College of Business Peace

Leadership and Governance

NMEC101 Economic Principles 1
1. The Central Problem of Economics

Thomas Masese March 2022

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 Hello!

I am Thomas Masese
I will be your instructor for this course. My contact details are as follows:
+263783725322 for calls and 0716661814 for WhatsApp

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SUBTOPICS TO BE COVERED IN THIS LESSON

NATURE OF THE BASIC ECONOMIC PRODUCTION THE BUSINESS

ECONOMICS PROBLEM POSSIBILITY CURVES ORGANISATION
• Introduction • Production possibility • Types of business organisations
• The basic economic problem curve and society’s
• What is economics? • Aims, legal forms and internal
• Scarcity, choice and
• Why study economics choices. organization
opportunity cost •
• Scope of economics- Economic Systems • The business envronment
• Economic resources and their
micro/macro, payments
positive/normative
NMEC101 Economic Principles 1: Africa University 2021
 1. Define what is meant by ‘economics’.
2. Outline the ways in which an economist thinks.
What are our 3. Understand the importance of graphs, diagrams and charts to
Learning the economist.
4. Appreciate that the subject matter of economics is split into
Objectives microeconomics and macroeconomics and be clear as to the
distinction between the two.
On completion of this topic, 5. Discuss the economic merits and weaknesses of the market
students should be able to: economy.
6. Outline the differences between a market economy and a
planned economy.
7. Distinguish between positive and normative economics.
8. Explain the role of opportunity cost, rationality and marginal
costs and benefits when analysing microeconomic choices.
9. Explain the problem of scarcity and outline the microeconomic
decisions that need to be made.
10.Compare and contrast the main features of different economic
systems.
11.Identify the different aims of businesses.
12.Analyse the relative advantages and disadvantages of different
legal forms of business.
13.Examine the relative merits of different types of the internal
 What is Economics All about ???
• What determines the demand for a good or service?
• What happens to the demand for a good if its price rises or
falls?
• Why do firms supply goods?
• How can firms charge different prices for the same good or
service to different groups of customers? What causes
unemployment?
• What determines the wage level? What is the role of money in
the economy?
• What causes inflation?
• Is there a need for government intervention in the economy?
• These are the types of questions economists are interested
03 in and around which theories have been developed in
order to aid our understanding
 Introduction
 In this course we will be looking at introductory
economic principles and the environment in which
firms operate and how economic analysis can be used
in the process of business decision taking.
 In doing so, you will gain an insight into how
economists think and the sorts of concepts they use to
analyse business problems.
. choices.
 But what particular aspects of
business does the economist
study?
. be relatively simple.
 Firms are essentially concerned with using
inputs to make output. Inputs cost money
and output earns money. The difference
between the revenue earned and the costs
incurred constitutes the firm’s profit.
 Firms will normally want to make as much
profit as possible, or at the very least to make
satisfactory profits and certainly to avoid a
decline in profits.
 In order to meet these and other objectives,
managers must make choices: choices of what
types of output to produce, how much to produce
and at what price; choices of what techniques of
production to use; what types and how many
workers to employ; what suppliers to use for raw
materials, equipment, etc.
 In each case, when weighing up alternatives,
managers will want to make the best choices for
their firm. Business economists study these
• They study economic decision making by
firms. All these choices will be affected by
the environment in which the firm operates.
If the firm is in a stable market with a well-
established customer base, the choices may
The Business
• The choices will be very different if firms are
Environment and in a rapidly changing market, with lots of
Business competition and new products and
processes being developed.
 The decisions of the firm are also affected by the much broader national and
international environment. Is the economy expanding or contracting? What is
happening to interest rates and taxes? Is there competition from other
countries? Are there opportunities for expanding abroad?
 The local, national and international economic and political environments all
crucially influence a firm’s decisions.
 What is Economics?
• Economics is the study of how individuals, households and societies choose
to use the scarce resources that nature and previous generations have
provided.
• It is a study of how society manages its scarce resources and how people
make choices given that all societies have limited resources.
• Economics is the study of how society allocates limited resources to the
production of goods and services to satisfy unlimited human wants.
• Economics is concerned with the efficient allocation, use or management of
limited (scarce) resources to achieve maximum satisfaction of human
material wants.
• Economics is a social science concerned with how individuals, institutions,
and society make optimal (best) choices under conditions of scarcity
• It is concerned with the management of society’s resources
• The management of society’s resources is important because resources are
NMEC101 Economic Principles 1: Africa University 2021
scarce
WHY STUDY ECONOMICS?
• There are four main reasons to study
economics:
1. To learn a way of thinking,
2. To understand society,
3. To understand global affairs, and
4. To be an informed citizen.

NMEC101 Economic Principles 1: Africa University 2021

1. TO LEARN A WAY OF THINKING
• Economics teaches you to think in terms
of alternatives
• Evaluate the cost of individual and
social choices
• Examine and understand how certain
events and issues are related.
• But there is the issue of terminology, some math, and GRAPHS,
GRAPHS AND SOME MORE GRAPHS!

NMEC101 Economic Principles 1: Africa University 2021

2. TO UNDERSTAND SOCIETY

• You cannot hope to understand

how a society functions without a
basic knowledge of its economy
and cannot understand a
society’s economy without
knowing its economic history

NMEC101 Economic Principles 1: Africa University 2021

 3. TO UNDERSTAND GLOBAL AFFAIRS

 News headlines are filled with economic stories- economic crisis in

USA, starvation and poverty in Africa, oil prices reach record high.
 All countries are part of a world economy and understanding
international relations begins with basic understanding of economic
links among countries.

NMEC101 Economic Principles 1: Africa University 2021

4. TO BE AN INFORMED VOTER
• A basic understanding of economics is
essential if we are to be well-informed
citizens.
• When we participate in the political process,
we are voting on issues that require a basic
understanding of economics.

NMEC101 Economic Principles 1: Africa University 2021

 The Scope of Economics
Microeconomics v.s. Macroeconomics
• There are two main branches of economics:
microeconomics and macroeconomics.
• Microeconomics deals with the analysis of individual parts
of the economy.
• It concerns factors determining the behaviour of a
consumer, the behaviour of a firm, the demand for a
good, the supply of a good, the price of a good, the
quantity of a good, the performance of a market, etc.
• Macroeconomics deals with the analysis of the whole
economy.
• It concerns factors determining aggregate variables such
as aggregate demand, aggregate supply, national output,
unemployment, inflation, the balance of payments, etc.
• As opposed to microeconomics which focuses on the
individual parts of the economy, macroeconomics looks at
the big picture of the economy.
Positive v.s. Normative Economics
• Economists often distinguish between positive economics and
normative economics.
• Positive economics is concerned with facts. It tells us what was,
what is or what will be.
• Normative economics is concerned with value judgments. It tells us
what should be.
• Disagreement over normative economics cannot be settled by an
appeal to facts. In other words, normative economics is not
verifiable.
• Positive statements are statements that describe the world as it is.
It is also called descriptive analysis and deals with facts
• Normative statements are statements about how the world should
be. It is also called prescriptive analysis and incorporates value
judgments about what the economy should be like.
• Positive economics is often divided into descriptive economics and
economic theory. Descriptive economics is simply the compilation
of data that describe phenomena and facts. Economic theory is a
statement or a set of related statements about cause and effect,
action and reaction
 Ceteris Paribus (Other things being constant)

• In constructing their theories, economists use the ceteris paribus

or other-things-equal assumption—the assumption that factors
other than those being considered do not change.
• They assume that all variables except those under immediate
consideration are held constant for a particular analysis.
• Using the device of Ceteris paribus (other things being equal)- is
one part of the process of abstraction.
• In formulating economist theory, the concept helps us simplify
reality in order to focus on relationships that we are interested in.

NMEC101 Economic Principles 1: Africa University 2021

The Economic Problem
• Economics studies the allocation, distribution and utilization of resources to meet human needs.
• A central element in the economic problem, then, is the allocation of scarce resources among
alternative uses.
• Resources (human, physical and financial) are limited in supply while human needs and desires
are infinite.
• These needs are usually called ‘wants’. Some of the wants are necessities such as
basic food, clothing and housing but there are also desires. Human wants are
unlimited while resources are limited (scarce).
• The same economic problem faces all individuals, organizations and societies –
unlimited wants, limited resources
• Since the resources are limited in supply (i.e. scarce) and there is the existence of
unlimited wants, choices have to be made – choices involving the allocation of
scarce resources among alternative uses to achieve given ends.
• Economics is also concerned with the distribution of resources between different
groups in society.
• Moreover, there is the problem of resource utilization, ensuring that all the
available resources are used effectively
SCARCITY, CHOICE AND OPPORTUNITY COST (cont)
• Scarcity means that society has limited resources
and therefore cannot produce all the goods and
services people wish to have.
• Scarcity restricts options and demands choices
• Just as a household cannot give every member
everything he or she wants, a society cannot give
every individual the highest standard of living to
which he or she might aspire.
• As a result of the economic problem, all societies
must answer three basic questions:
• What will be produced?
• How will it be produced?
• Who will get what is produced?
• The economic system must decide the allocation of
scarce resources among producers, the mix of the
output and the distribution of that output.
NMEC101 Economic Principles 1: Africa University
2021
 Opportunity Cost
 Resources are limited in supply and have alternative uses i.e. they have an opportunity cost.
 Opportunity cost can be defined as the best alternative forgone.
 This concept is central to the study of economics at a number of levels:
 At the individual level, if one decides to grow more potatoes in the garden then one has to

reduce the production of, say, carrots. The limited space in the garden can be viewed as the
scarce resource and one cannot produce more of one good, potatoes, and still produce the same
amount of another, carrots.
 At the level of the firm, limited capital equipment (e.g. machinery) currently used to produce,

say, milk chocolate cannot be used to manufacture plain chocolate.

 At government level, limited tax revenue may mean that a decision to build three new schools

may be at the expense of the alternative option of building a new hospital.

 Society has to decide what goods and services it is going to produce. This will involve choices because
producing more of one good or service will normally mean producing less of another if all existing
resources are being fully utilised.

NMEC101 Economic Principles 1: Africa University

2021
Economic Resources or Factors of Production
• The resources an economy has at its disposal are
used to satisfy the unlimited wants. These are
often termed by economists inputs or factors of
production.
• Resources or inputs are anything provided by
nature or previous generations that can be used
directly or indirectly in production of goods and
services to satisfy human wants.
• They are the means of producing the goods and
services society requires to meet human needs
and can normally be divided into four main
general categories:
• Land
• Capital
• Labour
• Entrepreneurial skills
Economic Resources or Factors of Production
• Land means much more to the economist than it does to most people.
• To the economist land includes all natural resources (“gifts of nature”) used in the production process,
such as arable land, forests, mineral and oil deposits, and water resources.
• Labor consists of the physical and mental talents of individuals used in producing goods and services.
The services of a logger, retail clerk, machinist, teacher, professional football player, and nuclear physicist
all fall under the general heading “labor.”
• For economists, capital (or capital goods) includes all manufactured aids used in producing consumer
goods and services Included are all factory, storage transportation, and distribution facilities, as well as
tools and machinery. Economists refer to the purchase of capital goods as investment.
• Capital goods differ from consumer goods because consumer goods satisfy wants directly, whereas
capital goods do so indirectly by aiding the production of consumer goods. Note that the term “capital” as
used by economists refers not to money but to tools, machinery, and other productive equipment.
Because money produces nothing, economists do not include it as an economic resource. Money (or
money capital or financial capital) is simply a means for purchasing capital goods.
• Entrepreneurial ability is a special human resource, distinct from labor. The entrepreneur takes the
initiative in combining the resources of land, labor, and capital to produce a good or a service. Both a
sparkplug and a catalyst, the entrepreneur is the driving force behind production and the agent who
combines the other resources in what is hoped will be a successful business venture.
 Resource Payments
• Rent- is the income received from land
and property resources.
• Interest- is the income received from
capital
• Wages- income accruing to those
supplying labor. These include salaries and
other wage supplements.
• Profits- this is income for
entrepreneurship.
The production possibility frontier (PPF)
• The central problem in economics of scarcity, choice, opportunity cost and
resource allocation can be analyzed by using a production possibility frontier (PPF)
• A production possibility frontier (PPF) is a curve or a boundary which shows all the
combinations of two or more goods and services that can be produced whilst using
all of the available factor resources and available technology efficiently
• A production possibilities table lists the different combinations of two products
that can be produced with a specific set of resources, assuming full employment.
• Such a curve displays the different combinations of goods and services that society
can produce in a fully employed economy, assuming a fixed availability of supplies
of resources and constant technology.
• Each point on the production possibilities curve represents some maximum
combination of two products that can be produced if resources are fully employed.
• Points inside the curve are attainable, but they indicate that full employment is not
being realized.
ASSUMPTIONS FOR PRODUCTION POSSIBILITIES CURVE
1. Full employment - The economy is employing all its available resources
and is achieving full production (efficiency).
2. Assumes two goods - The economy is producing only two goods:
consumer goods and capital goods.
3. Fixed resources - the quantity and quality of the factors of production
are fixed.
4. Fixed technology -The state of technology (the methods used to produce
output) is constant.
 Production Possibility Frontier
Production Possibility Curve
Production Possibility Table

Production Alternative
Type of A B C D E F
Product
Food 0 5 10 15 20 25
Clothing 30 28 25 21 15 0

We arbitrarily represent the economy’s output of clothing on the vertical axis and the output of food on the horizontal
axis. The production possibility frontier AF represents the boundary
between the goods and services which can be produced, namely on or
within the frontier, and those which cannot. The economy would prefer
to be at a point such as C or D on the frontier than at a point such as
G inside the frontier.
 Analyzing the PPF
• The above diagram represents a hypothetical production possibility frontier AF for an economy
producing two products: food and clothing.
• The PPF shows the alternative combinations of the two products that the country can produce if it fully
utilizes all of its resources.
• For example, if all the country’s resources were used in the production of clothing then the total output
would be 30 units of clothing and there would be no food production.
• This is represented by point A. If, however, all the resources were devoted to the production of food, the
economy would be at point F with 25 units of food produced but zero clothing.
• Alternatively, the economy could be at any point on the PPF producing a certain amount of food and
clothing. However, if the economy were at point G it would signify that the economy was underutilizing
its resources.
• There would be unemployed resources and by bringing those resources into use the economy could
move to a position on the curve such as point D, where more clothing and food could be produced.
• It is clearly sensible for an economy to be on the PPF rather than inside it since at point G the economy is
producing 15 units of clothing and 10 units of food, whereas at point D the economy is producing 21
units of clothing and 15 units of food.
• Once on the PPF it is not possible to increase the production of one of the two products without
reducing the production of the other product.
Economic Growth
• When we drop the assumptions that the quantity and
quality of resources and technology are fixed, the
production possibilities curve shifts positions and the
potential maximum output of the economy changes.
• A shift outwards in the PPF represents economic growth,
which means the ability to produce more goods
• This can be brought about either by technological
change, i.e. new and better ways of producing the goods
and services, or through an increase in the economy’s
productive capacity, achieved through an increase in the
supply of the factors of production
• The increase in supplies of resources, improvements in
resource quality, and technological advances that occur
in a dynamic economy move the production possibilities
curve outward and to the right, allowing the economy to
have larger quantities of both types of goods.

MEC101 Economic Principles 1: Africa University 2019 25

Unemployment and the
production possibilities curve.

Any point inside the production possibilities

curve, such as U , represents unemployment or a
failure to achieve full employment. The arrows
indicate that by realizing full employment,
the economy could operate on the curve. This
means it could produce more of one or both
products than it is producing at point U .
Efficiency
• Full production entails two kinds of efficiency- allocative and
productive efficiency are achieved.
• Allocative efficiency means resources are allocated to goods most
wanted by society.
• Productive Efficiency means that the least costly production
techniques are used to produce wanted goods and services
• Full production means producing the right goods (allocative
efficiency) in the right way (productive efficiency).

MEC101 Economic Principles 1: Africa University 2019 27

 The PPF and Opportunity Cost
• The frontier can be viewed in terms of opportunity cost
since to produce more units of one product needs
resources to be taken from the production of the other.
• In the diagram the frontier is concave to the origin and
this means that the opportunity cost will change as we
move along the frontier.
• If we start at point A and move down the curve we can
see how the opportunity cost changes (see Table)
• The opportunity cost increases as you move from A to F
• Our example illustrates the law of increasing
opportunity costs.
• As the production of a particular good increases, the
opportunity cost of producing an additional unit rises.
• The economic rationale for the law of increasing
opportunity costs is that economic resources are not
completely adaptable to alternative uses.
Society’s Choices
• The point on the possibilities curve at which the economy will produce will be a result of
the values of the society as expressed by its control group- the government, the ruling
party, the electorate, the citizenry, the individual institutions or some combination thereof.
• An economy’s current choice of position on its production possibilities curve is a basic
determinant of the future location of that curve.
• A nation’s current choice favoring “present goods,” will cause a modest outward shift of
the production possibilities curve in the future. Goods of the present are mainly
consumers goods
• A nation’s current choice favoring “future goods,” will result in a greater outward shift of
the curve in the future.
• A current position favoring goods of the future such as capital goods, research and
education and preventive medicine which increase the quantity and quality of property
resources, enlarge the stock of technological information and improve the quality of
human resources. Goods of the future are ingredients of economic growth and they
include capital goods, infrastructure, education, health, research and development

NMEC101 Economic Principles 1: Africa University 2021

 Present Choices and Future
Possibilities
a. Presentville’s choices b. Futureville’s choices

• A nation’s current choice favoring

“present goods,” as made by
Presentville in (a), will cause a
modest outward shift of the
production possibilities curve in the
future.
• A nation’s current choice favoring
“future goods,” as made by
Futureville in (b), will result in a
greater outward shift of the curve in
the future.

MEC101 Economic Principles 1: Africa University 2019 30

International Trade
• Production possibilities analysis implies that an individual nation is limited to the
combinations of output indicated by its production possibilities curve. But we must
modify this principle when international specialization and trade exist.
• An economy can circumvent, through international specialization and trade, the
output limits imposed by its domestic production possibilities curve. International
specialization means directing domestic resources to output that a nation is highly
efficient at producing.
• International trade involves the exchange of these goods for goods produced
abroad. Specialization and trade enable a nation to get more of a desired good at
less sacrifice of some other good.
• Specialization and trade have the same effect as having more and better resources
or discovering improved production techniques; both increase the quantities of
capital and consumer goods available to society.
• Expansion of domestic production possibilities and international trade are two
separate routes for obtaining greater output.
Exam Extract: Data Based Question
• Below is a production possibilities table for consumer goods (cars) and capital goods (forklifts):

a. Show these data graphically. Upon what specific assumptions is this production possibilities curve based?
b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift?
c. Explain how the production possibilities curve reflects choice, opportunity costs, unemployment, economic growth and the law of
increasing opportunity costs.
d. If the economy characterized by this production possibilities table and curve were producing 3 automobiles and 20 fork lifts, what
could you conclude about its use of its available resources?
e. What would production at a point outside the production possibilities curve indicate? What must occur before the economy can
attain such a level of production?
f. Suppose improvement occurs in the technology of producing forklifts but not in the technology of producing
automobiles. Draw the new production possibilities curve.
g. Now assume that a technological advance occurs in producing automobiles but not in producing forklifts. Draw
the new production possibilities curve.
h. Now draw a production possibilities curve that reflects technological improvement in the production of both
goods.
ECONOMIC SYSTEMS
• Although all countries throughout the world have to face similar economic problems, the
economic system they adopt as a means of dealing with them will differ.
• Essentially there are three approaches to tackling the economic problem of allocation,
distribution and utilization of resources:
1. A market economy allocates resources through the price mechanism, with market prices
being determined by the forces of demand and supply.
2. A planned economy allocates resources through administrative decisions. Although this
type of economic system is no longer in evidence to any great extent worldwide, it may be
useful to briefly outline how the planned economic system has operated in parts of the
world.
3. A mixed economy contains features of both the market and planned economic systems,
with the government intervening in various ways to influence market prices. In practice
most economies are, strictly speaking, mixed economies.

NMEC101 Economic Principles 1: Africa University 2021

Exam Extract: Essay Question
• Over the last two decades the planned economies have introduced
elements of the market mechanism into their economic systems
resulting in mixed economies. To what extent could it be argued that
the market mechanism is better than the planned economy as a
means of allocating resources? (25 marks)

NMEC101 Economic Principles 1: Africa University 2021

The Business Organization
There are many factors that affect the behaviour of firms, and
here we focus on three key things:

1. the legal status of the business

2. the way in which the firm is

organised – whether as a simple top-
down organisation or as a more
complex multi-department or multi-
division organisation;

3. the aims of the firm – is profit

maximisation the objective of
the firm, or are there other
aims?

NMEC101 Economic Principles 1: Africa University 2021

 Limited liability: Where the liability of the owners for the debts of a company is
limited to the amount they have invested in it.

U-form business organisation: One in which the central organisation of the

firm (the chief executive or a managerial team) is responsible both for the firm’s
day-to-day administration and for formulating its business strategy.

Definitions
M-form business organisation One in which the business is organised into
separate departments, such that responsibility for the day-to-day management
of the enterprise is separated from the formulation of the business’s strategic
plan.

Flat organisation One in which technology enables senior managers to

communicate directly with those lower in the organisational structure. Middle
managers are bypassed.

H-form or holding company A business organisation in which the parent

company holds interests in a number of other companies or subsidiaries
The Sole Trader/ Sole
Proprietor
In a small firm, the owner or owners are likely to play a major part in
running the business
Here, the business is owned by just one person. Owners of small shops, builders
and farmers are typical examples.
Such businesses are easy to set up and may require only a relatively small initial
capital investment. However, they suffer two main disadvantages:
 Limited scope for expansion. Finance is limited to what the owner can raise
personally, for example through savings or a bank loan.
 Also there is a limit to the size of an organisation that one person can
effectively control.
 Unlimited liability. The owner is personally liable for any losses that the
business might make. This could result in the owner’s house, car and other
assets being seized to pay off any outstanding debts, should the business
fail.
NMEC101 Economic Principles 1: Africa University 2021
 Partnerships
This is where two or more people own the business. In most partnerships there is
a legal limit of 20 partners. Partnerships are common structures for solicitors,
accountants, surveyors, etc
Scope for Expansion Unlimited Liability Not suitable for
high risk
businesses
Can raise extra capital • Since 2001 limited liability
• Where large amounts of
• Whilst partnerships do • Extra finance can partnerships have been possible.
capital are required and/or
mean a loss of control, usually be raised and as • However, many firms still retain when the risks of business
as decision making is partners can specialise unlimited liability. failure are relatively high,
now shared, with more in and control different • This problem could be very partnerships are not
owners there is scope areas of the business, a serious, as the mistakes of one generally an appropriate
for expansion. larger organisation can partner could jeopardise the form of organisation.
personal assets of all the other
become more viable. partners.

NMEC101 Economic Principles 1: Africa University 2021


Joint Stock Company
• A company is legally separate
from its owners. This means that
it can enter into contracts and
own property. Any debts are its
debts, not the owners’.
• The owners are the shareholders.
Each shareholder receives his or
her share of the company’s
distributed profit: these
payments are called ‘dividends’.
NMEC101 Economic Principles 1: Africa University 2021
• The owners have only limited liability. If the company
01 goes bankrupt, the owners will lose the amount of
money they have invested in the company, but not
personal property.
Limited liability is where the liability of the owners for the
debts of a company is limited to the amount they have
invested in it.
• This has the advantage of encouraging people to
become shareholders, thereby providing more finance
to businesses and creating greater scope for expansion.
Shareholders often take no part in
02
the running of the
firm. They may elect a board of
directors which decides
broad issues of company policy.
03 The board of directors in
turn appoints managers who make the
day-to-day decisions. This can create
problems in terms of the divorce of
ownership (by shareholders) from control
(by managers),
 TYPES OF COMPANIES
There are two types of company: public and private.

Private
Public Companies
Company

• These are companies that can offer new
shares publicly: by issuing a prospectus,
they can invite the public to subscribe
to a new share issue.
• In addition, many public limited
companies are quoted on the Stock
Exchange where existing shares can be
bought and sold.
• A public limited company must hold an
annual shareholders’ meeting.
NMEC101 Economic Principles 1: Africa University 2021
• Private limited companies cannot
offer their shares publicly. Shares
have to be sold privately.
• This makes it more difficult for
private limited companies to raise
finance, and consequently they tend
to be smaller than public
companies.
• However, they are easier to set up
than public companies..
Co-operatives

• There are also two types of co-operatives.

• Consumer co-operatives. These are officially owned by the consumers,
although they play no part in running the business.
• Producer co-operatives. These are owned by the firm’s workers, who share in
the firm’s profits.
 The internal organization of the firm
The internal operating structures of firms are frequently governed by their size. Small firms tend to be centrally managed,
with decision making operating through a clear managerial hierarchy. In large firms, however, the organisational structure
tends to be more complex, although technological change is forcing many organisations to reassess the most suitable
organisational structure for their business.

U-form business organisation M-form business organisation The flat organisation

U-form business organisation
One in which the central
organisation of the firm (the
chief executive or a managerial
team) is responsible both for
the firm’s day-to-day
administration and for
formulating its business
strategy.
M-form business organisation
One in which the business is
organised into separate
departments, such that
responsibility for the day-to-day
management of the enterprise
is separated from the
formulation of the business’s
strategic plan.
NMEC101 Economic Principles 1: Africa University 2021
Flat organisation One in
which technology enables
senior managers to
communicate directly with
those lower in the
organisational structure.
Middle managers are by-
passed.
 The internal organization of the firm

U Form Business Organisation U-form business organisation

• In small to medium-sized firms, the managers of the various
departments – marketing, finance, production, etc. – are normally
directly responsible to a chief executive, whose function is to co-
ordinate their activities: relaying the firm’s overall strategy to them and
being responsible for interdepartmental communication.
• We call this type of structure U (unitary) form .
• When firms expand beyond a certain size, a U-form structure is likely to
become inefficient.
• This inefficiency arises from difficulties in communication, co-
ordination and control, as the Chief Executive’s office receives too
much information to make efficient decisions and so it becomes too
difficult to manage the whole organisation from the centre.

NMEC101 Economic Principles 1: Africa University 2021

 M-form business
•
organization
To overcome these organisational problems, the firm
can adopt an M (multi-divisional) form of
managerial structure. This suits larger firms.
• The firm is divided into a number of ‘divisions’.
Each division could be responsible for a particular
stage of production, a particular product or group of
products, or a particular market (e.g. a specific
country).
• The day-to-day running and even certain long-term
decisions of each division would be the
responsibility of the divisional manager(s).
• This leads to the following benefits:
• reduced length of information flows;
• the chief executive being able to concentrate on “

overall strategic planning;

• an enhanced level of control, with each division
being run as a mini ‘firm’, competing with
NMEC101 Economic other
Principles 1: Africa University 2021
 The flat organization
 One of the major problems with M-form
organisations is that they can become very
bureaucratic with many layers of management.
 Recent technological innovations, however,
specially in respect to computer systems such as
e-mail and management information systems,
have enabled senior managers to communicate
easily and directly with those lower in the
organisational structure.
 As a result, some companies have moved back
towards simpler structures. These flat
organisations, as they are called, dispense with
various layers of middle management and so can
speed up communication.

NMEC101 Economic Principles 1: Africa University 2021

 H- FORM OR HOLDING
COMPANY
As many businesses have expanded their operations, often on a
global scale, more complex forms of business organisation have
evolved.
 One such organisation is the H-form or holding company. A
holding company (or parent company) is one that owns a
controlling interest in other subsidiary companies.
 These subsidiaries, in turn, may also have controlling
interests in other companies. There may thus be a complex
web of interlocking holdings. While the parent company has
ultimate control over its various subsidiaries, typically both
tactical and strategic decision making is left to the individual
companies within the organisation.
 A good example of such an organisation would be Old
Mutual
NMEC101 ECONOMIC PRINCIPLES 1: AFRICA UNIVERSITY 2021
 Aims of the Firm
 Economists have traditionally assumed that firms
want to maximise profits.
 The ‘traditional theory of the firm’, as it is called,
shows how much output firms should produce and
at what price in order to make as much profit as
possible.
 Do firms necessarily want to maximise profits?
Over what time period do they may want to
maximise profits.
 A more fundamental criticism of the assumption of
profit maximisation, however, is that in large
companies it is not the owners that make the
decisions about how much to produce and at what
price. 128904
 In such cases other objectives may be pursued by
NMEC101 Economic Principles 1: Africa University 2021
these decision makers.
The divorce of ownership from control
Shareholders Directors
There is therefore a separation between the ownership and control of a firm .

They make
decisions om behalf
They own the firm
and elect Board of of shareholders and
Directors in turn employ
professional
managers

Managers They run the firm

on behalf of
shareholders and
they often have
considerable
discretion in
making decisions
on things such as
pricing, advertising,
costing, etc.

NMEC101 ECONOMIC PRINCIPLES 1: AFRICA UNIVERSITY 2021

 Principal-Agent Problem
 The owners (shareholders) may want to maximise profits to increase
their dividends, but what are the objectives of the managers?
 They will probably want to pursue their own interests, such as a
higher salary, greater power or prestige, greater sales, better working
conditions or greater popularity with their subordinates. The point is
that these aims may conflict with the aim of maximum profit.
 Managers will still have to ensure that sufficient profits are made to
keep shareholders happy, but that may be very different from
maximising profits. Alternative theories of the firm to those of profit
maximisation, therefore, tend to assume that large firms are profit
‘satisficers’.
 That is, managers strive hard for a minimum target level of profit, but
are less interested in profits above this level.
 Can the owners of a firm ever be sure that their managers will pursue
the business strategy most appropriate to achieving the owners’
goals (i.e. profit maximisation)?
 This is an example of the principal–agent problem. Are the managers
pursuing their own goals, rather than the goals of the owner?
 The crucial advantage that agents have over their principals is
NMEC101 ECONOMIC PRINCIPLES 1: AFRICA UNIVERSITY 2021
specialist knowledge and information.
 Owners employ managers for their specialist knowledge of a market
or their understanding of business practice. But this situation of
asymmetric information – that one party (the agent) knows more
than the other (the principal) – means that it will be very difficult for
the principal to judge in whose interest the agent is operating.
 The principal–agent problem: Where people (principals), as a result
of a lack of knowledge (asymmetric information), cannot ensure that
their best interests are served by their agents. Agents may take
advantage of this situation to the disadvantage of the principals.
 Principals may attempt to reconcile the fact that they have imperfect
information, and are thus in an inherently weak position, in the
following ways.
1. Monitoring the performance of the agent. Shareholders could
monitor the performance of their senior managers through
attending annual general meetings. The managers could be
questioned by shareholders and ultimately replaced if their
performance is unsatisfactory.
2. Establishing a series of incentives to ensure that agents act in the
principals’ best interest e.g. linking remuneration to performance
The External Business Environment

The decisions and performance of a firm are

affected not just by its internal organisation and
aims; they are also affected by the external
environment in which the firm operates.

It is normal to identify various dimensions to the

external business environment. These include
political, economic, social/cultural and
technological factors.

The behaviour and performance of firms is

affected by the business environment. The
business environment includes social/cultural (S),
technological (T), economic (E), ethical (E),
political (P), legal (L) and environmental (E)
factors. The mnemonic STEEPLE can be used to
remember these.
NMEC101 Economic Principles 1: Africa University 2021
Classifying Production
When analysing production it is common to distinguish three broad categories.

Primary production. This refers to the

production and extraction of natural resources
such as minerals and sources of energy. It also
includes output from agriculture

Secondary production. This refers to the output

of the manufacturing and construction sectors of
the economy. Deindustrialisation is a decline in
the share of the secondary sector in GDP.

Tertiary production. This refers to the production

of services, and includes a wide range of sectors
such as finance, the leisure industry, retailing,
tourism and transport.

NMEC101 Economic Principles 1: Africa University 2021


 Political factors. Firms are directly
affected by the actions of government
and other political events. These
might be major events affecting the
whole of the business community or
1 4ethnicity, gender, physical attributes, etc.),
just one part of the economy
 Economic factors. Businesses are
affected by a whole range of economic
Dimensions of
Social/cultural factors. This aspect of the
business environment concerns social
attitudes and values. These include attitudes
towards working conditions and the length of
the working day, equal opportunities for
different groups of people (whether by
the nature and purity of products, the use
and abuse of animals, and images portrayed
in advertising.
Legal factors. Businesses are affected by

the external
factors, such as a rise in the cost of raw the legal framework in which they
2 5
materials, or a price cut by a rival firm, or operate. Examples include industrial
new taxes, or movements in interest relations legislation, product safety
rates or exchange rates. A firm must
constantly take such factors into account business standards, regulations governing
pricing in the privatised industries and
laws preventing collusion between firms
environment
when devising and implementing its
business strategy. to keep prices up.
3 6 Ethical factors. Firms are increasingly under
 It is normal to divide the economic
pressure to adopt a more socially
environment in which the firm operates into
responsible attitude towards business.
two levels: The microeconomic
Corporate responsibility is a major concern
environment includes all the economic
for many firms, whether in terms of working
factors that are specific to a particular firm
conditions, the safety and quality of their
operating in its own particular market. The
products, truthful advertising, their attitudes
macroeconomic environment is the
towards the environment, concern for local
national and international economic situation
residents and the general avoidance of what
in which a business as a whole operates e.g.
might be seen as ‘suspect’ business
tax policy, exchange rates
practices.
Classifying firms into industries and Classifying industries
• One of the most important elements of the economic environment of a firm is the nature of the
industry in which it operates and the amount of competition it faces.
• Knowledge of the structure of an industry is therefore crucial if we are to understand business
behaviour and its likely outcomes.
• An industry refers to a group of firms that produce a particular category of product. Thus we could
refer to the electrical goods industry, the tourism industry, the aircraft industry or the insurance
industry.
• Industries can then be grouped together into broad industrial sectors, such as manufacturing
industry, or mining and quarrying, or construction, or transport.
• Classifying firms into industrial groupings and subgroupings has a number of purposes. It helps us
to analyse various trends in the economy and to identify areas of growth and areas of decline.
• It helps to identify parts of the economy with specific needs, such as training or transport
infrastructure.
• Perhaps most importantly, it helps economists and businesspeople to understand and predict the
behaviour of firms that are in direct competition with each other.
• In such cases, however, it may be necessary to draw the boundaries of an industry quite narrowly.
 THANK YOU!

NMEC101 ECONOMIC PRINCIPLES 1: AFRICA UNIVERSITY 2021