left (if demand decreases).
On the other hand a change in the quantity demanded occurs when prices change but
other factors mentioned above remain the same; (ceteris paribus). For changes in quantity
demanded, the curve remains the same, moving along the curve leads to a different level
of sale at the new price.
Some examples from the real world, showing the difference between changes in demand
and changes in quantity demanded:-
1. If the number of teenagers in the population increases (60% of the Zimbabwe
population). The demand for soft drinks increases meaning that larger quantities
would be bought at every price. This is a change in demand, which will cause the
demand curve to shift to the right from D1 to D2.
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2. Falling incomes, would force people to postpone purchases of new household
appliances. Smaller quantities would be bought at every price. This is a change
in demand, as demand decreases, the demand curve shifts to the left from D1 to
D2.
3. Lower prices for stereo equipment lead to larger sales. This is a change in
quantity demanded. Owners of new stereos buy more records, thus increasing
the demand for records since they are complimentary goods. There is a change in
demand for records, and the demand curve will shift to the right.
SUPPLY
Customers or consumers demand what they are provided by the firms or precisely by
sellers. The sellers decide what to supply to customers and how much they will supply at
any given price.
The principle guiding the sellers’ decisions is called the law of supply which states that
sellers normally choose to provide smaller quantities of a good at low prices and larger
quantities at high prices.
This is the case because of the fixed quantity of some resources of the firm. Resources
like the plant and equipment are designed to produce certain amounts of output over
some limited range of time. To push quantity produced by the same fixed resources in
the short run, results in inefficiency which involves higher production costs for each
additional unit. Under such conditions, if suppliers are to produce more, they must be
offered a higher price so that they can cover the costs. If the price is low, suppliers will
reduce their output.
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SUPPLY OF TOMATOES
PRICE PER KG QUANTITY IN KG
$1000 100
750 90
500 70
250 40
100 20
The combination of prices and quantities above give rise to what is called a supply
schedule. The schedule shows the relationship between quantity and price during a
particular period of time, with the assumption that all other things remain the same
“ceteris paribus”. The line connecting the points on the graph above is called the supply
curve and generally supply curves slope upward. This is because higher prices generally
mean larger quantities.
$
Price Supply Curve
1000
800
600
400
200
0 20 40 60 80 100
Quantity in Kgs
As time moves on other things may change causing the supply curve to shift to the right
or to the left. For example, if more tomatoes become available on the market, at every
price, it means the curve will shift to the right, and if there are less tomatoes on the
market, the curve will shift to the left.
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CHANGES IN SUPPLY
A number of things may happen which may result in a change in supply. These include
the following:-
1. Changes in the Cost of Production The cost of supplying a good or service
may fall because of improved technology or because the prices of resources used
in production have fallen. In the case of tomatoes, prices could go down because
the farmers have modern machines for tiling the fields thereby employing less
labour. The opposite would be the case if farmers employed more labour which
will increase production costs and prices.
2. Prices of Other Goods Farmers who produce tomatoes produce onions, okra,
cabbages and other vegetables as well. In most cases they produce that
combination of products that are profitable to them. For example, a farmer may
produce a combination of maize and cotton. If the price of maize begins to fall,
the farmer will plant more acres of cotton. When that happens, the supply curve
of cotton will shift to the right and that of maize will shift to the left.
3. Changes in the Supplier’s Expectatins about Prices The supply of a good or
service will change if the price of such a good or service has not risen yet but is
expected to rise in the near future. The expectations of suppliers will cause
supply to change resulting in shortages of the good or service in the short run.
This has been a common trend of business in Zimbabwe due to supply shortages
of goods.
Presently in Zimbabwe builders and real estate agents are heavily investing in building
residential homes because they expect a continuous upswing in the prices of houses. This
results in the supply curve shifting to the right.
4. Change in the Number of Suppliers If more suppliers bring their tomatoes on
the market, at the same prices, there would be more supply and the supply curve
will shift to the right. This is under the assumption that other tings remain the
same and supply only is changing.
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CHANGES IN SUPPLY VS CHANGES IN QUANTITY SUPPLIED
The phrase “all other things remain constant” has been used a number of times in this
section. Under supply, the things that have to remain constant are the four factors
discussed above. If one of them changes, a new supply curve will have to be drawn
showing either an increase or decrease in supply.
A change in quantity supplied comes about as a result of a change in price. This is what
we have on supply schedule at the beginning of the discussion on supply. As prices
increase, quantities supplied also decrease – the law of supply.
MARKET EQUILIBRIUM
It will probably make life a bit easier if we start by defining market equilibrium. This is a
point on either the schedule or graph where quantity supplied equals quantity demanded.
Supply and demand go hand in hand, that is why economists, whenever they speak of
supply, they speak of demand as well. This is because the interaction of supply and
demand is what determines the actual prices at which goods will be sold and the actual
quantity that will be exchanged.
DEMAND FOR AND SUPPLY OF TOMATOES
PRICES PER KG QUANTITY DEMAND QUANTITY SUPPLY
IN KGS IN KGS
$1000 0 100
750 30 75
500 50 50
250 75 25
100 90 10
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1000 Supply
Price
800
600 Equilibrium
400
20 Demand
0
20 40 60 80 100
Quantity in Kgs
Figures above show the market equilibrium for demand and supply of tomatoes in both
schedules and graph form. The demand and supply curves intersect where we have the
Equilibrium Price and Equilibrium Quantity of .50 and 50kgs respectively.
To explain further, the concept of market equilibrium, we can see from both the schedule
and the graph that quantity supplied at the price of $1.00 is greater than demanded.
Sellers are at a disadvantage and have to make some adjustments in order to get rid of
their tomatoes before they go bad. As such they move down the supply curve by
reducing the price. By making such a move, they (sellers) invite more buyers who are
willing to buy more quantities as the price falls thereby moving down their demand
curves.
Finally, a price is reached that just clears the market, that is where quantity supplied is
equal to quantity demanded. At that point the market is said to be in equilibrium. There
is Equilibrium Quantity and at Equilibrium Price there is no surplus or shortage.
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At a price of .50 cents a kilogram, buyers willing to pay this price will be satisfied and all
suppliers willing to provide tomatoes will be satisfied. With such an analysis, we come
out with what is called a price system where the law of supply and demand is left to
determine prices for all goods and services.
In real life, the price system does not work due to a number of factors which are as
follows:-
1. Changes in Supply and Demand Market equilibrium keeps on changing due to
a number of factors such as
consumer tastes,
consumer income,
natural factors such as the weather.
For example, due to too much rain, the tomatoes rot and the farmers harvest very small
quantities that season. The supply of tomatoes will fall and the prices will in turn go up
thereby creating a new market equilibrium.
Because of the poor harvest the supply curve has moved to the left, thereby creating a
new market equilibrium.
As much as supply can change, demand can change too. It can either decrease or
increase. Suppose demand increases, the general effect of such an ocurrance will be a
change in market equilibrium with the new equilibrium price and equilibrium quantity.
E1
Price E D1
D
Quantity
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If demand was to fall and supply remain the same, the equilibrium price and quantity will
also fall. If supply increases and demand remains the same, the equilibrium price will
fall and quantity will increase.
Supply
E
Price E1 D
D1
Quantity
If buyers expect prices to fall, they will postpone their purchases and curves will shift to
the left in the short-run. By the same token, suppliers can increase their supply if they
expect prices to fall in the near future. The changes in supply will shift the supply curve
to the right in the first instance and to the left in the second instance – these are the
immediate effects of the supplier’s actions.
What we have been discussing about market equilibrium is true under the assumption that
all other things remain the same (ceteris paribus). In the real world it is difficult to
control the movements of everyday events in our economy, and as such market
equilibrium may not occur at all.
Market equilibrium may not occur due to price rigidity or sticky prices. Prices do not
always respond quickly to changing market conditions, especially if they (prices) are
falling. In most cases sellers will hold on to the high prices until they have been
discovered by the legal authorities.
The shortages and surpluses we experience every now and then prevent market
equilibrium. Shortages usually occur as a result of sellers who are willing to sell their
products below the equilibrium price. When that happens, demand for the product
increases while supply remains the same and the result is a supply shortage. Suppliers
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in this case charge a higher price than the equilibrium price which repels buyers from
buying and hence the suppliers remain with a surplus.
Price controls which the government set in order to protect the interests of low and
middle income consumers may also affect the market equilibrium. Normally, the
government will either set a price which should not be surpassed and that is the price
ceiling or a price sellers should not go below – which is the price floor.
If sellers sell below the price ceiling, there will be more demand for the goods and
services resulting in shortages. If they sell above the price floor, demand will fall and
the result will be a surplus of the goods and services.
Elasticity and demand
To begin with, elasticity literally means flexibility. Economically, elasticity measures the
response of quantity demanded to a change in price, and the price can either increase or
decrease. Elasticity is just a convenient shorthand way of expressing the important
relationship between price and quantity demanded.
Normally, the extent to which a consumer purchases certain units of a product depends
on the utility he/she gets from consuming the particular products. The utility of a
product diminishes as more units of that product are consumed. For example, if a person
is hungry and he/she gets a plate of food, the usefulness of that plate is quite high. After
eating that plate, if he/she is brought another plate of food the usefulness of that second
plate might be nil or very little. This trend of diminishing utility of the next product
consumed is referred to as diminishing marginal utility. Marginal means additional
purchase. So if the marginal utility of products falls the consumer is no longer interested
in that product. Normally marginal utility is expressed in terms of price as Mu/p.
The marginal utility of products is influenced by some factors such as substitution and
income.
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The Substitution Effect
In life, we find that some goods have consistently high marginal utility because they are
easily substituted for other goods when a consumer shops around. For example, chicken
can easily substitute for beef because they have similar characteristics. If the price of
beef rises consumers tend to eat less beef and more chicken because the Mu/p. will have
diminished for beef. If the price of chicken goes down more chicken will be consumed
because Mu/p. will have gone up.
In essence, the substitution effect and the Mu/p. ratio are an extension of the law of
demand which states that consumers buy more at low prices and less at high prices.
The Income Effect
Income can also influence the demand for a product. For example, if a price of a good or
product falls, consumers have more income to spend on all the things on the shopping
list.
When income increases, the goods households buy are further subdivided durable and
non durable goods into superior and inferior goods. When households have more
disposable income they buy more superior goods and those they buy less are called
inferior goods.
Superior goods include beef, designer clothes, TV sets, etc and inferior goods include
chicken, pork, matemba, canvas shoes, etc.
The Circular Flow
The relationship between buyers and sellers can simply be illustrated by a simple diagram
called the circular flow.
1. flows of spending from buyers to sellers
2. flows of goods and services from sellers to buyers.
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THE CIRCULAR FLOW
INCOME (Wages, Rent, Interest, Profit)
(income
approach to GDP
Factors of Production
HOUSEHOLDS BUSINESSES
Goods and Services
Expenses approach to GDP
Consumer Expenditure
From the above diagram we can also talk about National Income, which refers to the
system of adding up all goods and services produced in an economy. This is also referred
to as National income Accounting which results into gross National Product (GNP).
Gross National Product then is a measure of the market value of all the goods and
services produced during a given period of time (usually a year). Market value here
refers to the actual prices at which goods are sold.
DIFFERENT APPROACHS TO CALCULATING GNP
1. GNP using the output approach which measures output of the economy at the
sources of production which include households, firms, government and net
exports. Adding up of the production of goods and services in each of the sectors
will result in the GNP figure.
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2. GNP using the expenditure approach. That is referred to as GNE and it measures
the payments made for goods and services therefore GNE=GNP.
3. GNP using the Income Approach (GNI) that involves measuring income earned
by the factors of production in the form of wages, salaries, rent, profits, interests
and dividends. Therefore GNP=GNE=GNI
GNE (Flow of Expenditure) GNI (Flow of Income)
1 Households’ purchases Wages and salaries
2 Gvt purchases Rent, Profit, Interest and dividends.
3 Business Exp on Capital Investment Other indirect charges
4 Net Exports
SAVINGS AND INVESTMENT (John Maynard Keynes’ Theory)
If people save, then demand for goods is reduced. Investment adds to the circular flow it
results into the hiring of workers to produce goods and services.
Sources of Aggregate Demand are Consumption+ Investment+ General expenditure
+Net Exports. Consumption mainly by households and it depends on income. At lower
levels of income there is a higher propensity to consume and vise-vesa. Other
determinants of consumption include changes in tastes, changes in liquid assets owned,
expectations, cultural attitudes and other demographics.
SAVING depends on disposable income. Therefore Savings=DI-Consumption.
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PART V
PRICING PRODUCTION AND COST ANALYSIS
PRICING OBJECTIVES
Each firm pricing a good or service must determine what is to be accomplished by its
pricing plans. Managers should know why certain prices are being charged as well as
why these prices might differ from buyer to buyer and from time to time. Because many
objectives are possible, various forms of pricing mechanisms have been developed. A
firm could face any number of problems and choose from among a great number of
objectives. Some of these objectives are shown in Exhibit 5-1, along with possible
pricing steps to be undertaken for each objective.
The important thing to note is that each price strategy, each type and level of price, has
logic and reason behind it. Prices are set to help bring about a result. The hoped for
results is the pricing objective. Clearly the organization needs such objectives because
“price” suggests a vast array of dollar values from one cent to millions of dollars.
Objectives narrow the range of possibilities considerably and that greatly facilitate the
determining of price.
Objectives Must be Consistent
Although we are concerned here with pricing, it should be remembered that pricing
objectives must be coordinated with the firm’s other objectives. These must, in turn,
flow from the company’s overall objectives.
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EXHIBIT 5-1Some Organisational Objectives and the Role Pricing Can Play in Attaining Them
Objectives MainlyConcerned with: Pricing Steps Taken Why Take Such Steps?
Income*Achieve a target ROI Identify price levels that Firm may have a required
will yield the required return on investment and return on investment. may drop product lines that
cannot reach that return.
*Increase cash flow Adjust prices and discounts Company may face a seriousto encourage purchases and cash flow problem and be rapid payment. Unable to meet its
obligations
*Maximize profits Control costs and adjust “All” companies would likeprices to achieve point-of- to achieve profit profit maximization. Maximization for obvious
reasons. Some come close to this goal, particularly for certain items in their product mixes.
*Keep a going concern Adapt prices to permit The organization may be for the organization to “hold sale, and it is easier to sell a on” in periods of business going-concern than one that downturns or until a buyer is out of business.can be found.
Sales*Maintain a share of Assure that prices Many companies, G.M. Market contribute to sales rema- in domestic autos and
ining in roughly the same Procter & Gamble in deter-proportion to those gents, are long-time numberCompetitors. One companies and want to
Keep their positions of leadership.
*Encourage sales growth Adjust price and discounts The firm may need a largerto encourage more purch- group of customers to ases by existing buyers and protect against disasterto attract new buyers should some of their existing
customers stop buying.
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Competition*Meet competition Set prices about equal to A great number of American
those of competitors. Do firms do this to avoid pricethe same with discounts competition and price cuttingoffered. Wars, and attempt to compete
by means of non-price competitive moves.
*Avoid competition Set prices at a level that A firm with a local monopolywill discourage competi-. might choose to keep pricestion in the firm’s markets. on the low side so new
competitors would not beattracted to its area.
*Undercut competition Set prices lower than the The organisation might competition’s. undercut competition to
project a bargain image orto draw customers away fromcompetitors.
Social Concern*Behave ethically Due to special conside- A manufacturer of prescri-
rations, set prices at levels ption medicines could chargelower than they could almost any price for effectivehave been. Drugs but “does what’s right”
though this is partly to avoid government regulations.
*Maintain employment Set prices at levels that An organisation with strongwill maintain production community ties may seek toand employment of keep townspeople employedworkers. at least until a buyer for the
company can be found.
PRICING MECHANISMS IN THE SHORT-RUN
Different pricing mechanisms are used in different market structures both in the short-run
and long run periods. These are:
1. Cost-plus pricing
2. Target-profit pricing
3. Price leadership
4. Cartelisation
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5. Government tempering
1. Cost-Plus Pricing / Markup Pricing
Sometimes referred to as “full-cost” pricing usually involves estimating the average
variable costs of producing and distributing the product, and then adding a charge for
overhead and a percentage mark-up for profits. The adding of a common percentage
mark-up to the wholesale cost of goods sold is quite common in retailing.
Cost – Plus calculations
1. Estimate the job’s direct cost – mainly material and labour
2. Add a charge for indirect costs or overhead – usually by allocating them at some
rate per unit of direct labour, machine hours, or other appropriate variable
3. Add a margin for profit – usually calculated as some percentage of the total
arrived at in the two previous steps
Before coming up with a price certain factors have to be considered
a) the ratio of fixed costs to variable costs
b) the economies of scale available to a firm
c) the cost structure of a firm vis-à-vis competitors
2. Target – profit pricing
This is applied in manufacturing. Originally devised by G.M executives to achieve a
target rate of profit which is a certain percentage of investment and not sales.
- Target profit does not vary with output. Therefore in times of economic trouble
the prices will have to be raised and cut them in booms.
- But customers would not buy the product if the price is too high
3. Price leadership
Experienced on the Oligopoly/Monopoly market structures. The leader just sets high
prices and the rest of the firms will follow suit
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4. Cartelization
A cartel is defined as an explicit arrangement among, or on behalf of, enterprises in the
same line of business that is designed to limit or eliminate competition among them. It
is known for fixing prices . Example is OPEC – Organisation of Petroleum Exporting
Countries. There is uniformity of behaviour and the cartel is legal.
Cooperation is refined, formalised and often pursued with vigor when cartelisation is
applied to pricing, the results can include less variasion (price) across firms, greater
stability over time.
5. Government Intervention – Price controls and suppliers will be required to observe
such a policy.
IN THE LONG- RUN
The firms can pursue different Pricing Mechanisms such as
1. Entry Limit Pricing
Used as a barrier to new entrarnts to the market.
In this case the sellers set prices high enough to make excess profits but not so
high as to attract new entry.
2. Open Pricing
Here the established firms deliberately give up part of the market to new entries
by setting up high prices which attract entry. In the short-run they earn high
profits before they share the demand with the new entrants.
As entry of new companies proceeds the market share for the established firms
shrink and market price will fall.
Some firms can actually use both pricing mechanisms at the same time.
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PRODUCTION AND COST ANALYSIS
Production and cost Analysis are considered both in the short run and long-run. In the
short-run quantities of some inputs are variable e.g. labour while others are in fixed
supply e.g. capital.
- In the long run all factors may be varied. Long-run is time period required for
expanding the firm’s fixed resources i.e. plant, equipment, land, manager’s salary
and other expenses that do not vary with the level of output.
Production in the Short Run
Production Function refers the relationship that exists between the inputs and the outputs
in the production process. In general we can say output is dependent upon the inputs in
an unspecified way. In other words we can say Quantity produced is a function of the
inputs of capital and labour Q=f{K,L}
During the short run the plant, the equipment and salaries of administrative
personnel are fixed because of their nature.
Labour together with the electricity used, raw materials etc are factors that vary
with production levels.
Quantities of the above factors (i.e. labour, electricity and raw materials) can be
adjusted quickly hence they are called variable resources.
The length of the short run differs among firms e.g. for example a fast food
restaurant in the short run may increase raw materials and hire extra labour who
are paid on hourly basis to meet demand.
Whereas with a capital intensive firm like a bus company it is difficult in the
short-run to meet demand.
In some industries the short-run depends on the time it takes to hire and train
skilled labour.
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Production decisions in the short-run
Given the fixed capital in the short-run the firm can only vary the variable resources to
maximise the output.
The variable factor – labour in this case can be increased and production will keep on
increasing up to a point when the marginal product will fall down due to the fact that the
fixed capital cannot produce beyond the capacity it is designed for in the short run.
Marginal product here refers to the contribution to output of the last unit of a
variable resource hired, i.e. the last worker hired.
Beyond some quantity of output in the short run the marginal product of a
variable resource tends to decline.
This is because of the limitations of the fixed resource
This principle is referred to as the principle of diminishing marginal product or
the law of diminishing returns .
So we can say that in the short run in any industry the output from the use of variable
resources falls in a similar pattern. Output can be said to move through stages
1. Without variable resources there can be no output.
2. When a small quantity of variable resources is employed each unit adds more to
total output than the one before (i.e. marginal product increases).
3. Over some range of production, marginal product may be constant. This may be
an indication that the fixed resource has reached full capacity utilisation.
4. Beyond the constant output total output will increase by smaller amounts as more
variable resources are added.
- We say that marginal product is diminishing.
5. Total output reaches a maximum, using more variable resources will not produce
any change in total output.
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COSTS IN THE SHORT RUN
The cost of a firm’s fixed plant and equipment in the short run is fixed hence Fixed Cost.
This includes such things as the rent, interest repayment of debt, salaries of top
management.
Fixed costs remain the same throughout the month regardless of the level of
output.
Cost of variable resources fluctuate with outputs hence as output increases
variable costs increase and in the short-run its only variable costs which are
changing.
AFC which is FC falls as more units of output are produced Economies of Scale Q
AVC = VC which increases as cost increases with increased output Marginal cost Q
– is the change in total cost resulting from a unit change in output. This is of
great importance to the firm because the decision-maker wants to know the cost
of a change in program or an activity. What will it cost to produce an additional
unit of output product. MC = ∆ in TC
∆ in QP
Marginal product and Marginal Cost may be constant over a range of time. When MP is
increasing, MC declines along with average variable cost and A.T.C. When MP begins
to fall MC increases because each unit of output begins to cost more.
In the short-run MC always increases after a certain point as production
approaches the limits of available resources or the capacity of the plant itself.
In the long run more equipment can be rented or bought.
Hire additional workers or ask present workers to put more hours.
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Cost Data Summary
1. Fixed cost of plant, equipment and management salary is fixed.
2. Average Fixed cost per unit declines as output increases.
3. Variable Cost (VC) rises slowly first with increases in output, then more rapidly.
4. AVC – Unit cost of variable resources declines at first but rises as AP starts to
decrease.
5. TC i.e. FC + VC increases slowly as output increases then more rapidly as output
increases in the short run.
6. ATC Unit cost {AFC + AVC} decreases at first and then increases at higher
levels of output.
7. Marginal Cost – additions to Total Costs decreases and then increases as output
approaches the limit of fixed resources in the short run.
- If MC is below AC it pulls the average cost down, if MC is above AC it pulls the
average up.
Profit Maximization in the Short run
Economic Profit is TR-TC
Break Even Point (BEP) – that level of output at which total revenue just covers cost.
BEP = FC
SP-VC
- Increasing level of production would increase revenue therefore increasing profit.
- But applying the Law of Diminishing returns the increase in production is only
profitable up to a certain point. Beyond that point of the level of production no
profit is realist.
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Total Revenue (TR)
5 Total Cost (TC)
BEP
Graphically 4Fixed Cost
3Total Cost &Revenue 2In 000’s
1
01 2 3 4 5
Output in 000s
Given that a firm’s Fixed costs are $3500Variable Costs (VC) are $10 per item = 3500
7Selling Price (SP) is $17BEP = 500 units
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PART VI
UNEMPLOYMENT AND INFLATION
Unemployment is a situation where people who are willing and able to work fail to get
employment. Naturally, it is not possible for an economy to reach full employment
because of the different types of unemployment that are experienced.
Types of unemployment
1. Seasonal Unemployment
Unemployment in some industries tend to fluctuate with the season, for example the
agricultural sector, the construction industry and to some extend the tourism industry are
characterised by seasonal unemployment.
2. Frictional Unemployment
It occurs due to labour immobility or as people move from job to job. Even at what we
may call full employment there is still an element of frictional unemployment because of
the time constraint involved in changing jobs.
3. Structural Unemployment
This is a result of a mismatch between the skills of the work force and the jobs available.
Specifically the causes of structural unemployment are:
a) The occupational immobility of labour i.e. the unwillingness to abandon skills and
acquire new ones.
b) The geographical immobility of labour – workers are reluctant to move to
vacancies elsewhere due to cultural, family or financial ties to the region.
c) Technological change
d) Development of substitute e.g. the effect of man-made fibres such as nylon on the
cotton industry
e) The growth of overseas competition.
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4. Cyclical Unemployment
It is caused by a lack of demand within the domestic economy. For Gross Domestic
Product to increase consumption, Investment and Government expenditure must
increase. When those components of GDP decrease then there is unemployment.
INFLATION
Inflation refers to a Generalised and Sustained rise in the Price Level or a Fall in the
value of money.
both of which amount to the same thing – that a unit of currency will buy fewer
goods
Inflation refers to the fact that the price of all goods is rising
And the rate of increase is usually stated as the annual rate of inflation as
measured by a Price index.
The Consumer Price Index
It is constructed from the prices of a collection of goods and services which enter
a typical shopping “basket” each item being weighted in accordance with its
importance in the household budget.
The “basket of goods” is then revalued in each subsequent year at current prices,
and inflation is represented by the increase in the index.
The composition of the basket is changed periodically to keep up with the times
The index is calculated basing the prices on a base year say 1990 and the index
for that year will be 100
If in 1991 the index is 115 then the index has risen by 15 percent.
If incomes increase by 20% over a year and inflation has risen by 15% then the real
increase in income is 5%
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Cause/Types of Inflation
1. Demand – Pull Inflation
Were aggregate demand exceeds aggregate supply at current prices
Prices are “pulled up” by the increase in demand for the product
Too much money is chasing too few goods
This type of inflation is associated with the full employment of resources,
and in the short run it may be difficult to meet the demand by increasing
output consumers compete for products and price goes
Hence the result in the short run is an increase in the price level.
We have experienced demand- pull inflation here in Zimbabwe due to shortages of
commodities.
2. Cost – Push Inflation Causes
Comes about as costs go up resulting into higher prices for goods and
services
Increase in wages which are greater than the increase in productivity
A fall in the exchange rate which increases the cost of imported material
A rise in the cost of imported materials due to other factors abroad, for
example the OPEC Cartel
Increases in indirect taxation (i.e. taxes on goods and services).
Cure for Cost-Push Inflation
To begin with this occurs when suppliers are able to raise their prices to other
producers who pass along the higher prices to consumers e.g. suppliers of building
material and building contracts who in turn pass the high prices to the consumers.
To curb cost-push inflation, the government can employ income policies where
incomes are kept low by freezing or fixing both wages and prices in some way.
In theory there are two types of income policies government can adopt.
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(a) wage – price guidelines
(b) wage – price controls
With the wage-price guidelines the government asks industry and labour to stay
within limits so as to avoid a sharp rise in both wages and prices.
Wage-Price control is a policy established by government which prevents and stops
wage and price increases.
3. Expectations
If inflation is around for a period of time people start to think in terms of real wages
rather than nominal wages and union negotiators start to build a hedge against inflation
into wage negotiations. For example if unions want to gain a 10% increase in real wages
and anticipate inflation to be 15% and assume 5% will be given away through time lag.
The union will ask initially for 30%; 5% is lost during negotiations, 15% is lost due to
inflation and 10 % will be the increase in real wages
If business people think along those lines and build a similar hedge into their prices we
end up with a wage/price spiral.
4. Structural Inflation
As a result of shortages when a good is in short supply, naturally the suppliers charge
high prices for it as can be seen on the housing market.
This type of inflation is curbed by the introduction of price control policies. Otherwise
economists argue that the only cure for structural and other inflations caused by shortages
is time.
This strategy will, infact, stop any type of inflation but the economy becomes in
effect a command economy resulting in black markets.
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RELATIONSHIP BETWEEN UNEMPLOYMENT AND INFLATION
There is an inverse relationship between unemployment and Inflation as depicted by the
Phillips Curve below
20
Inflation 15Rate in %
10
5
02 4 6 8 10
Unemployment Rate in %
High inflation rates are associated with low unemployment rates. This suggests that
some trade-off between inflation and unemployment is necessary. This can be related to
the business cycles where at the peak stage inflation is high and unemployment is very
low.
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PART V11
FISCAL AND MONETARY POLICIES
FISCAL POLICY
The term fiscal policy refers to those decisions made by government, related to
expenditures and taxes that most directly affect the level of the economy. Deliberate
fiscal actions to remedy economic problems such as inflation and unemployment are
called discretionary and other fiscal actions such as unemployment benefits and
progressive income tax laws are put in place by government which are called non
discretionary (Chisholm and McCarty (1978).
What is more conspicuous is the discretionary fiscal policy. This is concerned with
changed in government spending and taxing designed to offset economic problems.
Government spending and taxing policies affect the level of Gross Domestic Product.
Depending at which stage of the business cycle the economy is Government can choose
to pursue either an expansionary fiscal policy or a contractionary fiscal policy.
At recovery stage government pursues the expansionary fiscal policy by increasing
government expenditure. By spending more on government programs demand is
stimulated and the economy picks up. If it, wants to implement a contractionary fiscal
policy government will reduce demand for goods and services produced in the economy.
At the peak stage government can reduce its expenditure to reduce inflation thereby
pursuing the contractionary fiscal policy with less government demand for goods and
services GDP is affected negatively.
A contractional fiscal policy targeting at government expenditure maybe more difficult to
pursue than an expansionary fiscal policy. The reason being that it is always easier to
increase spending because cutting down on spending means that some people will end up
with no jobs and the government of the day will become very unpopular.
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Besides focusing on Government expenditure, there are also taxation policies that can be
used to influence demand.
To follow an expansionary fiscal policy government lowers taxes and both individuals
and business will have more money in their possession and thereby demand more goods
and services. To pursue a contractionary fiscal policy government will raise the income
taxes and thereby leaving individuals and businesses with less money to spend.
To fight inflation at the peak of the business cycle, government may increase taxes
thereby reducing spending power from the economy and consequently demand for goods
and services.
At recession stage government reduces taxes and people will end up with more money to
spend thereby stimulating demand and employment.
MONEY SUPPLY AND MONETARY POLICY
Definition of Money
Currency plus demand deposits i.e. checking account money
Currency is government – created money
Demand deposits are bank-created money
Monetary Policy – policy adopted by Government through the Reserve bank to control
money supply to influence the economy
Objectives of Monetary Policy
1. Price stability – to fight Inflation
2. To influence the balance of payment
3. To stimulate Economic Growth
4. To ensure that the government can finance its budget
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Use of the Monetary Policy to Curb Unemployment and Inflation
At the trough stage of the business cycle output is at its lowest level and there is
unemployment.
To relieve unemployment Q must go up and this calls for employment of more people At
depression inflation (P) is not there since it is usually related to excessive demand for
goods and services. Inflation is generally a problem at the peak of the cycle
Looking at the equation at this stage both V and P may be constant. So a change in M
must result in a change in Q. If we increase money supply during a recession we are
fairly certain that output will increase. And as output increases unemployment decreases.
When the money supply expands, banks will have more money available for loans to
both consumers and businesses for investment purposes.
Through the multiplier effect more people will have money which money they will
deposit in banks and banks will in turn have more loanable funds.
The Peak and Inflation
At the peak stage Q is high and unemployment is low.
Demand grows as producers hire more workers to increase production
These workers will demand more goods and services on which to spend their money
Shortages may result and prices will begin to rise
Besides prices are inflated by the high costs of the demand for money which businesses
borrow as they expanded production to meet the demand.
At this stage we can safely say Q is constant and the economy, can be said to be at full-
employment
V is also constant
The problem at this stage is the increase in P
If M is reduced P will fall. This is because if there is a shortage of money people will be
less willing and able to buy. Prices will go down to clear the products.
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To bring P down the rate of M’s growth must be reduced, hence we have M growing
slowly. P will also fall, but again, more slowly.
Monetary Policy’s Activities and Goals
The monetary policy is highly influenced by commercial banks and the general public.
From the previous discussion it can be seen that the monetary policy can be used to
stimulate the economy at the trough stage of the business cycle. By increasing money
supply output will increase and unemployment will decrease. An increase in money
supply makes it easier and cheaper for investors to increase borrowing. Tying this up
with the multiplier effect, there will be certainly more money available in banks which
money is available for loans hence increasing output and employment. This is known as
the expansionary monetary policy.
Restraint
Government may decide to restrain the economy using monetary policy. As already
discussed, at the peak stage government may reduce money supply so as to reduce the
upward pressure on prices.
Some economists argue that when money supply is restricted then it becomes harder and
more expensive to borrow money from the banks.
This reduces consumption and investment and output falls.
Any way a decrease in money supply causes consumer spending to go down and this is
called a contractionary monetary policy or tight money policy
Monetary Policy Tools used to influence money supply
Quantitative Controls
1. Reserve ratios
The amount of reserves each member bank must hold at the Reserve Bank
depends on the amount and kind of deposits held by the bank.
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Time deposits {savings accounts} have lower reserve requiremnets than demand
deposits {checking accounts}
This is because time deposits are left in the depositors’ accounts longer than
demand deposits.
The reserve ratio also depends on the size of the bank.
Those with larger deposits must keep proportionately more on reserve as their
deposits grow.
Government can reduce the money supply (M) by increasing the reserve ratio
To expand the economy Government can reduce the reserve ratio thereby
increasing M.
This method can be too effective and is not often used.
Increasing M through the reduction of the reserve ratio may not always work
because the bank may do nothing with its money.
2. Discount Rate
Banks borrow money sometimes to meet their reserve requirements
Or to increase requirements
Or to meet short term needs of their customers
Example Agribank serving farmers may need a larger supply of cash in early summer to
supply the surrounding farm community until that time when the farmers are ready to
harvest and sell their crops.
A city bank may have to use its reserves to accommodate a corporate depositor
who suddenly wishes to transfer a huge deposit to a bank in another city.
Sometimes banks borrow from each other or the reserve bank or the Discount
houses and the interest paid on such loans is called the discount rate.. This
means that the amount of money the borrower {the member bank} receives is
“discounted” by the amount of the interest. The interest is paid at the time the
loan is negotiated instead of when it is repaid.
In other words interest on the loan is paid “up front”
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Commercial banks may pay the discount rate by giving the Reserve Bank some of
secured promisory notes {government bond} they are currently holding.
By changing the discount rate the reserve and discount houses may encourage
or discourage banks to borrow.
A higher discount rate means less borrowing from the Discount house and less
money available for loans to consumers and investors. And a lower discount
rate means more borrowing from the discount house.
A change in discount rates to commercial banks tends to create a corresponding
change in interest rates throughout the economy.
3. Open Market Operations
Reserve bank’s buying and selling of Government Treasury bills and bonds on the
open market –done to control money supply.
The customers are the commercial banks and the general public. If government
wants to restrain the economy it sells T bills or government securities to
commercial banks and that way the banks will be left with little money to lend
out. If it wants to stimulate the economy government can buy the bills from the
banks and that way it will be releasing money into the economy.
Other policy tools: Qualitative tools
These are a type of monetary fine tuning and they include:-
1. Moral suasion
2.Selective credit controls and
3.Selective interest controls
1. Moral Suasion or jawboning which is done by the Reserve Bank authorities
when they make speeches or give newspaper interviews on the economy.
The authorities may advocate less spending by consumers
Or advocate energy conservation to conserve the money supply that would
otherwise move to oil producing countries.
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They might warn the banking community against giving excessive loans,
therefore jawboning depends mainly on the responses of the bankers and the
community
2. Selective Credit Controls
Through hire purchase and the like
Consumers may be discouraged to credit by requiring the purchaser to make a
larger down-payment and by shortening the repayment period.
By not taking the loan from the bank because of the short repayment period it
means that the money may remain idle in the reserves of the bank.
Hence the money supply grows less rapidly
By the same token if the credit could be readily available this will contribute to a
rise in the prosperity of the industry and hence the economy.
3. Selective Interest Controls
Raising of the level of interest commercial banks are allowed to their depositer.
This will enable the commercial banks to become more competitive and help
create more deposits. They will probably take away some of the deposits from
building societies which otherwise were promoting the building/construction
industry.
The money created by the commercial banks will be loaned out to another sector
of the economy – perhaps to consumers or the investors in capital goods. The
Government must be very selective here.
Government may choose to Stimulate the economy through money supply by:
1. Increasing total reserves through open market purchases of securities
2. Or decrease the discount rate to encourage bank borrowing
3. Reduce the Reserve ratio and that way the money - multiplier will be increased
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OR
Restrain the economy by reducing money supply by
1. Open market sales of securities
2. Increasing the discount rate to discourage bank borrowing
3. Increase the Reserve Ratio and banks will have less loanable funds
Evaluating Monetary policy
Monetary policy is used in conjunction with fiscal policy
Pro Arguments
1. There is flexibility and speed with monetary policy, i.e. the reserve bank can act
quickly when problems appear in the economy by;
raising or lowering reserve ratios
the open market operations
Whereas with the fiscal policy it can take long because it is political.
2. Non political and yet politically accepted
The Governor can make decisions purely on economic lines (Open Market
Operations)
Whereas with the fiscal policy citizens are immediately aware of a tax law that
increases tax or lower taxes.
Decisions of the Governor or the Registrar of Banks do not have immediate and
direct impact on the consciousness of the people. This means that most people
are not immediately aware of the effect of the governor or the bank’s decision.
The consolling factor here will be that what people do not know would not cause
a political fuss.
3. Neutrality
Changes brought about by monetary policy are neutral, they affect the entire
economic community.
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Quantitative controls do not directly discriminate against or favour any single sector
Fiscal policy on the other hand is not neutral = large expenditures on one sector of
the economy discriminate against of other sectors.
Policy lags
Monetary as well as fiscal policy operate with lags.
1. The recognition lag – the delay between the time an economic disturbance
occurs and its recognition by the policy maker.
2. The Action lag - the delay between the recognition that policy action should be
taken and the taking of an action.
3. The impact lag – the delay between the taking of an action and the impact on the
ultimate targets.
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PART EIGHT
THE BUDGET DEFICIT, HOW CAN IT BE REDUCED and THE
BALANCE OF PAYMENT
1 a) Definition of a budget: A budget is an estimation of income and expenditure for
a future period of time.
b) Purpose: It aids in the planning and controlling of the financial affairs of a nation,
business or family unit.
c) National Budget: This sets out estimates of government expenditure and revenue
for a financial year and is presented by the Senior Minister in the Ministry of
Finance, Economic Planning and Development
d) Budget Statement: This is a revenue by the Minister, of economic conditions
and trends and Government expenditure during the previous fiscal year. Forecasts
for the coming year and proposed taxation changes are also announced e.g. tax on
bonuses.
e) Significance of the budget: With the increased role of Government in the
economy, the budget is an important tool in overall economic policy.
f) Balanced Budget: This happens when current expenditure is equal to current
revenue.
2 Elements of the budget
a) Revenue includes: taxes on income and profits
taxes on goods and services – Excise duty
-custom duty
Fees
International aid grants
User charges – pay for the services they get
b) Expenditure includes: recurrent – salaries, wages, interest etc.
Capital
Loan
Investments
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Subsidies – nonproductive sectors
4. How a deficit is incurred:
a) Change in revenue is less than change in expenditure i.e the government
is spending more than it is collecting in revenues like taxes.
b) Revenue collected is static whilst expenditure increases
c) Expenditure is stable but revenues decline
d) Revenue declines faster than the level of expenditure
5. Financing a budget deficit
a) Through foreign borrowings
b) Through domestic borrowings
Budget deficit shortfalls/Drawback
Crowding out problem
Capital stock is not replaced
A large budget deficit will affect the country’s balance of payment
Very high taxes are a disincentive for people to work. It results into tax evasion
and avoidance
Companies are less willing to invest
Hence a slow economic growth and if the economy is performing poorly there is a
deficit.
It is difficult to balance the budget because subsidies are difficult to cut because its either
the farmer is paid less or the consumer pays more.
Also people will lose their jobs
Government however has to prioritise its goals
5. How to reduce a budget deficit
A budget deficit per se is not necessarily a bad thing, what matters is how the
money is used. The first solution would be to increase revenues via:-
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i)a) Increase in taxes on goods, services, profits and income
b) Switch spending from recurrent to capital
c) Improve revenue collection via the `A’ Team or Tax Revenue Authority
d) Sell some state property
e) Increase duty on imports
f) Sell off parastatals to raise funds
g) Encourage production through export promotion, export incentives,
realistic pricing policies, flexible labour regulations, Investment Codes,
liberalising the economy etc. to expand the tax base.
h) Borrow
i) Stop crowding out the money market
ii) The second solution is to cut expenditure by:-
a) Reducing number of ministries and ministers
b) Reduce subsidies
c) Privatise parastatals
d) Initiate regional peace moves to cut defence expenditure
e) Stricter controls/audits on government expenditure
As can be seen from the foregoing, our budget deficit has for the past and present been
financed using methods outlined above. All these measures should be seen not only as
economic solutions as they have a big bearing on the political and social circumstances
prevailing. Therefore their judicious application is always called for.
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THE BALANCE OF PAYMENTS ACCOUNT (BOP)
A nation’s international transactions are recorded in its annual Balance of Payment
Statement. Out payments are for imports In payments for exports if I>E = deficit E > I
= surplus
1. Definations
a) The BOP account is a record of all inflows and outflows of foreign
currency in an economy in respect of goods and services over a given
period of time.
b) The BOP account is a reflection of the trading behaviour of an economy
viz a viz other economies.
c) The BOP account is influenced by both cash and barter transactions.
d) BOP is constructed on the basis of double-entry bookkeeping. As such the
BOP always balances in accounting sense
{Imports = Exports}
{Dr (negative payment Cr ( receipt / positive}
2 (A) Subaccounts of BOP
a) Current
b) Capital
c) Overall balance
d) Monetization or official financing
(B) The Current Account
a) visible
b) invisible – railway costs
c) unrequited transfers
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The visible account is made up of merchandise exports like tobacco, cotton lint and
minerals whilst merchandise imports are electricity, fuel, transport equipment etc.
This segment of Zimbabwe BOP account is the major source of our foreign currency
especially from proceeds from our merchandise exports. These are the funds used in
the main, to pay for our imports and to service maturing debt.
The significance of promoting merchandise exports can be illustrated by export
promotion programmes in place the Export Revolving Fund, Export Incentive
Scheme, Supplementary Allocation Scheme and the Expanded Export Promotion
Programme. Such as the Export Processing Zones.
On the invisible account service and income receipts are usually less than payments
which is typical of developing countries who are net capital importers.
Unrequit ed transfers are transactions which are difficult to classify and include such
items as:-
individual debts externally
expatriate salaries
pension remittances
monetary gifts
proceeds from deceased estates (inheritances)
maintenance payments
Commodity Import Programs
Lobola payments (Up to $1000) [1989]
C) Capital Account
a) Official
1. Long term transactions are loan repayments to institutions like IMF, World
bank etc. Taking over firms, and government has to pay the owners outside
the country
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2. Short term transactions are capital movements not related to reserves and of
less than one year duration. These funds are also known as `hot money’
b) Private
These are usually short to medium term loans by the private sector e.g.
Hwange, ZDB, Saltrama for project financing.
D) Overall balance
This is the balance on capital account plus balance on current account.
E) Official/Extraordinary Financing
This is the ‘bottom line’ in our BOP account. This means that the country
reduced its liabilities by that amount which means our foreign assets went up by a
similar amount hence the BOP always balances!
3.Ways of Improving a BOP deficit
a) Run down reserves
b) Borrow from IMF
c) Promote exports to boost current account balance
d) Compress imports via Exchange Control regulations, Imports licencing,
tariffs, quotas etc.
e) Devalue – subject to the import and export elasticities (a.k.a the Marshal
Lerner Condition)
f) Suspension of remittance of dividends, interest, rentals i.e. reduce income
payments
g) Cut Holiday Travel, Business Travel, Educational, Lobola, Book
allowances etc.
h) Encourage investment via Investment Codes to improve income receipts
i) Gradual depreciation of currency
j) Appeal for public assistance in the form of aid, C.I.Ps, low interest
concessional loans etc.
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Why Balance of Payment Problems
1. Structural problems which are long and standing and they originate from the
major exports of particular products.
2. Trade imbalances – imports cost more than the exports
3. Export instability – exports have very volatile prices depending on supply and
demand. If our tobacco is of poor quality how do we get rid of it – batter and no
cash as the ZTA would like.
4. Supply side hurts the exports – drought, spare parts – lack of locomotives to
carry our exports to the sea.
5. Monetary cause of a Bad BOP
Inflation has bad effects on the BOP because exports become less and less
competitive on the international market.
This could be as a result of Cost Push Inflation as Price takers we loose because
of the high price we will be asking for because of the competition.
6. Government cause – BOP difficulties by setting wage levels that contribute to
the costs of the production of goods.
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