ECONOMICS

In any economy there are millions of individuals and institutions and to reduce things to a manageable proportion they are consolidated into three important groups; namely; Households, Firms and Central Authorities. Household refers to all the people who live under one roof and who make or are subject to others making for them, joint financial decisions. The household decisions are assumed to be consistent, aimed at maximizing utility and they are the principal owners of the factors of production. The firm is the unit that uses factors of production to produce commodities then it sells either to other firms, to household, or to central authorities. The firm is thus the unit that makes the decisions

 

11

 

regarding the employment of the factors of production and the output of commodities. They are assumed to be aiming at maximizing profits. Central authorities which is a comprehensive term includes all public agencies, government bodies and other organizations belonging to or under the direct control of the government. They exist at the centre of legal and political power and exert some control over individual decisions taken and over markets.

 

2.1 Concept of Demand

 

Demand is the quantity or amount of a commodity that buyers are willing and able to buy at a given price over a given period of time. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand. The term demand signifies the ability or the willingness to buy a particular commodity at a given point of time. Effective demand is the ability to buy a commodity supported by the willingness to buy. Desire to buy but no money or having money but no will to buy isn‘t demand hence it is called desire.

 

Law of demand

 

The law of demand states that, if all other factors remain equal (ceteris peribus), the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).

 

Abnormal Demand Curves

 

 

12

 

The law of demand does not hold for all commodities in all situations. There are exceptions when more is demanded when the price increases. These happen in the case of:

 

(i)           Inferior goods: Cheap necessary foodstuffs provide one of the best examples of exceptional demand. When the price of such a commodity increases, the consumers may give up the less essential compliments in an effort to continue consuming the same amount of the foodstuff, which will mean that he will spend more on it. He may find that there is some money left, and this he spends on more of the foodstuff and thus ends up consuming more of it than before the price rise. A highly inferior good is called Giffen good after Sir Robert Giffen. In addition, Increase in prices of some low quality goods may mean improvement in quality therefore the demand will increase with increases in price.

 

(ii)           Articles of ostentation (snob appeal or conspicuous consumption): There are some commodities that appear desirable only if they are expensive. In such cases the consumer buys the good or service to show off or impress others. When the price rises, it becomes more impressive to consume the product and he may increase his consumption. Some articles of jewellery, perfumes- and fashion goods fall in this category.

 

(iii)        Speculative demand: If prices are rising rapidly, a rise in price may cause more of a commodity to be demanded for fear that prices may rise further. Alternatively, people may buy hoping to resell it at higher prices. In all the above three cases, the demand curve will be positively sloped i.e. the higher the price, the greater the quantity bought. These demand curves are called reverse demand curves (also called perverse or abnormal demand curve).

 

(iv)       Necessities: These are things that one cannot do without; hence demand will not change even if the prices go up e.g. Maize flour.

 

(v)    Habitual goods and services: Some goods and services will be consumed at the same quantities at any price because goods and services become habitual e.g. alcohol, cigarettes.

 

Different types of demand

 

a)Negative demand: If the market response to a product is negative, it shows that people are not aware of the features of the service and the benefits offered. Under such circumstances, the marketing unit of a service firm has to understand the psyche of the potential buyers and find out the prime reason for the rejection of the service. For example: if passengers refuse a bus conductor's call to board the bus. The service firm has to come up with an appropriate strategy to remove the misunderstandings of the potential buyers. A strategy needs to be designed to transform the negative demand into a positive demand.

 

b)No demand: If people are unaware, have insufficient information about a service or due to the consumer's indifference this type of a demand situation could occur. The marketing unit of the firm should focus on promotional campaigns and communicating reasons for potential customers to use the firm's services. Service differentiation is one of the popular strategies used to compete in a no demand situation in the market.

 

c)Latent demand: At any given time it is impossible to have a set of services that offer total satisfaction to all the needs and wants of society. In the market there exists a gap between desirables and the available. There is always a search on for better and newer offers to fill the gap between desirability and availability. Latent demand is a phenomenon of any economy at any given time, it should be looked upon as a business opportunity by service firms and they should orient themselves to identify and exploit such opportunities at the right time. For example a passenger traveling in an ordinary bus dreams of traveling in a luxury bus. Therefore, latent demand is nothing but the gap between desirability and availability.

 

13

 

d)Seasonal demand: Some services do not have an all year round demand; they might be required only at a certain period of time. Seasons all over the world are very diverse. Seasonal demands create many problems to service organizations, such as: - idling the capacity, fixed cost and excess expenditure on marketing and promotions. Strategies used by firms to overcome this hurdle are like - to nurture the service consumption habit of customers so as to make the demand unseasonal, or other than that firms recognize markets elsewhere in the world during the off-season period. Hence, this presents and opportunity to target different markets with the appropriate season in different parts of the world. For example the need for Christmas cards comes around once a year or the, seasonal fruits in a country.

 

Other types of demand

 

·         Effective demand: This occurs when a consumers desire to buy a good can be backed up by his ability to afford it.

 

·         Derived demand: This occurs when a good or factor of production such as labour is demanded for another reason

 

·      Composite Demand – A good which is demanded for multiple different uses

·      Joint demand – goods bought together e.g. printer and printer ink.

 

Demand Curve Derivation a) Demand schedule

 

The plan of the possible quantities that will be demanded at different prices is called demand schedule. The plan of the possible quantities that will be demanded at different prices by an individual is called individual demand schedule. Such a demand schedule is purely hypothetical, but it serves to illustrate the First Law of Demand and Supply that more of a commodity will be bought at a lower than a higher price. Theoretically, the demand schedule of all consumers of a given commodity can be combined to form a composite demand schedule, representing the total demand for that commodity at various prices. This is called the Market demand schedule as shown in the table below;.

Price (Ksh)		20	18	16	14	13	12	10	11	9	8
Quantity	demanded	100	120	135	150	165	180	200	240	300	350
(per week) (000)

 

These prices are called Demand Prices. Thus, the demand price for 200,000 units per week is KShs 11 per unit.

 

b) Demand Curves

 

The quantities and prices in the demand schedule can be plotted on a graph. Such a graph after the individual demand schedule is called The Individual Demand Curve and is downward sloping. An individual demand curve is the graph relating prices to quantities demanded at those prices by an individual consumer of a given commodity. The curve can also be drawn for the entire market demand and is called a Market Demand Curve as below:

 

 

 

 

 

 

 

 

 

 

 

14

 

 

 

 

 

 

 

 

 

 

 

 

Consider a market consisting of two consumers:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

.At price P1 above, consumer 1 demands q1, consumer II demands quantity q2, and total market demand at that price is (q₁+q₂). At price p2, consumer 1 demands q'₁, and consumer II demands quantity q'₂ and total market demand at that price is (q'₁+q_'2). DD is the total market demand curve.

 

Changes in the price of a product bring about changes in quantity demanded, such that when the price falls more is demanded. This can be illustrated mathematically as follows:

Q_d = a - b_p

Where Qd is quantity demanded

 

a is the factor by which price changes p is the price

 

Thus, ceteris paribus (all other things constant), there is an inverse relationship between price and quantity demanded. Thus the normal demand curve slopes downwards from left to right as follows:

P

 

D

 

 

 

 

 

 

 

Shift and Movement along Demand Curve a)Movement along demand curve

 

A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies

 

15

 

that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

 

 

 

 

 

 

 

 

Price

 

 

 

 

 

 

 

 

 

 

 

 

When price falls from p1 to p2, quantity demanded increases from q1 to q2 and movement along the demand curve is from A to B. Conversely when price rises from p2 to p1 quantity demanded falls from q2 to q1 and movement along the demand curve is from B to A.

 

b) Shifts in Demand Curve

 

A shift in a demand curve occurs when a good's quantity demanded changes even though price remains the same. This occurs when, even at the same price, consumers are willing to buy a higher quantity of goods. The position of the demand curve will shift to the left or right following a change in an underlying determinant of demand.

 

Increases in demand are shown by a shift to the right in the demand curve. This could be caused by a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the price of a complement. Conversely, demand can decrease and cause a shift to the left of the demand curve for a number of reasons, including a fall in income, assuming a good is a normal good, a fall in the price of a substitute and a rise in the price of a complement. Decreases in demand are shown by a shift of the demand curve to the left as explained in the figure below.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

16

 

 

 

 

 

Price

 

 

 

 

 

 

 

 

 

 

 

 

In the figure below, DD represents the initial demand before the changes. When the demand increases, the demand curve shifts to the right from position DD to positions D2D2. The quantity demanded at price P₁ increases from q₁ to q'₁. Conversely, a fall in demand is indicated by a shift to the left of the demand curve from D₂D₂ to DD. The quantity demanded at price P₁ decreases from q₁ to q₁

 

Factors That Cause Shifts in Demand Curve

Some of the factors that can cause a demand curve to shift include:

 

i) Change in income - If consumer incomes increase, we might reasonably expect that demand for some luxury goods will increase.

 

ii Change in preferences/tastes - If a product becomes more (less) liked, the quantity demanded will increase (decrease).

 

iii)Change in prices of goods that are complimentary - If the price of gasoline goes up substantially, the demand curve for large SUV's should shift down.

 

iv)    Changes in prices of goods that are substitutes - If the price of pork increases (decreases), demand for beef would likely increase (decrease).

 

v)    Advertising - An effective advertising campaign could increase the quantity demanded of a particular good. It could also decrease the demand for a competing good.

 

vi)    Expectations - If consumers expect a good to become more expensive or hard to get in the future, it could alter current demand

 

vii)  Shifts in market demographics - As segments of the population age or their composition changes, their demands also change. Because segments are not equally distributed – that is, there are not a consistent number of people in every age category – larger segments have a more noticeable impact on demand. The baby boomers are an excellent example of this.

 

viii)  Distribution of income - For example, if the rich get richer, and the poor get poorer, demand for luxury goods could increase.

 

2.2 Factors Determining Demand of a Product

 

Even though the focus in economics is on the relationship between the price of a product and how much consumers are willing and able to buy, it is important to examine all of the factors that affect the demand for a good or service. These factors are also called Determinants of demand and they include;

 

17

 

a) Price of the Product

 

There is an inverse (negative) relationship between the price of a product and the amount of that product consumers are willing and able to buy. Consumers want to buy more of a product at a low price and less of a product at a high price. This inverse relationship between price and the amount consumers are willing and able to buy is often referred to as The Law of Demand. E.g. if there is an increase in price from p2 to p1 then there will be a fall in demand from Q2 to Q1

 

 

 

 

 

 

 

 

 

 

 

 

 

b)The Price of Related Goods

 

demand of some commodities is affected by demand of other commodities depending on their relationship e.g. for complimentary goods – goods used together like pen and ink, when prices of ink increases, the demand for a pen will fall as a result of decrease in demand for ink. For Substitutes which are commodities that can be used instead of each other e.g. coffee and tea. A rise in price of coffee reduces its demand and instead consumers will tend to consume more tea thereby raising its demand i.e some goods are considered to be substitutes for one another: you don't consume both of them together, but instead choose to consume one or the other.

 

c) The Aggregate National Income and its distribution among the population

In normal circumstances as income goes up the quantity demanded goes up.  In such a case

 

the good is called a normal good. However, there are certain goods whose demand shall increase with income up to a certain point, then remain constant. In such a case the good is called a necessity e.g. salt. Also there are some goods whose demand shall increase with income up to a certain point then fall as the income continues to increase. In such a case the good is called an inferior good.

 

d) Changes in taste, fashion and preferences of consumers

 

Individual tastes and preferences greatly influence the demand for a commodity. If taste change in favor of a commodity, more of the commodity is likely to be bought even if it is expensive e.g. imported goods change in fashion which affects demand since more of the commodity is demanded when in fashion and less when out of fashion.

e) Government policy

 

Governments may come up with policies to encourage or discourage consumption of a commodity through;

 

i)  Tax-increase in taxes leads to increase in price leading to low demand and vice versa

ii)  Subsidies-Leads to decrease in price leading to high demand.

 

iii)   Legislation – passing laws made to encourage or discourage consumption e.g. opening bars for a few hours to discourage alcohol consumption.

 

iv)  Price control- Controlling prices to ensure that they do not go beyond certain limits

 

 

18

 

f) The Consumer's Expectations

 

One‘s expectations for the future can also affect how much of a product one is willing and able to buy. For example, if you hear that Apple will soon introduce a new iPod that has more memory and longer battery life, you (and other consumers) may decide to wait to buy an iPod until the new product comes out. When people decide to wait, they are decreasing the current demand for iPods because of what they expect to happen in the future. Similarly, if you expect the price of petrol to go up tomorrow, you may fill up your car with petrol now. So your demand for petrol today increased because of what you expect to happen tomorrow.

 

g) The Size and Structure of the Population

 

A larger population, other things being equal, will mean a higher demand for all goods and services. Changes in the way the population is structured also influences demand. Many European countries have an ageing population and this leads to a change in the demand. Goods and services required by the elderly increase in demand as a result. The demand for retirement homes, insurance policies suitable for elderly drivers and smaller cars may increase as a result.

 

Also as population increases, the population structure changes in such away that an increasing proportion of the population consists of young age group. This will lead to a relatively higher demand for those goods and services consumed mostly by young age group e.g. fashions, films, nightclubs, schools, toys, etc.

 

h) Advertising

 

An effective advertising campaign could increase the quantity demanded of a particular good. It could also decrease the demand for a competing good.

 

2.3 The Concept of Elasticity of Demand

 

Elasticity is a term widely used in economics to denote the ―responsiveness of one variable to changes in another.‖ In proper words, it is the relative response of one variable to changes in another variable. The phrase ―relative response‖ is best interpreted as the percentage change.

 

The quantity of a commodity demanded per unit of time depends upon various factors such as the price of a commodity, the money income of consumers, the prices of related goods, the tastes of the people, etc., etc. Whenever there is a change in any of the variables stated above, it brings about a change in the quantity of the commodity purchased over a specified period of time. The elasticity of demand measures the responsiveness of quantity demanded to a change in any one of the above factors by keeping other factors constant.

 

When the relative responsiveness or sensitiveness of the quantity demanded is measured to changes in its price, the elasticity is said be price elasticity of demand. When the change in demand is the result of the given change in income, it is named income elasticity of demand. Sometimes, a change in the price of one good causes a change in the demand for the other. The elasticity here is called cross electricity of demand. The three Main types of elasticity are now discussed in brief.

 

Types of Elasticity of Demand a) Price elasticity of demand

 

Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a change in its price. Precisely, it is defined as the ratio of proportionate change in the quantity demanded of a good caused by a given proportionate change in price (ceteris paribus, i.e. holding constant all the other determinants of demand, such as income).. The formula for measuring price elasticity of demand is:

 

19

Price elasticity of demand= Proportionate (percentage) change in quantity demanded Proportionate (percentage) change in price

 

It can be described in symbolic terms.

E_d= (ΔQ/Q)×100/(ΔP/P)×1OO = (ΔQ×P)/(ΔP×Q)

Where ΔQ is change in quantity demanded, Q is initial quantity demanded, ΔP is change in price, P is the initial price, E_d is price elasticity of demand.

 

Example: Let us suppose that price of a good falls from sh. 10 per unit to sh. 9 per unit in a day. The decline in price causes the quantity of the good demanded to increase from 125 units to 150 units per day. The price elasticity using the simplified formula will be:

 

E_d= (ΔQ/Q)×100/(ΔP/P)×1OO = (ΔQ×P)/(ΔP×Q)

 

= ({150-125}/125)×100/ ({10-9}/10)×1OO = (25×10)/(1×125) = 2

The elasticity coefficient is greater than one. Therefore the demand for the good is elastic.

 

The concept of price elasticity of demand can be used to divide the goods into three groups.

 

(i). Elastic: When the percent change in quantity of a good is greater than the percent change in its price, the demand is said to be elastic. When elasticity of demand is greater than one, a fall in price increases the total revenue (expenditure) and a rise in price lowers the total revenue (expenditure)

 

 

 

 

 

 

 

 

 

 

 

 

(ii) Unitary elasticity: When the percentage change in the quantity of a good demanded equals percentage in its price, the price elasticity of demand is said to have unitary elasticity. When elasticity of demand is equal to one or unitary, a rise or fall in price leaves total revenue unchanged.

 

 

 

 

 

 

 

 

 

 

 

 

 

(iii)Inelastic: When the percent change in quantity of a good demanded is less than the percentage change in its price, the demand is called inelastic. When elasticity of demand is

 

20

 

inelastic or less than one, a fall in price decreases total revenue and .a rise in its price increases total revenue

 

 

 

 

 

 

 

 

 

 

 

Factors influencing Price Elasticity of Demand:

Price elasticity of demand is influenced by:

a)  Nature of Commodity

 

b)  Availability of Substitutes

c)  Number of Uses

 

d)  Durability of commodity

e)  Consumer‘s income

 

(b) Income Elasticity of Demand

 

Income is an important variable affecting the demand for a good. When there is a change in the level of income of a consumer, there is a change in the quantity demanded of a good, other factors remaining the same. The degree of change or responsiveness of quantity demanded of a good to a change in the income of a consumer is called income elasticity of demand. Income elasticity of demand can be defined as the ratio of percentage change in the quantity of a good purchased, per unit of time to a percentage change in the income of a consumer. The formula for measuring the income elasticity of demand is:

Income elasticity of demand= Proportionate (percentage) change in demand Proportionate (percentage) change in income

 

 

Putting this in symbol gives;

 

E_i= (ΔQ/Q)×100/ (   Y/Y)×1OO = (ΔQ×Y)/(   Y×Q)

 

Where ΔQ is change in quantity demanded, Q is initial quantity demanded, Y is change in income, Y is the initial income, E_i is income elasticity of demand.

 

A simple example will show how income elasticity. of demand can be calculated. Let us assume that the income of a person is sh. 4000 per month and he purchases six CD‘s per month. Let us assume that the monthly income of the consumer increase to sh. 6000 and the quantity demanded of

CD‘s per month rises to eight. The elasticity of demand for‘ CD‘s will be calculated as under:

 

ΔQ =8-6=2,     Y= 6000-4000 = sh 2000, original quantity demanded = 6, original income sh. 4000

 

E_i=2×4000/ 2000×6 = 0.66

 

21

 

The income elasticity is .66 which is less than one.

 

Categories of income elasticity

 

When the income of a person increases, his demand for goods also changes depending upon whether the good is a normal good or an inferior good. For normal goods, the value of elasticity is greater than zero but less than one. Goods with an income elasticity of less than 1 are called inferior goods. For example, people buy more food as their income rises but the % increase in its demand is less than the % increase in income.

 

c) Cross Elasticity of Demand:

 

The concept of cross elasticity of demand is used for measuring the responsiveness of quantity demanded of a good to changes in the price of related goods. Cross elasticity of demand is defined as the percentage change in the demand of one good as a result of the percentage change in the price of

Cross elasticity of demand= Proportionate (percentage) change in demand of commodity A Proportionate (percentage) change in price of commodity B

 

 

another good. The formula for measuring cross elasticity of ‗demand is:

 

Putting this in symbol gives;

 

E_AB= (ΔQ_A/Q_A) / ( P_B/P_B) = (ΔQ_A×P_B)/(  P_B×Q_A)

 

Where ΔQ_A is change in quantity of A demanded, Q_A is initial quantity of a demanded, P_B is change in price of B, P is the initial price of B, E_AB is cross elasticity of demand of

commodities A&B.

 

The numerical value of cross elasticity depends on whether the two goods in question are substitutes, complements or unrelated.

 

(i)Substitute good: When two goods are substitute of each other, such as coke and Pepsi, an increase in the price of one good will lead to an increase in demand for the other good. The numerical value of goods is positive Coke and Pepsi which are close substitutes. If there is increase in the price of Pepsi called good A by 10% and it increases the demand for Coke called good B by 5%, the cross elasticity would be 0.2, therefore, Coke and Pepsi are close substitutes.

 

(ii) Complementary goods: However, in case of complementary goods such as car and petrol, cricket bat and ball, a rise in the price of one good say cricket bat by 7% will bring a fall in the demand for the balls (say by 6%). The cross elasticity of demand (-6/7)= - 0.85 (negative).

 

(iii)Unrelated goods: The two goods which are unrelated to each other, say apples and pens, if the price of apple rises in the market, it is unlikely to result in a change in quantity demanded of pens. The elasticity is zero of unrelated goods.

 

 

 

 

 

 

 

 

22

 

 

 

 

 

 

 

 

 

 

 

 

Two goods that complement each other show a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls

 

 

 

 

 

 

 

 

 

 

 

Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for good X rises

 

 

 

 

 

 

 

 

 

 

Two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for good X stays constant