Importance of competition and incentives

- Widens consumers’ choice due to existence of many producers

hence better welfare or standard of living.
- Better quality products are produced due to competition
- Promotes consumer sovereignty as the consumer becomes the
king in decision making i.e. deciding what is produced.
- Results in lower prices for goods and services as producers
compete for market
- Promotes efficiency in an economy by rewarding those
producers who respond to consumer demand
- Workers have chance to earn high wages as producers compete
for their skills
- Employment opportunities are created due to existence of many
firms

N.B.

1. Actual competition arises when there are many firms in the industry

2. Potential competition occurs when it is easy for potential firms to

enter or leave an industry.

Private and Public sectors

Private sector refers to that part of the economy where resources are
owned, controlled and allocated by private individuals with minimum
to no government intervention. It is a profit motivated sector and
responds to market forces

The public sector is the part of the economy where resources are
owned, controlled and distributed by the government. It consists of
state owned enterprises, also called nationalized industries. The major
priority is promoting the welfare of the population.
Allocative efficiency

This occurs when producers produce commodities which consumers

want/ demand in the right quantities i.e. resources are allocated in a
way that maximizes consumers’ satisfaction.

Illustration

Allocative inefficiency occurs when either too much or too little is

being produced.

Illustration of underproduction and over production

Market forces can be used to correct the inefficiencies.

1. In case of under production, the high prices motivate producers

to produce more which lowers prices back to equilibrium level.
2. In case of over production, the lower prices discourage
production and
hence less is supplied which pushes prices up to equilibrium
level.
 Productive efficiency

This occurs when the firm produces at the lowest possible cost per
unit.

Illustration

Dynamic efficiency

This is productive efficiency which occurs overtime as a result of

investment and innovation i.e. firms spend on research and
development leading to new innovations due to profit motive and the
threat of going out of business.

Activity

a. Identify two differences between the private sector and the public
sector.(2)
b. Analyse the role of profit in a market economic system.(6)
MARKET FAILURE (title page)
This occurs when market forces fail to produce products that
consumers demand in the right quantities and at the lowest possible
cost i.e. it arises when markets are inefficient. (Market failure occurs
when market forces fail to allocate resources efficiently).

Indicators of market failure include;

- Existance of Surpluses
- Existance of Shortages
- High prices for goods and services
- Poor quality goods and services
- Lack of innovation in the firms or economy

Forms of market failure/ Causes of market failure:

1. Failure to take into account all costs and benefits

The production and consumption of goods usually affects those that

are not involved in production or consumption (third parties) either
positively or negatively. This leads to either costs or benefits to society.

In case the effects are positive, then social benefits occur.

Social benefits are the total benefits to society of an economic

activity e.g. employment created, improved transport, security lights,
etc from construction of a firm in an area. They include both private
and external benefits

However, if the benefits are only to the proprietor then we refer to

them as private benefits i.e. benefits received directly by those
producing or consuming a product e.g. benefits from driving a private
car.
External benefits are those enjoyed by those that are not involved in
the consumption and productive activities of others directly e.g. the
benefits of education and training, health care, law enforcement, etc.

In case the side effects are negative, then social costs occur.

Social costs are the total costs to society of an economic activity e.g.
pollution of air, water and noise. They include both private and
external costs.

If the costs affect the proprietor alone, then they are referred to as
private costs i.e. these are costs suffered by those producing or
consuming a product e.g. cost of raw materials, wages, fuel, diseases,
etc.

However, if the costs are suffered by those not directly involved in

production or consumption then they are referred to as external costs
e.g. congestion, air pollution, cigarette smoking, littering and too much
advertising.

Market failure here occurs when social costs and social benefits are not
equal i.e. either greater or lesser.

2. Information failure

This occurs when there is inadequate or lack of information to enable

people make the right choices e.g.

i) Workers need to know what jobs are on offer, their location,

qualifications required and remuneration.
ii) Producers need to know what products are on demand, where
to buy cheap raw materials and the prices of their products.
iii) Consumers need to know where to buy the cheapest products
of the best quality.

Information failure leads to wrong choices or decisions hence market

failure.

3. Merit goods
Are goods that are more beneficial to consumers than they realize e.g.
education and health care. They have benefits to those not involved in
their consumption as well i.e. the third parties.

Merit goods are usually under consumed and under produced due to
lack of information when left to the market forces.

The government can persuade their consumption by providing

information on their benefits e.g. the benefits of inoculation or
immunization, education, etc.

The government can also provide subsidies to the producers of such

goods to increase their production and hence consumption.

4. Demerit goods

These are goods that are more harmful to consumers than they realize
and have external costs e.g. cigarette smoking, alcohol consumption,
gambling, etc.

Demerit goods are usually over produced and over consumed. To

tackle this problem, the government could:-

- Impose taxes on their production and consumption

- Provide information about their harmful effects
- Ban their production and consumption e.g. many countries have
banned public smoking.

(to be continued)

5. Public and private goods

Public goods are those that are non rivalry and non excludable in
consumption and hence need to be financed by taxation i.e. once
provided to a particular group become available for others to use at
zero or no extra cost.
Those that use these goods freely or take advantage are called free
riders e.g. those that take advantage of security lights put up by other
people.

Characteristics of public goods

- Non-excludable
- Non-rivalry
- Non-rejectable e.g. police service
- The cost of supplying to one more consumer is zero e.g. the army
defending one more person.

Private goods are those that involve rivalry and are excludable in
consumption i.e. only benefit those that directly pay for them.

Characteristics include;

- There is rivalry in consumption ie the consumption of a

commodity by one person prevents others from consuming it.
- They are excludable ie it is possible to exclude others from using
it through the price paid.

6. Abuse of monopoly power.

A monopolist is a single seller or producer of commodities without

close substitutes i.e. consumers have no choice but to consume what is
put on the market.

Monopolists are allocatively, productively and dynamically inefficient

because of lack of competitive pressure. They have too much power
and hence exploit consumers through;

- Charging high prices

- Producing low quality products
- Low quantity of output
Market failure can also occur when there are more than one producer
but due to collusion, they act as one e.g. if they fixed the same high
price (price fixing).

Note that to control monopoly, government can;

- Remove restrictions on entry to increase competition and make

it illegal to fix prices
- Stop firms from merging
- Impose high taxes on monopoly firms to discourage monopoly

7. Immobility of resources

This means the inability of resources to move either geographically or

occupationally leading unemployment and underutilization of
resources.

Qn. Make a list of what the government can do to increase mobility of

labour.

8. Short termism

This means that firms in the private sector under invest and hence do
not plan ahead as they concentrate on making short term profits. This
explains why most businesses die with the death of the owners.

Government can stimulate private sector investment by cutting taxes

and undertaking some investment itself.

Revision questions

a) Distinguish between an external cost and private cost, with

examples. (4)
b) With examples, explain the difference between merit and demerit
goods. (4)
c) Analyze why the social benefit of education exceeds the private
benefits. (6)
THE MIXED ECONOMIC SYSTEM

Note that in year 9, we covered the following;

- Definition of the mixed economic system

- Characteristics of the mixed economic system
- Advantages and disadvantages of the mixed economic system

Government measures to address/ reduce market failure.

1. Maximum and minimum prices

Maximum price (price ceiling) is one set by the government below the
equilibrium price to prevent consumer exploitation by producers. It’s
the highest price that can be set for commodities and it is illegal to sell
or buy above it.

It is set below the equilibrium price because the existing price is too
high for consumers to afford goods and services.

Once set, the poor can afford basic goods and services at lower prices.

Disadvantages

i) Lower prices lead to shortages of goods and services

ii) Emergency of black markets (illegal markets)

The solution lies in rationing the essential goods so that most people
can have access to them.

Illustration (leave space for diagram)

Minimum price (price floor)

This refers to the price set by the government above the equilibrium
price to discourage or prevent exploitation of producers.

It is the lowest price that can be charged for commodities and it is

illegal to sell/buy above it.

It is set above the equilibrium price because the existing price is too
low and may discourage production in the economy.

Once set, producers have stable incomes and are assured of making
some profits.

However, it creates surplus in the economy since the set high price
encourages producers to produce more. To solve this problem, the
government buys off the surplus on the market through what is known
as price support.

Illustration (leave space)

2. Subsidies and indirect taxes.

Subsides refer to direct payments given by government to firms to

reduce their costs of production.

The impact of a subsidy depends on the Price Elasticity of Demand.

With inelastic PED, the consumer benefits more than the producers
once a subsidy is given.

(Leave space for diagram)

With elastic PED, the producer benefits more than the consumers when
a subsidy is given.

(leave space for the diagram)

Therefore, when a subsidy is given, costs of production reduce, which

reduces the price of the commodity as supply increases.

Indirect taxes are mainly imposed on demerit goods and have an

impact of increasing the costs of production which reduces quantity
replied and thus increases prices of such commodities.

(leave space for diagram)

3. Government can also use the competition policy.

This aims at promoting competitive pressures and preventing
firms from abusing their market power.
This can be done by preventing mergers that the government
thinks will not be in the interest of consumers, removal of
barriers to entry and exit into markets, regulation of monopolies
and prohibition of uncompetitive practices e.g. predatory pricing
and limit pricing.
N.B. i) Predatory pricing is where a firm sets a price below its
costs of production with the aim of driving rival firms out
of production.
 ii) Limit pricing is the setting of a very low price to
discourage entry of new firms into the market.

4. Use of environmental policies.

The government may place restrictions on the amount of
pollutants emitted by firms into the air, sea, rivers or lakes and
fine those that exceed these limits.
Government can also adopt use of tradable permits where
government issues polluting permits to firms. Those that pollute
more have to buy more permits from firms that pollute less
which increases their costs of production hence losing market
share as they have to increase prices of their products due to the
increased costs incurred.
This forces them to adopt measures to pollute less.

5. Use of regulations.
These include rules and laws that place restrictions on the
activities of firms.
Government can regulate target audience for a product, the
quality of the product and mode of staff management by firms
e.g.
 Banning sale of cigarettes to children
 Require firms to ensure that firms meet certain quality
standard
 Firms allow their workers a specified number of holidays
 Restrict time for opening &closing of firms.
 Control routes buses must follow.
Advantage – Backed by laws & easily understood.
Problem

 Expensive to implement and supervise by the government.

 It only works when people agree e.g. helmets for riders.
 May be too restrictive hence reducing flexibility.
 They do not directly as a result of market failure.

6. Nationalization and privatization

Nationalization refers to the transfer of ownership and control of an

enterprise from the private sector to the government.

Firms owned by the government are called public corporations. They

do not aim at making a profit but at welfare maximization.

Advantages:

 Consider the cost benefit analysis in their decisions.

 Can be used to boost economic activity e.g. increase output to
boost economic growth.
 They don’t usually abuse monopoly power where it’s only
possible to have one firm.
 Ownership of whole industry by government ensures easier
coordination and planning e.g. train system.
 Ensures that basic industries survive, charge low prices and
produce good quality goods
Disadvantages.

 Difficult to manage and control hence slow decision making

(bureaucracy)
 They become inefficient produce low quality goods and charge
high prices due to lack of competition.
 They need to be subsidized when making a loss hence expensive
to the government (opportunity cost)
Privatization is the sale of state owned enterprises to the private
individuals (sector). This is done for either the whole enterprises or
part of the enterprise.

Advantages.

 Respond to consumer demands ie promotes consumer

sovereignty
 Charge lower prices to consumers due to competition
 Produce high quality goods due to competition
 Results in greater choice for consumers due to variety produced
 Reduces administrative costs by the government as its
involvement is minimal.
 Responds fast to changing conditions due to entrepreneurial
spirit.
Disadvantages.

 They may develop into monopolies hence exploit consumers

through high prices and low quality output.
 Don’t consider cost benefit analysis in decision making e.g. can
lead to pollution and environmental degradation.
 Reduces government control of the economy.

7. Direct provision.

In this case, the government directly provides some essential goods

and services directly to its people e.g.

- Affordable housing
- Education
- Health care
- Street lights
These are provided either free of charge or at subsidized prices.

Government can stimulate consumption of merit goods by:

  Paying private firms to produce them.
 Providing information.
 Making their consumption compulsory.

8. Preventing Unfairness (promoting equity)

Sometimes government intervention as aimed at reducing unfairness

(ensure equity) e.g. through ensuring more equitable distribution of
income and providing essentials to the poor.

- Financial assistance can be provided to poor

- Access to basic necessities e.g. education, health care (these are
financed with taxation)
Note, taxation and other benefits can be used to reduce income and
wealth inequality.

Problems of inequality.

 Unfair
 Socially divisive
 Some workers become less productive.
 Elderly and sick may be unable to earn a living
 Social unrests
Effectiveness of government intervention

Government intervention can reduce market failure.

There is a risk though; government failure may occur e.g.

overestimating private benefits of consuming merit goods and find it
hard to calculate efficient quality of public goods to supply.

- Government decisions may take long (bureaucracy) and may be

influenced by political factors and corruption.
- May reduce economic efficiency by reducing incentives e.g. high
income taxes & unemployment benefits are disincentive work
while corporate taxes discourage investment