You are on page 1of 50

Unit 1


Positive and Normative Economics

Positive Statements
A positive economic statement is a statement that can be proved with
empherical (real world) evidence. These statements are objective in nature
and do not contain any value judgments. They can be tested true or false
with facts and figures. Examples:1. The inflation rate of UK rose by 15% in 2001.
2. Unemployment in Sri Lanka is higher than that of India.
3. The latest Maruti car costs Rs. 1.35 Million
Normative statement
These statements are value judgments. They contain peoples opinions or
views and are subjective in nature. Very often they contain cords such as
ought to, must, unfair, should etc. Examples:1. Unemployment rate of Sri Lanka is too low.
2. The Porsche is more beautiful than a donkey.
Needs and Wants
Needs are goods which are essential for living and are used on daily basis.
Example: - Food, Clothing, Shelter
Wants are goods that people like to have. Thus, it could be concluded that
human wants are unlimited and needs are limited.
Factors of Production-These are resources that are used up in the production
process. They are essential for the production of any good or service.

Land Rent
Labor Wages
Capital Interest

Entrepreneurship - Profit

This is the basic economic problem encountered by every society and
human being. It states that the resources available to satisfy human wants
and needs are limited. Thus, every government has to come up with an
annual plan as to how to use these scarce resources to satisfy all needs and
wants of a country to its maximum possibility.
As a result of scarcity, people cannot do everything they want. As a result
they are forced to make a choice. When they make a choice, they do this by
sacrificing and alternative they would like to have. What they sacrifice is
known as the opportunity cost of what they have chosen.
Therefore, opportunity can be defined as the next best alternative forgone.

Production Possibility Curve (PPC)/ Production Possibility Boundary (PPB)/

Production Possibility Frontier (PPF)/ Transformation Curve (TF)/ Opportunity
Cost Curve (OCC)
A Production Possibility Curve is a graph that shows the maximum
possible combination of 2 types of goods that can be produced by a
country when all resources are fully utilized given the level of
technology is constant

The PPC and Efficiency

A Represents a situation where a countys producing/operating at a point

inside the PPC. This means that some of the resources of the country are
unutilized. In other words, the unemployed resources represent inefficiency.
Therefore it is possible to move towards the PPC curve without an
opportunity cost.
B Represents a situation where a countrys operating on a point on the
PPC. It represents maximum efficiency where the resources of a country are
fully utilized. In order o move from one point on the PPC to another point
there will be an opportunity cost since resources are currently fully utilized,
and in order to produce more of one good, more of another goo will have to
be sacrificed.
C Represents a point where a countys operating outside the PPC.
However, this is unattainable with the current resources. For this to happen
there should be a rightward shift of the PPC, meaning economic growth.

Shifts of the PPC

According to the above diagram, a movement from AB to AC indicates that

the productive capacity of apples in a country has increased whilst oranges
have remained the same. This could be due to technological advances,
human capital investment, improvements in the productivity of apples
industry whilst everything remains the same in the orange industry.

According to the diagram above, the PPC has shifted to the right from A to B.
This means that the productive capacity of both goods has increased. Thus,
the country will be able to produce more of both these goods. This occurs
when there is economic growth and it requires one or more of the following;

Improvements in the productivity of labour
Human Capital Investment (HCI)
Improvements in technology
Discovery of natural resources

According to the above, the PPC of the country has shifted to the left. It is a
situation where the productive capacity has decreased. It is a very rare
situation and it represents negative economic growth. It may occur due to;

Increase in death rates

Destruction to natural resources by war or natural disasters
Migration to other countries
Fall in the productivity of labour

Concave and Convex PPC

The above PPC is said to be concave to the origin. This means that the
opportunity cost is increasing.

The above PPC is said to be convex to the origin. This means that the
opportunity cost is decreasing.
Economic Systems

Types of Economic Systems


Traditional/ Subsistence Economies

Market Economy
Planned Economy
Mixed Economy

1. Traditional/ Subsistence Economies

These economies are so named because people in these economies
are used to doing things the way they have always been done
(according to the age old customs). In other words, the way of life in
these economies has not changed for centuries. These are also known
as subsistence economies.
2. Market Economy
Any arrangement which enables buyers to do business with sellers is
known as a market. A market is one in which there is considerable
freedom for buyers to buy what they want and sellers to sell their
products. The prices are determined by the market forces of demand
and supply. This is also known as a capitalist economy.
Features of a Market Economy
Private property
Individuals have the right to own, control and dispose of land,
machinery, building etc. It is this feature of market economies that
causes them to be described as capitalist economies.
Freedom of choice

Individuals are free to set up in business for themselves, firms are free
to decide what and how they should produce, workers are free to enter
and leave occupations, customers are free to spend their income as
they wish.
Self interest
The system encourages them to do what is best for themselves. Firms
will try to maintain their profits, workers will try to maximize their
income and consumers will maximize their satisfaction.
Price mechanism (competition)
In a market economy, the prices mechanism acts as a signaling device
to both producers and consumers. Rising prices will encourage
produces to shift resources from one good to another and more firms
to enter the industry. Falling prices will discourage production, however
encouraging consumers to buy more of this product.
A very limited role for the government
A market economy is very often described as a free enterprise
economy where the word free means free from government control.
3. Command economy/ Central Planned Economy
These economies are so named because the government has the
power to command the nations economic resources. It has complete
control over the way these resources are being used. It is the
government that decides what to produce, how to produce, whom to
produce and when to produce. These are known as the questions of
resource allocation.
Features of a command economy
Public ownership
In this type of economic system all resources are owned by the
government. The private sector owns only the personal possessions of
Planned production
In a planned economy, production is carried according to a national
plan. Resources are allocated to the government sector firms every
year in advance. In this type of economic systems resources are

allocated to different users of the economy. However, in a market

economy, resources allocation is carried out to the highest bidder.
In a planned economy, prices cannot change in response to change in
demand and supply. They are fixed by the government.
The main objective of the private sector organization is to make a
profit. However, in a command economy, goods and services are
produced by the government in order to satisfy consumer needs. The
main objective of these organizations is to provide a good service even
at a loss.

4. Mixed economy
In the real world there is neither completely planned economy nor a
complete market economy. Instead, majority of the economies of the
world are mixed.
In these economic systems, there is both a public sector and a private
sector. There is both government intervention and free market forces.
The public sector produces goods and services that are not provided by
the private sector. (Public goods and merit goods/ goods those are not

Demand And Supply

Law of demand
This states that more will be demanded at lower price than at a higher price.

Definition of demand
This is the quantity that consumers are willing to buy at a given price over a
given period of time.

Extensions and contractions in demand

When the price of a good it is believed that the quantity demanded will
increase. This is known as a movement along the same demand curve
(extension in demand).
When the price of a good rises, the quantity demand will fall thus causes a
movement along the same demand curve (contraction in demand).

Shifts of the demand curve

When there are changes in the price, there will be either an extension or
contraction in demand. However, when any other factor apart from price,
affecting the demand for a good changes, there will be a shift of a demand
curve to the left (decrease) or to the right (increase).

Other factors affecting demand: -

1. Incomes of consumer
If the income of the consumers increases, the demand for the product
in concern will also increase, resulting in a right shift of the demand
When the incomes of consumers fall, the demand for the product in
concern would also fall, causing the demand curve to shift to the left.
2. Prices of substitute goods
When the price of a substitute good increases, the demand for the
product in concern will increase causing the demand curve to shift to
the right, whereas the demand curve would shift to the left when the
price of a substitute good decreases as the demand for the product in
concern would also decreases.
3. Prices of complementary goods
If the price of a complementary good increases, the demand for the
product will decrease this will result in a left shift of the demand curve
and vice versa.
4. Advertising
If there is excellent advertising, the demand for the product will
increase and if there is poor advertising, the demand for the product
will decrease.
5. Taste and fashion
A positive change in taste and fashion towards the product would
cause demand to increase whereas a negative change would cause
demand to decrease.

Law of supply
This states that more will be supplied at higher prices than at lower prices.

Definition of supply
This is the quantity that producers are willing to sell at a given price over a
given period of time.

Extensions and contractions in supply

When the price of a good increases it is believed that the quantity supplied
will increase which is known as an extension in supply. A contraction in
supply occurs when the quantity supplied decreases due to a fall in the price
of a good.

Other factors affecting supply

1. Cost of production
If the cost of production increases, less will be supplied and thus the
supply curve would shift to the left and vice versa.
2. Weather conditions
Excellent whether will increase the agricultural goods supplied thus
causing the supply curve to shift to the right and vise versa.
3. Improvements in technology
Advances in technology will increase the amount supplied creating a
shift in the supply curve to the right and vise versa.
4. Taxes and subsidies
When governments give subsidies to firms, this would encourage firms
to produce more into the market thus causing the supply curve to the

Governments increasing taxes on firms would decrease the amount

supplied to the market, which would result in the supply curve shifting
to the left.

Normal goods and Inferior goods

Normal goods
These are goods which have positive relationship with income and demand.
In other words, when income increases, the demand would increase and vise

Inferior goods
These are goods which have an inverse relationship between income and
demand. If Income increases, the demand would decrease and vise versa.
Theyre considered to be low quality goods and are demanded by the low
income groups in society. When income increases it is said that the demand
for these goods will fall as people tend to be better off and can afford to buy
luxury goods (better quality goods).

Compliments and Substitutes

These are goods that are demand together. In other words, the usage of one
good requires the usage of another.
Example: - Car & Petrol.
When the price of one good increases, the demand for the other good will

There are goods that are used to satisfy the same need instead of another
good used satisfy the same need.
Example: - Butter and margarine
When the price of one good increases, the demand for the other good will
also increase.

Types of Demand
1. Composite demand
This refers to the demand that has many uses.
2. Joint demand
Demand for complimentary goods.
Example: - Tyres and tubes
3. Competitive demand
Demand for substitutes.
4. Derived Demand
Demand for one good that arises from the demand for another good.

Example: - Labour is said to have a derived demand. This is because

the demand for labour arises from the demand for the product of

The Effect of Taxes ad Subsidies

Effect of taxes (burden)
The immediate effect of a tax is a shift of the supply curve to the left. This is
because when a tax is imposed, the cost of production increases and
suppliers are discouraged to supply.

When demand is perfectly inelastic consumers bears the entire tax.

When the demand is perfectly elastic - producer bears the entire tax.

Effect of a subsidy
The immediate effect of a subsidy is a shift of the supply curve to the right.
This is because when a subsidy is given, cost of production decreases and
suppliers are encouraged to supply.

When the government imposes a direct tax, it affects the demand

Therefore, all the diagram drawn above (excluding the effect of
subsidies) are based on INDIRECT TAXES.

Types of taxes (indirect taxes)

1. Specific tax (unit tax)
2. Ad valorem tax (percentage tax on price)

1. Specific tax (unit tax)

This is a fixed rate of tax where the amount of tax is the same for
every unit produced. Therefore, the supply curve will shift to the left as
a parallel line.

2. Ad valorem tax (percentage tax on price)

This is a percentage of tax changed on the price of the product. Thus,
the supply curve will shift to the left by a high proportion at a higher
price and a lower proportion at a lower price.

Producer and Consumer Surplus

Producer Surplus
This refers to the benefit a producer gets as a result of being able to sell a
product at a higher than a lower price he was willing supply.

This depends on the electricity to the supply curve

Supply elastic Producer surplus reduces
Supply inelastic Producer surplus increases

Consumer surplus
This refers to the benefit a consumer gets as a result being able to buy a
product at a lower price than a higher price he was willing to pay.

This depends on the elasticity of the demand curve

Demand elastic Consumer surplus reduces
Demand inelastic Consumer surplus increases

Agricultural Markets
1. Inelastic Demand
The demand for agricultural goods is sold to be relatively inelastic to
the response to changes in prices. Therefore, an increase of prices will
lead to a fall in the quantity demanded but the proportion of this fall
would be relatively smaller compared to the change in price and vise
This is mainly because agricultural products mainly represent food
items such as rice and changes in prices of these goods will have little
effect on consumers demand. For example, a rise in the prices of rice
would mean that consumers would still continue to purchase since rice
is considered as a basic food commodity.
On the other hand, falling prices will encourage consumers to purchase
more rice but it will be limited due to the fact that food items are
consumed to a certain limit.
2. Inelastic supply
The supply of these primary commodities is said to be inelastic with
regard to changes in the prices. Increasing prices will encourage
producers to sell more to the market, but this increase in supply
depends on a number of other factors such as weather and a good

3. Low income elasticity of demand

YED is the responsiveness of demand to a change in incomes of
consumers. Agricultural goods are said to have a lower YED (inelastic)
when incomes ro consumers change. This is because changes in
consumers incomes will lead to a rise/ fall in demand but the
proportional change will be comparatively lower since food items have
limits to its consumption.
The prices of agricultural goods are said to fluctuate more widely and
more frequently compared to that of manufactured goods. This is due
to the 3 factors mentioned above (inelastic demand, inelastic supply
and YED < 1)
Diagrammatic analysis of inelastic demand and inelastic supply with
regard to agricultural goods.
1) Inelastic demand illustrations

2) Inelastic supply illustration

PED on a downward sloping demand curve

PED when price changes from $10 to $6

PED when price changes from $6 to $4

PED when price changes from $4 to $2

On a common demand curve sloping from left to right, its bearing

would change from being elastic (PED > 1) to unitary elastic ( PED = 1)
to an inelastic value (PED < 1)

Market Failure
This occurs when the price mechanism causes an inefficient allocation of
resources or when the market forces of demand and supply cannot bring and
efficient allocation of resources.
Sometimes market failure is also referred to as a situation when resources
are not allocated to their best or optimum use leading to a net welfare loss in
the society.
There are various types of market failure which can be classified into;

Public goods and merit goods (missing markets)
Imperfect market information (asymmetric information)
Labour immobility
Unstable commodity markets

This is defined as effects(cost/benefit) on a third party who is neither the
producer nor the consumer that is ignored by the price mechanism. This is
also known as indirect costs and benefits, as spillovers (spillover effect) from
production or consumption of a good or service, External costs are commonly
known as negative externalities/negative spillover effects and external
benefits as positive externalities/positive spillover effects.

External costs (Negative externalities)

This arises due to a divergence between social costs and private costs. It is
where the marginal social costs exceed the marginal private cost.
External costs can came about in both production and consumption. An
example for one in production can be pollution by firms and one through
consumption can be passive smoking.

Private costs
This refers to those costs incurred by a firm or an individual in order to
produce or consume a good or service. In a free market, producers are only
concerned with the private costs of production. These are costs internal for a
firm, for which it directly pays for. They include wages, rent, payment, for
raw materials, electricity etc. On the other hand, private costs for an
individual will be the market price that a consumer pays for a good or

Social costs
By adding private costs to external costs, we obtain social cos. This means
that external costs are the difference private costs and social costs. The
marginal private cost and social cost curves often diverge indicating that
external costs increase disproportionately with output. Given below is a
diagram indicating the relationship between private cost, social cost and
external cost

External benefits
This may occur in the production and consumption of a good or service. An
example of an external benefit in production is the recycling of waste
An external benefit in consumption is the vaccination of an individual against
various diseases.

Private Benefits
In a free market, consumers are only interested with their private benefits.
Private benefits can arise from the production and consumption of goods and
services. The private benefits on production can be the revenue obtained by
a firm and the private benefit of consumption can be the satisfaction of

Social benefits
By adding private benefits to external benefits, we obtain social benefits.
This means that external benefits are the benefits between private benefits
and social benefits. The marginal private benefit and the marginal social
benefit curves often diverge, indicating that benefits increase
disproportionately with output consumed. This is shown in the diagram

The market equilibrium

The supply curve for a firm is the Marginal Private Cost curve (MPC). The
addition of all the MPC curves of firms in a market for a particular good or
service will form the market supply curve.
The demand curve for consumers is the Marginal Private Benefit curve (MPB).
Economists assume that it is possible to measure the benefit obtained by a
consumer good or service by the price theyre willing to pay. As an individual
consumes more units of a good, the marginal benefit (marginal utility) will
fall. This is why the demand curve slopes downwards from left to right. The
addition of all the consumers MPB curves from a particular good or service
will form the market curve. Market equilibrium occurs when MPB = MPC

The Social Optimum Equilibrium

The Social optimum equilibrium level of output or price for a good or service
occurs where Marginal Social Cost (MSC) equals Marginal Social Benefit
(MSB) when the social optimum is reached in market welfare is maximized.

External costs and the triangle of welfare loss

The free market ignores negative externalities. However, adding external
cost on to the production of a good or service causes its costs to go up thus
shifting the supply curve to the left and becoming the Marginal Social Cost
curve (MSC).

In an unregulated market, firms will only take into account of its private costs
and private benefits. Therefore, it will produce where MPB=MPC. Firms ignore
the external cost it creates. Therefore, the cost of production will be lower
than if the external costs were considered. The result is that output will be
greater than the socially optimum level. This leads to overproduction and
under pricing. Due to overproduction of output, there is a loss of social
welfare (depicted by the shaded triangle). The failure to take into account
the negative externality effects is a market failure. The market has failed
because external costs are ignored.

External benefits and the triangle of welfare gain

The free market ignores positive externalities. However, adding external
benefits onto the consumption of a good or service such as the consumption
of vaccination causes the demand curve to shift to the right and become the
marginal social benefit curve.
Assuming there are no external costs in the consumption of vaccinations in a
free market, the social optimum price is OP2 and quantity OQ2. When
external benefits are ignored, there is under pricing and under production.
There is an excess of social benefits over social costs for the marginal output
from OQ to OQ2, welfare could be increased.
The excess of social benefits over social costs is shown by the triangle MTZ.
This is the area of welfare gain to society. The market has failed since
positive externalities have been ignored.

Public Goods
The case for insufficient quantities of public goods and merit goods being
offered by the private sector is very often known as missing markets.
These goods involve a large consumption such as national defense, flood
defense system, criminal justice system etc.
Public goods are commonly known for two important characteristics;
1. Non - Excludability
This means that once a good has been produced for the benefit of one
person, it is impossible to stop others from using it. This is commonly
known as the Free Rider Problem.
2. Non - rivalry/ Non diminishability
This means that as more people consume a good, and enjoy its
benefits, it does not reduce the amount available for others.
Example: - Street lights

Once a public good has been provided the cost of supplying it to an extra
consumer is zero. Further, examples lighthouses, firework displays, public
beaches, public parks, street lighting etc.

The under provision of public goods

Public goods are under provided for 2 basic reasons;
1. The free rider problem
Once a public good has been provided for one individual, it is
automatically provided for all. The market fails because it is not
possible for firms to withhold the good from those consumers who
refuse to pay for it.
2. The valuation problem
It is difficult to measure the value obtained by consumers of
established a market price for them. It is the interest of consumers to
under value the benefit gained from a public good do that they pay
less for it. But its in the interest of the producers to over value the
benefit gained by a public good in order to charge a higher price. The
uncertainty over valuation may deter (prevent) firms from providing
public goods.

Quasi public goods (Semi public goods)

In practice, there are often ways in which providers of public goods can
exclude consumers from benefiting.
Example: 1) A motorist can be charged a tax for using the road.
2) Entrance fees for the national museum ( which is considered as a
public good)

Merit goods
These are goods that are provided by the free market but would be under
provided. Typical examples are education and healthcare where the benefit
can be seen to the entire economy. If left to the market, it would be under
provided and only those who can afford it will consume it.

De merit goods
The consumption of these goods is considered unhealthy or socially
undesirable due to perceived negative effects on the consumers themselves.
It is over consume and over produced of left to the free market forces.
Example: - alcohol, tobacco, gambling, junk food etc
Because of the nature of these goods the government imposes taxes on
these goods and in some cases ban in consumption or advertisement of
these goods.

Private goods
Private goods are the opposite of public goods. They display characteristics
of rivalry and excludability in consumption. An example of a private good is a
creamy full of chocolate doughnut, the consumption of which directly
excludes others from consuming that particular doughnut. The owners of
private goods are able to use private property rights which prevent others
from consuming them.

Government provision of public goods

In a mixed economy, the government tends to provide public goods in order
to correct market failure. It raises funds from general taxation to pay for their
provision. Without government intervention, public goods may be under
provided or not provided at all. The actual amount produced will be less than
the quantity required for achieving the socially optimum level.

Imperfect market knowledge

Symmetric information
In the study of competitive markets, it is often assumed that consumers and
the producers have perfect market knowledge upon which to make their
economic decisions. This is known as symmetric information where
consumers and producers have perfect and equal market information of a
good or service. Assuming that consumers and producers act in a rational
way, it will lead to an efficient allocation of resources.

Asymmetric Information
In reality, consumers and producers have imperfect and unequal market
knowledge upon which to make their economic decisions and this could lead
to a misallocation of resources. This is known as asymmetric information.
Often producers may know more than consumers about a good or service. A
second hand car salesman for example, may have greater knowledge of the
history of the vehicles for sale as well as more technical knowledge than
consumers. This would lead to a consumer paying too much for a low quality
Sometimes consumers have more market knowledge than producers. For
example, a consumer may purchase an insurance policy concealing
information about him or simply know more about his intended future
actions. This might include a risky lifestyle.

When there is imperfect market information, markets are likely to fail. This
can be seen in the under consumption of healthcare, education and pensions
(merit goods) or the over consumption of tobacco, alcohol and gambling
(sometimes known as de merit goods).

Lobour immobility
The mobility of labour refers to the ability of labour to change form one job to
another geographically, occupationally and industrially.
Unemployment while people search for a job and fill them is known ad
frictional unemployment. However, a more serious type of unemployment is
due to a mismatch of sill and location between job seekers and job providers.
The gives rise to immobility of labour and structural unemployment.
Geographical immobility refers to the obstacles that prevent labour from
moving from one are to another to find work. There are several causes such
as family and social ties the financial costs involved with moving homes,
imperfect market knowledge (asymmetric information) on available work,
regional variation in house prices and the cost of living. The biggest problem
tends to be the lack of affordable housing in many parts of the UK.
Occupational immobility refers to the obstacles which prevent labour from
changing their type of occupation to find work. There are several causes,
including insufficient education, training, skills and work experience.

Government measures to increase geographical mobility of labour

There are various measures thats government might under take to increase
the geographical mobility of labour and this includes;
Relaxation of planning laws which enable construction firms to build
housing, especially in green belt areas and the south east of England.
Increase in the construction of social housing such as council
properties and charities where rental costs tend to be more affordable
than mortgages.
Offering housing subsidies to certain groups of workers where acute
shortages exist, such as teachers, nurses and fire fighter.
Improving the operation of job centres, so that more information is
available on job vacancies in an area.

The measures a government might use to increases occupational mobility of

Increasing the provision of training schemes especially for the
unemployed. This might include subsidies to private sector companies
to offer training services.
Increasing the provision of further education, especially in the post
16 (after 16) sector.
Increasing the provision of higher education. There has been a rapid
increase in the number of students in this sector over recent years.
Increasing access to students loans and limiting tuition fees might help

Unstoppable commodity markets

Commodities refer to raw materials used in the production of goods. They
may be minerals and metals such as oil, coal, tin , copper etc. They also
include agricultural goods such as rice, sugar, wheat, flour etc. Typically,
commodities are used to manufacture goods and services.
Commodity markets are characterized by fluctuating prices and producer
incomes which make it difficult to plan future investment programs markets
where the climate may affect the supply in any one year.
The problem of uncertain supply of commodities in any one years is
compounded by the tendency of demand for thee goods to the price
inelastic. A good harvest generally leads to a larger fall in prices and
revenue whereas a poor harvest will lead to a larger rise in price
and total revenue. Consequently, farmers may make huge profits one year
and huge losses another. It gives rise to market failure.
In the long run, the supply of agricultural commodities has increased
dramatically due to major technological innovations. For example, GM crops
increase yield and resistance to drought and pests. However, the growth in
demand has failed to keep up with the supply. Commodities tend to become
inelastic in demand since each individual has limited food intake. This leads
to a further fall in the price of commodities and revenue of farmers.

Labour Market

What determines the wage rate in the labour market?

In a competitive labour market, the wage rate is determined by the market
forces of demand and supply. The demand for labour is undertaken by firms,
which require workers to help produce goods and services. The supply of
labour comes from the general population and, in particular, the workforce of
an economy.

The demand for labour

The demand for labour is a derived demand. This means that the demand
for labour comes from the demand for the product of labour. For example,
the demand for building workers is derived from the demand for new
The figure below shows how an increase in demand for new housing will
cause an increase in demand for building workers such as brick layers and
carpenters. The effect is to increase the wage rate from We to W1 and the
quantity employed from Ne to N1.

a) New housing market

b) Labour market for building workers

An increase in demand for new housing and building workers.

Determinants of demand for labour

Demand for final product
An increase in demand for a good or service is likely to cause an
increase in demand for the labour involved in making it. Firms have a
profit incentive, if demand and prices increases, to supply more of a
good or service.

The wage rate

A fall in the wage rate means that labour becomes more affordable and
firms are likely to demand for more labour.

Other labour costs

For example, a fall in employers national insurance contributions on
behalf of their staff is likely to the raise the quantity demanded.

Price of other factor inputs

An increase in the price of capital might encourage firms to employ
more labour and cut back on the use of machinery and equipment
where possible. This is because labour and capital may be substitutes
in the production process.

Government employment regulations

The fewer the number of regulations, the greater the demand for
labour is likely to be. For example, if it becomes easy to hire and fire
staff, or to change working conditions, then the increased labour
flexibility may encourage firms to employ more people.

The supply of labour

This refer to the quantity and quality of labour hours offered to work
over a given time period. Sometimes it is also defined as the number
of hours a worker is willing to work at a given wage rate over a period
of time.

The wage rate

An increase in the wage rate will encourage more people to offer their
service for work. A higher wage rate means the opportunity cost
of leisure time increases, encouraging people to work longer
Working conditions
Improvements in working conditions will tend to increase the supply of
labour such as a good pension, paid holidays, job security and
promotion prospects.

Net Migration
This refers to the difference between immigration and emigration of
labour. Over recent years, the UK has experienced significant increase
in immigration from Central and Eastern Europe helping to boost the

Income tax
A reduction in income tax will increase disposable income and so offer
a greater incentive for people to work. Many people will substitute
work for leisure time, decreasing the supply of labour.

Trade unions
Trade unions act to increase improve wage rates and improve other
working conditions through collective bargaining with employers. This
may lead to an increase in the supply of labour.
Government regulations
An increase in the employment protection or the introduction of a
national minimum wage will tend to improve working conditions and so
increase the supply of labour. However, it is also possible that the
government regulation reduce the supply of labour in occasions such
as maximum working hours per week.
Social trends
There has been a significant increase in the number of women in the
workforce over the past 40 years. This reflects an improvement in
equal opportunity childcare facilities and social attitudes.

How Do Governments Attempt To Correct Market Failure?

The government could attempt to use a number of different policies/

measures in order to correct market failure. They include;

Indirect taxation
Tradable pollution permits
Extension of property rights
Buffer stock schemes
Minimum prices

1. Indirect taxation
These are levied on the expenditure of goods and services. The
government often imposes taxes on goods which have significant
external costs as petrol, tobacco and alcohol.
The following diagram shows the market for petrol, including both the
MPC curve and the MSC curve. In a free market, the equilibrium price is
OPe and the equilibrium quantity OQe. However, the social optimum
price is OP1 and social optimum quantity is OQ1, where MSC = MSB.
The vertical distance ZY represents the external costs (air pollution) for
each litre of petrol consumed.
By placing a tax equal to the external cost of ZY per litre, the
government successfully internalise the externality (pollution). The
total tax collected is shown by the area P1YZW. Both producers and
consumers pay the tax, depending on the relative elasticises of
demand and supply. The consumer tax area is YP1PeT and the
producer tax area is PeTZW.

Advantages of indirect taxes to correct market failure:

Indirect taxes are based on the principle that the polluters pay both
producers and consumers.
Indirect taxes work with market forces helping to internalise the
external cost while maintaining the consumer choice.
The level of pollution should fall as output of the good and service is
reduced and the price is increased the social optimum position of
MSB =MSC can be achieved.
Tax funds are raised for the government and these can be used to
clean up the environment or to compensate the victims of pollution.

Disadvantages of indirect taxes to correct market failure:

It is difficult to quantify the pollution and then place a monetary value

on it. Consequently, the social optimum position might not be
Indirect taxes increase the cost of production for firms, making them
less competitive, compared to firms in other countries where such
taxes are not applied.
Firms might relocate to other countries with less stringent taxes on
The demand for goods and services maybe relatively price inelastic
and so the overall deduction in pollution levels maybe small.
The tax revenue collected may not be used to compensate victims or
clean up the environment.
It might encourage the development of illegal markets such as tobacco
and alcohol smuggling to paying high taxes.

2. Subsidies
A subsidy is a grant provided by the government to encourage the
production and consumption of a particular good and service.
Subsidies are often applied on goods and services with significant
external benefits such as education and healthcare. They may also be
given to alternative forms of economic activity which create less
pollution such as public transport and renewable energy.

Advantages of subsidies applied to renewable energy markets:

They reduce air pollution.

Using renewable sources helps to promote sustained economic growth.
The rate of consumption of non renewable resources is reduced.
Subsidies work with the market forces of demand of supply. They help
to internalise the external benefits from renewable forms of energy.

a) Electricity from renewable energy source ( wind and water)

b) Electricity from non renewable energy sources ( coal and oil)

Disadvantages of subsidies applied to renewable energy markets:

There is an opportunity cost to the government of subsidies. It may

lead to higher taxes or cuts in government spending.
Firms may become inefficient in production if they rely upon subsidies.
Wind power may be less reliable source of energy that traditional

3. Tradable pollution permits ( Carbon emissions trading)

This is where the government sets a limit or cap on the amount of
pollution that can be emitted. Firms are allowed to pollute up to a
certain limit. Beyond this limit if they are to pollute, they would have to
purchase pollution permits from the government. These permits are
tradable, i.e. if a firm reduces its pollution level below the permit, it
could then sell this permit to another polluter at a higher price.
Therefore, this scheme encourages firms to invest in clean technology
and environmentally friendly methods of production.The emissions
trading scheme also allows firms to invest in schemes that reduce
carbon dioxide emissions outside the EU.
Advantages of tradable pollution permits:

Firms will genuinely try to reduce pollution because they have a

financial incentive to do so.
The government can raise funds by selling up to 10% of their permits
to polluters. The revenue could be used to clean up the environment or
compensate victims.
Productions costs will increase for firms that exceed their pollution
allowances since they have to purchase additional permits and this
provides a source of revenue for cleaner firms that can sell their excess
pollution permits.
Firms may be able to bank their excess pollution permits for use in the

Disadvantages of pollution permits:

The European commission may issue too many permits so that there is
little incentive for firms to reduce pollution.
The European commission may allocate too few carbon permits so that
production costs for EU firms increase rapidly, reducing their
international competitiveness.
Disputes have risen over the allocation of carbon permits to firms some
firms believe they should receive larger allowances and have taken
legal proceedings against the European commission.
Some firms may simply pass the cost of purchasing permits to the
consumer for products whose demand is inelastic.
Pollution permits may create an entry barrier for new firms to enter the
industry, so restricting competition.

There is a cost to the government of monitoring pollution emissions

from the many firms within the scheme.
EU firms may avoid in investing in expensive technology to reduce
their own emissions by funding cheaper carbon off setting schemes in
developing countries.

The emissions trading system allows firms to invest on schemes

that reduce carbon dioxide emissions outside the EU. Eg:- China and

4. Extension of property rights

This involves the government allocation property rights to
organisations over the ownership of resources regarding to what uses
they can be put to and what rights others have over them and
extension f property rights has been applied to the seas, rivers,
mountains and air n certain seas.
All too often, negative externalities arise when there is a lack of
property rights over a resource there is an incentive to abuse the use
of a resource if there is no property rights; for example over fishing in
the North Sea.

Advantages of property rights:

Property rights use the market mechanism to ensure an efficient use of

resources. This means the owner of the property right will charge
consumers and producers for using it.
There is an increase in the knowledge and expertise for the
organisation with the property right. It takes away pressure away from
the government to access the pollution.
There is a greater likelihood that the property (resources) will be
managed carefully to ensure its availability for future generations, as
with the control of cod catchers from the North Sea.
Property right owners can charge firms that need to pollute the
environment. The funds can be used to clean up the environment and
compensate the sufferers.
Firms that damage the environment without permission can be
prosecuted and made to pay for clean up operation.

Disadvantages of property rights:

It is often difficult for a government to extend property rights For

example, UK membership of the EU means that the EU fishing boats
are entitled to fish in UK territorial waters.
It may be difficult for government to extend a property right which
covers more than one country. For example, the logging of the
Amazonian rain forest in Brazil is out of the jurisdiction of developed
countries. The external costs which arise cannot easily be internalised.
It could be difficult to trace the source of environmental damage. In
the case of Asbestos sufferers who work for more than one Asbestos
company, it has been extremely difficult to prove which caused the
disease. Consequently, compensation payments have been withheld.
The legal cost involved in prosecuting a polluter could extremely high,
determining victims from taking compensation.

5. Government regulations
In attempt to correct market failure, the government may pursue a
policy of regulation. This can be followed in 2 basic ways. The first
would be to request the firms polluting to cut down their production
levels or in extreme cases, shutting them down. However, there are a
number of other measures which can be seen as forms of government
regulation that are used to regulate the operation of firms that involve
in creating negative externalities. For example, the Environmental
Protection Act which sets minimum standards, the imposition of fines
or perhaps the provision of subsidies to firms that are involved in
environmentally friendly methods of production.


Theyre simple to understand. For example, the setting up of legal

restrictions on the age limits for the sale of tobacco and alcohol.
It is possible to fine or shutdown companies which have abused the
regulations. For example, by emitting dangerous levels of toxic waste.
The establishment of consumer protection laws against firms that sell
unsafe products or make false claims about their product. May help
reduce the problem of asymmetric information.


It may be expensive to monitor the behaviour of firms.

There may be extra costs to firms. For example, the cost of installing
pollution monitoring equipment.
It may be difficult to quantify and attach a monetary value to pollution
Regulation prevents the operation of the price mechanism over ruling
it completely rather than working with it.

6. Buffer stock schemes

A buffer stock scheme may be operated by a government agency to
reduce price fluctuations of a commodity and stabilise producer
incomes. It involves the agency setting a target price range for a
commodity (a max and min price), and then intervening to make sure
that the price remains within this band despite sudden changes in
supply or demand.
Example: - Coffee bean Cocoa etc.
In times of a good harvest (and increase in supply) the price may be in
danger of falling too low and so the agency buys up the excess supply
of the commodity, adding to its stockpile. In times of poor harvest (a
decrease in supply), the price maybe in danger of rising too high and
so the agency sells from its stockpile.
Part (a) of the following diagrams shows the operation of a buffer stock
scheme for cocoa. The initial equilibrium price Pe is within the price
range of P5 and P3. However, a very good harvest in one year,
increases supply to Q1 which causes the price to fall to P1. The agency
intervenes by purchasing the quantity XY which prevents the price
from falling below the minimum target price P3. Total agency spending
is shown by the area XYQ1L. It has increased its stock pile of cocoa.
Part (b) shows a poor harvest in another year which reduced supply to
Q6, putting pressure on the price to rise to P6. The agency intervenes
by selling quantity VW from its stockpile which prevents price from
rising above the minimum target price P5. Total agency revenue is
shown by the area VWHQ6. It has reduced its stockpile of cocoa.
The scheme is meant to be self financing, since the agency
purchases stock at a lower price (P3) and sells at a high price

(a) Agency purchase of stocks (a good harvest)

(b)Agency sale of stocks (a poor harvest)

Advantages of buffer stock scheme:They reduce commodity price fluctuations, helping to stabilise
producer incomes.
There is greater certainty in the market, leading to more investment.
They help to ensure provision of commodities for consumers even in
times of poor harvest.

Disadvantages of buffer stock scheme:

A series of good harvest in consecutive years may put too much

fictional pressure on the agency that has to keep purchasing additional
stocks and it may become too expensive to fund. This problem may
reflect the initial setting of the price in the first place often at too
high a level due to asymmetric information between producers and the
government agency.

The long run trend of increased productivity in the agricultural sector

creates a continuous pressure on the agency to purchase additional
stocks and requires a downward adjustment of the intervention price
range (should reduce the minimum price).
There may be significant costs associated with the storage and
security of stockpiles. Usually, large buildings are required.
The stocks may be perishable over a long period of time, specially
agricultural commodities. The agency may lose money if the crops get
A series of poor harvests may lead to the agency running out of stocks
to release to the market. This means the market price exceeds the
maximum price and so the buffer stock scheme breaks down.
Opportunity cost.

7. Minimum pricing
The government may stabilise commodity prices and producer incomes
through a guaranteed minimum price for many commodities including
sugar, wheat and barley. Usually the minimum price is set above the
free market price, causing agricultural surpluses. These are purchased
by the government agencies at the guaranteed minimum price. This
is shown in the diagram.
A minimum price of P2 causes demand to contract from Qe to Q1, and
supply to extend from Qe to Q2. It leads to an excess supply of Q1Q2.
Government expenditure on the surplus is shown by the area Q1Q2YW
and total farm revenue increases from OPeXQe to OP2YQ2. The excess
supply is stockpiled by the government.

Advantages of minimum price:

A reduction of commodity price fluctuations makes it easier for

consumers to budget their spending.
Farm incomes are stabilised and increased, leading to greater
investment in agriculture.
Employment in the countryside is maintained, helping to reduce rural
urban inequality.
Supply of agricultural commodities is guaranteed even in times of poor
harvest, due to surplus stockpiles.
Agricultural surpluses can be used as a form of foreign aid to
developing countries.

Disadvantages of a minimum price:

The price of food increases, which could lead to hardship for

consumers on low incomes.
Government spending on agricultural surpluses involves an opportunity
cost. It may have to raise taxes or cut on spending on other programs.
There are increased storage and security costs for the food surplus.
The agricultural surplus may have to be destroyed due to their
perishability: for example milk, fresh peaches, tomatoes etc.
The agricultural surpluses may be sold in overseas markets at a very
low price. This could damage farmers in developing countries, who are
unable to compete against cheap government owned food.
Excess supply represents an inefficient allocation of resources.
Farmers are guaranteed an income which might cause them to become
less efficient over time. There is less incentive for farmers to improve
the quality of the food or to keep production costs down.

All these disadvantages are instances of government failure.

Government Failure
This occurs when the government intervention in the free market leads to a
net welfare loss rather than a gain. It is where the government causes a
misallocation of resources in a market.

Examples of common forms of government failure

Higher taxes have encouraged illegal smuggling of tobacco and alcohol
into the UK. Organised crime has entered these markets, leading to
smuggling on a massive scale. The government has lost a significant
amount of tax revenue from these illegal activities.
The proposed tax on household waste may sound fine in theory but be
unworkable in practice. Some local councils have proposed charging
households an extra fee if they have more than 2 sacks of rubbish
collected each week. This could adversely affect large families and low
income households. It could lead to an increase on fly tipping or
disputes between households over the ownership of rubbish bags,
especially in multi - occupancy properties.
Subsidies to bus transport may not lead to a substantial rise in
passenger numbers as motorists often prefer the convenience of
private car journeys. In some cases, bus transport may be considered
an inferior good. As real incomes increase, the demand for bus services
will fall. This suggests that the government subsidies are a waste of tax
payers money.
Road pricing - A congestion scheme will help reduce external costs
such as noise pollution, traffic congestion and air pollution. However, if
the charge is set too high, it could lead to an under utilisation of road
space. It may also lead to unfairness to low income motorists who
cannot afford to pay the daily charge. Furthermore, it may reduce trait
for business within the congestion charge zone. The socially optimum
quantity of traffic may not be achieved.
Buffer stocks and minimum prices in agricultural markets
These schemes often lead to huge food surpluses which have to be
destroyed or dumped in markets of developing countries. The
government has distended the operation of these markets, leading to

an over supply and misallocation of resources. This also represents a

waste of tax payers money.
National Minimum Wage (NMW)
A NMW set above the free market wage may lead to unemployment in
certain labour markets such as agriculture, textiles etc. The purpose of
the NMW is to protect low paid workers but in the some cases, it may
increase poverty leading to unemployment.
Allocation of fishing quotas
The European commission is responsible for ensuring a sustainable
level of fishing in the North Sea by allocating fish catchers (quotas) for
each commercial fishing boat. However, environmentalists point to
reducing fish stocks and blame the government for setting fish quotas
at too high a level. Theres a further problem of fishing boats throwing
dead fish to keep them within their quotas and the poor monitoring of
fish catchers.
Government bureaucracy (red tape)
There are various government rules and regulations, known as red tape
that hinders the operation of market forces. For example, concerning
proposals for constructing a third runaway at the Heathrow Airport.
Various times consuming planning inquiries have to be undertaken
before major projects can go ahead. This could lead to
underinvestment in the physical infrastructure of the economy,
reducing UK inward investment and UK international competitiveness.
It is an example of the time likes involved in government decision
making which indicates it is too inflexible to respond to the needs of
both producers and consumers.
Poor mechanism and its function as a rationing device.
The price mechanism refers to the interaction of the market forces of
demand and supply in order to derive at the equilibrium price and
quantity to be produced/ sold.
In a free market economy, resources are allocated by the producers
according to high priced commodities being produced first. Therefore,
due to scarcity, in order to discourage the have-nots, producers
charged higher prices thus making goods available only for those who
can afford them (this is known as rationing).