1. ECONOMIC SYSTEMS:

While there are a million variations on answers to these questions; when we look around the
world we find that there are only a limited number of ways in which societies have set about
answering them. These ways or methods are called Economic systems. They are free enterprise,
centrally planned and mixed economies. We will now examine these briefly.
a) THE FREE ENTERPRISE: THE PRICE SYSTEM
The free market system is where the decision about what is produced is the outcome of
millions of separate individual decisions made by consumers, producers and owners of
productive services. The decisions reflect private preferences and interests.
For the free enterprise to operate there must be a price system/mechanism.
The price system is the situation where the vital economic decisions in the economy
are reached through the workings of the market price.
Thus, everything – houses, labour, food, land etc come to have its market price, and it is
through the workings of the market prices that the "What?", "How?", and "For whom?"
decisions are taken. The free market thus gives rise to what is called Consumer Sovereignty –
a situation in which consumers are the ultimate dictators, subject to the level of technology,
of the kind and quantity of commodities to be produced. Consumers are said to exercise this
power by bidding up the prices of the goods they want most; and suppliers, following the lure
of higher prices and profits, produce more of the goods.
The features of a free market system are:
(i) Ownership of Means of Production
Individuals are free to own the means of production i.e. land, capital and enjoy incomes from them
in the form of rent, interest and profits.
(ii) Freedom of Choice and Enterprise
Entrepreneurs are free to invest in businesses of their choice, produce any product of their choice, workers are free
to sell their labour in occupations and industries of their choice; Consumers are free to consume products of their
choice.
(iii) Self Interest as the Dominating Motive
Firms aim at maximising their profits, workers aim at maximising their wages, landowners aim at
maximising their return from their land, and consumers at maximising their satisfaction
(iv) Competition
Economic rivalry or competition envisages a situation where, in the market for each
commodity, there are a large number of buyers and sellers. It is the forces of total demand and
total supply which determine the market price, and each participant, whether buyer or seller,
must take this price as given since it's beyond his or her influence or control.Introduction to Economics
ECONOMICS
10
(v) Reliance on the Price Mechanism
Price mechanism is where the prices are determined on the market by supply and demand, and
consumers base their expenditure plans and producers their production plans on market prices.
Price mechanism rations the scarce goods and services in that, those who can afford the price
will buy and those who cannot afford the price will not pay.
(vi) Limited Role of Government
In these systems, apart from playing its traditional role of providing defence, police service and
such infrastructural facilities as roads for public transport, the Government plays a very limited
role in directly economic profit making activities.
Resource allocation in a free enterprise
Although there are no central committees organising the allocation of resources, there is supposed
to be no chaos but order. The major price and allocation decisions are made in the markets. The
market being the process by which the buyers and sellers of a good interact to determine its price and quantity.
If more is wanted of any commodity say wheat – a flood of new orders will be placed for it. As
the buyers scramble around to buy more wheat, the sellers will raise the price of wheat to ration
out a limited supply. And the higher price will cause more wheat to be produced. The reverse will
also be true.
What is true of the market for commodities is also true for the markets for factors of production
such as labour, land and capital inputs.
People, by being willing to spend money, signal to producers what it is they wish to be produced.
Thus what things will be produced will is determined by the shilling votes of consumers, not
every five years at the polls, but every day in their decisions to purchase this item and not that.
The “How?” questions is answered because one producer has to compete with others in the
market; if that producer can not produce as cheaply as possible then customers will be lost to
competitors. Prices are the signals for the appropriate technology.
The “for whom?” question is answered by the fact that anyone who has the money and is willing
to spend it can receive the goods produced. Who has the money is determined by supply and
demand in the markets for factors of production (i.e. land, labour, and capital). These markets
determine the wage rates, land rents, interests rates and profits that go to make up people‟s
incomes. The distribution of income among the population is thus determined by amounts of
factors (person-hours, Acres etc) owned and the prices of the factors (wages-rates, land-rents etc).
Advantages of a Free Market System
Incentive: People are encouraged to work hard because opportunities exist for individuals to
accumulate high levels of wealth.
Choice: People can spend their money how they want; they can choose to set up their own firm
or they can choose for whom they want to work.
Competition: Through competition, less efficient producers are priced out of the market; more
efficient producers supply their own products at lower prices for the consumers and use factors of
production more efficiently. The factors of production which are no longer needed can be used
in production elsewhere. Competition also stimulates new ideas and processes, which again leads
to efficient use of resources.Lesson One
STRATHMORE UNIVERSITY ● STUDY PACK
11
A free market also responds well to changes in consumer wishes, that is, it is flexible.
Because the decision happen in response to change in the market there is no need to use
additional resources to make decisions, record them and check on whether or not they are being
carried out. The size of the civil service is reduced.
Disadvantages of a Free Economy
The free market gives rise to certain inefficiencies called market failures i.e. where the market
system fails to provide an optimal allocation of resources. These include:
Unequal distribution of wealth: The wealthier members of the society tend to hold most of the
economic and political power, while the poorer members have much less influence. There is an
unequal distribution of resources and sometimes production concentrates on luxuries i.e. the
wants of the rich. This can lead to excessive numbers of luxury goods being produced in the
economy. It may also result to social problems like crimes, corruption, etc.
Public goods: These are goods which provide benefits which are not confined to one individual
household i.e. possess the characteristic of non-rival consumption and non-exclusion. The price
mechanism may therefore not work efficiently to provide these services e.g. defence, education
and health services.
Externalities: Since the profit motive is all important to producers, they may ignore social costs
production, such as pollution. Alternatively, the market system may not reward producers whose
activities have positive or beneficial effects on society.
Hardship: Although in theory factors of production such as labour are “mobile” and can be
switched from one market to another, in practice this is a major problem and can lead to hardship
through unemployment. It also leads to these scarce factors of production being wasted by not
using them to fullest advantage.
Wasted or reduced competition: some firms may use expensive advertising campaigns to sell
“new” products which are basically the same as may other products currently on sale. Other
firms, who control most of the supply of some goods may choose to restrict supply and therefore
keep prices artificially high; or, with other suppliers, they may agree on the prices to charge and so
price will not be determined by the interaction of supply and demand.
The operation of a free market depends upon producers having the confidence that they will be
able to sell what they produce. If they see the risk as being unacceptable, they will not employ
resources, including labour and the general standard of living of the country will fall..
b) PLANNED ECONOMIES
Is a system where all major economic decisions are made by a government ministry or planning
organisation. Here all questions about the allocation of resources are determined by the
government.
Features of this system
The command economies relies exclusively on the state. The government will decide what is
made, how it is made, how much is made and how distribution takes place. The resources –
factors of production – on behalf of the producers and consumers. Price levels are not
determined by the forces of supply and demand but are fixed by the government.Introduction to Economics
ECONOMICS
12
Although division of labour and specialisation are found, the planned economies tend to be more
self-sufficient and tend to take part in less international trade than market economies.
Advantages of Planned System
i) Uses of resources: Central planning can lead to the full use of all the factors of production,
so reducing or ending unemployment.
ii Large scale production: Economies of scale become possible due to mass production taking
place.
iii. Public services: “Natural monopolies” such as the supply of domestic power or defence can
be provided efficiently through central planning.
iv) Basic services: There is less concentration on making luxuries for those who can afford
them and greater emphasis on providing a range of goods and services for all the population.
v) There are less dramatic differences in wealth and income distribution than in market economy
Disadvantages of the Planned System
The centrally planned economies suffer from the following limitations:
Lack of choice: Consumers have little influence over what is produced and people may have little
to say in what they do as a career.
Little incentive: Since competition between different producers is not as important as in the
market economy, there is no great incentive to improve existing systems of production or work.
Workers are given no real incentives to work harder and so production levels are not as high as
they could be.
Centralised control: Because the state makes all the decisions, there must be large influential
government departments. The existence of such a powerful and large bureaucracy can lead to
inefficient planning and to problems of communication. Furthermore, government officials can
become over privileged and use their position for personal gain, rather than for the good of the
rest of the society.
The task of assessing the available resources and deciding on what to produce, how much to
produce and how to produce and distribute can be too much for the central planning committee.
Also the maintenance of such a committee can be quite costly.
The Mixed Economy
There are no economies in the world which are entirely „market‟ or planned, all will contain
elements of both systems.
The degree of mix in any one economy is the result of a complex interaction of cultural, historic
and political factors. For example the USA which is a typical example of a largely work-based
society, but the government still plans certain areas of the economy such as defence and provides
very basic care for those who cannot afford medical insurance.Lesson One
STRATHMORE UNIVERSITY ● STUDY PACK
13
Features of this system
The mixed economy includes elements of both market and planned economies. The government
operates and controls the public sector, which typically consists of a range of public services such
as health and education, as well as some local government services. The private sector is largely
governed by the force of mechanism and “market forces”, although in practice it is also controlled
by various regulations and laws.
Some services may be subsidised, provided at a loss but kept for the benefit of society in
general(many national railways, for example, are loss making), other services such as education or
the police may be provided free of charge (though they are paid for through the taxation system).
The private sector is regulated, i.e. influenced by the price mechanism but also subject to some
further government control, such as through pollution, safety and employment regulation.
Advantages of the Mixed Economy
Necessary services are provided in a true market economy, services which were not able to make
profit would not be provided.
Incentive: Since there is a private sector where individuals can make a lot of money, incentives
still exist in the mixed economy.
Competition: Prices of goods and services in the private sector are kept down through
competition taking place.
Disadvantages of Mixed Economy
Large monopolies can still exist in the private sector, and so competition does not really take place
There is likely to be a lot of bureaucracy and “red tape” due to existence of a public sector.
7. SPECIALIZATION AND EXCHANGE
a) Specialization
The economies of mass production upon which modern standards of living are based would not
be possible if production took place in self-sufficient farm households or regions.
As such, many societies and individuals specialize or concentrate on only one activity or type of
production.
Division of labour and specialisation
Division of labour refers to the situation in which the production process is split into very large
number of individual operations and each operation is the special task of one worker. The
workers then specialise on one activity. Four distinct stages can be distinguished in the
development of division of labour and specialization.
Specialisation by craft
Specialisation by process
Regional specialisation
International division of labourIntroduction to Economics
ECONOMICS
14
Advantages of Division of Labour
(i) Greater skill of worker
The constant repetition of a task makes its performance almost automatic. The workers thus
acquire greater skills at their job.
(ii) A saving of time
By keeping to a single operation, a worker can accomplish a great deal more, since he wastes
less time between operations. Less time, too, is required learning how to perform a single
operation than to learn a complete trade.
(iii) Employment of specialists
Specialisation makes it possible for each workman to specialise in the work for which he has
the greatest aptitude
(iv) Use of machinery
Specialisation permits the use of some tools specific to a particular task, which can make the
life of a worker that much easier.
(v) Less fatigue
It is sometimes claimed that the worker, habituated to the repetition of simple tasks, becomes
less fatigued by his work.
Disadvantages of Division of Labour and Specialisation
(i) Monotony
Doing the same work repeatedly can result in boredom, and this can offset the efficiency that
would otherwise result from experience.
(ii) Decline of craftsmanship
If a person does the same kind of work repeatedly according to laid down routine, he loses
initiative for innovation and this can lead to loss of job satisfaction.
(iii) Greater risk of unemployment
If a worker is highly specialised, he can be easily unemployed if something goes wrong with the
product of his industry (e.g. if the product is found to have negative effects to health, and
demands for it falls) or if a machine is introduced to perform his work.
(iv) Increased interdependency
Since each worker contributes only a small part towards the completion of the final product,
the efficiency and success of the whole process will depend on the efficiency and co-operation
of all the workers. If some of the workers are inefficient, they can frustrate the whole system
even if the rest of the workers are doing their work properly.Lesson One
STRATHMORE UNIVERSITY ● STUDY PACK
15
b) Exchange
When societies or individuals specialize, they are likely to produce a flood of “surplus” goods.
They are thus bound to exchange this surplus for what they don‟t produce. In primitive
cutlers, this exchange will take place in the form of barter. For example, it is not uncommon
for food to be exchanged for weapons; or for aid in the building of a house to be exchanged
for aid in cleaning a field. But exchange today in all economies – capitalist or communist takes
place through he medium of money.
8. RATIONALITY
One of the most important assumptions in economics and on which much economic theory is
based, is the rationality of human behaviour. In order to make predictions about human
behaviour, economists assume that human behaviour is "rational" and that consumers and
producers act rationally e.g. in what they will decide to buy or produce at any given price.
9. MICROECONOMICS AND MACROECONOMICS
Overall the study of economics is divided into two halves, microeconomics and macroeconomics.
(a) "Micro" comes from the Greek word meaning small, and microeconomics is the study of
individual economic units or particular parts of the economy e.g. how does an individual
household decide to spend its income? How does an individual firm decide what volume of
output to produce or what products to make? How is price of an individual product
determined? How are wage levels determined in a particular industry? It thus gives a
worm‟s eye view of the economy.
(b) "Macro" comes from the Greek word meaning large, and macroeconomics is the study of
"global" or collective decisions by individual households or producers. It looks at a national
or international economy as a whole, e.g. Total Output, Income and Expenditure,
Unemployment, Inflation Interest Rates and Balance of International Trade, etc and what
economic policies a government can pursue to influence the conditions of the national
economy. It thus gives a bird's eye-view of the economy.
10. CETERIS PARIBUS
The economic world is extremely complicated. There are millions of people and firms; thousands
of prices and industries. One possible way of figuring out economic laws in such a setting is by
controlled experiments. A controlled experiment takes place when everything else but the item
under investigation is held constant. This is an essential component of scientific method.
However economists have no such luxury when testing economic laws. Therefore, when
formulating economic principles economists are usually careful to state that such and such will
happen, ceteris paribus which is the Latin expression meaning all other things remaining
constant.
11. ECONOMIC THEORY
A body of economic principles built up as a result of logical reasoning, it provides the tools of
economic analysis. It is pursued irrespective of whether it appears to be of any practical advantage
ECONOMICS
16
12. ECONOMICS FOR ACCOUNTANTS
A few teachers and some students have questioned the rationale for including economics in a
course of study for professional accountants. In order to appreciate the need for the knowledge
of economics by accountants it is necessary to know something of the accountant‟s role. It
might be necessary to provide a brief survey of accountancy before going to the value of
economics to the accountant.
(i) Accountancy
In general terms accounting consists of procedures for recording, classifying and interpreting
selected experiences of an enterprise to promote effective administration. More specially, the
accounting function can and often is broken down into specializations, a common distinction
being made between management accounting and financial accounting. Briefly put, the role
of the management accountant is to provide management with the best possible information
upon which decisions can be based and enable both effective use of an organisations resources.
The older specialization of cost accounting is perhaps best considered as part of management
accounting which establishes budgets, standard costs and actual costs of operation and processes.
Financial accounting by contrast is concerned with the analysis, classification and recording of
financial transactions in order to illustrate the effects on the performance and financial position
of an undertaking. Both aspects of the accounting function must be executed if the
organisation is to have adequate information for its management to formulate policy and to
plan and control operations.
(ii) The role of economic knowledge
In no type of organisation can the accountant operate in isolation, however. He/she must have
a working knowledge of many other areas, which impinge on the business or undertaking. The
most relevant fields of knowledge are considered to be law, management, statistics, behavioural
studies, information technology and economics.
The accountant is not expected to be an expert in these subject areas but to have sufficient
knowledge to relate intelligently with specialists in such areas and to know enough to appreciate
when and where to go for this specialist knowledge.
As part of the management team or advisor to that team, the accountant needs to appreciate the
opportunities and constrains which the economic environment offers or impose on the
organisation. This is true whether the organisation is in the private or public sector. All
organisations must use the scarce resources available to them in an effective and efficient
manner if the members of the organisations and the society generally are to gain maximum
benefit. Given that allocation of resources is a central concern of economics, the relevance of
economics for the accountant follows.
The accountant as a key provider of financial information for planning, control and decision
making purposes will be better equipped to provide relevant information if he/she is aware of
the organisational objectives, and the environmental constrains within which those objective
are pursued.
As a final word one can also say that accountants need economics to understand analyse and
solve economic problems of the organisation and society in general.