Managerial Economics

Dr. Ahmed El Agamy

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 Chapter One : Introduction to Economics

Economics is a social science. This means that economists, in their study of

human interactions, use models to simplify, analyze, and predict human behavior.
Models include graphs and mathematical models.

The purpose of these graphs and mathematical models is to simplify the many
interactions that occur in an economy. In their use of models, economists usually
make the assumption, when analyzing the effect of a particular change on a market
or on a nation’s economy, that all else is held constant. The term we use for “all else
equal” is the Latin expressions, ceteris paribus.

Another assumption economist makes is that economic agents are rational and have
an incentive to make decisions that are always in their own self-interest. While in
reality human beings often act irrationally, by assuming people, businesses,
governments, and other agents are rational decision-makers, and by assuming ceteris
paribus, economists attempt to establish laws and make predictions about how
human interactions will affect society.

When thinking about economic problems, we can use either positive

analysis or normative analysis. Positive analysis is objective, fact-based, and
cause-and-effect thinking about problems. When economists disagree, it is typically
due to different normative analysis. When using normative analysis, the focus is on
what should happen or how desirable one action is compared to a different action.

The study of economics is sometimes broken down into two

disciplines: microeconomics and macroeconomics. Microeconomics examines the
interactions of buyers and sellers in individual markets for goods and services, the
competitive structure of markets, and the markets for resources. Macroeconomics
examines the interactions and behavior of entire nations' economies, such as why
recessions occur, what causes economic growth, and how countries can benefit from
specialization and trade.

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 Common Misperceptions
• Economics is not the study of stock markets, money, or how to run a business.
Although many new students believe they will be learning about these concepts,
economics is a social science that seeks to better understand and predict human
interactions; unlike business and finance, which focus on how to manage a business
organization and invest money in a way to earn the highest return for investors.

• One essential assumption made in most economic analysis is that all humans
are rational and will make choices based on what is always in their best interest. In
the real world, obviously, people, businesses, and even entire societies can be highly
irrational.

• Just because a decision is "irrational" in the economic sense, that doesn't mean
that it is inherently wrong, bad, or lesser than what an economist would call a
"rational" decision. In fact, the field of Behavioral Economics seeks to understand
better the many reasons humans choose to make economically "irrational" choices in
their decision making.

• One of the four economic resources that societies must decide how to allocate
is capital. When people use the word capital in everyday conversation, many people
are referring to money or “financial capital.” In economics, capital is defined as the
already-produced goods (tools, machinery, equipment, and physical infrastructure)
that are used in the production of other goods or services. A robot on a car factory
floor is defined as capital in economics; money you borrow to start your own
business is not.

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 Scarcity
If you want to sum up what economics means, you could do so with the
following statement:

Individuals and societies are forced to make choices because most resources are
scarce.

Economics is the study of how individuals and societies choose to allocate scarce
resources, why they choose to allocate them that way, and the consequences of those
decisions.

Scarcity is sometimes considered the basic problem of economics. Resources are

scarce because we live in a world in which humans’ wants are infinite but the land,
labor, and capital required to satisfy those wants are limited. This conflict between
society’s unlimited wants and our limited resources means choices must be made
when deciding how to allocate scarce resources.

Any economic system must provide society with a means of making choices that
answer three basic questions:

• What will be produced with society’s limited resources?

• How will we produce the things we need and want?

• How will society’s output be distributed?

Scarcity and Choice

Scarcity is why economics exist: we wouldn't have to worry about how scarce
resources are allocated if those resources were unlimited. It should be emphasized
that economics is primarily concerned with the scarcity of resources.

Positive vs. normative analysis

Economic analysis tends to focus mostly on positive analysis, that is, the
description of phenomena, facts, and concepts. It can be tempting to analyze things
using normative analysis, that is, describing things as they ought to be.

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 However, you shouldn't interpret that to mean that normative thinking is completely
absent in economics and especially in policy-making: both are important for well-
formed policy.

Economic models
A model is a simplification of a concept or process that is used to better understand
that process by cutting away as much as possible to focus on key aspects. For
example, a map is a model of how roads are laid out and where they intersect.
Maybe there is other useful or interesting information, like the location of an
interesting mural or the world's best taco stand, but if we are just interested in
getting to the store, we don't need that, we just need to know how to get there.

Economists rely on models because it's impossible to capture the full complexity of
human interaction, let alone try to do it in a straightforward and easy to read way!

Common errors
• Not all costs are monetary costs. Opportunity costs are usually expressed in
terms of how much of another good, service, or activity must be given up in order to
pursue or produce another activity or good.

• You might hear the fourth economic resource referred to as either

entrepreneurship or technology. The terms are used interchangeably but mean the
same thing: the ability to make things happen. Take the example of computers—a
computer itself would be considered a good, but our ability to make computers
would be considered technology.

• The word capital is used in everyday language to mean what economists

would call financial capital. If you see the word capital on its own in an economics
context, it refers to physical capital—equipment, machinery, or tools used to
produce goods and services. Physical capital is tangible, but financial capital isn't
always so.

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 ** Market Structure Forms **

** Market Definition:
• Consumers (households) demand or buy goods and services.
Producers (firms) produce, sell or supply goods and services.

• Market is a place which consumers and producers interact with each

other and exchange goods and services.

** Perfect Competition Market **

** Conditions of Perfect Competition Market:

1. There are many firms and many consumers in the market.
2. All firms sell identical product (homogeneous product).
3. Freedom of entry and exit the market.
4. Perfect information, which means that all firms & consumers are
informed about available products and prices.

• According to these conditions, no firm has any control over prices. So

the firm is a price taker, and it determines the produced quantities
which maximize its profit.

• This means that a firm can sell all of the production it wants at the
market price because its size is very small relative to the size of the
market.

• If the firm tried to increase the price above the market price, it
would sell zero unit of the product.

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• If the firm tried to decrease the price below the market equilibrium,
its total revenue and profit will decrease.
• Example: Wheat farmers, textile firm, and stock market.

** Pure Monopoly Market**

** Conditions Of Monopoly Market :

1. An industry with a single firm that produces no close substitutes.
2. There are significant barriers to entry, prevent other firms from
entering the industry to compete for profits.

• According to these conditions :

- The monopolist is the only seller in the market, so the supply of its
product equals the market supply of this product.
- Monopolist cannot determine the price and quantity at the same time.
- He can determine the price (price maker) and accept the quantity of
the market or alternatively, he can determine the quantity and
accept the price.

• Why Monopolies Arise?

• The fundamental cause of monopoly is the existence of barriers to
entry. This factor allows firms to earn supernormal profits in the long
run by making it unprofitable for new firms to enter the industry.

• Example: delivery of electricity, phone service, tap water, etc.

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 ** Perfect Competition Versus Monopoly Monopolistic **

Comparison points Perfect Competition Monopoly

Number of firms Many firms One firm
Product’s Identical product has One product has not
characteristics many substitutes any substitute
Barriers to entry or No barrier Many barriers
exist
The producer Price taker Price maker
Share of the Very small All the market
market

** Monopolistic Competition **

** Conditions of Monopolistic Competition Market :

1. Many sellers: there are many firms competing for the same group
of customers.

2. Product differentiation: each firm produces a product that is at

least slightly different from those of
other firms. Thus, rather than being a
price taker, as the case of perfect
competition, each firm has low power of
affecting the price.

3. Free entry: Firms can enter or exit the market without restrictions.
• Monopolistic Competition: Is a common form of market structure,
characterized by a large number of firms, no barriers to entry, and
product differentiation.
• Examples: books, CDs, movies, computer games, restaurants, and
so on.
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** Product Differentiation and Advertising :
1. Product Differentiation : A strategy that firms use to achieve
market power. Accomplished by
producing products that have distinct
positive identities in consumers' minds.

2. Advertising : When firms sell differentiated products, each firm has

an incentive to advertise in order to attract more
buyers to its particular product.

** Oligopoly **

** Conditions of Oligopoly Market :

1. A few number of firms.
2. Products may be homogeneous or differentiated.
3. The behavior of any one firm in an oligopoly depends to a great
extent on the behavior of others.
• All kinds of oligopoly have one thing in common:

• The behavior of any given oligopolistic firm depends on the behavior

of the other firms in the industry comprising the oligopoly.
• Example: Car industry, Mobile phone network, private schools .
•

** The Market equilibrium **

1. Market Equilibrium :
• Equilibrium: A condition that exists when quantity supplied and
quantity demanded are equal, At equilibrium: there is
no tendency for price to change.
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• So, equilibrium price is determined when :
Qd=Qs

** The Equilibrium Price and Quantity **

Excess Demand or Excess

P Qd Qs Supply
Excess Supply
10 4 11
(surplus) = 11-4 = 7
Excess Supply
8 6 10
(surplus) = 10-6 =4
Equilibrium
6 9 9 Qd = Qs = 9
P*= 6, Q* = 9
4 12 8 Excess demand
(shortage) = 12 – 8 = 4
2 15 7 Excess demand
(shortage) = 15 – 7 = 8

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2- Excess Supply :

• Excess supply or surplus exists when:

a - the current price is higher than equilibrium price.
b- Qs> Qd at the current price.
c- excess supply will cause the price to fail a to the equilibrium price
(Qd=Qs).
• When Qs exceeds Qd at the current price, the price tends to fall.
When price falls, Qs is likely to decrease and Qd is likely to increase
until an equilibrium price is reached where Qs and Qd are equal.

Excess supply “surplus”

• •

3. Excess Demand :
• Excess Demand, or Shortage exists when:
a-The current price is lower than equilibrium price.
b- Qd > Qs at the current price.
c- Excess demand will cause the price to rise up to the equilibrium price
(Qd=Qs).
• When Qd exceeds Qs, price tends to rise. When the price in a market
rises, Qd falls and Qs rises until an equilibrium is reached at which
Qd and Qs are equal and excess demand is eliminated.
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 P

• Equilibrium

• •

Excess demand
“shortage”
Q

4- Changes In Equilibrium :
A- Changes in Demand :
• Increase in demand can be caused by:
↑ income
↑ Prices of substitute goods
↓ Prices of complementary goods
↑ Changes in tastes in favor of this good
↑ Expected Income and prices

• Decrease in demand can be caused by:

↓ income
↓ Prices of substitute goods
↑ Prices of complementary goods
↓ Changes in tastes in disfavor of this good
↓ Expected Income and prices

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 A rise in demand causes an increase in both the equilibrium
price and the equilibrium quantity

A fall in demand causes a decrease in both the equilibrium price

and the equilibrium quantity

B- Changes in Supply :
• Increase in supply of X can be caused by:
↓ cost of production or Input prices.

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 ↑ level of technology.
↓ prices of related product Y (if firms can produce either X or Y).

• Decrease in supply can be caused by:

↑ cost of production or input prices.
↓ level of technology.
↑ prices of related product Y (if firms can produce either X or Y).

A rise in supply causes a decrease in the equilibrium price and

increase in the equilibrium quantity

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A fall in supply causes a increase in the equilibrium price and a
decrease in the equilibrium quantity

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 ** Demand and Supply Applications **

1. Constraints on the Market :

• Sometimes governments decide to use some mechanism other than
the market system to set prices.
• They impose the price of some products to protect consumers (price
ceiling) or producers (price floor).

2- Price Ceiling :
1. It is a maximum price; below or lower than the equilibrium price.
2. It is an obligatory price; not permitted to increase.
3. It is set to protect consumers.
4. The price ceiling creates a shortage (excess demand).

• This shortage causes:

1- Queuing: Waiting in lines to distribute goods and services.
2- Favored customers: Those who receive special treatment from
dealers during situations of excess demand.
• The black market: A market in which illegal trading takes place,
since the sellers sell the available quantity of a certain good at a
price higher than the price ceiling set by the government to increase
their revenue.

• As a solution for this shortage (excess demand), government may

distribute the limited amount of the products using ration coupons.
• Ration coupons are tickets or coupons that entitle individuals to
purchase a certain amount of a given product per month.
• A price ceiling that is set above the equilibrium price has no effect
because the equilibrium remains attanable.
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• A price ceiling that is set below the equilibrium price will reduce the
price , and this price ceiling will be binding and effective , and will
lead to excess in demand.

A price ceiling and black-Market pricing

P2
Price

E
P0
price ceiling
P1
Excess
D
Demand

q2 q0 q1
Quantity

3- Price Floor :
• price floor is a minimum price, set by government, above the
equilibrium price and is not permitted to fall.
1- It is a minimum price: above or higher than the equilibrium price.
2- It is an obligatory price: not permitted to decrease.
3- It is set to protect producers, (agriculture producers).
4- The price floor creates a surplus (excess supply).

P1

P0

Q2 Q0 Q1

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• As a solution for this surplus (excess supply) the government will
be forced to buy the surplus products resulted from this policy to get
rid of the excess supply.
• Example: minimum wage A price floor set for the price of labor, and
the result will be surplus of labor, or unemployment.
• Therefore: Attempts to bypass equilibrium price in the market and
to use alternative devices are sometimes more-difficult and more
unfair than simple price mechanism.

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 ** Demand Theory **

** Price and Quantity Demanded **

** Quantity demanded (Qd) :

• The amount of a product that a household (a consumer)

would buy at the current market price.

** The law of demand **

• There is a negative relationship between price of any product and its

quantity demanded, other factors remaining constant.
↑ P → ↓ Qd ↓ P → ↑ Qd
• This negative relationship because of:
1. The income effect .
2. The substitution effect .

** Demand Schedule: A table showing how much of a given product

a household would be willing to buy at
different prices.

**Demand Curve : A graph illustrating how much of a given product a

household would be willing to buy at different
prices.

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 25

20
Price

15

10

2 5 10 20
Q.D

** Demand Curves Slope Downward :

• The relationship between price (P) and quantity demanded (Qd)
presented graphically is called a denmand curve. Demand curve has
a negative slope, indicating that quantity demanded tends to fall
when price rises, and quantity demanded tends to rise when price
falls, ceteris paribus.

** Determinants of Demand **

• The price of the product is the main determinant of Quantity

demanded and it is represented by the law of demand.

** Non-price determinants:
1- The income.
2- The prices of other products.
3- The tastes and preferences.
4- The expectations about future income and prices.
1- Income :
• There is a positive relationship between household's income and
demand for normal goods, ceteris paribus.

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• Normal goods: movie tickets, restaurant meals, telephone calls.
↓ income → ↓ demand for normal goods
↑ income → ↑ demand for normal goods

• There is a negative relationship between household's income and

demand for inferior goods, ceteris paribus.
• Inferior goods: bad quality goods, such as beans, used clothes.

↓ income → ↑ demand for inferior goods

↑ income → ↓ demand for inferior goods

2- Prices of other Goods and Services :

A- Prices of Substitutes:
• Substitutes are Goods that can serve as replacements for one
another- Such as (tea, coffee), (beef, poultry), (rice, pasta), (car,
train); when the price of one increases, demand for the other
increases, other factors remaining constant (positive relationship).

↑ P(substitute) → ↑ Dx
↓ P(substitute) → ↓ Dx

• Example: An increase in the price of poultry, tends to decrease the

quantity of poultry demanded (law of demand) and
therefore increase the demand of its substitutes such as
beef (x).

B- Prices of Complements:
• Complementary goods are Goods that are consumed or used
together-such as (CD, CD player), (tea, sugar), (car, gasoline); a

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 decrease in the price of one results in an increase in demand for the
other, other factors remaining constant (negative relationship).

↑ P (complement) → ↓ Dx
↓ P(complement) → ↑ Dx

Example: An increase in the price of cars, tends to decrease the

quantity of cars demanded (law of demand) and therefore
decrease the demand for its complements such as gasoline,
since they are used or consumed together.

3- Tastes and Preferences :

• Tastes are volatile and personal, therefore, its effect on demand
curve location could be positive or negative.

• If tastes change in favor of(X) → ↑ Dx

• If tastes change in disfavor of (X) → ↓ Dx

• Adverts and medical reports can affect people's tastes and

preferences.

4- Expectations about the future :

• Expectation about prices and income:
• If the prices of (x) is expected to increase or the consumer's income
is expected to increase, the current demand for x will increase,
ceteris paribus (positive relationship).
↑ Px (expected) → ↑ Dx
↓ Px (expected) → ↓ Dx
↑ income (expected) → ↑ Dx
↓ income (expected) → ↓ Dx

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 ** Changes in Quantity Demanded versus **
** Changes in Demand **

1- Changes in Quantity demanded:

• Changes in the price of a product affect the quantity demanded per

period. It is represented graphically by a movement along a demand
curve.
• Thus, we say that an increase in the price of Coca-Cola is likely to
cause a decrease in the quantity of Coca-Cola demanded (movement
along a Coca-Cola demand curve).

** Change in Quantity Demanded (Qd)

• When the price of a good changes, we move along the demand curve
for that good.

2- Changes in Demand:
• Changes in any other factors, such as income or preferences, affect
demand, it is represented graphically by a shift of a demand curve.
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• Thus, we say that an increase in income is likely to cause an increase
in the demand for Coca-Cola (shift of a Coca-Cola demand curve).

** Change in Demand :
• It is caused by a change in any other factors that influences demand
(income & Weath, tastes, prices of other goods, and the expectations
about future), represented by a shift of the demand curve.
1- Change in income:

↑ income → demand for curve normal goods shifts to the right from D0
to D1 consumers demand more at the same price .

↓ income → demand for curve normal goods shifts to the left from D0
to D1 consumers demand less at the same price .

2- Change in Prices of Substitutes :

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↓ Price of coffee → ↑ Qd of coffee → ↓ demand for tea at the same price
(because tea and coffee are Substitutes), and demand shifts to the left.

3- Change in Prices of Complements :

↓ Price car → ↑ Qd of cars → ↑ demand for gasoline because car and

gasoline are complements, and demand shifts to the right .

4- Change in Tastes and Preferences :

Tastes change in favour of X Tastes change in disfavour of

→ ↑ demand for X at the same X → ↓ demand for X at the
price → demand shifts to the same price → demand shifts
right . to the left .

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5- Change in Expectations :

↑ Expected income or price → demand shifts to the right from D0 to D1

↓ Expected income or price → demand shifts to the left from D0 to D2

The Market Demand Curve:

Market demand The sum of all individual quantities of good

demanded at each price(horizontal summation of demand curves of
all consumer in the market).

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 Elasticitiy of Demand

*the elasticity of demand be as follows:

• Price Elasticity
• Income Elasticity
• Cross-Price Elasticity

First :Price Elasticity of demand:

1- Definition of Elasticity of Demand:

• Elasticity:is a general concept used to Quantify the response in one
variable when another variable changes.
• Price elasticity of demand measures the response of quantity
demanded to changes in price.

2-Calculating Elasticity:
• Price elasticity of demand: is the ratio of the perecentage of
change in quantity demanded to the perecentage of change in price.

• Price elasticity of demand = percentage change in quantity demanded

percentage change in price

• We use this formula when the available information is the percentage

change in Price and quantity.
•
Ed = %∆ Q
%∆ P

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3-Types of Elasticity:
1. Perfectly inelastic demand Ed=0

2. Inelastic demand Ed<1

3.unitary elasticity Ed=1

4.Elastic demand Ed>1

5.Perfectly elastic demand Ed=∞

1-Perfectly Inelastic Demand:

•Demand in which quanti ty demanded does not respond at all

to change in price.

Ed=0

Example:

goods don't have substitutes, such as life-saving medicines(insulin).

P
Demand
curve is
100 vertical
line.
50

Qd

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2-Inelastic Demand

demand in which quantity demanded responds less than the change in

Price.
% ∆ Qd<% ∆p
Ed<1

Example :

-Necessary goods such as food,especially wheat, corn,and bread.

p
Demand
curve steep
slope

3-Unitary Elasticity :

- unitary elasticity :A percentage change in quantity of a product

demanded is the same as the percentage change in price in absolute
value.

Ed = 1
%∆Qd=%∆p

Example:

-if the consumer decided to spend the same mony to buy the good
regardless its prices.

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 P
Demand
curve is
convex
towards the
origin.

4-Elastic Demand :

-Elasstic demand: consumers are responding a lot to a price change.

%∆Qd>%∆p
Ed>1

Example:

-Unnecessary goods,such as cars,soft drinks,electric devices.

P

Demand
curve flat
slope

Q
5-Perfectly elastic demand:

-perfectly elastic demand: demand in which quantity drops to zero at

the slightes increase in price.

%∆Qd/0=∞
Ed=∞
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 p
Demand
curve is
horizontal
line

40

300 Qd

4-The determinants of Demand Elastictiy:

1- the importance of good

Necessary good has lower elasticity of demand,since people cannot

reduce its quasntity demanded sharply when its price increases.

2-Availability of Substitues

when the number of substitues increases,elasticity of demand increases

as well.

3-Proprotion of income Spent on the Good

Where a good represent a smaller portion of a total budget, demand

will tend to be more inelastic.

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4-The Time Dimension

• In the long run,demand is likely to become more elastic because

households make adjustment over time and producers develop
substitue goods. So,the longer the time period, the higher the
elasticity.

** Income Elasticity of demand:

1- Definition of income elasticity of demand:

• A measure of the response of the quantity demanded of one good to
a chang in income.

Income elasticity of demand =Percentage Change in quantity demanded

Percentage Change in income

I.Ed = % ∆ Q
%∆I

2- The sign and value of income elasticity of demand:

If for good x I.Ed > 0, or positive

Income D Qd This good is Normal

I.Ed < 1 I.Ed >1

necessary good unnecessary good
-If for good x I.Ed <0, or negative

eIncom D Qd
This Good is Inferior
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 ** Cross-price Elasticity of demand **

1- Cross-price elasticity of demand: A measure of the response of

the one good demanded to a change in the price of anather good.

Cross-price elasticity of demand=

Percentage change in quantity of Y demanded

Percentage Change in price of x

Cross elasticity = % ∆ Qy
% ∆ Px

2- The sign of cross-price elasticity of demand and the

relationship between the two goods :

1- If an increase in the price of X causes an increase in the Qd of Y, the

cross-price elasticity is positive, Px Qy

X and Y are substitutes

2- If an increase in the price of X causes a decrease in the Qd of Y, the

cross-price elasticity is negative, Px Qy

X and Y are complements

3- If an increase in the price of X does not cause any change in the Qd

of Y, the cross-price elasticity = 0

X and Y are indepenodent goods

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 ** The Supply theory **

1- Price and Quantity Supplied :

• Quantity Supplied (Qs): The amount of a particular product that a
firm would be willing and able to offer for
sale at a particular price.
• Supply Schedule : A table showing how much of a product a firm
would sell at alternative prices.
• Supply Curve : A graph illustrating how much of a product a firm
would sell at different prices.
• Supply curve has a positive slope (slope upward), indicating that Qs
tends to increase when price rises, and Qs tends to fall when price
decreases, ceteris paribus.

• Law of Supply : There is a positive relationship between price of

any product and its quantity supplied, other factors
remaining constant.
↑ P → ↑ Qs ↓ P → ↓ Qs

2. Determinants of Supply :
• The price of the product is the main determinant of quantity supplied
and it is represented by the law of supply.
• Other Determinants of Supply :
a- Cost of production or input prices.
b- Level of technology.
c- Prices of related products.

1- Cost of Production or Input Prices (-) relation :

• Input prices: Prices of the inputs needed by the firm (labor, land,
energy, and capital).
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↑P of inputs (factors of productions) → ↑cost of production→ ↓ profit →↓s.

↓ P of inputs (factors of productions) → ↓cost of roduction → ↑ profit → ↑ S

2- Level of Technology (+) relation :

• The available technology that can be used to produce the product.
↑ Available technology → ↑ productivity of existing resources or
increase resources → ↓ cost of production → ↑ profit → ↑ s.

• For example: More advanced fertilizers can increase the outputs

and increase the productivity of the existing resources.

3- Prices of Related Products :

↑ P of Y → ↑ profit of producing Y → ↑ Qs of Y → ↓ Sx.

• If resources (inputs) can be used for producing either X (wheat) or Y

(corn), an increase in Y prices may cause individual producers to
shift inputs out of X production into Y. Thus, an increase in Y prices
decreases the supply of X.

3- Changes in Quantity supplied versus Changes in supply :

** Changes in Quantity supplied:

• a change in quantity supplied of a product per period is caused by a
change in the price of that product. It is represented graphically by a
movement along a supply curve.

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• When the price of a good changes, we move along the supply curve
for that good; the quantity supplied rises or falls.

** Changes in supply:
• a change in supply is caused by a change in cost of production,
technology or prices of related goods- It is represented graphically
by a shift of a supply curve.
• It is caused by a change in any other factors that affects supply (cost
of production, level of technology, and prices of related products)
represented by a shift of the supply curve).

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 ** Changes in Technology **

↑ Technology → ↑ resources or ↑ productivity of the existing resources →

↑ S, shifts from S0 to S1 and producers produce more at the same
price.
• Example: Developing newseeds → ↑ productivity of producing
soybeans → ↑ S of soybeans, shifts from S0 to S1 → ↑ Qs
at the same prices.

** Changes in Prices of Related Products **

↑ P of related product (corn) → ↑ profit of producing corn → ↑ Qs of corn

→ ↓ Supply of wheat .

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 ** Comparison between Changes in the Qs and Changes in Supply

Change in supply : Change in Qs:

It is caused by a change in any It is caused by a change in price,
other factors, and is represented and is represented by a
by a shfit of the supply curve. movement along a supply curve.

4. The Market Supply Curve :

• Market supply: The sum of all that is supplied at each price by all
producers of a single product, (horizontal
summation of the supply curves of all firms
working in that market).

-38-
 ** Elasticity of Supply **
** Price Elasticity of Supply :
• Elasticity of supply: A measure of the response of quantity of a
good supplied to a change in price of that good. Likely to be positive
in output markets.

elasticity of supply = % change in quantity supplied

% change in price

% ∆ Qs
Es= % ∆ P

** Types of price elasticity of Supply :

1- Perfectly inelastic supply |Es| = 0

2- Inelastic supply |Es| < 1
3- Unit elastic supply |Es| = 1
4- Elastic supply |Es| >1
5- Perfectly elastic supply |Es| =∞
1- Perfectly Inelastic Supply :

• Quantity supplied does not respond at all to a change in price.

-39-
** Examples:
• The supply of very rare painting for a famous artist (Picasso).
• The supply of football game tickets.

2- Inelastic Supply :

• Supply in which Qs responds somewhat, but not a great deal, to

changes in price.
% ∆ Qs < % ∆P
|Es| < 1
** Example: The supply of agriculture goods, which cannot be stored
easily such as tomatoes.

3- Unit Elastic Supply :

-40-
• A percentage change in quantity of a product supplied is the same as
the percentage change in price.

|Es| =1
% ∆ Qs = % ∆P

4- Elastic Supply :

• producers are responding a lot to a price change.

% ∆ Qs > % ∆P
|E|= >1

** Example: industrial goods, which can be stored easily.

5- Perfectly elastic supply :

-41-
• Supply in which quantity drops to zero at the slightest decrease in
price.
% ∆ Qs / 0 = ∞
|Es|= ∞

** The Determinants of Supply Elasticity :

1- Complexity of Production: more complex product, its supply is

difficult to respond a lot to a change in
its price, so its supply is inelastic and
vice versa.

2- Time to respond: The more time a producer has to respond to

price changes the more elastic the supply.

• For example, a cotton farmer cannot immediately respond to an

increase in the price of soybeans.

3- Inventories: A producer who has available storage capacity can

quickly respond to price changes. and supply will tend
to be more elastic.

-42-
 ** Production **

1- Production Definitions
• Production is the process by which inputs or resources are
combined, transformed, and turned into outputs.
A- Resources (inputs) :
• Are the factors of production or inputs used into the process of
production to produce goods and services.
• It consists of:
1- Natural resources: land, forest, minerals, timber, energy, rain,
wind.
2- Human resources: labor.
3- Capital resources: tools, equipments, buildings, software, roads,
bridges, factories.

B- Outputs :
• consists of all goods and services that people (households) would like
to consume .

C- Firm An organization that comes into being when a person or a

group of people decides to produce a good or service to meet a
perceived demand.

D- Profits :
• profit (economic profit) The difference between total revenue and
total cost.
profit = total revenue - total cost
• Total revenue The amount received from the sale of the product (q x
P).

-43-
** The Bases of Decisions: (1)
Market Price of Outputs,
(2)
Available echnology, (3)
and Input Prices :
• In the language of economics, a firm needs to know three things:
1. The market price of output.

2. The techniques of production that are available.

3. The prices of inputs.

• Output price determines potential revenues. The techniques

available tell me how much of each input l need, and input prices
tell me how much they will cost.

• Together the available production techniques and the prices of inputs

determine costs.

• The Production Process :

• production technology: The quantitative relationship between
inputs and outputs.
• labor-intensive technology: Technology that relies heavily on
human labor instead of capital.
• Capital-intensive technology: Technology that relies heavily on
capital instead of human labor .

2. Production Function :
• Production Function or total product function is a mathematical
expression of a relationship between inputs and outputs.
TP or Q=f (L,K)
• TP = Q = total product = quantity of output.
• L= labor ( number of workers).
• K = capital (number of machines).

-44-
** The difference between the short run and long run :
• Short run: The period of time in which some factors of production
are fixed, and firms can neither enter nor exit an industry.
• long run : That period of time for which there are no fixed factors of
production (all factors of production are variable), and firms can
enter or exit the industry.
** Production in the short run :
• Total product (TP): is the total amount of outputs the firm obtains
from a given amount of inputs.
• Average product of labor (APL): The average amount produced by
each worker. It measures the output per worker.

TP
A PL= L

average product of labor = Total product .

Total units of labor

• Marginal product of labor (MPL): The additional output that can

be produced by adding one more unit of labor, ceteris paribus. It
measures the output of the extra worker.

M PL = ∆T P
∆L

** Law of Diminishing Returns :

• In the short run, the law of diminishing returns states that as we add
more units of a variable input (labor) to fixed amounts of land and
capital, the marginal product of labor eventually declines (the change
in total output will at first rise and then fall).

-45-
 (1) (2) (3) (4) (5) Production
Capital Labor TP MP AP of stages
input input (Sandwich Of Labor Labor
(L) es per MPL= APL =
hour ∆ TP/∆L TP/L
2 0 0 - - Increasing
2 1 10 10 10 marginal
2 2 25 15 12.5 returns
2 3 45 20 (max) 15
2 4 60 15 15 (max) Decreasing
2 5 70 10 14 or
2 6 75 5 12.5 Diminishing
2 7 75 (max) 0 10.7 marginal
returns
2 8 70 -5 8.75 Negative
marginal
returns

What might cause marginal product to fall?

• After the optimal mix of factors of production (labor and capital),
new workers will not have as much capital equipment to work with,
so their production (MPL)witl decline.

3. Stages of Production in the short run :

• In the short run, as the quantity of labor employed increases, the
production process passes three stages;
1. Increasing Marginal Returns :
• Initially, the marginal product of a worker exceeds the marginal
product of the previous worker.

• TP is increasing at an increasing rate.

• MPL is increasing.
• APL is increasing.
• Increasing marginal returns arise from increased specialization and
division of labor.

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2. Diminishing Marginal Returns :
• Eventually, the marginal product of a worker is Less than the
marginal product of the previous worker.

• TP is increasing at a decreasing rate.

• MPLis decreasing.
• APL is increasing and then decreasing.

• Diminishing marginal returns arises because, each additional worker

has less access to capital and less space in which to work.

3. Negative Marginal Returns :

• The marginal product of worker is negative .
• TP is decreasing.
• MPL is negative.
• APL is decreasing .
** The Production Curves in the short run :
1- In the first stage of production :TP increases with an increasing
rate, MPL is increasing, APL is increasing too.

2- In the second stage of production: TP is increasing with a

decreasing rate & reach its maximum at the end of this stage, MPL
is decreasing & reach zero at the end of the stage, APL is
increasing, then decreasing.

3- The third stage: TP is decreasing, MPL is negative, APL is

decreasing & positive.

-47-
 •

•
•

-48-
** The Production Curves in the short run :
• Note that :
1- When TP reaches its maximum, MPL reaches zero.

2- APL cannot be negative because APL = TP/L. and both of TP & L are I
positive.

3. Firms should work in the diminishing marginal returns stage because

the optima) mix rate between factors of production occurs in this
stage.

** The Relationship Between Marginal Product And Average

Product :

1- When marginal product exceeds average product, average product

increases.

2- When marginal product is below average product, average product

decreases.

3- When marginal product equals average product, average product is

at its maximum.

-49-
• Explain why you agree or disagree with esach of the following
statements using graphs if possible:

1 -When the total product is increasing, marginal product has to be

increasing too.

2 -When the total product is increasing, average product has to be

increasing too.

3 -Total product is maximum when marginal product is equal to

average product.

4 - Total product reaches maximum when marginal product reaches

zero.

5 -Marginal product and average product curves are equal at maximum

point of marginal product curve (May 2015).

6 -When the average product is increasing, marginal product has to be

increasing too.

-50-
7 -When the average product is increasing, marginal product has to be i
above the average product.

8 -When the average product is decreasing, marginal product has to be

decreasing too.

-51-
 Chapter two: Introduction to Money

• Money is anything that is commonly accepted by a group of people for the

exchange of goods, services, or resources.

• Money, in some form, has been part of human history for at least the last
3,000 years, before that time, it is assumed that a system of bartering
was likely used.

• In order to barter, you have to find someone who wants what you are
offering, say a loaf of bread, and is at the same time offering something
you want, say a joint of meat, and then you have to agree that the bread
and the meat have nearly the same value.

1- Bartering and Commodity Money :

• Barter is the exchange of a good or service for another good or service, a

bag of rice for a bag of beans.

• However, what if you couldn't agree what something was worth in

exchange or you didn't want what the other person had. To solve that
problem humans developed what is called commodity money.

• A commodity is a basic item used by everyone. In the past, salt, tea,

tobacco, cattle and seeds were commodities and therefore were used as
money.

• However, using commodities as money had other problems. Carrying bags

of salt and other commodities was hard, and commodities were difficult to
store or were perishable.

-52-
• In other words, bartering is the trading of one product or service for
another. Usually there is no exchange of cash.

** Commodity money :
• Commodity money is a form of money which has an intrinsic (essential)
value, meaning it is worth something in its own right rather than simply
being a token of financial value such as a banknote.

• The best known form of commodity money is gold or silver coins, though
any commodity can fulfill this role.

• Most types of cash used today do not have any real intrinsic value, for
example, a banknote is virtually worthless in itself and only has value
because society accepts it as a measure of currency and a unit of
exchange. This type of currency is known as fiat money.

• Historically, other forms of money were used which did have an underlying
value, such as foods, fuels or metals.

• Such commodity money is not widely used in modern economies as its

underlying value can vary immensely from its agreed currency value.

• There is also the problem that many such commodities are prone to
spoiling or deteriorating.

• Some forms of commodity money may only fulfill the money role in very
specific circumstances.

• The best known example is the use of cigarettes as currency in prisons.

With no cash available to prisoners, cigarettes can serve as a medium of
exchange which avoids the need to rely on bartering for direct exchange of
items.

-53-
• But cigarettes also have intrinsic value as they can be smoked.

• Examples of commodities that have been used as mediums of exchange,

gold, silver, copper, rice, salt, peppercorns, alcohol, cigarettes, candy, etc.

2- Coins :
• The next stage of evolution for money was the creation of coins. Coins
effectively replaced the ineffective and troublesome barter and commodity
money system.
• Many archaeologists and historians believe that independent coinage
originated in the 17th century among the early people of the Aegean
Islands or in China.
• Coins come in all shapes and forms. Most coins were circular, while some
were oval, triangle, square or rectangular in form. Rare and unusual coins
with irregular shapes were used throughout history.
• Different metals were used in the creation of coins, from copper, to
bronze, iron, silver and gold.
• Although coins of the past were made of precious metals, the coins today
are mostly made from base metal and do not hold any value except as a
currency to exchange for goods and services, its value determined by
government law.

3- Paper money :

• Paper money known as a banknote is a promissory note issued by a

central bank of a country.
• It represented a store of value, backed by the credibility of the issuing
authority.
• Along with coins, paper money (banknotes) is a common form in most
countries today. While, banknotes are usually used as a higher value unit.

-54-
** Advantages of Paper Money :

1- Economical :
• Currency notes are cheapest media of exchange, Paper money practically
costs nothing to the government.
• It does not need to spend anything on the purchase of gold for minting
coins. Certain other expenditure or losses associated with metallic coins
are also avoided.

2- Convenient :
• Paper money is the most convenient mean of money. A large amount can
be carried conveniently in the pocket with out any body knowing about it.

3- Homogenous :
• Among the coins there are good and bad coins- But currency notes are all
exactly similar. It is therefore the substitute medium of exchange.

4- Stability :
• The value of money can be kept stable by properly regulating its issue.
Managed proper currency method is adopted by many countries.

5- Cheap Remittance :
• Money in the form of currency notes can be cheaply remitted from one
place to another in an insured cover.

6- Elasticity :
• Paper money is absolutely elastic. Its quantity can be increased or
decreased at the will of the currency authority. Thus paper money can
better meet the requirements of trade and industry.

7- Advantages to the Banks :

• Paper money is of great advantage to the banks. They can keep their cash
reserves against liabilities in this form, for currency notes are full legal
tender.

-55-
 ** Disadvantages of Paper Money :

1- No Value Outside the Country :

• Paper money is of no value outside the country where it is issued. Gold
and silver coins were accepted even by foreigners as they had no intrinsic
value.

2- Risk of Damage :
• There is always a possibility of damage to the paper. Fire may burn it,
water may tear it … etc.

3- Danger of Over Issue :

• A serious drawback in paper currency is the ease with which it can be
issued.
• There is always a danger of its over issue when the government is in
financial difficulties.
• This will lead to further notes printing until it losses all the value. This over
issue of notes is called over inflation.

4- Price Increase :
• Some times especially when the money loses its value there is always an
increase in the price of goods. As a result, labors and other people with
fixed income suffer greatly. The whole public feels the pinch.

5- Effect on Business :
• During the days of monetary stringencies in a monetary economy, the
business activities are affected very badly.
• The indirect result of price increase, shortage of currency etc, result in a
fall of exports and a rise in imports. It leads to the export of gold from the
country, which is not a desirable thing. Its balance of payments gets
unfavorable.

-56-
4- Bank or Credit Money :
• Bank money consist of demand deposit, which is drawn by cheques. A
deposit is like any other medium of exchange and being payable, on
demand, serves as a standard of value or unit of an account as it is
convertible into money .
• Today, all national currencies are known as fiat money, the only reason
why fiat money has any value is because of government regulation,
guarantee to repay law.

** Difference between Commodity money and Fiat money:

• Commodity money has another value or use, such as gold/jewelry or

possibly metal coins.

• Fiat money is worthless without a guarantee from a government.

• Commodity money derives its value from the commodity out of which the
money is made from.

• So if a gold coin was made, the value of the coin would be its value in
terms of gold rather than the face value of the coin.

• Commodity money developed as more convenient form of trade because it

is superior to barter.

• However, commodity money is prone to huge fluctuations in price.

• Imagine the commodity chosen was gold, and a new gold deposit is found.
Those who held lots of gold (banks) will lose a lot of their wealth.

• Also, if food (such as dried beans) are used, what happens during a

-57-
 drought or a famine? All the money is used for consumption, so trade
becomes more difficult.

• Fiat money was first introduced as a more convenient form of money.

Instead of having to carry gold/silver/ we could carry paper backed by the
government.

• Over time governments have been less willing to back up their fiat
currency with gold or other commodities, so fiat money has essentially
become faith based in your government who issues it. Most governments
require that their currency be accepted to pay debts.

5- Electronic Money :
• Electronic money is an online representation, or a system of debits and
credits, used to exchange value within another system.

• It is an electronic store of monetary value on a technical device that may

be widely used for making payments to undertakings other than the issuer
without necessarily involving bank accounts in the transaction, but acting
as a prepaid bearer instrument".

• We should note that "technical device" does not necessarily mean physical
device. While some, such as smart cards, are physical, it includes internet
based systems as well.

• A key element is that payments using it must be accepted by entities other

than the issuer.

• Thus, prepaid phone cards, for example, would not be considered

electronic money.

-58-
• Electronic funds transfer systems are already in common use. When a
customer pays for a purchase with a debit card, the amount may be
electronically taken from the customer's account and transferred to the
merchant's account.

** Forms of electronic money:

1- Offline Electronic Payment Systems:

EX. Payment cards and smart cards.
2- Online Systems:
3- PayPal :
4- Digital Cash:

** Central bank response :

• To meet the challenge of electronic money, the European Central Bank
proposes extensive regulation, including:

1- Issuers of electronic money must be subject to prudential supervision.

2- Electronic money schemes must have solid and transparent legal
arrangements.
3- Electronic money schemes must supply the central bank with whatever
information may be required for the purpose of monetary policy.
4- Issuers of electronic money must be legally obliged to redeem it at par
value.
5- The possibility must exist for the ECB to impose reserve requirements on
all issuers of electronic money." European Central Bank”.

• Huge amounts of money can be transacted quickly, securely and in real

time.

• Businesses, homes and cars are purchased making electronic transactions

instead of cash.

• On the flipside, the speed in which e-money can transact can also be a

-59-
 disadvantage, especially for those caught in a scam. Large amounts of
money can be squirreled via multiple fake banking accounts across the
world in a matter of minutes.

• With the rise of electronic transactions, cyber criminals are constantly

finding ways to rob and scam the unwary, often without the need to come
into contact with the victims themselves.

• Those may find their savings or investment accounts decimated by those

criminals.

-60-
 Chapter Three: Inflation

** Definition of Inflation :
• Inflation means that there is more supply availability of money in the
economy and there are less of goods and services to buy with that
increased money.

• Thus, goods and services command a higher price than actual as more
people are willing to pay a higher value to buy the same goods. In this
inflationary situation, there is no real growth in the output of the economy.

• It's simply more money chasing few goods and services.

• In other words, inflation can be defined as a rise in the general price

level and therefore a fall in the value of money.

• Inflation occurs when the amount of purchasing power is higher than the
output of goods and services.

• Inflation also occurs when the amount of money exceeds the amount of
goods and services available.

** The main causes of inflation :

1- Demand-pull inflation :
• Demand-pull inflation occurs when the consumers, businesses or the
governments demand for goods and services exceed the supply; therefore
the cost of the item rises, unless supply is perfectly elastic. Because we do
not live in a perfect market supply is somewhat inelastic, and the supply of
goods and services can only be increased if the factors of production are

-61-
 increased.
• The increase in demand is created from an increase in other areas, such as
the supply of money, the increase of wages which would then give rise in
disposable income, and once the consumers have more disposal income
this would lead to aggregate spending.

2- Cost-push inflation :
• Cost-push inflation is caused by an increase in production costs. It is
generally caused by an increase in wages or an increase in the profit
margins of the enterprises.
• When wages are increased, this causes the business owner in turn to
increase the price of final goods and services.
• As a result of the increase in prices for final goods and services the
employees realize that their income is insufficient to meet their standard of
living because the basic cost of living has increased.
• The trade unions then act as the mediator for the employees and negotiate
better wages and conditions of employment.
• If the negotiations are successful and the employees are given the
requested wage increase this would further affect the prices of goods and
services.
• On the other hand, when firms attempt to increase their profit margins
by making the prices more responsive to supply of a good or service
instead of the demand for that good or service.

3- Monetary inflation:
• Monetary inflation occurs when there is an excessive supply of money.
• It is understood that the government increases the money supply faster
than the quantity of goods increases, which results in inflation.
• Interestingly as the supply of goods increase the money supply has to
increase or else prices actually go down.

4- Structural inflation:
• Planned inflation that is caused by a government's monetary policy is
called structural inflation.

-62-
• This type of inflation is not caused by the excess of demand or supply but
is built into an economy due to the government's monetary policy.
• In developing countries they are characterized by a lack of adequate
resources like capital, foreign exchange, land and infrastructure.
Furthermore, over-population with the majority depending on agriculture for
their livelihood means that there is a fragmentation of the land holdings.
• There are other institutional factors like land-ownership, technological
backwardness and low rate of investment in agriculture.
• Food being the key wage-good, an increase in its price tends to raise other
prices as well. Therefore, some economists consider food prices to be the
major factor, which leads to inflation in the developing economies.

5- Imported inflation :
• Imported inflation occurs when the inflation of goods and services from
foreign countries increasing prices for that imported good or service and
this will directly affect the cost of living.
• Another way imported inflation can add to our inflation rate is when
overseas firms increase their prices and we pay more for our goods
increasing our own inflation.

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 ** Methods to Control inflation **
• A high inflation rate is undesirable because it has negative consequences.
However, the remedy for such inflation depends on the cause.

1- Monetary Policy :

• Inflation is primarily a monetary phenomenon. Hence, the most logical

solution to check inflation is to check the flow of money supply by devising
appropriate monetary policy and carefully implementing such measures.
• To control inflation, it is necessary to control total expenditures because
under conditions of full employment, increase in total expenditures will be
reflected in a general rise in prices, that is inflation, because easy bank
credit is available to them .

• By directly affecting the volume of cash reserves of the banks, can

regulate the supply of money and credit in the economy, thereby
influencing the interest rates and the availability of credit. Both these,
factors affect the components of aggregate demand and the flow of
expenditure in the economy.

2- Controlling inflation :
• Monetarists emphasize increasing interest rates (reducing the money
supply, monetary policy) to fight inflation.
• Keynesians emphasize reducing demand in general, often through fiscal
policy, using increased taxation or reduced government spending to
reduce demand .
• Another method attempted is simply instituting wage and price controls
(incomes policies). Wage and price controls have been successful in
wartime .
• Temporary controls may complement a recession as a way to fight
inflation.
-64-
• However, in general the advice of economists is not to impose price
controls, but to liberalize prices, assuming that the economy will adjust,
abandoning unprofitable economic activity.

-65-
 Chapter Four: Functions of money

• The basic function of money is to enable buying to be separated from

selling, thus permitting trade to take place without barter.
• If a person has something to sell and wants something else in return, the
use of money avoids the need to search for someone able and willing to
make the desired exchange of items.
• The person can sell the surplus item for general purchasing power — that
is, “money” to anyone who wants to buy it and then use the money to buy
the desired item from anyone who wants to sell it.

• In the past, money was generally considered to have the following four
main functions. That is, money functions as a medium of exchange, a unit
of account, a standard of deferred payment, and a store of value.

1- Medium of Exchange :
• Medium of exchange is anything used as money. It is most commonly a
currency, but it may be a commodity agreed-upon in a certain area as
having a value.
• In other words, when money is used to intermediate the exchange of
goods and services, it is performing a function as a medium of exchange.
It thereby avoids the inefficiencies of a barter system.
• To be widely acceptable, a medium of exchange should have stable
purchasing power (Value), and therefore it should posses the following
characteristics:
1- constant utility.
2- low cost of preservation .
3- transportability .
4- divisibility .
5- high market value .
6- recognizability .
7- resistance to counterfeiting .

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2- Unit of account: (measure of value)

• A unit of account is a standard monetary unit of measurement of

value/cost of goods, services, or assets. It is one of the well-known
functions of money.
• A unit of account is a necessary prerequisite for the formulation of
commercial agreements that involve debt. To function as a unit of account,
whatever is being used as money must be:
1- Divisible into smaller units without loss of value.
2- Fungible: that is, one unit or piece must be perceived as equivalent to
any other, which is why diamonds, or real estate are not suitable as
money.
3- A specific weight, or measure, or size to be countable.

3- Standard of deferred payment :

• A standard of deferred payment is an accepted way to settle a debt - a
unit in which debts are denominated, and the status of money as legal
tender, in those countries which have this concept, states that it may
function for the discharge of debts.
• When debts are denominated in money, the real value of debts may
change due to inflation and deflation .

4- Store of value :
• A recognized form of exchange can be a form of money or currency, or a
commodity like gold.
• To act as a store of value, these forms must be able to be saved and
retrieved at a later time, and be predictably useful when retrieved.
• With money being a storage of value was the start of monetary inflation
cycles where the under and over abundance of market goods can lead to
price instability.

-67-
• Common alternatives that act as stores of value are:
A) real estate .
b) gold - once the basis of the gold standard .
c) silver - once the basis of the silver standard .
d) precious stones, and precious metals .
e) collectibles, e.g. original art by a famous artist or antiques .
f) livestock (see African currency).
g) stock .
• Money is better than any other store of value because it has full liquidity in
comparison with other forms which act as a store of value .

-68-
 Chapter Five: Credit

• Credit: is the trust which allows one party to provide resources to another
party where that second party does not reimburse the first party
immediately (thereby generating a debt), but instead arranges to repay or
return those resources of equal value at a later date.
• The resources provided may be financial (e.g. granting a loan), or they
may consist of goods or services (e.g. consumer credit). Credit includes
any form of deferred payment.
• Credit is extended by a creditor, also known as a lender, to a debtor, also
known as a borrower.

** Credit Criteria **

• The types of Credit greatly differ according to different criteria:

A- the personality of the debtor criterion:

1- Personal Credit :
• Personal Credit is held by a legal person, such as natural persons or legal
persons of incorporations or private organizations.
• Granting the credit depends upon the trust enjoyed by the debtor.
2- Public Credit :
• Public Credit includes all of the debts of the state and the different
(1)
administrations thereof depending on the financial abilities of the society
(2)
and the banking institutions on one hand, and the trust of society in the
government on the other hand.

• Consequently, public credit cannot be achieved but through social, political

economic and financial stability.

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b- The criterion of credit purpose:
1- Investment and production credit:
• It is a type of credit to which many projects resort for the sake of
providing the needs for fixed capital, such as assets, machinery and
technical equipments.
• Such credit is a long term one as such type of projects requires a long
period of time for the aims thereof to be achieved.
• The suitable way for gaining such credit is through bonds.

2- Commercial credit:
• It is a type of credit to which many projects, resort for the sake of
providing the needs for ongoing capital.
EX: Purchases of raw materials and payment of wages .
• Such credit is a short term one as such type of projects requires a short
period of time for the aims thereof to be achieved.
• The suitable way for gaining such credit is through Drafts and
Promissory Notes.

3- Consumer credit:
• It consists of short-term loans made to people so that they can purchase
consumer goods and services for personal or household purposes.
• This type of credit takes the form of installment sale.

c- Term of credit criterion:

1- Short-term credit: less than one year.

2- Medium-term credit: Ranging in duration from one to five years.
3- Long-term credit: more than five years.

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d- Credit insurance criterion:
• Credit insurance criterion is the essence of the process of credit and it is
divided into two main branches:
1- Blank credit:
• It depends exclusively on the creditor's trust in the debtor's good
reputation and the strength of its financial state.

2- Real property credit:

• It is a type of the insured credit where the debtor shall present a real
property insuring the process of settling its debts. Real property credit
does exist in dealing with great projects and bargains of high levels of
risks.

• It deals with loans of medium and long terms. Such type of credit takes
several forms:
1- Loans granted on goods.
2- Loans granted on securities.
3- Loans granted on drafts .
4- Loans granted on several ways:
a- Loans granted on the salaries .
b. Contractors’ credits .
c- Export and import Credit.

** Credit Instruments **

• As for the process of crediting to be achieved between the creditor and the
debtor, there shall be some instruments evidencing the rights of the
former against the latter, namely the commercial papers, paper securities
and the governmental papers.

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 1- Commercial Papers :

• An unsecured, short-term debt instrument issued by a corporation,

typically for the financing of accounts receivable, and meeting short-term
liabilities.
• The debt is usually issued at a discount, reflecting prevailing market
interest rates.

• There are three types of commercial papers:

A- Promissory Note :
• The most fundamental type of commercial paper is a promissory note, a
written pledge to pay money.
• A promissory note is a two-party paper. The maker is the individual who
promises to pay while the payee or holder is the person to whom payment
is promised.
• The payee can be either a specifically named individual or merely the
bearer of the instrument who has it in his physical possession when he
seeks to be paid according to its terms.
• A note payable to "bearer" can be paid to the person who presents it for
remuneration. Such an instrument is said to be bearer paper.
B- Draft :
• A draft, also known as a bill of exchange, is a three party paper ordering
the payment of money.
• The drawer is the individual issuing the order to pay, while the drawee is
the party to whom the order to pay is given.
• As in the case of a promissory note, the payee is either a specified
individual or the bearer of the draft who is to receive payment according to
its terms.
• The draft is made payable on demand or on a certain date .
• A draft is often used in business to obtain payment for items that must be
shipped over long distances.

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C- Check :
• Check is a specific kind of draft, which is drawn on a bank and payable on
demand to a particular individual or to the bearer, in which case it can be
written payable to "cash" .
• An individual who opens a checking account is engaged in a contractual
relationship with a bank.
• The individual agrees to deposit money therein, while the bank agrees that
it is indebted to the depositor for the amount in the account, in addition to
promising to pay checks written for payment against the account when
there are sufficient funds on hand to do so.

2- Paper Securities:

A- Stock:
• Stock is a security issued by a corporation that represents an ownership
right in the assets of the corporation and a right to a proportionate share
of profits after payment of corporate liabilities and obligations.
• Nevertheless, a stockholder is a real owner of a corporation's property,
which is held in the name of the corporation for the benefit of all its
stockholders.
• An owner of stock generally has the right to participate in the management
of the corporation, usually through regularly shareholders meetings.

B- Bond:
• Bond is a security representing the debt of the company or government
issuing it.
• When a company or government issues a bond, it borrows money from the
bondholders; it then uses the money to invest in its operations.
• In exchange, the bondholder receives the principal amount back on a
maturity date stated in the bond.
• In addition, the bondholder usually has the right to receive coupons or
payments on the bond's interest.

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** The difference between bonds and stocks :
1- Bonds and stocks are both securities, but the major difference between
the them is that (capital) stockholders have an equity right in the
company (i.e., they are owners), whereas bondholders are creditors of
the company (i.e., they are lenders).

2- Bonds usually have a defined term, or maturity, after which the bond is
redeemed, whereas stocks may be outstanding indefinitely.

3- Government Securities:

A- Fiat Money:
• Fiat Money is a kind of negotiable instrument, a promissory note made by
a bank payable to the bearer on demand, used as money.
• Traditional banknotes, which were issued by commercial banks, have
largely been replaced with national banknotes issued by governments or
central banks.
• National banknotes usually are legal tender and are accepted at face value
without discounting.

B- Treasury Bill:
• A very short-term debt obligation issued and backed by the government
with a maturity of less than one year from their issuance date.
• Essentially, T-bills are a way for the governments to raise money from the
public.
• T-bills are purchased for a price that is less than their par (face) value;
when they mature, the government pays the holder the full par value.
• Effectively, the interest is the difference between the purchase price of the
security and the par value.

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 Chapter Six: Banking System

** Introduction :

• A bank is a financial institution that provides banking and other financial

services to their customers.
• A bank is an institution which provides fundamental banking services such
as accepting deposits and providing loans. There are also nonbanking
institutions that provide certain banking services without meeting the legal
definition of a bank.

** Need of the Banks :

• Before the establishment of banks, the financial activities were handled by
money lenders and individuals.
• At that time the interest rates were very high. Again there were no
security of public savings and no uniformity regarding loans.
• So as to overcome such problems the organized banking system was
established, which was fully regulated by the government.
• The organized banking sector works within the financial system to provide
loans, accept deposits and provide other services to customers.
• The following functions of the bank explain the need of the bank and its
importance:
1- To provide the security to the savings of customers.
2- To control the supply of money and credit .
3- To encourage public confidence in the working of the financial system,
increase savings speedily and efficiently.
4- To avoid focus of financial powers in the hands of a few individuals and
institutions.
5- To set equal norms and conditions (i.e. rate of interest, period of
lending etc) to all types of customers

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 Commercial Banks

• Banking occupies one of the most important positions in the modem

economic world. It is necessary for trade and industry.

** Meaning:

• A commercial bank is a profit-seeking business firm, dealing in money and

credit.
• We can say that a bank is a financial institution which deals in debts and credits.
It (1)accepts deposits, (2)lends and (3)creates money.

• It bridges the gap between the savers and borrowers. Banks are not
merely traders in money but also in an important sense manufacturers of
money .

** functions of commercial banks :

• Commercial banks have to perform a variety of functions which are

common to both developed and developing countries.
• These are known as “General Banking” functions of the commercial banks.
These functions can be divided into two categories: (a) Primary functions
and (b) Secondary functions .

A- Primary Functions :

• Primary banking functions of the commercial banks include:

1- Acceptance of Deposits:
• There are three types of deposits:
(a) Current Deposits: These deposits are also known as demand deposits.
These deposits can be withdrawn at any time.
• Generally, no interest is allowed on current deposits, and in this case, the
customer is required to leave a minimum balance undrawn with the bank.
• Cheques are used to withdraw the amount.

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• These deposits are kept by businessmen and industrialists who receive and
make large payments through banks.

• The bank levies certain incidental charges on the customer for the services
rendered by it.

(b) Savings Deposits: This is meant mainly for professional men and
middle class people to help them deposit their
small savings.
• It can be opened without any introduction. Money can be deposited at any
time but the maximum cannot go beyond a certain limit.
• There is a restriction on the amount that can be withdrawn at a particular
time or during a week.
• If the -customer wishes to withdraw more than the specified amount at
any one time, he has to give prior notice. Interest is allowed on the credit
balance of this account .
• The rate of interest is greater than the rate of interest on the current
deposits and less than that on fixed deposit.

(c) Fixed Deposits: These deposits are also known as time deposits. These
deposits cannot be withdrawn before the expiry of the
period for which they are deposited or without giving a
prior notice for withdrawal.
• If the depositor is in need of money, he has to borrow on the security of
this account and pay a slightly higher rate of interest to the bank.
• They are attracted by the payment of interest which is usually higher for
longer period.
• Fixed deposits are liked by depositors both for their safety and as well as
for their interest.

2- Advancing Loans: The second primary function of a commercial bank is

to make loans and advances to all types of persons, particularly to
businessmen.

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• Loans are made against personal security, gold and silver, stocks of goods
and other assets.
• The most common way of lending is by:

(a) Overdraft Facilities: In this case, the depositor in a current account is

allowed to draw over and above his account up to
a previously agreed limit.
• The bank allows the customer to overdraw his account through cheques.
The bank, however, charges interest only on the amount overdrawn from
the account.

(b) Cash Credit: Under this account, the bank gives loans to the borrowers
against certain security.
• But the entire loan is not given at one particular time, instead the amount
is credited into his account in the bank; but under emergency cash will be
given. The borrower is required to pay interest only on the amount of
credit availed to him.
• He will be allowed to withdraw small sums of money according to his
requirements through cheques, but he cannot exceed the credit limit
allowed to him.

(c) Discounting Bills of Exchange: This is another type of lending which is

very popular with the modem banks. The
holder of a bill can get it discounted by
the bank, when he is in need of money.
• After deducting its commission, the bank pays the present price of the bill
to the holder.
• Such bills form good investment for a bank. They provide a very liquid
asset which can be quickly turned into cash.
• The commercial bank can rediscount, the discounted bills with the central
bank when it is in need of money
• When the bill matures the bank can secure its payment from the party
which had accepted the bill.
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(d) Money at Call: Bank also grant loans for a very short period, generally
not exceeding 7 days to the borrowers, usually dealers
or brokers in stock exchange markets against stock or
debentures, etc., offered by them.
• Such advances are repayable immediately at short notice hence, they are
described as money at call or call money .

(e) Term Loans: Banks give term loans to traders, industrialists and now to
agriculturists against some collateral securities.
• Term loans are so-called because their maturity period varies between 1 to
10 years.
• Sometimes, two or more banks may jointly provide large term loans to the
borrower against a common security. Such loans are called participation
loans .

(f) Consumer Credit: Banks also grant credit to households in a limited

amount to buy some durable consumer goods such
as television or refrigerators, etc., or to meet some
personal needs like payment of hospital bills etc.
• Such consumer credit is made in a lump sum and is repayable in
instalments in a short time .

(g) Miscellaneous Advances: such as credits given to exporters for a short

duration, import finance advances against
import bills, finance to the self employed,
credit to the public sector, credit to the
cooperative sector and above all , credit to
the weaker sections of the community at
concessional rates.

4- Creation of Credit: A unique function of the bank is to create credit.

• Banks supply money to traders and manufacturers. Bank deposits are
regarded as money.
• They are as good as cash. The reason is they can be used for the purchase

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 of goods and services and also in payment of debts.
• When a bank grants a loan to its customer, it does not pay cash. It simply
credits the account of the borrower. He can withdraw the amount
whenever he wants by a cheque.

5- Promote the Use of Cheques: The commercial banks render an

important service by providing to their customers a cheap medium of
exchange like cheques.

• It is found much more convenient to settle debts through cheques rather

than through the use of cash.
• The cheque is the most developed type of credit instrument in the money
market.

6- Financing Internal and Foreign Trade: The bank finances internal and
foreign trade through discounting of exchange bills.
• Sometimes, the bank gives short-term loans to traders on the security of
commercial papers.
• This discounting business greatly facilitates the movement of internal and
external trade.

7- Remittance of Funds: Commercial banks, on account of their network of

branches throughout the country, also provide facilities to remit funds
from one place to another for their customers by issuing bank drafts, mail
transfers or telegraphic transfers on nominal commission charges.

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 ** Central Bank **
1- Central Bank is the entity responsible for overseeing the monetary system for a
nation .

2- Central banks have a wide range of responsibilities, from overseeing monetary

policy to implementing specific goals such as currency stability, low inflation and
full employment.

3- Central banks also generally issue currency, function as the bank of the
government, regulate the credit system, oversee commercial banks, and
manage exchange reserves and act as a lender to commercial banks during
times of financial crisis .

4- More specifically, a central bank is a public institution that manages a state's

currency, money supply, and interest rates.

5- In contrast to a commercial bank, a central bank possesses a monopoly on

printing the national currency, which usually serves as the nation's legal tender.

6- The main function of a central bank is to manage the nation’s money supply
(monetary policy), through active duties such as managing interest rates,
setting the reserve requirement , and acting as a lender of last resort to the
banking sector during tines of bank insolvency or financial crisis.

7- Central banks usually also have supervisory powers, intended to prevent

commercial banks and other financial institutions from reckless or fraudulent
behavior.

8- There are three key goals of modern monetary policy.

• The first goal: is price stability or stability in the value of money.
• Today this means maintaining a low rate of inflation.
• The second goal: is a stable real economy, often interpreted as high
employment and high and sustainable economic growth.
• The third goal: is financial stability. This includes an efficient and smoothly
running payments system and the prevention of financial crises.

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 ** Functions of central bank **
1- Governance arrangements for the monetary policy function:
• One of the most challenging tasks in central bank design is to organize the
governance structure in a manner that permits policy makers to meet their
macroeconomic stabilization objectives while remaining accountable for their
actions.

2- Delegation of independent authority:

• Monetary policy actions can be politically sensitive. For this reason, it is now
typical to insulate them from political pressure by assigning them to an
independent agency.

3- Setting objectives: Price stability is the primary objective in most central bank
legislation enacted over the past decade.
4- Exchange rate regime .
5- Governance arrangements for the financial stability function .
6- Management of financial system liquidity and lender of last resort.
7- Stability of the payment system .
8- Financial stability .
9- Financial regulation, prudential policy and prudential supervision.
10- Governance arrangements for other functions .

** Balance sheet of the bank **

• The balance sheet of a commercial bank is a statement of its assets and

liabilities. Assets are what others owe the bank, and what the bank owes
others constitutes its liabilities.

• The balance sheet is issued usually at the end of every financial year of
the bank.

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** Liabilities :
• Liabilities are those items on account of which the bank Is liable to pay
others.

1- Capital: :‫رأس المال‬

• The bank has to raise capital before commencing its business. Authorized
capital is the maximum capital up to which the bank is empowered to raise
capital by the Memorandum of Association.
• Generally, the entire authorized capital is not raised from the public. That
part of authorized capital which is issued in the form of shares for public
subscription is called the issued capital.
• Subscribed capital represents that part of issued capital which is actually
subscribed by the public.

2- Reserve Fund:
• Reserve fund is the accumulated undistributed profits of the bank. The
bank maintains reserve fund to tide over any crisis.

• But, it belongs to the shareholders and hence a liability on the bank. The
commercial bank is required by law to transfer 20% of its annual profits to
the Reserve fund.

3- Deposits:
• The deposits of the public like demand deposits, savings deposits and
fixed deposits constitute an important item on the liabilities side of the
balance sheet.

• The success of any banking business depends to. a large extent upon the
degree of confidence it can instill in the minds of the depositors.
• The bank can never forget the claims of the depositors. Hence, the bank
should always have enough cash to honor the obligations of the depositors.

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4- Borrowings from Other Banks:
• The bank takes loans from other banks, especially the central bank, in
certain extraordinary circumstances.

5- Bills Payable:
• These include the unpaid bank drafts and telegraphic transfers issued by
the bank, These drafts and telegraphic transfers are paid to the holders
thereof by the bank's branches.

6- Acceptances and Endorsements:

• This item appears as a contra item on both the sides of the balance sheet.
It represents the liability of the bank in respect of bills accepted or
endorsed on behalf of its customers and also letters of credit issued and
guarantees given on their behalf.

7- Contingent Liabilities:
• Contingent liabilities includes of those liabilities which are not known in
advance and are unforeseeable. Every bank makes some provision for
contingent liabilities.

8- Profit and Loss Account:

• The profit earned by the bank in the course of the year is shown under this
head.
• Since the profit is payable to the shareholders it represents a liability on
the bank .

9- Bills for Collection:

• This item also appears on both the sides of the balance sheet. It consists
of drafts and hundis drawn by sellers of goods on their customers and are
sent to the bank for collection, against delivery documents like railway
receipt, bill of lading, etc.
• All such bills are shown on both the sides of the balance sheet because
they form an asset of the bank, since the bank will receive payment in due
course, it is also a liability because the bank' will have to account for them
to its customers.
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** Assets :

• Assets are the claims of the bank on others. In the distribution of its
assets, the bank is governed by certain well defined principles.
• These principles constitute the principles of the investment policy of the
bank or the principles underlying the distribution of the assets of the bank.

• The most important guiding principles of the distribution of assets of the

bank are liquidity, profitability and safety or security.

1- Cash:
• It constitutes the most liquid asset which can be immediately used to meet
the obligations of the depositors. Cash on hand is called the first line of
defense to the bank.

• In addition to cash on hand, the bank also keeps some money with the
central bank or other commercial banks. This represents the second line of
defense to the bank.

2- Money at Call and Short Notice:

• Money at call and short notice includes loans to the brokers in the stock
market, dealers in the discount market and to other banks.
• These loans could be quickly converted into cash and without loss, and
when the bank requires. At the same time, this item yields income to the
bank.

• This process is called Window Dressing. This item constitutes the third line
of defense to the bank.

3- Bills Discounted:
• The commercial banks invest in short term bills consisting of bills of
exchange and treasury bills which are self-liquidating in character.
• These short term bills are highly negotiable and they satisfy the objectives
of liquidity and profitability.
• If a commercial bank requires additional funds, it can easily rediscount the
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 bills in the bill market and it can also rediscount the bills with the central
bank.

4- Bills for Collection:

• As mentioned earlier, this item appears on both sides of the balance sheet.

5- Investments:
• This item includes the total amount of the profit yielding assets of the
bank. The bank invests a part of its funds in government and non-
government securities.

6- Loans and Advances:

• Loans and advances constitute the most profitable asset to the bank.
• But, this item is the least liquid asset as well, The bank earns quite a
sizeable interest from the loans and advances it gives to the private
individuals and commercial firms.

7- Acceptances and Endorsements:

• As discussed earlier, this item appears as a contra item on both sides of
the balance sheet.

8- Fixed Assets:
• Fixed assets include building, furniture and other property owned by the
bank. This item includes the total volume of the movable and immovable
property of the bank.
• Balance sheet of a bank acts as a mirror of its policies, operations and
achievements.
• Thus, the balance sheet is a complete picture of the size and nature of
operations of a bank.

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