UNIT 1 NOTES:

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AS ECONOMICS

BASIC INTRODUCTION TO
ECONOMICS
DEFINITION OF BASIC ECONOMIC CONCEPTS
ECONOMICS
# Economics is a social science concerned with the allocation of scarce resources to satisfy
human wants.
# Economics is a study of human behavior as a relationship between human needs and the
scarce resources which have alternative uses.
# Economics is a social science concerned with the proper use and allocation of scarce
resources for the achievement of growth and stability.
THE BASIC ECONOMIC PROBLEM
Economics evolved out of the realization of the scarcity of resources in relation to the
existence of unlimited wants in human beings. There is therefore need to allocate the
resources in the best way possible so as to satisfy human wants in order of priority.
Economics is therefore concerned primarily with resource management.
SCARCITY
A commodity is considered scarce when it is limited in supply. Scarcity exists when what is
required is greater that what is available i.e. when demand exceeds supply. Due to this
problem not all wants can be satisfied using the available resources, hence individuals need
to prioritize their needs and make a choice on what needs to satisfy first.
CHOICE
Choice refers to the ability to select a preference bundle from a list of available options e.g.
one can choose to go seek a part time job rather than select an additional unit in college.
There is need to make a choice on how to utilize scarce resources in order to satisfy human
wants not only at an individual level but also at a national level.

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OPPORTUNITY COST
In choosing to satisfy certain wants, the satisfaction of other wants may be sacrificed.
Opportunity cost is the value or cost of the best alternative forgone/ sacrificed in making a
choice between two or more alternatives. It is the highest valued alternative that had to be
sacrificed for the option that was selected e.g. the opportunity cost of buying a new pair of
shoes might be a dinner outing foregone. The opportunity cost of setting aside land for use
as a National Park might be the shrinking of land available for housing. For a farmer the
opportunity cost of growing bio-fuel crops may be the food crops that he did not produce.

NB: The Opportunity cost concept necessitates the need for budget allocations.
THE PRODUCTION POSSIBILITY SCHEDULE
This refers to a table showing various combinations of output that can be obtained using
fixed quantities of inputs as shown below;

POSSIBILITY CONSUMER GOODS CAPITAL GOODS

A 0 250
B 100 230
C 150 200
D 200 150
E 250 0

From the diagram, A and E are possibilities in which the economy can produce either 250
units of consumer goods or 250 units of capital goods given fixed units of factor inputs.
These are extreme possibilities where the economy is engaged in the production of only one
commodity. However, other possibilities exist where the economy can produce both
commodities. For instance, the economy can produce 100 units of consumer goods and 230
units of capital goods. In order to increase the output of consumer goods to 150, it has to
sacrifice 30 units of capital goods. In order to produce more and more units of one
commodity, the economy produces less and less units of the other commodity.
THE PRODUCTION POSSIBILITY FRONTIER (PPF)
It is a graph showing the maximum possible combination of output that can be produced
when all resources are fully and efficiently utilized. The PPF is used to illustrate the concept
of choice and opportunity cost, by analyzing the tradeoffs that must be made as a result of
the basic economic problem.

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All the possibility combinations lying on the PPF represent the maximum possible output of
the two commodities that can be produced using the existing resources and technology in the
economy. The combinations are said to be technologically efficient.
Any combination lying inside the PPF such as x in the above diagram implies that the
economy is not using the existing resources and technology fully. Such a combination is
said to be technologically inefficient e.g. in a case where there are unemployed workers or
idle factories.
Any combination lying outside the PPF such as y in the diagram implies that the economy
does not possess sufficient resources to produce the combination. Such a combination is said
to be technologically infeasible or unobtainable.

ECONOMIC GROWTH AND THE PPF.

Economic Growth refers to the increase in the real output of a country during a given period
of time usually one year. It measures the increase in the productive potential of a country.
An increase in Economic Growth leads to an outward shift of the PPF.

From the diagram, Economic Growth pushes the PPF from PPF1 to PPF2 allowing the
economy to increase its maximum level of production. Growth in the economy can be
brought about by;
♦ Technological progress.

♦ Improvement in education and training.

♦ Improvement in healthcare services.

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♦ Discovery of new resources.

♦ An increase in investment e.g. Foreign Direct Investment.

♦ Improvement in infrastructure.

♦ Favourable weather conditions.

CHANGES IN THE PPF.

A MOVEMENT ALONG THE PPF

A movement along the PPF is usually caused by the re- allocation of resources from the
production of one commodity to another as shown below;

The movement from point A to point B is caused by the re-allocation of resources from the
production of primary products to the production of secondary products. The economy will
give up m-n units of primary products in order to produce q-p units of secondary products.

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A SHIFT IN THE PPF

A shift in the PPF is caused by changes in the quantity and quality of resources. A shift can
either be parallel to the original PPF of non-parallel.

I) A Parallel Shift
a) An outward shift

An outward shift of the PPF from PPF1 to PPF2 indicates an increase in Economic Growth.
This is because the production possibilities along PPF1 are more than the production
possibilities along PPF2.

Causes of an outward shift

♦ Technological progress.

♦ Improvement in education and training.

♦ Improvement in healthcare services.

♦ Discovery of new resources.

♦ An increase in investment e.g. Foreign Direct Investment.

♦ Improvement in infrastructure.

♦ Favourable weather conditions.

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b) An inward shift

An inward shift of the PPF from PPF1 to PPF2 indicates a decrease in Economic
Growth. This is because the production possibilities along PPF1 are less than the
production possibilities along PPF2.

Causes of an inward shift

♦ Use of inappropriate/ poor technology.

♦ Poor education and training.

♦ Increased incidence of disease e.g. the HIV Aids pandemic.

♦ Depletion of natural resources.

♦ A decrease in investment.

♦ A natural disaster e.g. an earthquake.

♦ Unfavourable weather conditions.

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II) A Non-Parallel Shift

a)

A shift of the PPF from PPF1 to PPF2 indicates an increase in Economic

Growth. The increase in growth is due to a more than proportionate increase in
the production of textile products in comparison to manufactured products.

Causes of the outward non-parallel shift

♦ An improvement in technology which is more efficient in the production of
textile products.
♦ An increase in the quantity of resources which are more efficient in the
production of textile products.
♦ Increased investment in textile goods production.

♦ Improved education and training which is relevant to textile goods

production.

b)

A shift of the PPF from PPF1 to PPF2 indicates a decrease in Economic

Growth. The decrease in growth is due to a more than proportionate decrease
in the production of textile products in comparison to manufactured products.

c)

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A shift of the PPF from PPF1 to PPF2 has been brought about by a fall in the
production of manufactured products and an increase in the production of textile
products. The change in economic growth will depend on the magnitude of decrease
in manufactured products and the increase in textile products. This type of shift may
result from;
● An increase in resources which are more efficient in the production of textile
products and a depletion of resources used for manufactured goods production.
● Increased investment textile products production and a fall in investment in
manufactured goods production.

SHAPES OF THE PPF

There are three different shapes of the PPF;

The Concave PPF
The Convex PPF
The Linear PPF

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The Concave PPF (Increasing Opportunity Cost)

CAPITAL GOODS CONSUMER GOODS OPPORTUNITY

COST
0 450 -
50 448 2
100 445 3
150 430 15
200 410 20
250 370 50
300 300 70
350 0 300

The opportunity cost of producing more and more units of capital goods in terms of
consumer goods is increasing along the PPF. This means that when resources are re-
allocated or shifted from the production of consumer goods to the production of capital
goods, the economy will sacrifice more of consumer goods for every additional unit of
capital goods produced. A concave PPF therefore represents increasing opportunity cost due
to the concept of diminishing marginal returns i.e. Resources are no equally efficient in the
production of both commodities.

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The Convex PPF (Decreasing Opportunity Cost)

CAPITAL GOODS CONSUMER GOODS OPPORTUNITY

COST
0 400 -
50 200 200
100 100 100
150 80 20
200 70 10
250 62 8
300 56 6

The opportunity cost of producing more and more units of capital goods in terms of
consumer goods is decreasing along the PPF. This means that when resources are re-
allocated or shifted from the production of consumer goods to the production of capital
goods, the economy will sacrifice less of consumer goods for every additional unit of capital
goods produced. A concave PPF therefore represents decreasing opportunity cost implying
that there are increasing returns along the PPF. Resources are not equally efficient in the
production of both commodities.
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The Linear PPF (Constant Opportunity Cost)

CAPITAL GOODS CONSUMER GOODS OPPORTUNITY

COST
0 300 -
50 250 50
100 200 50
150 150 50
200 100 50
250 50 50
300 0 50

For the economy to produce additional units of capital goods along its PPF, it will give up a
constant amount of consumer goods. The economy will give up a fixed quantity of one good
for every additional unit of another good produced implying that resources are equally
efficient in the production of both goods.

DIMINISHING RETURNS
In the production process, a firm uses several factors of production and combines them using
the available technology in order to obtain the desired output. Diminishing Returns occurs in
the short run when one factor input is fixed (e.g. Capital) because in the long run all factors
are variable. If the variable factor of production is increased, there comes a point where it
will become less productive and eventually the marginal product will decrease. Marginal
product refers to the increase in output brought about by a unit change in factor input. As
more and more inputs are used, a point is reached where the extra output attributable to each
additional unit of variable input declines. For example, if a firm uses two factors of
production namely capital and labour, an increase in the number of workers employed will
initially lead to an increase in the level of output. However, as more and more workers are
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employed, the firm will become so crowded that workers will get in each other’s way
resulting in less output than a case where a smaller number of workers was employed. This
can be illustrated in a table as shown below;
Capital Labour Output/ Marginal
Total product product
5 0 0 -
5 10 20 20
5 20 46 26
5 30 60 14
5 40 70 10
5 50 75 5
5 60 72 -3
The Law of Diminishing returns states that; “As the proportion of one factor in a
combination of factors is increased, after a point, the marginal product of that factor will
diminish.”
A good example of Diminishing Returns in the Agricultural sector is the use of chemical
fertilizers- a small quantity leads to a big increase in output. However, increasing its use
further may lead to declining Marginal Product (MP) as the effectiveness of the chemical
declines.
POSITIVE AND NORMATIVE STATEMENTS
A Positive statement deals with facts that can be verified as either being true or false by
appealing to data. Positive economics is concerned with scientific or objective explanations
and statements about the economy.  For example the statement; “in the case of normal
goods, an increase in the price will lead to a decrease in the quantity demanded” deals with
positive economics. 
Normative economics attempt to describe the economy through value judgment.  For
example the statement; "the rich should be taxed at a far higher rate than the poor" contains
value judgment about the role of the government and is therefore a normative statement.
Normative statements deal with what ought to be and contain words expressing value
judgment such as ought, should, bad, unfair, e.t.c.
Although economists give normative prescriptions to help solve economic problems, they
must do so within the confines/ framework of positive economics. For instance, prescribing
a minimum wage to help reduce poverty may actually lead to higher incidents of
unemployment hence increased poverty levels.
THE MARGIN AND DECISION MAKING AT THE MARGIN
What does it mean to think at the margin? It means to think about your next step forward.
The word “marginal” means “additional.” The first glass of lemonade on a hot day quenches
your thirst, but the next glass, maybe not so much. If you think at the margin, you are
thinking about what the next or additional action means for you.
How many additional tomatoes can you get by taking better care of your garden? If an hour
extra work weeding means you will get 12 more tomatoes, then one additional hour of work
results in 12 additional tomatoes. Economists sometimes summarize that by saying
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your marginal product of labor is 12.That just means you can get 12 more tomatoes for one
additional hour of work.
On the flip side of that, you could equally well say that the marginal cost of a producing one
additional tomato is 5 additional minutes (1/12th of an hour) of your labor. Every new
tomato costs you another five minutes of weeding. As another example, if one additional
Facebook friend costs you an additional 10 minutes of attention, then the marginal cost is 10
minutes of your time per new Facebook friend.
A bus that is half-empty can take on more riders with zero or very little extra cost–perhaps
just a few cents more for wear and tear and the cost of gas to haul an extra 150 pounds.
Economists would say the marginal cost of an additional rider is nearly zero. But, if buses
are always running packed with lines left standing, then the marginal cost of additional
riders would be the entire cost of adding another bus.It is very common to have to compare
different marginal costs for different scenarios in order to decide which alternative to
pursue.
When you drive around the block to park your car for a concert or event, you can keep
driving around the block waiting for that perfect, free, on-street parking spot to come
available. Or, you can weigh the alternative of spending $10 for a paid parking lot spot.
What matters is what you do in the next minute, ten minutes, hour, or day. The marginal
cost of finding a parking space could be only $10; or it could be another hour of driving
around hoping for a free spot to open up just as you are in position to grab it. If you already
spent an hour searching for a great parking spot, you may well do better to let that memory
go. Thinking at the margin means to let the past go and to think forward to the next hour,
day, year, or dollar that you expend in time or money. What’s better for you now or in the
next few minutes? If you think at the margin, you are thinking ahead. At some point, if you
continue to drive around the block again and again with no results, an economist would
encourage you to think about the future instead of bulleting on the past. You can’t change
the past, but you can change what you do next. (Economists sometimes summarize this by
saying, “Sunk costs are sunk.”) And in what you do next, you should weigh the costs and
benefits starting afresh for the next few minutes of your time–which is what economists
mean when they say, “Think at the margin.” At the margin, you could get a parking spot for
$10 or you could drive around and maybe get a parking spot for free with a probability of,
say, 20% in the next hour. Thinking at the margin means weighing those future options, and
not focusing on what you did in the previous hour of frustrating circling around.
The marginal cost of producing computer chips is the entire cost of producing one more
computer chip. Producing only one more from your existing equipment and workers may
entail only a small cost that is only an additional few pennies per chip. But if you are already
maxing out your production, producing even one more may entail producing a hundred
thousand more.Which in turn may entail building a new factory and hiring all its workers, or
even researching a whole new way to produce chips–perhaps an additional hundred
thousand dollars, at an average cost of a dollar per additional chip or even an additional few
million dollars. You have to consider all the additional costs for each option before making a
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decision. Maybe to get just one more chip you still have to pay extra to hire an extra worker
to work the night shift, plus hire someone to stand by to do a little more machine
maintenance. Maybe paying more overtime for even one more worker will mean paying
higher taxes or insurance fees, or will entail more explanations to other workers about why
you can’t offer full opportunities for the extra opportunities to everyone. The sum of all
those additional costs–from wages to insurance to taxes to emotional burdens and effects on
morale–to produce one more computer chip is what economists mean by the marginal cost
of a computer chip. You can’t add apples to oranges, so you may have to weigh the various
costs in different dimensions. See Real, Relative, and Nominal Prices and What is
Economics?
On a hot day, that first blast of cold air as you step into an air conditioned store gives you a
tremendous boost. Each succeeding few minutes, though, may give you less pleasure.
Economists say your marginal pleasure or marginal utility–your marginal benefit–
diminishes as you experience more.
The word “marginal” in common speech or layman’s use sometimes refers to an iffy project.
For example, suppose you make sneakers and you have a company division that makes gold-
colored sneakers with specialty soles and that division has turned out not to be the big
money-maker you hoped. Or maybe that division is breaking even but would be the first
division you would cut unless it starts to show more signs of promise. You might refer to
that division as being marginal. That usage of the word “marginal” is not what economists
mean by the term, although you might be able to see how they are related. The layman’s
usage means at the edge or borderline workable.
The term “marginal cost” is not the same as opportunity cost. Opportunity cost is from the
perspective of a buyer, while marginal cost is from the perspective of a seller or producer.
That is, opportunity cost refers to what you have to sacrifice–at the margin–as a buyer
because when you buy one thing you can’t buy something else. Marginal cost refers to what
a seller or producer has to sacrifice in order to sell or produce one more item.
If you enjoy math, you might find it helpful to see that in economics the word “marginal”
means the derivative or slope of a curve. It’s the additional cost or benefit that derives from
a very small change. For example, if you increase your saving by $1, what would be the
marginal benefit? It would be some small number–say, an additional 5 cents in interest you
might gain, plus some psychological marginal benefit–say, something you value at 2 cents–
in terms of additional feelings of security.The marginal benefit would thus be the sum of the
5 cents in interest plus the 2 cents in feelings of additional security, or $0.07 per additional
dollar saved. If you plot a curve between the benefits and costs, the slope is .07. That’s the
marginal benefit. The marginal cost is the inverse.

Since all the economic resources are scarce, we all need to make choices. One might think
while reading the O level lessons that we make choices whether to use this or that. However,
for necessities, we cannot make a decision whether to use or not to use them. For example,
even if the prices of water increases, we still will use water, we cannot bring the
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consumption of water to zero. However, increase in prices may result in people trying to
reduce the consumption a little bit.
This is where the concept of decision making at the margin comes in. A choice at the margin
is the decision to do a little more or a little less od something.
Many would argue that, one way to induce people to conserve water is to raise its price. A
common response to this recommendation is that a higher price would have no effect on
water consumption, because water is a necessity. Many people assert that prices do not
affect water consumption because people “need” water.
But choices in water consumption, like virtually all choices, are made at the margin.
Individuals do not make choices about whether they should or should not consume water.
Rather, they decide whether to consume a little more or a little less water. Household water
consumption in Male’ totals about 14000 tons per day. Think of that starting point as the
edge from which a choice at the margin in water consumption is made. Could a higher price
cause you to use less water brushing your teeth, take shorter showers, or water your flower
plants less? Could a higher price cause people to reduce their use, say, to 13500 tons per
day? or to 13000? When we examine the choice to consume water at the margin, the notion
that a higher price would reduce consumption seems much more plausible. Prices affect our
consumption of water because choices in water consumption, like all other choices, are
made at the margin.
Short Run vs. Long Run
In the study of economics, the long run and the short run don't refer to a specific
period of time, such as five years versus three months. Rather, they are conceptual
time periods, the primary difference being the flexibility and options decision-
makers have in a given scenario. In the second edition of "Essential Foundations of
Economics," American economists Michael Parkin and Robin Bade give an excellent
explanation of the distinction between the two within the branch of
microeconomics:
"The short run is a period of time in which the quantity of at least one input is fixed and the
quantities of the other inputs can be varied. The long run is a period of time in which the
quantities of all inputs can be varied.
"There is no fixed time that can be marked on the calendar to separate the short run from
the long run. The short run and long run distinction varies from one industry to another."

In short, the long run and the short run in microeconomics are entirely dependent
on the number of variable and/or fixed inputs that affect the production output.

Example of Short Run vs. Long Run

Consider the example of a hockey stick manufacturer. A company in that industry
will need the following to manufacture its sticks:
Raw materials such as
lumber
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Labor
Machinery
A factory

Variable Inputs and Fixed Inputs

Suppose the demand for hockey sticks has greatly increased, prompting the
company to produce more sticks. It should be able to order more raw materials with
little delay, so consider raw materials to be a variable input. Additional labor will be
needed, but that could come from an extra shift and overtime, so this is also a
variable input. Equipment, on the other hand, might not be a variable input. It
might be time-consuming to add equipment. Whether new equipment will be
considered a variable input will depend on how long it would take to buy and install
the equipment and to train workers to use it. Adding an extra factory, on the other
hand, is certainly not something that could be done in a short period of time, so this
would be the fixed input.
Using the definitions at the beginning of the article, the short run is the period in
which a company can increase production by adding more raw materials and more
labor but not another factory. Conversely, the long run is the period in which all
inputs are variable, including factory space, meaning that there are no fixed factors
or constraints preventing an increase in production output.

Implications of Short Run vs. Long Run

In the hockey stick company example, the increase in demand for hockey sticks will
have different implications in the short run and the long run at the industry level. In
the short run, each firm in the industry will increase its labor supply and raw
materials to meet the added demand for hockey sticks. At first, only existing firms
will be likely to capitalize on the increased demand, as they will be the
only businesses that have access to the four inputs needed to make the sticks.

In the long run, however, the factory input is variable, which means that existing
firms are not constrained and can change the size and number of factories they own
while new firms can build or buy factories to produce hockey sticks. In the long run,
new firms will likely enter the hockey stick market to meet the increased demand.

Short Run vs. Long Run in Macroeconomics

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One of the reasons the concepts of the short run and the long run in economics are
so important is that their meanings vary depending on the context in which they are
used. which also is true in macroeconomics.

MICROECONOMICS AND MACROECONOMICS

Economic theory is classified into two;
i) Microeconomics.
ii) Macroeconomics.
Microeconomics is the study of the economic actions or behavior of individual economic
entities. It is concerned with the study of individuals, households and firms e.g. how do
individuals make consumption decisions? How do firms make profits and price their goods
and services? It focuses on demand  and supply and other forces that determine the price
levels in the economy. For instance, microeconomics would look at how a specific company
could maximize its production and capacity so that it could lower prices and better compete
in its industry. The central focus of microeconomics is therefore markets i.e. product
markets, wage markets, rent markets, etc.
Macroeconomics is the field of economics that studies the behavior of the economy as a
whole. It is concerned with economy-wide phenomena, such as national income,
unemployment, the rate of economic growth, and price levels. For example,
macroeconomics would look at how an increase/decrease in net exports would affect a
nation's capital account or how GDP would be affected by unemployment rate

EFFICIENCY
Economic efficiency refers to a situation where factors of production are used to their
maximum potential so as to maximize the production of goods and services. Any point
along the PPF represents a productively efficient point. There are two categories of
economic efficiency;
Productive efficiency.
Allocative efficiency.

Productive efficiency
This type of efficiency exists when an economy is able to produce the maximum possible
output at the minimum possible cost i.e. when an economy is operating at its minimum
average cost.

Allocative efficiency
This exists when economic resources are allocated or used in the best way possible so as to
maximize the welfare of society.
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SPECIALISATION AND DIVISION OF

LABOUR
Because of the fact that choice involves opportunity cost, labour has to be used in the most
efficient way. This is achieved through Specialization and Division of Labour where every
individual performs a specific task so as to give the best output.
Specialisation
This refers to the concentration of economic resources in an economic activity in which they
are most efficient i.e. it is the use of economic resources in the production of goods and
services which they are best at.
Advantages of Specialisation
i) Improved efficiency and less wastage.
ii) An increase in production thereby leading to an increase in economic growth.
iii) Improved quality of goods and services.
iv) Decrease in the cost of production.
v) Invention of new ideas and technology.
vi) Specialization will lead to trade.
Disadvantages of Specialisation
i) Lack of variety.
ii) Specialization may lead to a high risk of the unemployment of resources.
iii) It may lead to the overproduction and exploitation of non-renewable resources.
iv) Interdependence between regions and countries.
Division of labour
Division of labour can be defined as the subdivision of a work process into a number of
tasks, with each task performed by a separate person or group of individuals or the process
of breaking down a production activity into separate tasks and assigning specific tasks to
different workers. For example in a pin factory, the production process can be subdivided
into the following tasks;
❖ Straightening the wire.

❖ Cutting the wire.

❖ Sharpening the point.

❖ Flattening the head.

Workers will then be assigned specific tasks in the production process.
Practical Illustration
In the trade of the pin-maker, a workman having no formal education in the business makes
not more than twenty pins in a day without the use of the machinery. But with specialization

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and division of labour, one man draws out the wire, another straightens it, a third cuts it, a
fourth points it, a fifth grinds it at the top for receiving the head. To make the head requires
two or three distinct operations while to put it on requires much skill. The business of
making a pin is, divided into about eighteen distinct operations, which, in some factories, are
all performed by distinct individuals although in others the same man will sometimes
perform two or three of them. In a small factory of this kind where ten men only were
employed, and where some of them consequently performed two or three distinct operations
with the necessary machinery, they could, make among them about forty-eight thousand
pins in a day. Each person, therefore, might be considered as making four thousand eight
hundred pins in a day.
Division of labour is most visible in assembly lines which are used for mass production of
goods e.g. a car assembly line.
ADVANTAGES OF DIVISION OF LABOUR
i) Practice makes workers more efficient in performing specialized tasks.
ii) Time is saved as the workers do not have to switch between tasks.
iii) Increased output due to increased production and efficiency.
iv) Easier supervision of workers
v) It promotes the use machines and specialist tools.

DISADVANTAGES OF DIVISION OF LABOUR

i) Repeatedly doing the same job can result in boredom for the workers
ii) Interdependence between workers may result in a bottleneck for the whole production
process if one worker is absent.
iii) Workers may feel disillusioned and disoriented because of not being in a position to
see the final result of their effort.
iv) There is a high risk of unemployment for the worker due to specialization which
leads to a limited occupational mobility of labour.
v) It leads to the production of standardized products because workers are not in a
position to alter the nature and quality of a product hence it leads to a limited variety
and choice for the consumer.

INTERNATIONAL TRADE
International trade is results from the fact that countries specialize in the production of
commodities that they are best at. Two principles explain the reason why countries trade;

The Absolute Advantage Principle

A country has absolute advantage over other countries if it can produce a commodity at less
input cost than other countries using the same quantity of resources.

Illustration
Production of 1 Production of I unit of
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car coffee
Japan 5 Hours 10 Hours
Kenya 10 Hours 5 Hours

Japan has an absolute advantage in the production of cars because it will use fewer resources
in terms of labour hours while Kenya has an absolute advantage in the production of coffee.
According to the absolute advantage principle, Japan should produce cars while Kenya
should produce coffee. The two countries should then trade.

The Comparative Advantage Principle

A country has Comparative advantage over other countries if it can produce one or more
commodities at less opportunity cost than other countries using the same quantity of
resources i.e. for each unit of the commodity it produces, it sacrifices less units of other
commodities than other countries.

Illustration
Production of Production Opportunity Opportunity cost
1 unit of Wine of I unit of cost of wine of cloth
Cloth production production
Portugal 80 Hours 90 Hours 0.89 1.13
England 120 Hours 100 Hours 1.2 0.83
Although Portugal has absolute advantage in the production of both commodities, England
has a comparative advantage in the production of cloth. Portugal has a comparative
advantage in the production of wine. According to the comparative advantage principle,
England should produce cloth while Portugal should produce wine. The two countries
should then trade.

Benefits of International trade

• It enables a country acquire commodities which it cannot produce.

• It enables a country earn foreign exchange
• It encourages international cooperation between countries.
• It discourages the duplication of industries i.e. setting up of industries which
already exist in other countries.
• It encourages competition and improvement in efficiency so as to reduce the costs
of production.
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 MARKETS IN ACTION

• It increases the global output of commodities since it encourages mass production

and the reaping of economies of scale.

Costs of International trade

• Transport costs could offset the advantages of specialization.

• It could lead to the importation of harmful substances into a country e.g. beef
infected with the mad cow disease.
• Less Economically Developed Countries (LEDC’s) produce similar commodities
hence specialization and exchange may not be relevant amongst such economies.
• It negates the need for diversification and self reliance.
• Countries could impose trade barriers which could water down the gains of
International trade e.g. tariffs and import quotas.
• It could lead to the death of infant industries.

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 MARKETS IN ACTION

ECONOMIC SYSTEMS
An economic system refers to the allocative mechanism through which scarce resources
reach the people who consume them. The economic system of a particular country
describes the means by which its people, businesses and the government make choices
concerning the management of economic resources. An economic system comprises of
the institutions which are concerned with the ownership and control of economic
resources in an economy hence it is primarily concerned with solving the basic economic
problem of what to produce, how to produce and for whom to produce. There are two
extreme types of economic systems;
● Free Market Economy

● Planned Economy
In between them, we have the Mixed Economy.

FREE MARKET ECONOMY / CAPITALISM

This is an economic system where resources are owned and controlled by the private
sector. The prices of commodities are determined by the market forces of demand and
supply.

Features of the Free Market Economy

• All the resources in a market economy are privately owned by individuals and
firms.
• Every business will aim at profit maximization.
• There is consumer sovereignty.
• Firms will only produce those goods which consumers want and are willing to pay
for.
• Price is determined through the price mechanism.
• There is competition between economic agents.

Advantages of the Free Market Economy

• Market economies respond quickly to people’s wants. For instance, if people want
a good or service that they can afford to pay for, it then becomes profitable to
produce such a good or service. Producers will mobilize resources towards the
production of such goods or services.
• Only Factors of production which are profitable will be employed.
• There is wide variety of goods and services in the market.

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 MARKETS IN ACTION

• Resources will be used efficiently leading to lower costs of production due to the
existence of competition.
• There is freedom of choice to consumers
• Invention and innovation of new ideas and technology due to competition.
• Improved quality of goods and services.
Disadvantages of the Free Market Economy
● Public goods such as street lighting and public roads may not be provided, thus the
government will have to interfere to provide these types of goods.
● Market economies may encourage consumption of harmful goods e.g. drugs such
as cocaine.
● Prices are determined by the demand and supply of goods and may at times be too
high for consumers.
● External costs such as pollution may not be considered while producing goods and
services.
● Income inequality may be rampant .

PLANNED ECONOMY/ COMMAND ECONOMY

This is an economic system where resources are owned and controlled by the
government. The government is responsible for making key decisions about the
production and allocation of economic resources.

Features of the Planned Economy

• The Government decides on how all scarce resources are to be used.
• The Government determines the prices of goods and services.
• The economy only has the Public Sector.
• The planned economy is a closed economy and does not participate in trade.
• Limited freedom of choice and enterprise.

Advantages of the Planned Economy

• There is no competition between firms thus resulting in less wastage.
• Government ensures that everybody is employed.
• Less gap between poor and rich

Disadvantages of the Planned Economy

• No incentives for businesses to produce.

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 MARKETS IN ACTION

• Production of goods is decided by government thus there is no consumer

sovereignty.
• Businesses usually are less efficient because of lack of profit motive.
 

MIXED ECONOMY
This is a system whereby resources are owned and allocated partly by the government
and partly by the private sector. Most economies in the world today are mixed economies
where markets allocate most of the resources while the government intervenes in order to
ensure that individuals attain a basic level of living standard.

Features
• There is freedom of choice and enterprise.
• It has both private and public sectors.
• There is Government regulation of the private sector.

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DEMAND AND SUPPLY ANALYSIS

THE PRICE MECHANISM
This refers to the interaction between demand and supply in the determination of price and
allocation of resources. It is the uninterrupted working of the market forces of demand and supply to
determine price and allocate resources. The functions of the price mechanism include;
i) It acts as a signaling device to firms and consumers when making production and
consumption decisions.
ii) It helps ration out scarce resources on a willing buyer willing seller basis.
iii) It acts as an incentive device indicating to producers which goods are most profitable to
produce.

DEMAND
Demand is defined as the quantity of a good or service that consumers are willing and able
to buy at a given price at a given time period.
Each of us has an individual demand for particular goods and services and our demand at
each price reflects the value that we place on a product, linked usually to the enjoyment or
usefulness that we expect from consuming it. Economists give this a term- utility.

Effective Demand
Effective demand is when a desire to buy a product is backed up by an ability to pay

Latent Demand
Latent demand exists when there is willingness to buy among people for a good or
service, but where consumers lack the purchasing power to be able to afford the product.
NB: Only when the consumers' desire to buy something is backed up by willingness and the
ability to pay for it do we speak of demand.
Derived demand
The demand for a product X might be connected to the demand for a related product Y –
giving rise to the idea of a derived demand. For example, demand for steel is strongly
linked to the demand for new vehicles and other manufactured products, so that when an
economy goes into a recession, so we expect the demand for steel to decline likewise.

THE LAW OF DEMAND

There is an inverse relationship between the price of a good and the demand for a good. The
law of demand states that the higher the price of a product the lower the quantity demanded
and vice versa.
The Demand Schedule

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 MARKETS IN ACTION

A Demand Schedule is a table showing the relationship between the price and quantity
demanded of a commodity. It is obtained by recording the quantity of a particular
commodity that a consumer is willing and able to buy at different price levels.
Price of hot air Number of hot air balloon
balloon rides (KSH) rides (Annually)
5000 12
10000 10
15000 8
20000 6
25000 4
30000 2
35000 0
The demand schedule can be plotted on a graph to obtain a demand curve.
The Demand Curve
A demand curve is a graph showing the relationship between the price of an item and
the quantity of that item demanded over a certain period of time. It is obtained by
plotting the price on the vertical axis and quantity demanded on the horizontal axis. For
most goods, more will be demanded as the price falls hence the demand curve slopes
downwards from left to right as shown below;

There are two reasons why more is demanded as price falls:

1. The Income Effect: There is an income effect when the price of a good falls because
the consumer can maintain the same consumption for less expenditure. Provided that the
good is normal, some of the resulting increase in real income is used to buy more of this
product.

2. The Substitution Effect: There is a substitution effect when the price of a good falls
because the product is now relatively cheaper than an alternative item and some
consumers switch their spending from the alternative good or service.

- As price falls, a person switches away from rival products towards the product
- As price falls, a person's willingness and ability to buy the product increases
- As price falls, a person's opportunity cost of purchasing the product falls
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 MARKETS IN ACTION

Note: Many demand curves are drawn as straight lines to make the diagrams easier
to interpret
DETERMINANTS OF DEMAND/ FACTORS THAT AFFECT DEMAND

● Price of the commodity

● Income (higher income will result in greater demand for all normal goods)
● Prices of substitute goods (an increase in the price of substitute goods will increase
the demand for a good)
● Prices of complementary goods (a decrease in the price of complementary goods will
result in an increase in demand for a good)
● Fashion, Tastes and Preferences(stronger preferences for a good will result in
increased demand for the good)
● Expectations (higher expected future prices, income, and wealth will increase
demand)
● Hire purchase facilities
● Advertising
● Population size.
● Weather conditions.
● Government policies e.g. subsidies.

NB: This list is not exhaustive.  It is possible for other things to cause a change in demand.  
CHANGES IN DEMAND
Demand for goods and services will always change in response to changes in the factors
affecting demand. A change in demand can either be a Movement along the Demand Curve
or a shift in the demand curve

A MOVEMENT ALONG THE DEMAND CURVE

A Movement along the Demand Curve is caused by changes in the price of a commodity
while holding all other factors constant. It can either be an Extension in demand or a
Contraction in demand.

Extension in demand
An Extension in demand is the downward movement along the demand curve due to a fall in
price, all other factors remaining constant.

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 MARKETS IN ACTION

A decrease in price from P1 to P2 will lead to a downward movement along the demand
curve from point A to point B thereby leading to an extension in quantity demanded from
Q1 to Q2.
Contraction in demand
A Contraction in demand is the upward movement along the demand curve in price, all other factors
remaining constant.

An increase in price from P1 to P2 will lead to an upward movement along the demand curve from
point A to point B thereby leading to a contraction in quantity demanded from Q1 to Q2.

A SHIFT IN THE DEMAND CURVE

Shifts in demand are caused by changes in all other factors affecting demand except for the price of
the commodity. The demand curve can either shift inwards or outwards.

a) An Outward Shift

An outward shift of the demand curve from D0 to D1 will lead to an increase in quantity
demanded from Q0 to Q1 at a constant price P0.

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 MARKETS IN ACTION

Causes of an Outward Shift

● An increase in the population size.

● Successful advertising

● An increase in the price of a substitute

● A decrease in the price of a complement

● An increase in the income of consumers

● A favourable change in tastes and preferences

● A fall in interest rates

● Future expectations of an increase in price

● Increased availability of credit facilities

● Favourable weather.

b) An Inward Shift

An inward shift of the demand curve from D0 to D1 will lead to a decrease in quantity
demanded from Q0 to Q1 at a constant price P0.
Causes of an Inward Shift
● A decrease in the population size.

● A decrease in the price of a substitute

● An increase in the price of a complement

● A decrease in the income of consumers

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● An unfavourable change in tastes and preferences

● An increase in interest rates

● Future expectations of a fall in price

● Reduced availability of credit facilities

● Unfavourable weather.
CONSUMER SURPLUS

This refers to the difference between the price that consumers are willing to pay for a good
and what they actually pay. It measures the welfare that consumers derive from their
consumption of goods and services, or the benefits they derive from the exchange of goods. 

The market price is $5, and the equilibrium quantity demanded is 5 units of the good. The
market demand curve reveals that consumers are willing to pay at least $9 for the first unit
of the good, $8 for the second unit, $7 for the third unit, and $6 for the fourth unit. However,
they can purchase 5 units of the good for just $5 per unit. Their surplus from the first unit
purchased is therefore $9 - $5 = $4. Similarly, their surpluses from the second, third, and
fourth units purchased are $3, $2, and $1, respectively. These surpluses are illustrated by the
vertical bars shown in the above diagram. The sum total of these surpluses is the consumer
surplus. It is given by the area below the market demand curve and above the market price.

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INTRODUCTION TO BEHAVIOURAL ECONOMICS

Behavioural economics attempts to understand the effect of individual psychological processes,
(including emotions, norms, and habits) on individual decision-making in a variety of economic
contexts.
All economic behaviour involves decision-making by individuals, and theories of economic
behaviour assume that economic agents apply rational thought to each and every decision to achieve
the maximisation of personal benefit (utility) or, in the case of producers, the maximisation of
profits. The assumption of the rational individual ('economic man' or homo economicus) is central to
most micro-economic theory, and can be seen most clearly in marginal analysis. Marginal analysis
suggests that economic agents carefully weigh-up the expected costs and benefits of alternative
decisions based on accurate information, and select the option that maximises their personal gain. In
other words, individual economic agents are driven by self-interest, and if all agents are driven by
self-interest based on all the information they have, each marginal decision will be rational.
This idea explains the theory of how markets work to allocate scarce resources, and is the basis of
micro-economics. However, the real world seems full of examples of where decision making does
not seem rational, nor in the individual’s self-interest. The cases of cigarette smoking, over-eating,
and failing to save enough for retirement are just a few of the apparently irrational decisions
routinely made by individuals across the developed world. Behavioural economics challenges the
long held view in economics that individuals are ‘unemotional’ maximisers who make rational
decisions. It also offers suggestions as to how individuals can be influenced towards more effective
decision-making.

Challenging the assumptions of traditional economics

Behavioural economists identify at least three questionable assumptions contained in traditional
theory.
1. That individuals make decisions based on ‘unbounded (unlimited) rationality’ accurately
processing all the information at their disposal.
2. They the use ‘unbounded willpower’ to convert wants into actions and consumption (or
production), and have absolute self-control when confronted with choices i.e. they can resist
making ‘poor’ choices.
3. They are driven by ‘unbound selfishness’ to achieve maximum benefit for themselves.

The assumption of diminishing marginal utility

In traditional theory, the additional benefit from consumption of a good or service will decline with
each extra unit consumed - marginal utility will diminish. The second unit provides less marginal
utility than the first, and the third less than the second, and so on. The assumption of diminishing
marginal utility is one way that economists derive the downward sloping demand curve. However it
is an inaccurate description of the compulsive gambler, or the over-eater?

EQUI-MARGINAL PRINCIPLE
The Law of Equi-Marginal Utility is an extension to the law of diminishing marginal utility. The
principle of equi-marginal utility explains the behavior of a consumer in distributing his limited
income among various goods and services.
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This law states that how a consumer allocates his money income between various goods so as to
obtain maximum satisfaction.
Let us assume there are only three commodities available in the market, A, B and C. Also assume
that Tom has a daily income of only $15 to spend and that he can order his utility preference for
each of the three products. Product A costs $1 per unit, Product B costs $3 per unit and Product C
costs $5. Note that diminishing marginal utility sets in immediately for each of the three products.
Marginal utility information is described on per $ basis, because a consumers choice are influenced
not only by the amount of additional utility that successive units give him but also how many dollars
he give up to get them.
Let us consider each dollar spent. Marginal utility per dollar shows that one dollar spend on Product
A provides the highest satisfaction of 20 utils as opposed to only 12 and 8 utils from products B and
C, respectively.
Second dollar spends again buys the highest utility of 15 utils. However, when Tom spends the third
dollar, a switch to Product B promises 15 utils of added satisfaction as opposed to 11 utils from
Product A. Following the principle, the best combination Tom can purchase with $15 would be 4
units of A, 2 units of B and 1 unit of C. The total utility generated would be 154 utils. $4 spent on A
give 54 utils of satisfaction; $6 spent on Product B gives 60 utils and $5 spent on C gives 40 utils.
This gives a total of 154 utils. No other combination will result in as high utility as this with an
expenditure of $15.

The results from the table above can be generalised to n commodities and the following condition
should hold in equilibrium:

SUPPLY
Supply is defined as the quantity of a good or service that a producer is willing and able to
offer in the market at a given price at a given time period.
THE LAW OF SUPPLY
The law of supply states that the higher the price of a product the higher the quantity
supplied and vice versa.

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The Supply Schedule

Price of a pair of Number of Jeans
Jeans (KSH) supplied(monthly)
500 0
1000 2000
1500 4000
2000 6000
2500 8000
3000 10000
3500 12000
A Supply Schedule is a table showing the relationship between the price and quantity
Supplied of a commodity. It is obtained by recording the quantity of a particular commodity
that a producer is willing and able to sell at different price levels.

The supply curve

A supply curve is a graph showing the relationship between the price of an item and
the quantity of that item supplied over a certain period of time. It is obtained by
plotting the price on the vertical axis and quantity supplied on the horizontal axis. For
most goods, more will be supplied as the price increases hence the supply curve slopes
upwards from left to right as shown below;

DETERMINANTS OF SUPPLY/ FACTORS THAT AFFECT SUPPLY

● Price of the commodity

● Government policies e.g. subsidies.
● Costs of production
● production technology
● Climatic/ Weather conditions
● number of producers in the market
price of a producer substitute
●
NB: This list is not exhaustive.  It is possible for other things to cause a change in supply.  
CHANGES IN SUPPLY

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Supply for goods and services will always change in response to changes in the factors
affecting supply. A change in supply can either be a Movement along the Supply Curve or a
shift in the Supply Curve

A MOVEMENT ALONG THE SUPPLY CURVE

A Movement along the supply Curve is caused by changes in the price of a commodity
while holding all other factors constant. It can either be an Extension in supply or a
Contraction in supply.

Extension in supply
An Extension in supply is the upward movement along the supply curve due to an increase
in price, all other factors remaining constant.

An increase in price from P1 to P2 will lead to an upward movement along the supply curve
from point A to point B thereby leading to an extension in quantity supplied from Q1 to Q2.
Contraction in supply
A Contraction in supply is the downward movement along the supply curve due to a fall in
price, all other factors remaining constant.

A decrease in price from P1 to P2 will lead to a downward movement along the supply curve
from point A to point B thereby leading to a contraction in quantity supplied from Q1 to Q2.
A SHIFT IN THE SUPPLY CURVE

Shifts in supply are caused by changes in all other factors affecting supply except for the
price of the commodity. The supply curve can either shift inwards or outwards.

a) An Outward Shift

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 MARKETS IN ACTION

An outward shift of the supply curve from S0 to S1 will lead to an increase in quantity
supplied from Q1 to Q2 at a constant price P0.

Causes of an Outward Shift

● Favourable weather conditions

● A decrease in the Costs of production

● A decrease in the price of a producer substitute
● An increase in producer subsidies or a fall in indirect tax.
● An increase in the price of goods which are in joint supply.
● An improvement in production technology
● Increase in the number of producers in the market
● Future expectations of an increase in profits or revenue.

a) An Inward Shift

An inward shift of the supply curve from S0 to S1 will lead to a decrease in quantity supplied
from Q1 to Q2 at a constant price P0.

Causes of an Inward Shift

● Unfavourable weather conditions

● An increase in the Costs of production

● An increase in the price of a producer substitute
● A decrease in producer subsidies or a fall in indirect tax.
● A decrease in the price of goods which are in joint supply.
● Use of inappropriate production technology
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● A decrease in the number of producers in the market

● Future expectations of a decrease in profits or revenue.

PRODUCER SURPLUS

This refers to the difference between the price that producers are willing to receive for a
good or service and what they actually receive. It measures the welfare that producers
derive from the production of goods and services, or the benefits they derive from the
exchange of goods. The level of producer surplus is shown by the area above the supply
curve and below the market price.

The market price is $50, and the equilibrium quantity demanded is 5 units of the good. The
market supply curve reveals that producers are willing to receive at least $10 for the first
unit of the good, $20 for the second unit, $30 for the third unit, and $40 for the fourth unit.
However, they sell 5 units of the good at $50 per unit. Their surplus from the first unit sold
is therefore $50 - $10 = $40. Similarly, their surpluses from the second, third, and fourth
units purchased are $30, $20, and $10, respectively. The sum total of these surpluses is the
consumer surplus and is illustrated by the shaded region in the above diagram.. It is given by
the area below the market price and above the supply curve.

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EQUILIBRIUM PRICE AND OUTPUT

EQUILIBRIUM ANALYSIS
In a market, the prices of commodities are determined competitively by the forces of
demand and supply where the price mechanism yields a single price at which the market will
clear i.e. the equilibrium price. The market equilibrium is the point at which the market
supply is equal to the market demand. It is attained at the point where the demand and
supply curves intersect.

From the above graph, P represents the equilibrium price, Q the equilibrium quantity and X
the equilibrium point.
Practice Question
From the joint demand and supply schedule below, use a supply and demand diagram to determine
the equilibrium price and quantity in the market for coffee;

PRICE PER KG QUANTITY DEMANDED QUANTITY SUPPLIED

(KSH)
100 70 40
150 60 50
200 50 60
250 40 70
300 30 80

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DISEQUILIBRIUM
This occurs when the market demand is not equal to the market supply i.e. when there is
either excess demand (shortage) or excess supply (surplus).

Excess supply

At the price P1, the quantity demanded is Q0 while the quantity supplied is Q1. There is
therefore excess supply in the market equivalent to Q1-Q0.

Excess demand

At the price P1, the quantity supplied is Q0 while the quantity demanded is Q1. There is
therefore excess demand in the market equivalent to Q1-Q0.

Practice Question
The diagram below shows the market for CD’s;

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 MARKETS IN ACTION

On the diagram, draw and label a new supply or demand curve to show how the following could
have caused the change in equilibrium price and quantity.
a) Downloading music from the internet.
b) Retail shops starting to sell CD’s.

ELASTICITY
PRICE ELASTICITY OF DEMAND
Definition
Price elasticity of demand refers to the degree of responsiveness of demand to a change in
price. It is a measure of the relationship between a change in quantity demanded and a
change in price.
PED= % change in quantity demanded
% change in price

Practice Question
Given the values in the table below, calculate the price elasticity of demand for the data;
ORIGINAL VALUES NEW VALUES

QUANTITY PRICE QUANTITY PRICE

DEMANDED (£) DEMANDED (£)
a) 100 5 120 3
b) 20 8 25 7
c) 12 3 16 0
d) 150 12 200 10
e) 45 6 45 8
f) 32 24 40 2

%
original new original change
quantity quantity price newprice I q % change I p ped
100 120 5 3 20.00 -40.00 -0.50
20 25 8 7 25.00 -12.50 -2.00
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12 16 3 0 33.33 -100.00 -0.33

150 200 12 10 33.33 -16.67 -2.00
45 45 6 8 0.00 33.33 0.00
32 40 24 2 25.00 -91.67 -0.27

Types of PED

Unitary Elastic Demand

If the PED is equal to one in absolute terms, the good has unit elasticity. The
percentage change in quantity demanded is equal to the percentage change in price
i.e. Demand changes proportionately to a price change. E.g. when a 10% change in
price leads to a 10% change in demand as illustrated below;

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 MARKETS IN ACTION

Relatively Elastic Demand

If the PED is greater than one in absolute terms, the good has relatively elastic
demand. The percentage change in quantity demanded is greater than the percentage
change in price i.e. Demand changes more proportionately to a price change. E.g.
when a 5% change in price leads to a 15% change in demand as illustrated below;

Relatively Inelastic Demand

If the PED is less than one but greater than zero in absolute terms, the good has relatively
inelastic demand. The percentage change in quantity demanded is less than the percentage
change in price i.e. Demand changes less proportionately to a price change. E.g. when a 20%
change in price leads to a 12% change in demand as illustrated below;

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 MARKETS IN ACTION

Perfectly Elastic Demand

If the PED has an infinite value, the good has perfectly elastic demand. This demand curve is
associated with firms operating in perfectly competitive markets.This occurs when the
product is demanded only at one price and any small change in price will cause quantities
demanded to fall to zero as illustrated below;

Perfectly Inelastic Demand

If the PED is zero, the good has perfectly elastic demand. This is where a change in
price does not affect demand in any way whatsoever as illustrated below;

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Determinants of price elasticity of demand

1. Availability of close substitutes
The more and the closer the substitutes available in the market the more elastic demand will
be in response to a change in price. Products for which there exists a wide range of
substitutes usually have a higher PED.

2. Degree of necessity
Necessities tend to have a more inelastic demand curve, whereas luxury goods and services
tend to be more elastic. For instance, the demand for entertainment is more elastic than the
demand for medical care.

3. Percentage of income spent on a good

The smaller the proportion of income spent on purchasing a good or service the more
inelastic demand will be.

4. Habit forming goods

Goods such as cigarettes and drugs tend to be inelastic in demand. Habitual consumers of
certain products become indifferent to changes in price.
5. Time
Demand tends to be more elastic in the long run rather than in the short run. In the short run,
buyers stick to their spending patterns through habit or lack of information but in the long
run, they have the time and opportunity to change these patterns.
APPLICATION OF PED IN FIRMS
PED is important to firms because it guides them on how to go about their pricing strategies.
This is because PED greatly affects total revenue (sales revenue) of a firm in the event of a
change in price. Firms should therefore forge a link between their pricing strategies and
PED. If the PED is inelastic, an increase in price increases the total revenue while a fall in
price reduces total revenue as illustrated below;

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When the price increases from P1 to P2, the firm gains region A in terms of total revenue
but loses only region B. There is therefore a net increase in total revenue. With a fall in price
from P2 to P1, the firm gains region B but loses region A hence there is a fall in total
revenue. Firms which face inelastic demand for their products e.g. milk producers should
therefore guard against a fall in the prices of their products. Instead, they could retain the
same price but increase the quantity offered for sale e.g. selling two items for the price of
one.

If the PED is elastic, an increase in price reduces the total revenue while a fall in price
increases total revenue as illustrated below;

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When the price increases from P1 to P2, the firm loses region B in terms of total revenue but
gains only region A. There is therefore a net decrease in total revenue. With a fall in price
from P2 to P1, the firm gains region B but loses region A hence there is a net increase in
total revenue. Firms which face elastic demand for their products e.g. bread manufacturers
should therefore guard against an increase in the prices of their products. Instead, they could
retain the same price but reduce the quantity offered for sale e.g. reducing the weight of a
loaf of bread from 500grams to 400grams.
APPLICATION OF PED TO GOVERNMENTS
In order to understand the impact that taxation policies may have on producers or
consumers, the government should be conversant with PED. The more price inelastic the
good, the greater the proportion of an indirect tax paid by the consumer rather than by the
producer. This is because any price increase induced by a tax increment results in increased
total revenue for the firm.
INCOME ELASTICITY OF DEMAND
Definition
Income elasticity of demand refers to the degree of responsiveness of demand to a change in
income. It is a measure of the relationship between a change in quantity demanded and a
change in income.
YED= % change in quantity demanded
% change in disposable income
Normal goods have a positive income elasticity of demand implying that as the disposable
income increases more is demanded at each price level. A normal good is one where an
increase in consumers’ income leads to an increase in demand. Necessities have an income
elasticity of demand of between 0 and +1. Demand rises less than proportionately than the
rise in income. This is because there is a limited need to consume additional quantities of
necessary goods as living standards improve e.g. the demand for fresh vegetables or the
demand for toothpaste. Demand is not very sensitive to fluctuations in income hence the
products are said to be income inelastic.
Inferior goods have a negative income elasticity of demand. Demand falls as income rises.
In a recession the demand for inferior products might actually grow depending on the
severity of the change in income. An example of an inferior good is public transport.

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APPLICATION OF YED IN FIRMS

Firms should be aware of the YED for their products so as to anticipate a change in
consumption patterns by consumers resulting from changes in income. Firms should
therefore not just specialize in making products that appeal to one income bracket but rather
should produce a broad spectrum of highly differentiated products. This would prevent the
loss of customer loyalty because rather than purchase products from rival firms, consumers
upon a change in income would select alternative varieties of products from the same firm.
APPLICATION OF YED TO GOVERNMENTS
The government should be aware of the YED of various commodities so as to determine the
impact of taxation and tax relief policies e.g. how a tax relief would affect the demand for
food and nutrition.

Practice Question
Question 1
Given that the increase in demand for good X from 578 to 625 units was due to an increase in the
level of a consumer’s income from $10,000 to $14,000, calculate the value of YED.
Question 2
If the increase in demand for good Y from 1500 units to 1200 units resulted from an increase in the
level of a consumer’s income from $1250 to $1700, calculate the value of YED.
Interpretation: When the value of YED is greater than 1 in absolute terms, demand is income
elastic i.e. a change in income will lead to a more than proportionate change in demand. When the
value of YED is less than 1 in absolute terms, demand is income inelastic i.e. a change in income
will lead to a less than proportionate change in demand. When the value of YED is positive, the
good is a normal good, and if the YED is negative, the good is an inferior good.

CROSS ELASTICITY OF DEMAND

Cross elasticity of demand refers to the degree of responsiveness of demand for one product
to a change in the price of another product. It measures the sensitivity of demand for a
product to a change in the price of other related products.
XED = % change in the demand for Good X
% change in the price of Good Y
The main use of cross price elasticity concerns changes in the prices of substitutes and
complements.
With substitute goods such as tea and coffee, an increase in the price of one good will lead
to an increase in demand for the rival product. Cross price elasticity will therefore be
positive. For instance a fall in the price of new cars will lead to an increase the demand for
new cars and a fall in the demand for second hand cars and public transport.
With goods that are complements such as cars and petrol, a fall in the price of one good will
lead to an increase in demand for the other good. Cross price elasticity will therefore be
negative. For instance a fall in the price of DVD players will lead to an increase in demand
for DVD players, leading to an increase in demand for DVD videos.
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NB: When there is no relationship between two products, the cross price elasticity of demand is
zero.
Practice Question
● When the price of coffee rose from sh100 to sh120, the monthly demand for tea increased
from 250kgs to 350 kgs. Calculate the XED for tea and coffee.
● What is the interpretation of the XED value?

PRICE ELASTICITY OF SUPPLY

Price elasticity of supply refers to the degree of responsiveness of supply to a change in
price. It is a measure of the relationship between a change in quantity supplied and a change
in price.
PES= % change in the Supply
% change in the Price
Types of PES
Unitary elastic supply

This occurs when the percentage change in supply is exactly proportional to the change in
price. PES =1.

Relatively elastic supply

This occurs when a change in price leads to a greater proportionate change in supply. PES >
1.

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Relatively inelastic supply

This occurs when a change in price leads to a less than proportionate change in supply. PES
< 1.

Perfectly inelastic supply

This is a situation where a change in price has no effect upon supply. PES = 0.

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Perfectly elastic supply

This is a case where suppliers are only willing to supply the commodity at one price. A
small change in price will cause quantities supplied to fall to zero. PES = infinity.

DETERMINANTS OF PES

The value of price elasticity of supply is usually positive, because an increase in price is
likely to increase the quantity supplied to the market and vice versa. The elasticity of supply
depends on the following factors:

SPARE CAPACITY

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When a firm has plenty of unutilized resources, supply is more elastic because the firm will
be able to increase output quite quickly following an increase in price without a rise in costs
of production.

UNSOLD STOCK
If the stock of raw materials, components and finished products is high then the firm is able
to respond to a change in demand quickly by supplying these stock to the market hence
supply will be elastic

EASE OF FACTOR SUBSTITUTION/ AVAILABILITY OF PRODUCER

SUBSTITUTES
When there exists goods which producers can produce as alternatives, supply is more elastic
because they can easily shift from one substitute to another following a change in price. If
capital and labour resources are occupationally mobile then the elasticity of supply for a
product is likely to be higher than if capital equipment and labour cannot easily be switched
and the production process is fairly inflexible in response to changes in the pattern of
demand for goods and services.

TIME PERIOD/ GESTATION PERIOD

Supply is likely to be more elastic, the longer the time period a firm has to adjust its
production. In the short run, the firm may not be able to change its factor inputs. In some
agricultural industries the supply is fixed and is determined by seasonality, and climatic
conditions, which affect the production. In the construction industry,

NB: Economists sometimes refer to the momentary time period - a time period that is short
enough for supply to be fixed i.e. supply cannot respond at all to a change in demand.

NATURE OF THE GOOD.

Manufactured goods have a more price elastic supply than primary products due to the
following reasons;

a) It is possible to store manufactured goods when prices are low and release them to the
market when prices increase. On the other hand, most agricultural goods are
perishable in nature and hence cannot be stored for a long time.
b) The time required to make manufactured goods is shorter than the time required to
grow agricultural commodities.

BARRIERS TO ENTRY

Patents or high cost of entry and advertising could make it hard for new firms to enter the
market hence limiting supply.
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RAW MATERIALS AVAILABILITY

If raw materials are readily available, supply will be relatively elastic because it will be
relatively easy to expand production.

AREAS WHERE PRICE ELASTICITY OF SUPPLY IS IMPORTANT

♦ The supply for Housing– inelastic supply of new housing in response to rising
demand pushes up property prices.
♦ The supply for Oil– the inelastic supply of crude oil as global demand expands
pushes up fuel prices.
♦ The Commodity market- the inelastic supply of many commodities makes prices
very volatile especially in markets where there is strong speculative activity.
♦ The Labour market- elasticity of supply for labour is a major determinant of wage
differentials. However migrant workers can help to relieve shortages of labour and
improve the elasticity of supply.
♦ The renewable energy market e.g. bio-fuels

Why is supply more elastic in the long run?

Because the firm can change both the fixed and variable factors i.e. all the factors of
production. It can also find new or cheaper sources of raw materials, improve the training of
labour and introduce new technology or better machines. This enables the company to
increase TR by producing more output without the need for an increase in price.

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GOVERNMENT INTERVENTION IN MARKETS

The government can intervene in markets using the following policies;
1. Price control.
2. Taxation.
3. Subsidies.

PRICE CONTROLS
The government can control market prices directly by setting either a Minimum Price or a
Maximum Price.
Minimum Price
A minimum price is a price floor/ the lowest price set by the government in order to prevent
any further decrease in price. The policy is usually designed to protect the earnings of
producers in certain industries where prices are subject to great fluctuations. It is commonly
used in the agricultural sector to protect farmers against selling their produce at a throw
away price especially during a bumper harvest. Minimum prices will guarantee producers
income in periods when prices would otherwise have been very low. To guarantee a certain
level of earnings – workers can also be given a minimum wage so that their earnings don’t
fall below a certain (unacceptable) level. The Minimum Price is always set above the
equilibrium market price for it to be effective. The diagram below shows the effects of a
minimum price:

S
  B C

Effects of the Minimum Price

⮚ There will be excess supply Q2-Q1

⮚ Producers will benefit by selling at a higher price P1 hence the producer surplus will
increase by P1CAPe
⮚ Consumers will be worse off due to a fall in price leading to a fall in consumer
surplus by P1BAPe

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⮚ In order to maintain the minimum price, the government must buy the excess supply.
Government expenditure is therefore going to increase by Q1BCQ2
⮚ Total revenue to producers will increase from Pe * Qe to P1 *Q2
Maximum Price
A maximum price is a price ceiling/ the highest price set by the government in order to
protect the interests of consumers who may not afford some goods or services at the market
price. The policy is usually designed to safeguard the welfare of consumers especially
following the realization that the equilibrium market price is too high for consumers. The
Maximum Price is always set below the equilibrium market price for it to be effective. The
diagram below shows the effects of a maximum price:
 

Effects of the Maximum Price

⮚ There will be excess demand (a shortage) in the market i.e. Q2-Q1

⮚ Consumers will benefit by paying a lower price P1 hence the producer surplus will
increase by PeABP1
⮚ Producers will be worse off because they are selling at a lower price. Producer
surplus will fall by PeAX P1
⮚ This policy can lead to the development of an illegal/ black market where some
traders may buy the product at the price P1 and sell it in the black market to desperate
consumers at the black market price P2.
⮚ This policy can lead to rationing where producers are instructed by the government
not to sell to an individual consumer beyond a specified quantity.
⮚ This policy can lead to the hoarding of stock by producers to create artificial shortage
in order to sell the stock later at a higher price.

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NB: the Maximum Price policy can be used in certain markets such as the housing
market to control the amount of rent.

TAXATION
A tax is a compulsory transfer of income, resources or wealth from firms and individuals to
the government. There are two main types of tax;
i) Direct tax- this is a tax on income or company profits and is paid directly by the
producer. Examples include corporate and income tax.
ii) Indirect tax- this is a tax on the expenditure on goods and services and is paid by the
seller of the good, who usually asks the consumer to pay some or all of it. Examples
include V.A.T.
Types of Indirect tax
a) Specific/ Unit tax – this is a tax where a fixed sum is paid per unit sold i.e. the
amount of tax is expressed in money value per unit of output produced.  Examples of
such taxes in the UK are excise duties on tobacco, alcoholic drinks and petrol where
the government would for instance impose a £2 tax for every unit of output sold.
b) Ad valorem tax - this is a tax where a certain percentage is added on to the price of
each unit sold i.e. the amount of tax expressed as a percentage of the price  A UK
example is Value Added Tax (VAT) adjusted from 17.5 per cent to 20 per cent
effective from 4 January 2011.
The incidence of taxation
The incidence of taxation is the burden of tax shared between consumers and producers.
This will be influenced by the type of indirect tax as well as the elasticity of demand and
supply.
a) The incidence of a Specific Tax
A specific tax will increase the cost of production resulting in a parallel shift of the supply
curve by the amount of the tax.

▪ The tax will lead to an increase in the cost of production thereby resulting to an
upward shift of the supply curve from S to S+ tax.

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▪ The tax per unit charged by the government is the vertical distance between the two
supply curves at the new level of output i.e. P1- P2 or BE
▪ The tax per unit paid by the consumer is P1- P0 or BX

▪ The tax per unit paid by the producer is P0- P2 or XE

▪ The total tax paid by the consumer is given by the area P1BXP0

▪ The total tax paid by the producer is given by the area P0XEP2

▪ The total tax revenue received by the government is given by the area P1BEP2

The amount of tax paid by either the producer or consumer will depend on the price
elasticity of demand and supply. A heavier tax burden will fall on consumers when the
demand is inelastic while producers will incur a heavier tax burden when demand is elastic
The case of inelastic demand and elastic supply
 

In the event of inelastic demand and elastic supply, the tax burden will fall heavily on the consumer.
The consumer will pay a tax represented by the area P1BXPO while producers will pay a tax
represented by the area POXEP2.
NB: When demand is perfectly inelastic, consumers will pay the whole tax.

The case of elastic demand and inelastic supply

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In the event of elastic demand and inelastic supply, the tax burden will fall heavily on the
producer. Consumers who are very sensitive to changes in price will pay a tax represented
by the area P1BXPO while producers will pay a tax represented by the area POXEP2.
NB: When demand is perfectly elastic, producers will pay the whole tax.
The incidence of an Advalorem Tax 
An Advalorem tax is expressed as a percentage of the price. It will lead to a leftward divergent shift
of the supply curve indicating that the amount of tax paid per unit of output will be increasing as the
price increases. The incidence of an Advalorem tax will depend on the PED and PES in very much
the same way as the incidence of a specific tax.

The tax per unit is given by the vertical distance between the two supply curves at the new quantity
Q1 i.e. P1- P2 or BE.
The total tax paid by consumer is represented by the area P1BXP0
The total tax paid by producer is represented by the area P0XEP2
The total tax revenue received by the government is represented by the area P1BEP2 or (P1- P2)*Q1

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SUMMARY OF TAX INCIDENCE

·        When demand is inelastic the consumer’s tax burden is greater than the producer’s.
·        When demand is elastic the producer’s tax burden is greater than the consumer’s.
·        When supply is elastic the consumer’s tax burden is greater than the producer’s.
·        When supply is inelastic the producer’s tax burden is greater than the consumer’s.

SUBSIDIES
A subsidy is an incentive given by the government to producers or consumers in order to encourage
the production or consumption of certain goods or services. The effect of a subsidy is to reduce the
cost of production or consumption of a product. Subsidies can either be financial or non financial
incentives e.g. financial grants, tax cuts tax holidays etc.

Subsidies given to producers.

These will lower the cost of production resulting in an increase in production and supply. The
supply curve will shift outwards as illustrated below.

Effects of the subsidy.

● The subsidy will lead to a fall in the cost of production causing the supply curve to shift
outwards from S to S+Subsidy. The equilibrium price will fall from P 0 to P1 while the
equilibrium quantity will increase from Q0 to Q1.

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● Consumers are better off due to an increase in consumer surplus by P0ABP1

● Producers are better off due to an increase in producer surplus by P0EAP0

● The subsidy per unit is given by the vertical distance between the two supply curves at the
new equilibrium output Q1 i.e. P2- P1 or EB.
● The total government expenditure on the subsidy is represented by the area P 2EBP1 or (P2-
P1)*Q1

Practice Question
The following data represents the daily demand and supply schedule for a good. (You may use the
blank column in your explanation).
PRICE QUANTITY QUANTITY SUPPLIED QUANTITY SUPPLIED
DEMANDED BEFORE SUBSIDY AFTER SUBSIDY
16 2000 2800
14 2200 2600
12 2400 2400
10 2600 2200
8 2800 2000
If the government introduced a subsidy of £4 per unit of output to be paid to producers of the good,
the new equilibrium price will be;
A) £8 B) £10 C) £12 D) £14

Subsidies given to consumers.

When subsidies are given to consumers, their demand for goods and services will increase due to an
increase in their purchasing power. This will lead to an outward shift of the demand curve as shown
below;

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Effects of the subsidy.

● The subsidy will lead to an outwards shift of the demand curve from D to D+ Subsidy . The
equilibrium price will increase from P0 to P1 and the equilibrium quantity from Q0 to Q1.
● Consumers are better off due to an increase in consumer surplus by P0ACP2

● Producers are better off due to an increase in producer surplus by P1BAP0

● The subsidy per unit is given by the vertical distance between the two demand curves at the
new equilibrium output Q1 i.e. P1-P2 or BC.
● The total government expenditure on the subsidy is represented by the area P 1BCP2 or (P1-
P2)*Q1

Practice Question

The above diagram shows how an indirect tax imposed on the sale of a product causes its supply
curve to shift from S to S1. Which of the following describes the market situation above?
a) The tax is charged at a flat rate on each unit sold and its incidence falls mainly on producers.
b) The tax is an Advalorem tax charged as a percentage of the price and its incidence falls
mainly on consumers.
c) The tax is charged at a flat rate on each unit sold and its incidence falls mainly on
consumers.
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d) The tax is an Advalorem tax charged as a percentage of the price and its incidence falls
mainly on producers.

APPLICATION OF MARKET PRINCIPLES IN THE PRODUCT MARKET

The market principles of demand and supply can be applied to markets such as;

a) The Agricultural Market

b) The Labour Market
c) The Market for Oil
d) The Housing Market
e) The Precious Metals Market
f) The Stock exchange Market

THE AGRICULTURAL MARKET

The supply for agricultural products keeps fluctuating from season to season making prices of
agricultural goods very unstable. The fluctuation is mainly brought about by changes in weather
conditions, pests and disease, natural disasters, seasonality in production e.t.c. There is also the time
lag phenomena owing to the fact that crops take a long time to grow and mature. Livestock may also
take several years to start producing meat and dairy products.
Fluctuating prices are bad for producers/ farmers because they lead to unstable incomes. Consumers
are also disadvantaged since many agricultural products are basic necessities. Farmers are usually
worse off during the good harvest seasons and worse off during a poor harvest. This can be
illustrated graphically as follows;

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⮚ The income of the farmer during poor harvest will be P2 * Q2

⮚ The income of the farmer during good harvest will be P1 * Q1

⮚ The area P2 * Q2 is greater than P1 * Q1 implying that farmers will earn higher incomes
during poor harvest. This problem is referred to s the paradox of poverty.

PED OF AGRICULTURAL PRODUCE

The PED of agricultural produce is usually inelastic due to the following factors;
▪ Most agricultural products are basic necessities.

▪ Most agricultural products have very few substitutes

▪ Some agricultural products are important raw materials in the production of other goods.

PES OF AGRICULTURAL PRODUCE

The PES of agricultural produce is usually inelastic due to the following factors;
▪ A long gestation period

▪ Perishability of some agricultural products e.g. fresh vegetables.

▪ The production of agricultural products is prone to uncontrollable factors.

NB: the supply of agricultural products is sometimes considered to be perfectly inelastic due to the
time lag phenomena.

THE IMPACT OF AN INCREASE IN AGRICULTURAL PRICES ON CONSUMERS.

1. High food prices will lead to an increase in the cost of living resulting to a fall in living
standards.
2. There will be a high opportunity cost i.e consumers will sacrifice expenditure on other
commodities in order to spend more on food items.
3. There will be increased malnutrition due to the prevalence of poor dietary habits.

THE IMPACT OF AN INCREASE IN AGRICULTURAL PRICES ON MANUFACTURERS

OF OTHER PRODUCTS.
1. A high cost of production.
2. A fall in revenue and profits.
3. Some producers may shift to other synthetic substitutes.

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THE HOUSING MARKET

The housing market is very important because it is likely to stimulate economic activities in an
economy. For instance, when house prices increase, there will be an increase in consumer
confidence since the value of the wealth of home owners will be increasing thereby leading to an
increase in their confidence level of consuming other goods. Besides, their purchasing power will
also increase.

TYPES OF HOUSING
i) Owner Occupied Housing
ii) Rented Accommodation.
iii) Council Housing
iv) Housing provided by NGO’s.

Owner Occupied Housing

This entails owning a personal house or property either through constructing or buying it. Owner
Occupied Housing and rented accommodation are substitutes.
Determinants of demand for Owner Occupied Housing
● The price of houses.

● Income

● Rent – if the rent paid under rented accommodation is high, demand for Owner Occupied
Housing will be high.
● Mortgage interest rate

● Population size

● Lifestyle e.g Preference for privacy and freedom.

● Government policy e.g tax relief on mortgage interest.

● Future expectations e.g expectations of political instability.

● Economic growth.

Determinants of supply for Owner Occupied Housing

● The cost of construction

● Availability of land

● Planning permission.

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● Natural disasters.

● Weather conditions

● Government policy e.g subsidies to construction companies.

NB: the demand and supply for housing is relatively price inelastic. This is because housing is a
necessity and houses take a long time to construct.
Rented Accommodation
This is a market for housing where landlords supply the houses to tenants and charge a price called
rent for the use of the housing facility.
Determinants of demand for Rented Accommodation
● Rent

● Income

● Location e.g. proximity to workplace, social amenities, market etc.

● Price of owner occupied housing.

● Population or family size.

● Tastes and preferences.

● Security

● Advertising.

Determinants of supply for Rented Accommodation

● Rent

● Planning permission.

● Type of tenant e.g residential or commercial.

● Government policy

● Cost of construction

RENT CONTROL

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The government can impose a rent ceiling to be charged by private landlords especially because the
demand and supply for housing is relatively inelastic. The effect of rent control can be illustrated
graphically as follows;

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Effects of a rent Ceiling

● There will be excess demand for housing i.e a shortage of rented accommodation Q2-Q1

● Tenants will be better off and consumer surplus will increase by ReABR1.

● Landlords will be worse off and producer surplus will fall by ReACR1.

● The development of an illegal housing market due to excess demand. Some tenants will be
willing to pay a higher rent above the rent ceiling in order to acquire rental accommodation.
The possible black market rent will be R2.
● There will be a search activity where people will be looking for houses due to the low rent.
This activity is expensive in terms of time and shoe leather cost.

The impact of high rent to tenants.

● A high cost of living.

● Tenants might shift to owner occupied housing.

● An increase in the use of poor housing facilities e.g. slums.

● A high opportunity cost.

● Lower standards of living e.g poor dietary habits.

The impact of high rent to landlords.

● An increase in revenue and profits.

● Loss of tenants to owner occupied housing.

● Motivation to construct more houses i.e. increased investment in the housing market.

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THE LABOUR MARKET

This is the market where labour services are traded. Labour services can either be skilled, unskilled
or semi- skilled.

Demand for Labour.

Labour has a derived demand i.e. the demand for labour is derived from the demand for products
that labour will help to produce.

Determinants of Demand for labour.

● Wages.

● Availability of labour substitutes e.g. machines.

● Demand for the products produced by labour.

● Government policy e.g. the National Minimum Wage.

Determinants of Supply for labour.

● Wage rate.

● Working conditions.

● Labour mobility

● Population size and structure.

● Retirement age.

● The education system i.e. the number of years in school.

● Trade union powers.

● Unemployment benefits.

● Changes in migration patterns.

Elasticity of demand for labour.

This is the degree of responsiveness of demand for labour due to a change in the wage rate.

Determinants of the Elasticity of demand for labour.

❖ Availability of labour substitutes e.g. machines- if labour can easily be replaced with
machines, demand will be relatively elastic.
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❖ Wages as a Percentage of the total costs of production- demand will be more elastic for
highly paid workers.
❖ Elasticity of the product produced by labour- when the demand for the product is elastic,
demand for labour will also be elastic.
❖ Time- demand for labour is inelastic in the short run but elastic in the long run.

❖ Skills required- demand for skilled labour is relatively inelastic.

Elasticity of Supply for labour.

This is the degree of responsiveness of the supply for labour due to a change in the wage rate.

Determinants of the Elasticity of Supply for labour.

❖ Mobility of labour- the supply for labour will be elastic when labour is either geographically
or occupationally mobile.
❖ Length of training- the longer the training period, the lower the elasticity of supply for
labour.
❖ The unemployment level- the higher the unemployment level, the higher the elasticity of
supply for labour.
❖ Specialized skills- supply for labour will be inelastic for workers with specialized skills.

NB: skilled workers have inelastic demand and supply while unskilled workers have elastic demand
and supply. This is the main reason why wage differentials exist between skilled and unskilled
workers.

Imperfections in the labour market

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IMPERFECTIONS IN THE LABOUR MARKET

Most labour markets are not perfect due to government intervention where the government
may establish the national minimum wage. Imperfections may also be brought about by
trade union powers where the union bargains for higher wages. The market can also be
imperfect when there is a single major employer in the market (monopsony).

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The National Minimum Wage

This is the lowest wage rate set by the government in order to prevent wages from falling below
minimum. It is aimed at protecting workers earning low wages from exploitation by employers. The
national minimum wage is always set above the equilibrium wage rate as illustrated below.

Effects of A National Minimum Wage

a) Benefits
● Workers are protected from exploitation by their employers.

● Improvement in the living standards of low paid workers

● It will encourage firms to use labour more efficiently.

● The motivation and productivity of workers will improve

● It will encourage the unemployed to enter the labour market

● It will encourage firms to develop efficient substitutes.

b) Costs
● There will be an increase in the unemployment rate since the supply of labour at W2
is greater than the demand for labor. The total unemployment level is N3-N2 where
N1-N2 costs of the workers who have been retrenched from active employment due
to the high cost of labour while N3-N1 represents new entrant into the labour market
who are attracted by the high wage rate.
● The national minimum wage will result in an increase in the cost of production
thereby leading to cost-push inflation.
● The NMW will encourage firms to substitute labour with capital thereby creating a
further increase in unemployment.
● It may lead to development of an illegal labour market where some desperate
workers will accept a lower wage rate.
● It may lead to a decrease in the production of cheap domestic products which may
result in an increase in the demand for imports.
● The national minimum wage is an incentive to work and may lead to an increase in
school drop outs.

Trade Unions

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A trade union is an association of workers formed to promote and protect their interests. Its main
functions include;
i) Bargaining with employers to improve the wages of its members.
ii) Bargaining for better working conditions.
iii) Protecting workers against discrimination.
iv) Protecting workers against unfair dismissal from work
v) Bargaining for a better pension package.

The power of a trade union can influence the wage rate in the market i.e. a powerful trade union will
be effective in bargaining for higher wages. This can be illustrated diagrammatically as follows;

▪ Without the trade union, the equilibrium wage rate is W 1. After the trade union
intervention in bargaining for higher wages, the wage rate will increase to W 2.
▪ Without the trade union, the supply curve is S but with the trade union, the supply
curve for labour is W2XS i.e. the supply curve is perfectly elastic until point X after
which it slopes upwards between X and S.
▪ There will be excess supply of workers at the union wage rate W 2 thereby leading to
unemployment i.e. Ns- Nd.

MOBILITY OF LABOUR
This is the ability and willingness of workers to move from one region to another or from one job to
another.

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TYPES OF MOBILITY
1. Geographical Mobility – This is the willingness and ability of a worker to move from one region
to another.

2. Occupational Mobility – This is the willingness and ability of a worker to move from one job to
another.

IMMOBILITY OF LABOUR
This refers to a situation where workers are either unwilling or unable to move from one region to
another or from one job to another.

CAUSES OF OCCUPATIONAL IMMOBILITY

1. Lack of necessary skills.
2. Lack of information about job vacancies.
3. Professional group restrictions.
4. Trade union restriction.
5. Discrimination.

SOLUTIONS TO OCCUPATIONAL IMMOBILITY

1. Setting up job centers.
2. Setting on worker training schemes.
3. Job advertisement.
4. Passing of laws to prevent discrimination.

CAUSES OF GEOGRAPHICAL IMMOBILITY

1. Social ties.
2. The high cost of movement.
3. The high cost of living in some areas.
4. Security reasons.
5. Lack of information about job vacancies in other areas.
6. Some individuals may not want to disrupt the schooling of their children.

SOLUTIONS TO GEOGRAPHICAL IMMOBILITY

1. Setting up of job centers.
2. Encouraging employers to cover part of the transfer costs and to give hardship allowances.
3. Encouraging employers to provide housing facilities.
4. Promotion of World Peace

BENEFITS OF LABOUR MOBILITY

1. Low unemployment levels.
2. Low cost of labour leading to low cost of production.
3. Low inflation rates.

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THE MARKET FOR OIL

Oil is a necessity in the industrial, transport and household sector. Demand for oil is there for
relatively inelastic. Due to the activities of OPEC, the production of oil is subject to fluctuations.

Determinants of Demand for Oil

1. The price of oil.
2. Economic growth- an increase in economic growth will lead to an increase in demand for oil due to
the increase in production and consumption activities in the economy.
3. Stock piling- buildup of strategic oil reserves by major economies e.g. USA when major economies
are building up their oil reserves, there will be a high demand for oil.
4. Changes in the price of oil substitute’s e.g. hydroelectric power, natural gas etc.
5. The high demand for oil in emerging economies such as China.
6. Changes in the exchange rate- an appreciation in the value of the dollar will lead to an increase in the
price of oil for the oil importing countries. This will lead to a fall in the demand for oil.

Determinants of Supply of Oil

1. The actions of OPEC- OPEC can control the supply of oil by changing the production quotas
allocated to its members.
2. Political stability in oil producing countries- political instability in the oil producing
countries may affect the supply of oil. For instance, the supply of oil has been influenced by
the political instability of Iraq.
3. New discovery of oil deposits- the discovery of oil deposits may lead to an increase in the
supply of oil in the world market.
4. Oil reserves- the supply of oil in the world market can increase when major economies such
as the USA are releasing their oil reserves.

THE ELASTICITY OF DEMAND AND SUPPLY OF OIL.

a) Elasticity of Demand.
The demand for oil is price inelastic due to the following reasons;
i) Oil is a necessity in industrial, transport and domestic consumption.
ii) There are very few perfect substitutes for oil.

b) Elasticity of supply.
The supply of oil is relatively inelastic due to the following reasons;
i) It takes a long time to discover and extract oil.
ii) Supply is inelastic in the short run because consumers and producers will require
time to adjust to the changes in oil prices. In the long run, supply could be elastic
since oil producers can extract more oil in response to price changes.
iii) A low rate of technical substitution.
Reasons why oil prices are constantly rising
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i) A high demand for oil in China.

ii) The very inelastic nature of the short run supply of oil.
iii) Growth in the production capacity is lower than the growth in demand.
iv) Lack of investment in the production of oil.
v) Decision by OPEC to reduce production Quotas.
vi) Buildup of strategic oil reserves by the USA.
vii) Political instability in oil producing countries.
viii) Appreciation of the dollar against other currencies.

Policies to Deal with the Oil Crisis

i) Improving the public transport sector
ii) Encouraging investment in oil exploration
iii) Making greater use of alternative energy sources
iv) Developing oil substitutes (the use of hybrid vehicles)

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THE STOCK EXCHANGE MARKET

This is a market where financial security instruments or stocks such ass shares are traded. A share is
a unit of ownership of a company. Share prices are determined by the forces of demand and supply
based on economic fundamentals both locally and internationally.

Determinants of Demand for Shares

▪ Share prices

▪ Income

▪ Expected returns in terms of dividends or capital gain

▪ Objectives or goals of the investor e.g. short term vs. long term investment.

▪ Financial performance of the company

▪ Economic performance of the country e.g. recession, boom, recovery or slump

▪ External financial shocks e.g. the global credit crunch

▪ Changes in the prices of other shares in the market

▪ Risk attitude of investors e.g. risk takers vs. risk averse

▪ Activities of speculator

▪ The number of individual and institutional investors

Determinants of supply for shares

▪ Share prices

▪ The number of quoted companies in the stock market

▪ Regulation imposed by market authorities

▪ Activities of spectators

▪ Privatization of nationalized industries through the stock market.

▪ Offshore trading

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▪ Percentage of shares offered by the public limited companies

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MARKET FAILURE
This occurs when the price mechanism or price systems fails to allocate resources efficiently
leading to a welfare loss. Indicator of market failure includes;

⮚ Externalities

⮚ Unemployed resources

⮚ Failure to provide public goods

⮚ Under provision of merit goods

⮚ Depletion /exhaustion of resources

⮚ Information asymmetry / imperfect knowledge of the market / lack of information.

⮚ Monopoly elements or market dominance

⮚ Factor immobility

⮚ Undesirable income and wealth distribution

EXTERNALITIES
These are spillover effects of production or consumption activities that affect third parties. They
represent a divergence between the private and social costs/ benefits. There are two types of
externalities;
a) Negative externalities
b) Positive externalities
Negative Externalities / External Costs
These are harmful / negative spillover effects of production and consumption activities that
affect third parties. They are not reflected in the market price that a consumer pays for the
good or service. This leads to under pricing, over-consumption and over production.
There is a market failure when resources are put into the production of goods that are
harmful to the society i.e. misallocation of resources. Negative externalities represent an
excess of social costs over private costs.

Private Costs

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These are the costs that are internal to an exchange. They are the costs incurred by individual
producers or consumers due to the production or consumption of a good or service e.g. the cost of
raw materials or the price of an air ticket.

Social Costs
They represent the sum of all the costs a society incurs from production and consumption
activities i.e. the sum of private and external costs of producing and consuming a good or service.

EXTERNAL COSTS AND MARKET FAILURE

In order to determine the output and consumption level, firms and consumers only consider their
marginal private cost and marginal private benefits. Marginal private costs are measured along
the supply curve (S=MPC) while marginal private benefits are measured along the demand curve
(D = MPB)

The free market level of output is Q m determined where MPB = MPC. The socially optimum level
of output is Qs determined where MSB = MPC.
Market failure arises because
● The market level of output (Qm) exceeds the socially optimum level of output (Q s) implying
that more resources are put into the production of the good beyond what the society
considers beneficial.

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● Additional units of the good or service produced beyond Q1 impose costs on the society in
excess of the benefits. (MSC > MSB). The welfare of the society is reduced as indicated by
the shaded area.

● The market price does not cover the full social cost leading to under pricing which
encourages over consumption.

EXTERNALITIES IN THE TRANSPORT SECTOR / INDUSTRY

ROAD TRANSPORT
In most countries roads have become more congested due to several reasons;
(i) An increase in car ownership.

(ii) An increase in real income which was as increased the demand for cards

(iii) Inadequate or unreliable public transport which forces people to use private car.

(iv) People are increasingly living far away from their places of work.

(v) An increase in population in most countries and towns.

NEGATIVE EXTERNALITIES IN ROAD TRANSPORT

(i) Congestion

(ii) Air population from exhaust fumes.

(iii) Lateness to work which reduces labour productivity.

(iv) High transport costs for firms /fuel and labour costs

NB: Externalities arise because private road users are only concerned about private cost like fuel,
maintenance and journey times. They tend to ignore the externalities that they generate resulting
in the overuse of road space.
Policies to Deal with Negative Externalities
(i) Fuel / carbon tax

(ii) Road pricing

(iii) Subsidizing public transport

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(iv) Congestion charge(s)

AIR TRANSPORT
Statistics around the world indicate that there is growing demand for air transport due to the
following factor;

(i) An increase in real incomes and economic growth

(ii) Convenience and easy access of air travel

(iii) Growth of international trade which necessitates quick means of travel by business
executives.

(iv) Increased availability of low cost /cheap airlines

Negative Externalities
(i) Air pollution – planes are the worst air pollutants

(ii) Noise pollution

(iii) Global warming due to the depletion of the o zone layer

(iv) Loss of countryside to the construction of airport

(v) Sound proofing of houses located near the airport

Positive Externalities
(i) Employment creation

(ii) Attraction of foreign investment

(iii) Promotion of tourism

(iv) Promotion of exports especially in the horticulture industry

Assignment: Read on Acid Rain, Global warming and O Zone layer depletion

Externalities and Natural Resources

Over –Fishing
The fishing industry operates under competitive conditions. Fishermen have no control over the
price of fish and may have to compete for fish in international water where there are no fishing
rights / properly rights. Each fisherman wishes to maximize his private benefits resulting in over
fishing and the depletion of fish stocks.

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• The market level of fish caught is Q* i.e., where MPB = MPC. The socially optimum level is
Q1 (MSC = MSB) thus fishermen extended the fish catch beyond the socially optimum level by
ignoring the externalities involved. The excess fish caught between Q1 and Q* impose social
costs greater than social benefits (MSC>MSB) hence leading to a welfare loss.

External Costs of over fishing

● Depletion /extinction of some fish species.

● Depletion of fish stocks that leads to shortage.

● Loss of jobs in related industries e.g. fish processing industries, not making industries etc.

● Decline in the income of local business in regions heavily dependent on fishing.

Polices to Regulate Over fishing

● A complete ban on fishing. This may however be difficult to implement and supervise.

● Banning of fishing in major breeding areas.

● Limit fishing to particular seasons to allow for re-stocking.

● Issue tradable fishing quotas which allow fishermen to catch certain volume of fish and over a
given period of time. Fishermen pay for the quota which internalizes the externality and
generates additional revenue to the government. However quotas are difficult to monitor and
difficult to set appropriately.

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EXTERNALITIES AND PROPERTY RIGHTS

Property rights constitute legal entitlement to use and sell property and to charge for the use or
damage of such property. Externalities such as a noise pollution, air pollution, over fishing etc
arise because people do not have property rights over the resources being damaged. This implies
that they cannot charge for the use or damage of the resources has externalities generated are not
internalized. This is partly because;
(i) It is difficult to divide up the water
(ii) It is difficult to enforce property rights over the atmosphere.

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POLICIES TO DEAL WITH NEGATIVE

EXTERNALITIES
TAXATION
Taxes will increase the cost of production because the externalities are internalized. The curve
shifts to the left by the full amount of the tax. The output and consumption will decrease from the
free market level to the socially optimum level while the price will increase as shown below;

Advantages of Taxation
1. An increase in tax revenue to the governmental which can be used to finance pollution
reducing schemes.

2. The higher prices due to taxation encourage consumers and producers to use resources more
efficiently e.g. private motorists may cut down on unnecessary journeys while some may
resolve to use public transport. Producers may invest in R & D to come up with
environmentally friendly technology and product e.g. low sulphur diesel.

3. Taxes help to internalize external costs of production and consumption activities i.e. the
externalities are reflected in the higher prices.

Disadvantages of Taxation
1. It is difficult to quantify and place the right money value on external costs like pollution.

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2. Pollution taxes will increase costs of production to producers leading to higher prices of
commodities which may reduce the competitiveness of a country’s exports.

3. Fuel taxes will increase transport costs for firms which may lead to cost push inflation.

4. The burden of pollution taxes may fall more on the low income earners as the prices of goods
and services rise leading to an increase in income inequality.

5. Some producers could simply absorb the pollution taxes by reducing profit margins and
maintaining the same level of production. Others could pass the tax on to consumers through
higher prices hence the tax will not be effective in reducing externalities.

TRADABLE POLLUTION PERMITS

These are sold by the government to firms allowing them to cause some level of pollution. The
permits can be traded in the market. Firms that manage to reduce their pollution levels could sell
of their excess permits to other firms that may cause relatively more pollution. Buying a pollution
permit increases the production costs for the firm. The cost of the permit internalizes the
externality through the “polluter pays” principle. Firms are also encouraged to adapt cleaner
environmentally friendly technology to cut down the cost of buying pollution permits in the long
run.
The government benefits from additional revenue which it may use to finance pollution reducing
schemes and awareness campaigns.
Disadvantages of Tradable Permits
1. It is immoral to give producers a right to damage the environment simply because they can
pay for it.

2. Permits may reduce the rate of economic growth in poor countries that use less
environmentally friendly technology. Firms would have to buy permits and operate at higher
costs which could reduce the competitiveness of exports hence slowing down the rate of
economic growth.

3. Permits may not succeed in reducing pollution by firms since firms may pass on the cost of the
permits to consumer through price increases. Other could accept lower profit margins to cover
the cost of pollution permits.

REGULATION
This entails the use of laws to regulate / control production and consumption activities. The laws
can also stipulate furious or penalties to be imposed on individuals or firms responsible for the
negative externality. This could involve facing the offenders to clean up or to repair damages
imposed on the environment. Examples of regulations include;
● Compulsory use of seatbelts and helmets

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● Compulsory use of speed governors and speed limits

● Banning the use of leaded fuel

● Regulating the number of years a car can be on the road.

Disadvantages of Regulations
1. It is expensive to administer
2. It may not succeed if the penalties for breaking the rules are light.
3. Governments may not have adequate information to be able to set effective laws/rules.
4. Political objectives may conflict with economic ones.

ROAD PRICING
This is a system of charging road users for the use of the road and parking spaces through toll and
parking fees. Road pricing helps to internalize the externalities caused by motorists. It increased
the marginal cost of journeys and encourages motorists to cut down on the unnecessary and
journeys or to switch to environmentally friendly forms of transport such as cycling and working
and public transport.
Advantages of Road Pricing
1. It helps to reduce congestion on roads as people switch to environmentally friendly forms of
transport.
2. The reduction in congestion reduces lateness and increases labour productivity.
3. It generates revenues for the government.
4. Motorists are made to pay for the damage they cause to the environment and the congestion
on roads.
Disadvantages of Road Pricing
1. It increases the transport cost of firms that have to deliver goods which may lead to higher
prices of goods and services.

2. It is expensive to implement and administrator road pricing because toll stations have to be
constructed and people have to be employed to run them.

3. In some areas, demand for the use of private cars is elastic due to the absence of reliable
transport hence in such cases, road pricing will not be effective in reducing congestion and
other externalities caused by private motorists,

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4. Road pricing does not distinguish between times or areas of low and heavy congestion
especially in instances when a flat rate is charged thus road tolls will not serve as incentives to
motorists to avoid periods of heavy traffic.

SUBSIDIZING PUBLIC TRANSPORT

Public transport generates external benefits and helps reduce external costs associated with road
transport. Its benefits include;
(i) Reduced traffic congestion
(ii) Reduced air pollution hence a cleaner environment
(iii) Reduced journey times and lateness to work which helps to increase labour
productivity
(iv) Reduced transport costs for firms in terms of lower fuel and wage costs
To increase the production and consumption of public transport, the government could give
subsidies to operator, which could help increase the supply of public transport and to reduce the
fare. The subsidy could also be used to operators to improve the quality of public transport i.e. the
frequency, reliability, cleanliness, safety etc. However, it implies an increase in government
expenditure.
The success of the subsidy in increasing the number of people traveling by public transport will
depend on;
1. The PED for public transport – The subsidiary will be more effective if demand is price
elastic.
2. The extent to which people regard public transport as an inferior good.
3. The amount of subsidiary – a small subsidiary might have little or no impact on fares and
number of additional commuters.
4. How the operators use the subsidiary – whether they use it to improve the quality of the
service.

Practice Question
What are the likely (positive and negative) externalities of hosting the 2012 Olympic games in
London? [16 marks]

Positive Externalities / External Benefits

These are the beneficial / positive spillover effects of production and consumption activities
that affect third parties. Positive externalities are common in the production and
consumption of;

● Education

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● Healthcare

● Public transport

● Garbage collection

External benefits are not reflected in the market price. There is market failure because the
goods and services that generate external benefits are usually under provided and under
consumed by the society.
Positive externalities represent an excess of social benefits over private benefits.

Private benefits
This is the satisfaction or utility derived by consumers or producers following the consumption or
production of a product e.g. the revenue obtained by a producers or the convenience of using a car.

Social Benefits
They represent the sum of private and external benefits of producing and consuming a good or
service.

EXTERNAL BENEFITS AND MARKET

FAILURE
External benefits are the positive spillover effects of production or consumption activities that
are enjoyed by a third party. They increase the social welfare of people in general. Where
external benefits are involved, the market fails because of the tendency to under provide, under
consume and overprice the goods and services i.e. not enough resources are put in the
production of goods or services. The market level of production and consumption is less than
the socially optimum level shown below.

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The free market level of production is Q*(MPB = MPC) while the socially optimum level is Q 1
(MSB = MSC).
Additional units of the good consumed between Q * and Q1 would add social benefits greater than
social costs (SMB > SMC). Failure to produce / consume these units leads to a loss in welfare
gain represented by the shaded area.

Merit Goods & Market Failure

Merit goods generate private benefits to individual consumers and external benefits to third
parties. Examples of merit goods include; education and healthcare.
The market fails with regard to merit goods in that they are underprovided, overpriced and under
consumed. This is mainly because:
1. Imperfect knowledge – producers and consumers do not know the full benefits and
quantities of merit goods that they will require overtime.

2. Income inequalities – the rich tend to consume more goods than the poor who may not
afford them. The market ignores the external benefits to be derived from merit goods.
Thus the amount produced of merit goods basically for the rich will be less than the
socially optimum level hence allocative inefficiency.

3. The free rider problem.

Healthcare
It generates several external benefits in form of:
⮚ Protection from infectious diseases through vaccinations.

⮚ High labour productivity from a healthy workforce

⮚ Reduced absenteeism from work

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⮚ High rate of economic growth

⮚ High standard of living

Education
It provides private benefits to students in form of good job opportunities and high incomes upon
graduation. It also generates external benefits to third parties / society in general. They include:
⮚ High labour productivity from a skilled labour force.

⮚ High rate of economic growth.

⮚ High standard of living for everyone as income per head rises.

⮚ Large tax revenues from the high employment incomes of the graduates which can be used
to provide public or merit goods and to improve infrastructure.

Justification for Government Funding of Education / Health

In many countries governments either provide free education and healthcare or offer subsidies to
increase production and consumption. In the UK, the government provides free healthcare
through the NHS.
Many arguments have been raised to support the case for government funding of these services
because;
1. External Benefits: The social marginal benefits (SMB) of education/health care exceed the
private marginal benefits (PMB). If these services are left out to the free market to provide
them, there would be under provision / under consumption.

Thus, government funding of these, services ensures that output and consumption are up to
the socially optimum levels.
2. Private colleges / hospitals would not provide unprofitable services e.g. courses in the
university or some forms of treatment that may be socially desired.

3. University education is closely linked to R&D which leads to innovations and inventions that
promote economic growth by increasing productivity. Private Universities may not afford
expensive research programmes which justifies the need for government intervention to fund
higher education.

4. Government funding may enable universities and hospitals to pay competitive salaries so as to
attract qualified staff. Private hospitals and universities may not afford this.

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Problem of Sate funding of Education and Healthcare

1. Increase in government spending which may lead to reduction in spending in other areas.

2. State funding /provision of these services may lead to over consumption through the free
rider problem.

3. Resource misallocation as the government diverts resources from other uses to increase the
output of over consumed services.

Policies to Correct Market Failure in the case

of Positive Externalities
Regulations
The government can use laws/rules to encourage consumption of goods that generate positive
externalities to ensure that the consumption is up to the socially optimum level. The UK
government has used this method to encourage the use of can seat belts, motor cycle crash
helmets. It has also used it to enforce consumption of education for youth under the age of 16
and health care in form of vaccinations.
However regulation has its limitations.
- It is difficult to determine the socially optimum, output / consumption level.

- It is expensive to monitor

- Producers may ignore the rules if the fines are not large enough

- Free provision

Governments may finance the provision of merit goods / education / healthcare out of
taxation to force the consumption to socially optimum levels. However this may cause many
problems e.g. the free rider problem, resource, misallocation etc.

Information
Government may advertise the benefits of merit goods through awareness campaigns. This
works to encourage people to increase the consumption up to the socially optimum levels e.g.
parents may be advised on the value of vaccinations and education.
However this is an expensive method and depending on the means or medium used some
people may not be reached.

Subsidies
Governments may subsidise the production/consumption of merit goods if subsidies are given
to producers, supply would increase and the price would fall to encourage increased
consumption (refer to diagram and notes on public transport).
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SUMMARY
Where externalities exist, the market price of goods and services does not reflect the full social
cost and benefit since producers and consumers are only interested in their private costs and
benefits. Externalities are ignored i.e. they are not internalized hence the market fails in two ways;
● Where negative externalities are involved, there is a tendency to under price the goods
which leads to over consumption and over production.

● Where positive externalities are involved, there is a tendency to overprice the goods or
services resulting in under consumption and under production.

Public Goods & Market Failure

Public goods are goods/services which once provided are automatically available to everyone
without charge e.g. defense, law and order, street lights.
Public goods have two main characters.
1. Non – excludability / non-exclusion in consumption
It is not possible to exclude people who have not paid from consuming the good or service
i.e. people consume the good whether they want to or not.
2. Non – rivalry / non-exhaustible
Consumption by one individual does not reduce the amount of the good/service available
for other individuals to consume.
Given these characteristics, public goods cannot be provided in the free-market though they
generate positive externalities. This is because of the free – rider problem i.e. once a good is
supplied by a firm, it is impossible to prevent others from consuming it free of charge thus the
benefits from the good are also enjoyed by those who are not prepared to pay for them.
The market fails in that no resources are allocated towards the production of public goods.

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Government Intervention in Markets

Government intervene in markets to correct market failure. They do this in several ways.
● Reducing fluctuations in prices and income in the agricultural market.

● Reducing the exploitation of consumers and workers maximum prices and minimum
wages.

● Regulating external costs

● Regulating the production and consumption of merit goods

Government Intervention in Agricultural Market

Prices of agricultural commodities fluctuate widely due to:
● Inelastic supply

● Changes in weather conditions

● Inelastic demand

● Cobweb model
These fluctuations in prices cause several problems e.g.
● Fluctuations in producer incomes

● Fluctuations in GDP

● Fluctuations in Forex earnings

● Uncertainties about producer incomes discouraging farmers to switch resources to other

users.
NB: All the above are forms of market failure.
To correct market failure in agricultural markets and to ensure constant supplies of food and raw
materials at reasonable prices, governments intervene in agricultural market using:
● Buffer stocks

● Guaranteed prices

● Set aside schemes

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● Quotas

Buffer Stock Schemes

These are government schemes that buy up excess output often during a good harvest. The
output is stored and released in times of shortages (poor harvest).
Buffers stock schemes aim at regulating the quantity of the good on the market so as to stabilise
price and producer incomes.
A buffer stock scheme will set a target price and then intervene in the market to maintain the
quantity that will ensure that price. It will buy up excess supply following good harvest and
sell/release stocks on the market following poor harvest.

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The target price is P. To maintain this price, the buffer stock has to maintain quantity Q in the
market.
After a good harvest, supply increases to Q1 (S1). The price threatens to fall to P1. To prevent
this, the scheme buys up, the excess supply Q1 – Q and keeps it in stock.

A bad harvest could reduce supply to Q 2 (S0). The price would threaten to rise to P 2. To prevent
this, the scheme would release quantity Q1 – Q to the market.
Through intervention buying and selling, the price is maintained at P. However, this
government intervention leads to inefficiency and resource misallocation (government failure) in
several ways.
● Buffer Stock Schemes guarantee fixed markets for the product. This encourages
overproduction, causing resource misallocation i.e. too many resources being put into the
production of a good beyond what the society would wish. They also provide an
insurance against poor harvests and may encourage producers to be inefficient.
● Additional costs to society, such as building costs, extra storage, insurance and costs of
managing the scheme.
● Buffers stocks are ineffective in the case of perishable goods or those that require cold
storage e.g. butter.
● The system relies on starting with a good harvest. Without stocks in the system it is not
possible to react to a poor harvest.
● Buffer stocks do not prevent the initial problem from arising.

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Guaranteed Prices

They are usually set above the free – market level with the objectives of:
● Raising and stabilizing prices

● Raising / stabilising farmers’ incomes

● Encouraging producers to remain in business

A government or agency can establish a target price, and then guarantee to pay farmers and
growers this price, whatever output is produced. If the market price rises above this guarantee,
the market price will prevail. But if the market price falls below the guarantee, then the
guaranteed price will prevail.
However guaranteed prices result in government failure in several ways.

● They encourage over production / excess supply.

● They have administrative costs – buying up and storing the excess supply.

● They lead to allocative inefficiency – too many resources being put into the
production of agricultural goods.
NB: The problems of guaranteed prices can be seen in the example of the common agricultural
policy (CAP) of the EU. Its aim was to stabilise price and producer incomes and to ensure
sufficient food supplies in the EU. It would protect rural employment and the rural
environment. However the outcome of CAP has been overproduction / excess supply (wine
lakes and Butter Mountains). It has also led to environmental damage as farmers use
pesticides and fertilisers to increase output.

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Set – Aside Schemes

Farmers are paid to cut down production if the good (SA) is in excess supply. They either leave the
land furrow (idle) or diversity into other crops. The decrease in supply helps to raise price and
producer incomes, however these schemes are expensive to fund and they involve opportunity
costs.

The Common Agricultural Policy

The EU protects its farmers and growers through its Common Agricultural Policy (CAP). Through
the CAP, European farmers receive annual subsidies of around £30 billion each year.
The evolution of CAP
CAP was created by the Treaty of Rome (1957) to ensure food supplies for Europe, and provide a
fair income for European farmers. Price support schemes, such as guaranteed prices, were first
introduced in 1962, and became the main means of supporting European farmers.
By the mid 1980s, over-production created massive surpluses and this led to major reforms,
including the use of set-aside programmes.
By the early 1990s, there was a movement away from guaranteed prices towards direct subsidies to
farmers, irrespective of the output they produced.
The Fischler Reforms, of 2003, continued the process of decoupling subsidies and farm output, and
introduced a ‘green’ element to CAP, forcing farmers to meet environmental and animal welfare
standards.
The UK receives a controversial rebate against payments into the EU to compensate for that fact
that it receives relatively little income from CAP in comparison with France and Spain.
Farming subsidies in the EU are based on the size of farms, so countries with the largest farms gain
the most.

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France takes the biggest slice of the subsidies, with Spain and Germany a distant second and third.
French farmers receive, on average, approximately €17,000 per capita.
Because the UK derives such a low proportion of its national income and employment from
farming, it is given a rebate as compensation.

Government Intervention in Labour Market

Governments intervene in labour markets to avoid the exploitation of workers, to reduce relative
poverty and to increase gender equality. The government may also intervene to help reduce
unemployment through higher minimum wages. The minimum wages are usually fixed above the
free market level and despite the well intended reasons for intervention they lead to worse
economic outcomes (government failure). This is in form of;

● Unemployment as labour supply exceeds demand.

● Inflation as the minimum wage pushes up production costs.

● Damage to export competitiveness as the minimum wage pushes up production costs and
exports prices.
● Discrimination against young inexperienced workers as employers prefer experienced
workers with high productivity.

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GOVERNMENT FAILURE
It occurs when government intervention in markets results in worse economic outcome and more
inefficient allocation of resources. Government intervention to resolve market failure may fail to
achieve a socially efficient allocation of resources. Government failure is a situation where
government intervention in the economy to correct market failure creates inefficiency and leads to
a misallocation of scarce resources.

Causes of Government Failure

1. Inadequate Information- the government may not have enough data to assess the effect /
success of the intervention e.g. the government may not be able to determine the
appropriate pollution tax to be charged to motorists.
2. Government may fail to account the full environmental impact of its proposed projects.
3. Government intervention is associated with administrative and opportunity costs e.g. the
cost of building and running toll stations, buying and storing excess farm output.
4. Government intervention disturbs markets and reduces the effectiveness of the price
mechanism in allocating resources e.g. high guaranteed prices to EU farmers have resulted
in the overproduction of milk, butter and wine.
GENERAL EXAMPLES OF GOVERNMENT FAILURE INCLUDE:

1. Government can award subsidies to firms, but this may protect inefficient

firms from competition and create barriers to entry for new firms because
prices are kept ‘artificially’ low. Subsidies, and other assistance, can lead
to the problem of moral hazard.
2. Taxes on goods and services can raise prices artificially and distort the
efficient operation of the market. In addition, taxes on incomes can create
a disincentive effect and discourage individuals from working hard.
3. Governments can also fix prices, such as minimum and maximum prices,
but this can create distortions which lead to:

● Shortages, which may arise when government fixes price below the market rate.
Because public healthcare is provide free at the point of consumption there will
be long waiting lists for treatment.
● Surpluses, which may arise when government fixes prices above the natural
market rate, as supply will exceed demand. For example, guaranteeing farmers
a high price encourages over-production and wasteful surpluses. Setting a
‘minimum wage’ is likely to create an excess of supply of labour in markets
where the ‘market clearing equilibrium’ is less than the minimum.
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4. Excessive bureaucracy is also a potential government failure. This is caused

by the public sector when it tries to solve the principal-agent problem.
Government must appoint bureaucrats to ensure that its objectives are
pursued by the managers of public sector organisations, such as the NHS.
5. Finally, there is the problem of moral hazard associated with the payment of
welfare benefits. If individuals know that the state will provide unemployment
benefit, or free treatment for their poor health, they are less likely to take
steps to improve their employability, or to avoid activities which prevent poor
health, such smoking, a poor diet, or lack of exercise.

Real life examples of Government failure

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