COMPETITIVE STRATEGY
their products or services. Almost all companies, large or
The main purpose of competition among firms is to gain
market share. But depending on whether the competition is
price-based or innovation-based, the economic implications
are very different.
PRICE-BASED COMPETITION
 Price-based competition usually involves mature products
in a saturated market.
 Since there are no new features to attract customers, the
only way to gain or maintain market share is to undercut
or match the price of competitors. The number of
competitors depends on the capital requirement. When
the capital requirement is small, there are a lot of small
firms (perfect competition). And when the capital
requirement is big, there are a few large firms (oligopoly).
 When price-based competition is accompanied by single-
pricing, most of the economic surplus goes to consumers
as consumer surplus. The zero-profit firms have little
resources to innovate or to maintain service quality.
Surprisingly, this state of market entropy is regarded as
the model of market efficiency in conventional economic
theory because price of the last unit sold is close to or
equal to marginal cost.
INNOVATIVE-BASED PRODUCT COMPETITION
 But this kind of market efficiency is at best static. The
economy will stagnate if the market trades only mature
products. A dynamic economy requires innovative
products that change the competitive landscape.
Innovation-based product competition introduces
dynamic market efficiency.
 Innovative products command premium prices for early
adopters and capture most of the economic surplus in the
form of profit. But prices will be lowered successively over
the product cycle to attract more customers with less
urgent needs as most of the R & D costs have been paid
for by the early adopters. By practicing such
longitudinal price discrimination, the successful firm can
use the captured economic surplus to improve the
products and come up with additional innovative
products. Such innovations may be encouraged by
temporary patent protection to slow down copycats.
 As the innovative products mature, entry of competitors
will usher in a period of price-based competition where
most of the economic surplus will be shared with the
consumers.
 Within innovation-based competition, there is a whole
range of strategies to prolong the dominance of the
innovative products. For example, there is the fight for
standards and brand dominance, the lock-in effect of
networked products, and the extension of market
dominance in one product to complementary products,
and the gradual introduction of upgrade features to
already acceptable products, etc.
COMPETITIVE STRATEGY
A competitive strategy may be defined as a long-term plan of
action that a company devises towards achieving a
competitive advantage over its competitors after examining
the strengths and weaknesses of the latter and comparing
them to its own. The strategy can incorporate actions to
withstand the market’s competitive pressures, attract
customers and assist in cementing the company’s market
position.
Pricing Strategy is one of the competitive strategies a
company can make to reshape the competitive environment
to their advantage.
PRICING STRATEGY
 Pricing strategy refers to method companies use to price
small, base the price of their products and services on
production, labor and advertising expenses and then add
on a certain percentage so they can make a profit. 
 5 MOST COMMON PRICING STRATEGIES
Pricing a product is one of the most important aspects of
your marketing strategy. Generally, pricing strategies include
the following five strategies.
 Cost-plus pricing—simply calculating your costs and
adding a mark-up
 Competitive pricing—setting a price based on what the
competition charges
 Value-based pricing—setting a price based on how much
the customer believes what you’re selling is worth
 Price skimming—setting a high price and lowering it as
the market evolves
 Penetration pricing—setting a low price to enter a
competitive market and raising it later
 THE ROLE OF MARKUP PRICING
 MARKUP PRICING – a long established business
practice for determining product prices. It is a way of
calculating the price of a product by determining the
average cost of producing the product and then setting
the price a given percentage above that cost.
 From a manager’s perspective, markup pricing is
considered a means of dealing with uncertainty in
demand estimation, a method that is “fair” to both
customers and firms and a simplified approach to the
pricing of large numbers of products, as the procedure
involves only determining a product’s average cost of
production and then applying a percentage markup to
that cost to determine the product price.
 PRICE DISCRIMINATION
The practice of charging different prices to various groups of
customers that are not based on differences in the costs of
production. This can entail charging different prices to
different groups when the costs of production do not vary or
charging the same price to different groups when there are
differences in the costs of production.
 BASIC REQUIREMENTS FOR SUCCESSFUL
PRICE DISCRIMINATION
1. Firms must possess some degree of monopoly or
market power that enables them to charge a price in
excess of the costs of production. This can be used
by firms in all market structures except perfect
competition, where individual firm has no influence on
price.
2. Firms must be able to separate customers into
different groups that have varying price elasticities of
demand (an economic measure of the change in the
quantity demanded or purchased of a product in
relation to its price change).
3. Firms must be able to prevent resale among the
different groups of customers. Otherwise, consumers
who are charged a low price could resell their product
to customers who are charged a much higher price.
 PRICE DISCRIMINATION and MANAGERIAL DECISION
MAKING
PRICE DISCRIMATION STRATEGIES
 PERSONALIZED PRICING – the strategy is to determine
how much each individual customer is willing to pay for
 the product and to charge him accordingly. The purpose
of personalized pricing is that the retailer has an idea of
who the customer is and incentivizes the customer based
on their characteristics and actions. he idea behind
personalized pricing is that highly loyal customers will
receive better price offers than unknown customers who
have no history with the brand. This pricing method offers
unique deals to consumers who keep coming back.
These deals are extended to shoppers in specific
circumstances and are preferably done one-on-one.  
 PRICE DISCRIMINATION and MANAGERIAL DECISION
MAKING
PRICE DISCRIMATION STRATEGIES
 GROUP PRICING – different prices are charged to
different groups of customers based on their underlying
price elasticity of demand. It can only be achieved,
however, when those customers cannot re-sell goods to
one another.
TWO REASONS OF GROUP PRICING
 LOCK-IN – achieving brand loyalty and a stable
consumer base for a product by making it expensive for
consumers to switch to as substitute product.
 NETWORK EXTERNALITIES – these externalities result
when the value an individual places on a good is a
function of how many other people also use that
good. It is the phenomenon by which the value or utility a
user derives from a good or service depends on the
number of users of compatible products. Network effects
are typically positive, resulting in a given user deriving
more value from a product as other users join the same
network.
 PRICE DISCRIMINATION and MANAGERIAL DECISION
MAKING
Some common examples of group pricing are:
 Pricing across countries Businesses often charge
different prices to consumers in different countries. For
instance, automobile manufacturers generally charge
higher prices in Japan than they do in the United States.
 Airline pricing Airlines routinely charge higher prices for
those travelers who want to make a return trip without
staying a Saturday night than they do for travelers who
will stay a Saturday.
 Pricing of services by lawyers, doctors and
accountants Service providers such as doctors, lawyers
and accountants often charge different prices for different
groups of customers.
 PRICE DISCRIMINATION and MANAGERIAL DECISION
MAKING
PRICE DISCRIMATION STRATEGIES
 VERSIONING – offering different versions of a product to
different groups of customers at various prices, with the
versions designed to meet the needs of the specific
groups. The advantage of this strategy is that the
consumers reveal their willingness to pay for the different
versions of the product through the choices they make.
Versioning a product gives the consumer the option of
purchasing a higher valued model for more money or a
lower-valued model for less money. In this way, the
business is attempting to attract higher prices based on
the value a customer perceives.
 PRICE DISCRIMINATION and MANAGERIAL DECISION
MAKING
PRICE DISCRIMATION STRATEGIES
 BUNDLING – selling multiple products as a bundle where
the price of the bundle is less than the sum of the prices
of the individual products or where the bundle reduces
the dispersion in willingness to pay. Bundle pricing is a
pricing strategy in which a company or seller combines
several products and then sells them at a single price
instead of charging separate prices for each of them. 
 TWO BASIC BUNDLE STRATEGIES
1. Pure bundling - when products are only sold
together. In some cases, products don’t exist outside
the bundle. The best example for that are TV
channels offered by cable providers. They offer a
number of packages and each one has a different
combination of channels. If you want a specific one,
that is offered in only one package, you have to get
all of the others from that one. For example, if you
want HBO, you will have to pay for HBO2 and HBO3
too, and other channels that go with it (depending on
the provider). When you think about it, it makes
sense for such products.
 TWO BASIC BUNDLE STRATEGIES
2. Mixed bundling - also called custom bundling, is when
customers are offered to purchase a bundle or separate
products on their own. Consumers are offered complete
cable, internet, and telephone packages. The price will
depend on the level of service that the package provides. If
you choose high-speed internet and maximum channels, it’s
going to be much more expensive than getting a package
with low-speed internet and minimum channels. Each of
these services can be bought separately, but it’s just like the
restaurant example — it will be more expensive.
 PRICE DISCRIMINATION and MANAGERIAL DECISION
MAKING
PRICE DISCRIMATION STRATEGIES
 PROMOTIONAL PRICING – using coupons and sales to
lower the price of the product for those customers willing
to incur the costs of using these devices as opposed to
lowering the price of the product for all customers.
Promotional Pricing (or price promotions) is a pricing
strategy that involves offering products and services at a
reduced price and/or improving the offering with the aim
to increase sales and reach more price-sensitive
customers. The reason it’s so widespread is that it’s one
of the easiest and most simple pricing strategies to
employ.
 PRICE DISCRIMINATION and MANAGERIAL DECISION
MAKING
PRICE DISCRIMATION STRATEGIES
 TWO-PART PRICING – charging customers a fixed fee
for the right to purchase a product and then a variable fee
that is a function of the number of units purchased. It is a
form of pricing in which consumers are charged both an
entry fee (fixed price) and a usage fee (per-unit price).
Examples of two-part pricing include a phone contract
that charges a fixed monthly charge and a per-minute
charge for use of the phone.
 MACROECONOMICS and PRICING POLICIES
 The ability of different firms to mark up price above cost
base on the price elasticity of demand is also influenced
by overall macroeconomic conditions.
 SUMMARY
Pricing is important since it defines the value that
your products are worth for you to make and for your
customers to use. It is the tangible price point to let
customers know whether it is worth their time and investment.
Regardless of your product, pricing decisions remain an
afterthought for many growing businesses. Your pricing
strategies could shape your overall profitability for the future.
Pricing is simply the exchange rate you put on all the tangible
and intangible aspects of your business. Pricing is the
reflection of everything you do as a business, from your
product development all the way down to a link to your
website, because we live in a world driven by value. It is one
of the first considerations for many customers and it
determines the profit margin on products. Pricing is an
important decision-making aspect after the product is
manufactured. Price determines the future of the product,
acceptability of the product to the customers and return and
profitability from the product. It is a tool of competition.
REMEMBER!
 Pricing strategies are the goals that guide your business
in setting the cost of a product or service to your existing
or potential consumers.
 A pricing strategy underpins the pricing process for a
product and it should reflect your company's marketing,
financial, strategic and product goals, as well as
consumer price expectations and the levels of your
available stock and production resources.
 Some examples of pricing strategies include maximizing
profits, increasing sales volume, matching competitors'
prices, deterring competitors – or just pure survival.  an analytical method that does not identify and evaluate risks
 Each pricing strategy requires a careful plan/research in
order to successfully achieve your business goals. It
requires you to have a firm understanding of both your
product attributes and the market.
 Your choice of a pricing strategy does not have to last
forever.  As business and market conditions change,
adjusting your pricing objective may become necessary
or appropriate.  
Risk is defined in financial terms as the chance that an
outcome or investment's actual gains will differ from an
expected outcome or return. Risk includes the possibility of
losing some or all of an original investment.
The Basics of Risk
Everyone is exposed to some type of risk every day –
whether it’s from driving, walking down the street, investing,
capital planning, or something else. An investor’s personality,
lifestyle, and age are some of the top factors to consider for
individual investment management and risk purposes. Each
investor has a unique risk profile that determines their
willingness and ability to withstand risk. In general, as
investment risks rise, investors expect higher returns to
compensate for taking those risks.
RISK
Life is full of risks for example risk is involved in simple things
like turning on the gas at home or when dealing with life
threatening medical emergency decisions. Risk plays an
important role in the way we manage our economy,
organization or our family. Risk can be rather complex when
household money is involved; such as for individuals or
families.
The types of risks involved influence decisions on how to
manage or invest money in shares, bonds or property. When
faced with risks, the challenge is how well prepared are we to
overcome risks.  the unpredictable variation in product demand and cost
RISK ANALYSIS
Risk analysis is the process of assessing the likelihood of
an adverse event occurring within the corporate, government,
or environmental sector. Risk analysis is the study of the
underlying uncertainty of a given course of action and refers
to the uncertainty of forecasted cash flow streams, the
variance of portfolio or stock returns, the probability of a
project's success or failure, and possible future economic
states. Risk analysts often work in tandem with forecasting
professionals to minimize future negative unforeseen effects.
RISK ANALYSIS
 Risk analysis is the process of assessing the likelihood of
an adverse event occurring within the corporate,
government, or environmental sector.
 Risk can be analyzed using several approaches including
those that fall under the categories of quantitative and
qualitative.
 Risk analysis is still more of an art than a science.
 Risk analysis can be quantitative or qualitative.
QUANTITATIVE
Under quantitative risk analysis, a risk model is built using
simulation or deterministic statistics to assign numerical
values to risk. Inputs that are mostly assumptions
and random variables are fed into a risk model. For any given
range of input, the model generates a range of output or
outcome. The model is analyzed using graphs, scenario
analysis, and/or sensitivity analysis by risk managers to make
decisions to mitigate and deal with the risks.
QUALITATIVE
with numerical and quantitative ratings. Qualitative analysis
involves a written definition of the uncertainties, an evaluation
of the extent of the impact (if the risk ensues), and
countermeasure plans in the case of a negative event
occurring. Examples of qualitative risk tools include SWOT
Analysis, Cause and Effect diagrams, Decision Matrix, Game
Theory, etc. 
CONCEPTS OF RISK and UNCERTAINTY
Investors sometimes know with uncertainty the outcomes that
each possible course of action will produce. Even when
events cannot be predicted exactly, only a modest level of
decision uncertainty is present in such situations. Many other
important managerial decisions are made under conditions of
risk or uncertainty.
ECONOMIC RISK – chance of loss due to the fact that all
possible outcomes and their probability of occurrence are
unknown.
Actions taken in such a decision environment are purely
speculative, such as the buy and sell decisions made by
speculators in commodity, futures and option markets. All
decision makers are equally likely to profit as well as to lose;
luck is the sole determinant of success or failure.
UNCERTAINTY – when the outcomes of managerial
decisions cannot be predicted with absolute accuracy, but all
the possibilities and their associated probabilities of
occurrence are known.
Under conditions of uncertainty, informed managerial
decisions are possible. Experience, insight and prudence
allow investment managers to devise strategies for
minimizing the chance of failing to meet business objectives.
GENERAL RISK CATEGORIES
BUSINESS RISK – chance of loss associated with a given
managerial decision. Such losses are a normal by-product of
conditions.
MARKET RISK – chance that a portfolio of investments can
lose money because of swings in the financial markets as a
whole. Managers must also be concerned with this risk
because it influences the cost and timing of selling new debt
and equity securities to investors.
INFLATION RISK – danger that a general increase in the
price level will undermine the real economic value of any
legal agreement that involves a fixed promise to pay over an
extended period. Leases, rental agreements and corporate
bonds are all examples of business contracts that can be
susceptible to inflation risk.
INTEREST-RATE RISK – market risk that stems from the
fact that changing interest rates affect the value of any
agreement that involves a fixed promise to pay over a
specified period. A rise in interest rates will decrease the
value of any agreement that involves fixed interest and
principal payments.
CREDIT RISK – chance that another party will fail to abide by
its contractual obligations. A number of companies have lost
substantial sums because other parties were either unable or
unwilling to provide raw commodities, rental space or
financing at agreed-upon prices.
LIQUIDITY RISK – difficulty of selling corporate assets or
investments that have only a few willing buyers or are
otherwise not easily transferable at favorable prices under
typical market conditions.
DERIVATIVE RISK – chance that volatile financial derivatives
such as futures and options could create losses in underlying
investments by increasing rather than decreasing price
volatility.
SPECIAL RISKS OF GLOBAL OPERATIONS
CULTURAL RISK – chance of loss because of product
market differences due to distinctive social customs, making it
difficult to predict which products might do well in foreign
markets.
CURRENCY RISK – loss due to changes in the domestic-
currency value of foreign profits. Because price swings in the
relative value of currencies are unpredictable and can be
significant, many multinational firms hedge against currency
price swings using financial derivatives in the foreign currency
market. This hedging is expensive and risky during volatile
markets.
GOVERNMENT POLICY RISK – chance of loss because
foreign government grants of monopoly franchises, tax
abatements and favored trade status can be tenuous.
EXPROPRIATION RISK – danger that business property
located abroad might be seized by host governments.
PROBABILITY CONCEPTS
PROBABILITY – chance of occurrence
PROBABILITY DISTRIBUTION – list of possible events and
probabilities
STANDARD NORMAL CONCEPT
NORMAL DISTRIBUTION – symmetrical distribution about
the mean or expected value
STANDARDIZED VARIABLES – variable with a mean of 0
and a standard deviation equal to 1.
UTILITY THEORY AND RISK ANALYSIS
The assumption of risk aversion is basic to many decision
models in managerial economics.
POSSIBLE RISK ATTITUDES
 RISK AVERSION – desire to avoid or minimize
uncertainty. (most managers and investors)
 RISK NEUTRALITY – focus on expected values, not
return dispersion (some business decision making)
 RISK SEEKING – preference for speculation
(entrepreneurs, innovators, inventors, speculators and
lottery-ticket buyers)
In practice, many individuals prefer high-risk projects and the
corresponding potential for substantial returns, especially
when relatively small sums of money are involved.
What Is Utility Theory?
Are all monies created equal? They all have the same
amount of purchasing power, but does money give you the
same amount of satisfaction?
In economics, utility theory values a peso by how much
satisfaction you get from what you spent it on. By that
measure all monies certainly aren't equal! The peso you
spent on pizza when you were really hungry gave you more
satisfaction than the peso you spent on many other things.
There is another interesting concept from economics
called diminishing marginal utility. This simply states that
every peso you earn is worth less in terms of utility than the
peso earned before it. The first few income any of us earn go
toward paying for our homes and food. Those are pretty
valuable pesos, and certainly more valuable than additional
peso that goes to pay for attending sporting events and
concerts, outings we may love but can do without.
UTILITY THEORY
Utility is a measure of preferences over some set of goods
and services. The concept is an important underpinning of
rational choice theory in economics and game theory,
because it represents satisfaction experienced by the
consumer of a good. A good is something that satisfies
human wants. Since one cannot directly measure benefit,
satisfaction or happiness from a good or service, economists
instead have devised ways of representing and measuring
utility in terms of economic choices that can be measured.
Economists have attempted to perfect highly abstract
methods of comparing utilities by observing and calculating
economic choices. In the simplest sense, economists
consider utility to be revealed in people’s willingness to pay
different amounts for different goods.
SUMMARY
Risk analysis plays an integral role in the decision process for
most business problems. This unit defines the concept of
economic risk and illustrates how the concept can be dealt
with in the managerial decision-making process. Decision
making under conditions of uncertainty is greatly facilitated by
use of the tools and techniques discussed in this unit.
Although uncertainty can never be eliminated, its harmful
consequences can be minimized.
Whatever your role, it's likely that you'll need to make a
decision that involves an element of risk at some point.
Risk is made up of two parts: the probability of something
going wrong, and the negative consequences if it does.
Risk can be hard to spot, however, let alone prepare for and
manage. And, if you're hit by a consequence that you hadn't
planned for, costs, time, and reputations could be on the line.
This makes Risk Analysis an essential tool when your work
involves risk. It can help you identify and understand the risks
that you could face in your role. In turn, this helps you
manage these risks, and minimize their impact on your plans.
GOVERNMENT the system or group of people governing an
organized community, often a state, but also other entities
like for example companies, especially in the case of colonial
companies. sometimes referred to as the "public sector”
BRANCHES OF GOVERNMENT
EXECUTIVE BRANCH composed of the President and the
Vice President who are elected by direct popular vote and
serve a term of six years. The Constitution grants the
President authority to appoint his Cabinet. These
departments form a large portion of the country’s
bureaucracy.
LEGISLATIVE BRANCH authorized to make laws, alter, and
repeal them through the power vested in the Philippine
Congress. This institution is divided into the Senate and the
House of Representatives.
JUDICIAL BRANCH holds the power to settle controversies
involving rights that are legally demandable and enforceable.
This branch determines whether or not there has been a
grave abuse of discretion amounting to lack or excess of
jurisdiction on the part and instrumentality of the government.
It is made up of a Supreme Court and lower courts.
ECONOMIC FUNCTIONS of the GOVERNMENT
1.EFFICIENCY
★a market maximizes net benefit by achieving a level of
output at which marginal benefit equals marginal cost.
★ guiding the economy’s scarce factors of production to their
best uses.
✔ ️The government should attempt to correct market failures
like monopoly and excessive pollution to ensure efficient
functioning of the economic system. Externalities (or social
costs) occur when firms or people impose costs or benefits
on others outside the marketplace
EXTERNALITIES
● Arises when economic activity among producers and
consumers influences the well-being of a third party who is
neither compensated for damages nor pays for benefits.
● NEGATIVE EXTERNALITIES - external costs or
uncompensated damage tied to production or consumption
which harms the well-being of a 3rd party who is not
compensated for any resulting damages (water wastage,
environmental degradation and pollution)
● POSITIVE EXTERNALITIES - external benefits or
uncompensated benefit tied to production or consumption
which helps the well-being of a 3rd party who doesn't pay for
resulting benefits (education)
PUBLIC GOODS
● Goods that are neither excludable nor rival
● Goods and services offered by the government that cannot
be provided and allocated in optimal quantities by the private
sector.
CHARACTERISTICS OF PUBLIC GOODS
● They feature nonrival consumption - when use by certain
individuals, it does not reduce availability for others.
● They are non exclusionary - impo s s i b l e o r prohibitively
expensive to confine the benefits of consumption to paying
customers
● Freely available to everyone
● e.g. National Defense, Law enforcement, police and fire
protection, radio and TV broadcasts
IMPERFECT COMPETITION
● the situation prevailing in a market in which elements of
monopoly allow individual producers or consumers to
exercise some control over market prices.
● individual firms face downward-sloping demand curves and
will charge prices greater than marginal cost.
● Consumers in these markets will be faced by prices that
exceed marginal cost, and the allocation of resources will be
inefficient.
● produce less of a good than is efficient
2. INFRASTRUCTURE
● the basic physical and organizational structures and
facilities (e.g. buildings, roads, power supplies) needed for
the operation of a society or enterprise.
✔ ️The government should provide an integrated
infrastructure. Infrastructure (or social overhead capital)
refers to those activities that enhance, directly or indirectly,
output levels or efficiency in production.
3. EQUITY
● the quality of being fair and impartial
✔️Markets do not necessarily produce a distribution of income
that is regarded as socially fair or equitable. As market
economy may produce unacceptably high levels of inequality
of income and weather. Government programs to promote
equity use taxes and spending to redistribute income toward
particular groups.
INCOME REDISTRIBUTION A more fundamental reason for
concern about income distribution is that people care about
the welfare of others. People with higher incomes often have
a desire to help people with lower incomes. This preference is
demonstrated in voluntary contributions to charity and in
support of government programs to redistribute income.
CATEGORIES OF INCOME REDISTRIBUTION
● A means-tested transfer payment is one for which the
recipient qualifies on the basis of income; means-tested
programs transfer income from people who have more to
people who have less. (Healthcare to the poor)
● A non-means-tested transfer payment is one for which
income is not a qualifying factor. (social security program,
unemployment compensation, aids to farmers)
4. ECONOMIC GROWTH OR STABILITY
● an increase in the amount of goods and services produced
per head of the population over a period of time.
✔ ️Governments rely upon taxes, expenditures and monetary
regulation to foster macroeconomic growth and stability to
reduce unemployment and inflation while encouraging eco-
nomic growth.
10 PRINCIPLES OF ECONOMICS
How People Make Decisions
1. People Face Tradeoffs
- “There is no such thing as a free lunch.” To get one thing
that we like, we usually have to give up another thing that we
like. Making decisions requires trading one goal for another.
Example: trade-off between efficiency and equality.
Efficiency: the property of society getting the maximum
benefits from its scarce resources.
Equity: the property of distributing economic prosperity fairly
among the members of society.
Tax paid by wealthy people and then distributed to poor may
improve equality but lower the incentive for hard work and
therefore reduce the level of output produced by our
resources. This implies that the cost of this increased equality
is a reduction in the efficient use of our resources.
2. The Cost of Something is What You Give Up to Get It -
Opportunity cost is the second best alternative foregone.
Because people face tradeoffs, making decisions requires
comparing the costs and benefits of alternative courses of
action. When making any decision, decision makers should
consider the opportunity costs of each possible.
3. Rational People Think at the Margin - Marginal changes
are small, incremental changes to an existing plan of action.
Economists generally assume that people are rational.
Rational: systematically and purposefully doing the best you
can to achieve your objectives.
Consumers want to purchase the bundle of goods and
services that allow them the greatest level of satisfaction
given their incomes and the prices they face. Firms want to
produce the level of output that maximizes the profits.
- People will only take action of the marginal benefit exceed
the marginal cost
4. People Respond to Incentives
- Incentive is something that causes a person to act. Because
people use cost and benefit analysis, they also respond to
incentives. Incentives may possess a negative or a positive
intention. It may be in a positive or a negative way.
e.g. offering a raise in the salary of whosoever works harder
can induce people to work hard which is a positive incentive.
Whereas putting a higher tax on a good, say cigarettes, can
induce people to consume it less and prevent smoking which
is a negative incentive.
How People Interact With Each Other
5. Trade Can Make Everyone Better Off
- Trade allows countries to specialize according to their
comparative advantages and to enjoy a greater variety of
goods and services. Trade is not like a sports competition,
where one side gains and the other side loses.
6. Markets Are Usually a Good Way to Organize Economic
Activity - Market prices reflect both the value of a product to
consumers and the cost of the resources used to produce it.
Centrally planned economies have failed because they did
not allow the market to work. Adam Smith made the
observation that when households and firms interact in
markets guided by the invisible hand, they will produce the
most surpluses for the economy. The invisible hand is a
metaphor for the unseen forces that move the free market
economy. Through individual self-interest and freedom of
production as well as consumption, the best interest of
society, as a whole, are fulfilled. The constant interplay of
individual pressures on market supply and demand causes
the natural movement of prices and the flow of trade.
7. Governments Can Sometimes Improve Economic
Outcomes
There are two broad reasons for the government to interfere
with the economy: the promotion of efficiency and equality.
Government policy can be most useful when there is market
failure.
Market failure: a situation in which a market left on its own
fails to allocate resources efficiently. Market failures occur
when the market fails to allocate resources efficiently.
Governments can step in and intervene in order to promote
efficiency and equity.
Because a market economy rewards people for their ability to
produce things that other people are willing to pay for, there
will be an unequal distribution of economic prosperity. Note
that the principle states that the government can improve
market outcomes. This is not saying that the government
always does improve market outcomes.
The Forces and Trends That Affect How The Economy as a
Whole Works
8. The Standard of Living Depends on a Country's Production
- The more goods and services produced in a country, the
higher the standard of living. As people consume a larger
quantity of goods and services, their standard of living will
increase. Differences in the standard of living from one
country to another are quite large. Changes in living
standards over time are also quite large. The explanation for
differences in living standards lies in differences in
productivity.
PRODUCTIVITY - the quantity of goods and services
produced from each hour of a worker’s time.
Thus, policymakers must understand the impact of any policy
on our ability to produce goods and services. To boost living
standards the policy makers need to raise productivity by
ensuring that workers are well educated, have the tools
needed to produce goods and services, and have access to
the best available technology.
9. Prices Rise When the Government Prints Too Much Money
- When too much money is floating in the economy, there will
be higher demand for goods and services. This will cause
firms to increase their price in the long run causing inflation.
When the government creates a large amount of money, the
value of money falls .
INFLATION - sustained increase in the overall level of prices
in the economy. Inflation is the steady increase in the price of
goods and services over time. It devalues units of currency
(like the U.S. Dollar), resulting in consequences like higher
cost of living. Think about how much a candy bar cost when
you were a little kid. Now, think about how much that same
candy bar costs to day.
10. Society Faces a Short-Run Tradeoff Between Inflation
and Unemployment
- In the short run, when prices increase, suppliers will want to
increase their production of goods and services. In order to
achieve this, they need to hire more workers to produce those
goods and services. More hiring means lower unemployment
while there is still inflation. However, this is not the case in the
long-run.
Most economists believe that the short-run effect of a
monetary injection (injecting/adding money into the economy)
is lower unemployment and higher prices.
An increase in the amount of money in the economy
stimulates spending and increases the demand of goods and
services in the economy.
Higher demand may over time cause firms to raise their
prices but in the meantime, it also encourages them to
increase the quantity of goods and services they produce and
to hire more workers to produce those goods and services.
More hiring means lower unemployment.
Some economists question whether this relationship still
exists. The short-run trade-off between inflation and
unemployment plays a key role in analysis of the business
cycle.
Business cycle: fluctuations in economic activity, such as
employment and production.
Policymakers can exploit this trade-off by using various policy
instruments, but the extent and desirability of these
interventions is a subject of continuing debate.
POINTS TO REMEMBER
➢ One role of government is to correct problems of market
failure associated with public goods, external cos t s and
benefits , and imperfect competition.
➢ Government intervention to correct market failure always
has the potential to move markets closer to efficient solutions,
and thus reduce deadweight losses. There is, however, no
guarantee that these gains will be achieved.
➢ Governments redistribute income through transfer
payments. Such redistribution often goes from people with
higher incomes to people with lower incomes, but other
transfer payments go to people who are relatively better off.
SUMMARY OF THE RATIONALE FOR GOVERNMENT
INTERVENTION IN THE ECONOMY

Government must allocate resources to correct the various

instances of market failure: the failure of the market to
provide public goods, the failure of the market to internalize
externalities (both positive and negative), the failure of the
market to protect common property and the failure of the
market to keep monopoly practices in check. Thus
government has an allocation role/function.

Government has a distributive (or redistributive) function in

the sense that it must take steps to achieve a more socially
acceptable and equitable distribution of income than that
produced by an unregulated market economy.

Government's stabilization function refers to the steps taken

by government to addres s the macroeconomic instability
(unemployment, inflation and balance of payments instability)
that is a normal aspect of market economies.