FUNDAMENTALS OF ECONOMICS STUDY NOTES
CONTENTS
1. Introduction to economics
2. Demand, supply and equilibrium
3. Consumer demand theory
4. The theory of production
5. The market structure
6. National income
7. Money and banking
8. Inflation
9. Economic growth and development
10. Labour and unemployment
11. Public finance
12. Agriculture and industry
13. International trade and finance
I. INTRODUCTION TO ECONOMICS
Definition of key terms
The word economics comes from the Greek word iokonomia where oikos means house and nomos means
managing. Adam Smith defines economics as a science that studies the nature and cause of national wealth.
Alfred Marshall defines economics as the study of mankind in the ordinary business of life. Lionel Robbins
defines economics as science which studies human behaviour as a relationship between ends and scarce
means which have alternative uses,.
In general, economics is defined as a social science which studies the allocation of scarce resources that
have potential alternative uses among the competing and virtually limitless wants of consumer in a society.
Scarcity, choices and opportunity cost
When resources available to people are insufficient to satisfy all their wants, then such resources are
deemed to be scarce. Choice is to be made because resources are limited. The choice to satisfy one want
implies others are foregone. Opportunity cost refers to the value of the benefit expected from the best
second alternative forgone.
Economic resources are ingredients available for providing goods and services in order to satisfy human
wants. A resource must be scarce and have money value. They are classified into two, natural and ma-made
resources. Natural resources are unlimited in supply and given by God. Example; Rivers, lakes, mountains.
Man-made resources refer to anything created by man to assist in further creation of goods and services.
Production possibility frontier/curves provide a graphical illustration of the problem of scarcity, choice and
opportunity cost. The curve shows what a country produces with existing supply of land, capital and
entrepreneurship abilities.
Branches of economics
Micro-economic theory is the branch of economics that studies the behaviour of individual decision-
making units such as consumers, resource owner and business firms.
Macro-economic theory is the study of the behaviour of the economy as a whole where a relationship is
considered between broad economic aggregates such as national income, prices and unemployment.
Methodology of economics
Positive economics deals with what is or how the economic problems facing the society are actually solved.
Positive statements deal with facts, example when we say ‘Kenya is a member of the east African
community’ it is a fact.
FUNDAMENTALS OF ECONOMICS notes Prepared by Mr. Antony Ambia Page 1
,Normative economics is concerned with what ought to be, how the economics problems facing the society
should be solved. Normative statements usually reflect people’s moral attitude and are expressions of what a
particular group of people think. A statement like ‘upper income class ought to be taxed heavily’ is a
normative statement.
Economics uses scientific methods to develop its theories. The following procedure is adopted.
The concepts are defined in a way that can be measured in order to test the theory against facts.
A hypothesis is formulated through the process of logical reasoning using observed facts and
certain assumption.
The hypothesis is then used to make predictions.
The hypothesis is test by considering whether its predictions are supported by facts.
The Rationality Assumption in Economics
In economics, it is assumed that economic agents are rational in that they behave in a manner that is
constant with a set of rules governing preference.
Level of Analysis
Comparative statics Analyses and compares two or more equilibrium positions without considering the
transition period and the process involved in adjustment.
Dynamic considers the time path and the process of adjustment itself.
Partial equilibrium analysis refers to the study of the behaviour of individual decisions making units and
the functioning of individual markets.
General equilibrium analysis studies the behaviour of all individual decision making units and all individual
markets simultaneously.
A. A Free Market System
A free market system is a market system with no government intervention and forces of demand and supply
operate freely.
Characteristics of a free market
o The ownership of private property institutions and individuals has the right to own, control and
dispose factors of production.
o There is freedom of choice and enterprise. Individuals are free to buy and hire economic resources and
organise them for production and sell the products in the market of their choice.
o Each economic agent is guided by self-interest where they attempt to do what is best for itself.
o With a large number of buyers and sellers and there is a competition and that market determines the
price of products.
Advantages of a Free Market
i. Producers undertake production in line with consumer preference, consumers therefore influence
what goods and services are produced.
ii. It responds faster to changes in international economic environment because firms are exposed to
a much greater competition in the international market.
iii. Firms have greater incentive to bear risks since profit incentive exists. This encourages hard work
and initiative.
iv. It encourages foreign investment because of low level of political risks.
v. It encourages efficiency since firms that do not produce at a low cost may go out of business.
vi. Consumers have a greater choice due to large number of producers, a large number of goods and
services are availed in the market.
Disadvantages of a Free Market
i. It gives rise to development of monopolies as technology has made it possible for large scale producers
to obtain many economies of scale.
ii. Because of a high focus on private costs and benefits, social costs such as pollution and noise leads to
reduction in welfare of the people.
iii. A free market may not produce public goods.
iv. A free market under provides for merit goods which may make them too expensive for the majority of
the population.
FUNDAMENTALS OF ECONOMICS notes Prepared by Mr. Antony Ambia Page 2
, v. Undesired goods and services, demerits goods such as drugs and alcohol may be produced since
demand for such goods exists and they may be profitable to produce.
vi. It is likely to generate inequality in income distribution since those whose skills are on high demand
will command much higher remunerations than those whose services are in low demand.
vii. It subjects an economy to a cyclical unemployment. Market labour imperfection may result in
structural unemployment.
B. A Centrally Planned Economy
A planned economy is one where resource allocation decisions are determined by the state through an
economic planning body which implements major economic goal.
Characteristics of a centrally planned economy
o Allocation of resources is achieved by the use of an overall plan which sets production targets for
different sectors of the economy.
o The rationing of certain commodities to predetermined the demand for them.
o The fixing of prices and wages by the state.
o Often economic resources are owned by the state.
Advantages of a Centrally Planned Economy
i. All essential goods are provided for by the state regardless of whether consumers can afford to pay
for them.
ii. The nation’s wealth tends to be evenly distributed.
iii. The state checks on monopoly powers since private monopolies are not allowed to develop.
iv. It takes into account the external cost and benefits of all activities.
v. Economic fluctuations may be stabilised by the government’s macro-economic policies.
Disadvantages of a Centrally Planned Economy
i. There is a greater likelihood of wastage of resources since the state may not have assessed consumer
demand in advance.
ii. The cost of administering the system of planning may outweigh its benefits since the cost of
gathering information on what, how and for who to produce require expertise of professionals like
statisticians, economists, engineers, planners and administrators.
iii. There is no incentive of hard work and innovation due to absence of profit motive which gives rise
to inefficiency.
iv. There is limitation on consumer freedom since demand is manipulated to match the limited range of
available goods.
v. There is a time lag between collection of information and formulation of production plans, and also
a time lag between implementation of production plans and the realisation of production targets.
vi. The absence of competition reduces efficiency.
Implications of the Transition of a Planned Economic System in Eastern and Central Europe
Challenges faced by the Soviet Union in making a transition to a free market economy.
i. The need to develop entrepreneurial culture which was not encouraged under planned
economy. Such a culture will take time for it to develop.
ii. Liberalisation of the economy may lead to unemployment due to discarding of previously
produce goods which are no longer required.
iii. A fall in output has led to a fall in tax revenue at a time of need especially for social
expenditure.
iv. The danger of black market characterised by illegal speculation may arise.
C. A Mixed Economy
A mixed economy combines features of a planned economy and those of a market oriented economic
system. It combines the advantages of a planned economic system and of a free market while aiming to
eliminate their disadvantages. The government influences allocation of resources in the following ways;
By use of taxes and subsidies, the government either encourages or discourages production of
certain commodities.
It influences allocation of resources by way in which it spends its income earned from taxes.
By way of producing goods and services itself especially in case of public goods.
FUNDAMENTALS OF ECONOMICS notes Prepared by Mr. Antony Ambia Page 3
, Through income distribution by levying high taxes on the wealthy and transferring to less well-off
sectors.
By setting minimum and maximum prices
Consumer Sovereignty
Consumer sovereignty refers to the freedom of individuals and households to decide for them what they
want to buy. This freedom is however limited by the following factors;
The nature of economic system. Consumers are more sovereign in a free market economic set up where
commodities are produce in line with consumer preference than in any other economic setup.
The size of consumers’ income. The larger the size of income of consumers, the greater is there
sovereignty since they can afford to choose from a wide range of goods and services which they can
afford.
The range of goods available. The wider the range of goods available, the greater the consumer
sovereignty.
The existence of monopolies limits consumer sovereignty by providing high priced and low quality
goods.
The provision of standardised goods limits consumer sovereignty since there is less regard for individual
taste and preference.
Individual consumers have different habits which they are reluctant to change.
Consumer behaviour is linked to prevailing trends in the society and the reluctance to contravene
established conventions limits consumer freedom.
II. DEMAND, SUPPLY AND EQUILIBRIUM
A. Demand
Demand is the quantity of a commodity that consumers are willing and able to purchase at any given price
over a given period of time.
The law of demand states that, ceteris peribus, the lower the price of a commodity, the higher the demand
for that commodity and the higher the price of a commodity, the lower the demand for that commodity.
Exceptions to the law of demand
Some demand curves slopes downwards from the right to the left. This type of demand curves are known as
regressive, exceptional or abnormal demand curve. It happens under the following circumstances;
When there is fear of more drastic changes in prices in future, consumers will be forces to buy more of
that product at present.
In case of giffen goods/inferior goods.
In case of goods of ostentation/Veblen goods/luxury goods.
Determinants of demand
The price of the product
The price of related products
o Complementary goods
o Substitutes goods
Changes in disposable real income of consumers
Changes in taste, preference and fashion.
Government policy on consumption of certain goods.
Seasonal changes
Future expectations of changes in prices of the product.
Changes in general population
The distribution of income
FUNDAMENTALS OF ECONOMICS notes Prepared by Mr. Antony Ambia Page 4
CONTENTS
1. Introduction to economics
2. Demand, supply and equilibrium
3. Consumer demand theory
4. The theory of production
5. The market structure
6. National income
7. Money and banking
8. Inflation
9. Economic growth and development
10. Labour and unemployment
11. Public finance
12. Agriculture and industry
13. International trade and finance
I. INTRODUCTION TO ECONOMICS
Definition of key terms
The word economics comes from the Greek word iokonomia where oikos means house and nomos means
managing. Adam Smith defines economics as a science that studies the nature and cause of national wealth.
Alfred Marshall defines economics as the study of mankind in the ordinary business of life. Lionel Robbins
defines economics as science which studies human behaviour as a relationship between ends and scarce
means which have alternative uses,.
In general, economics is defined as a social science which studies the allocation of scarce resources that
have potential alternative uses among the competing and virtually limitless wants of consumer in a society.
Scarcity, choices and opportunity cost
When resources available to people are insufficient to satisfy all their wants, then such resources are
deemed to be scarce. Choice is to be made because resources are limited. The choice to satisfy one want
implies others are foregone. Opportunity cost refers to the value of the benefit expected from the best
second alternative forgone.
Economic resources are ingredients available for providing goods and services in order to satisfy human
wants. A resource must be scarce and have money value. They are classified into two, natural and ma-made
resources. Natural resources are unlimited in supply and given by God. Example; Rivers, lakes, mountains.
Man-made resources refer to anything created by man to assist in further creation of goods and services.
Production possibility frontier/curves provide a graphical illustration of the problem of scarcity, choice and
opportunity cost. The curve shows what a country produces with existing supply of land, capital and
entrepreneurship abilities.
Branches of economics
Micro-economic theory is the branch of economics that studies the behaviour of individual decision-
making units such as consumers, resource owner and business firms.
Macro-economic theory is the study of the behaviour of the economy as a whole where a relationship is
considered between broad economic aggregates such as national income, prices and unemployment.
Methodology of economics
Positive economics deals with what is or how the economic problems facing the society are actually solved.
Positive statements deal with facts, example when we say ‘Kenya is a member of the east African
community’ it is a fact.
FUNDAMENTALS OF ECONOMICS notes Prepared by Mr. Antony Ambia Page 1
,Normative economics is concerned with what ought to be, how the economics problems facing the society
should be solved. Normative statements usually reflect people’s moral attitude and are expressions of what a
particular group of people think. A statement like ‘upper income class ought to be taxed heavily’ is a
normative statement.
Economics uses scientific methods to develop its theories. The following procedure is adopted.
The concepts are defined in a way that can be measured in order to test the theory against facts.
A hypothesis is formulated through the process of logical reasoning using observed facts and
certain assumption.
The hypothesis is then used to make predictions.
The hypothesis is test by considering whether its predictions are supported by facts.
The Rationality Assumption in Economics
In economics, it is assumed that economic agents are rational in that they behave in a manner that is
constant with a set of rules governing preference.
Level of Analysis
Comparative statics Analyses and compares two or more equilibrium positions without considering the
transition period and the process involved in adjustment.
Dynamic considers the time path and the process of adjustment itself.
Partial equilibrium analysis refers to the study of the behaviour of individual decisions making units and
the functioning of individual markets.
General equilibrium analysis studies the behaviour of all individual decision making units and all individual
markets simultaneously.
A. A Free Market System
A free market system is a market system with no government intervention and forces of demand and supply
operate freely.
Characteristics of a free market
o The ownership of private property institutions and individuals has the right to own, control and
dispose factors of production.
o There is freedom of choice and enterprise. Individuals are free to buy and hire economic resources and
organise them for production and sell the products in the market of their choice.
o Each economic agent is guided by self-interest where they attempt to do what is best for itself.
o With a large number of buyers and sellers and there is a competition and that market determines the
price of products.
Advantages of a Free Market
i. Producers undertake production in line with consumer preference, consumers therefore influence
what goods and services are produced.
ii. It responds faster to changes in international economic environment because firms are exposed to
a much greater competition in the international market.
iii. Firms have greater incentive to bear risks since profit incentive exists. This encourages hard work
and initiative.
iv. It encourages foreign investment because of low level of political risks.
v. It encourages efficiency since firms that do not produce at a low cost may go out of business.
vi. Consumers have a greater choice due to large number of producers, a large number of goods and
services are availed in the market.
Disadvantages of a Free Market
i. It gives rise to development of monopolies as technology has made it possible for large scale producers
to obtain many economies of scale.
ii. Because of a high focus on private costs and benefits, social costs such as pollution and noise leads to
reduction in welfare of the people.
iii. A free market may not produce public goods.
iv. A free market under provides for merit goods which may make them too expensive for the majority of
the population.
FUNDAMENTALS OF ECONOMICS notes Prepared by Mr. Antony Ambia Page 2
, v. Undesired goods and services, demerits goods such as drugs and alcohol may be produced since
demand for such goods exists and they may be profitable to produce.
vi. It is likely to generate inequality in income distribution since those whose skills are on high demand
will command much higher remunerations than those whose services are in low demand.
vii. It subjects an economy to a cyclical unemployment. Market labour imperfection may result in
structural unemployment.
B. A Centrally Planned Economy
A planned economy is one where resource allocation decisions are determined by the state through an
economic planning body which implements major economic goal.
Characteristics of a centrally planned economy
o Allocation of resources is achieved by the use of an overall plan which sets production targets for
different sectors of the economy.
o The rationing of certain commodities to predetermined the demand for them.
o The fixing of prices and wages by the state.
o Often economic resources are owned by the state.
Advantages of a Centrally Planned Economy
i. All essential goods are provided for by the state regardless of whether consumers can afford to pay
for them.
ii. The nation’s wealth tends to be evenly distributed.
iii. The state checks on monopoly powers since private monopolies are not allowed to develop.
iv. It takes into account the external cost and benefits of all activities.
v. Economic fluctuations may be stabilised by the government’s macro-economic policies.
Disadvantages of a Centrally Planned Economy
i. There is a greater likelihood of wastage of resources since the state may not have assessed consumer
demand in advance.
ii. The cost of administering the system of planning may outweigh its benefits since the cost of
gathering information on what, how and for who to produce require expertise of professionals like
statisticians, economists, engineers, planners and administrators.
iii. There is no incentive of hard work and innovation due to absence of profit motive which gives rise
to inefficiency.
iv. There is limitation on consumer freedom since demand is manipulated to match the limited range of
available goods.
v. There is a time lag between collection of information and formulation of production plans, and also
a time lag between implementation of production plans and the realisation of production targets.
vi. The absence of competition reduces efficiency.
Implications of the Transition of a Planned Economic System in Eastern and Central Europe
Challenges faced by the Soviet Union in making a transition to a free market economy.
i. The need to develop entrepreneurial culture which was not encouraged under planned
economy. Such a culture will take time for it to develop.
ii. Liberalisation of the economy may lead to unemployment due to discarding of previously
produce goods which are no longer required.
iii. A fall in output has led to a fall in tax revenue at a time of need especially for social
expenditure.
iv. The danger of black market characterised by illegal speculation may arise.
C. A Mixed Economy
A mixed economy combines features of a planned economy and those of a market oriented economic
system. It combines the advantages of a planned economic system and of a free market while aiming to
eliminate their disadvantages. The government influences allocation of resources in the following ways;
By use of taxes and subsidies, the government either encourages or discourages production of
certain commodities.
It influences allocation of resources by way in which it spends its income earned from taxes.
By way of producing goods and services itself especially in case of public goods.
FUNDAMENTALS OF ECONOMICS notes Prepared by Mr. Antony Ambia Page 3
, Through income distribution by levying high taxes on the wealthy and transferring to less well-off
sectors.
By setting minimum and maximum prices
Consumer Sovereignty
Consumer sovereignty refers to the freedom of individuals and households to decide for them what they
want to buy. This freedom is however limited by the following factors;
The nature of economic system. Consumers are more sovereign in a free market economic set up where
commodities are produce in line with consumer preference than in any other economic setup.
The size of consumers’ income. The larger the size of income of consumers, the greater is there
sovereignty since they can afford to choose from a wide range of goods and services which they can
afford.
The range of goods available. The wider the range of goods available, the greater the consumer
sovereignty.
The existence of monopolies limits consumer sovereignty by providing high priced and low quality
goods.
The provision of standardised goods limits consumer sovereignty since there is less regard for individual
taste and preference.
Individual consumers have different habits which they are reluctant to change.
Consumer behaviour is linked to prevailing trends in the society and the reluctance to contravene
established conventions limits consumer freedom.
II. DEMAND, SUPPLY AND EQUILIBRIUM
A. Demand
Demand is the quantity of a commodity that consumers are willing and able to purchase at any given price
over a given period of time.
The law of demand states that, ceteris peribus, the lower the price of a commodity, the higher the demand
for that commodity and the higher the price of a commodity, the lower the demand for that commodity.
Exceptions to the law of demand
Some demand curves slopes downwards from the right to the left. This type of demand curves are known as
regressive, exceptional or abnormal demand curve. It happens under the following circumstances;
When there is fear of more drastic changes in prices in future, consumers will be forces to buy more of
that product at present.
In case of giffen goods/inferior goods.
In case of goods of ostentation/Veblen goods/luxury goods.
Determinants of demand
The price of the product
The price of related products
o Complementary goods
o Substitutes goods
Changes in disposable real income of consumers
Changes in taste, preference and fashion.
Government policy on consumption of certain goods.
Seasonal changes
Future expectations of changes in prices of the product.
Changes in general population
The distribution of income
FUNDAMENTALS OF ECONOMICS notes Prepared by Mr. Antony Ambia Page 4
