SSC 102

TOPIC 6: ECONOMIC AGENTS AND INSTITUTIONS

Lecturer: Dr. Ojeyinka T. A.

Economic agents refer to those individuals and organizations that engage in production, exchange,
specialization and consumption. Basically, there are three economic agents and these are:

1) Household individuals
2) Firms/enterprises
3) Government

Households: This refers to a group of individuals whose economic decision making is interrelated.
In other words, household refers to the collection of people who live together, operate a common
budget and are subject to common financial decision. The objective of the household is to
maximize utility. In economic theory, households perform two major roles.

a) Households enter the market place (Commodity market) as buyers or consumers of goods
and services produced by firms
b) Households provide factor inputs to firm for production of goods and services. Hence, they
are the principal owners of factors of production.

Firms/Enterprises: These are economic agents whose role is to transform factor of production
into goods and services. In other words, firms refer to the “transformation unit” concerned with
converting factor inputs into higher valued intermediate and final goods and services. Hence, they
perform the role of producers. For the firm, the goal is to maximize profit. In economic theory,
firms are the principal users of factors of production. Also, firms enter into labour market as buyers
of factor input such as labour.

Government: This is an economic agent which provides rules for how firms and individuals
should interact. The government provides the legal framework and services needed for the
effective operation of a market economy. The word “government” in economic theory is
understood to comprise all public agencies, government bodies and other organizations belonging
to or under the direct control of the state (all tiers of government). In Nigeria, we have local, state
and Federal governments that constitute the decision-making body in the country. The
government’s economic role could be extensive or restricted, depending on the socio-economic
system of a country. Basically, there are three economic systems which include the command or
centrally planned economy, market or free enterprise economy and mixed economy. However,
irrespective of the economic system that is practice in a country, government has a crucial role to
play to ensure smooth and efficient working of the economy.

Government is regarded as one of the key economic agents whose responsibility is to provide a
conducive environment for other economic agents such as households and business firms to
operate. Essentially, the criticisms leveled against the free market economy popularly termed as
“market failure” led to the intervention of government in an economy and most especially in a

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market driven economy. Accordingly, market failure establishes a basis for government
intervention.

The concept of Market failure

In a free enterprise economy, the fundamental economic questions of what to produce?, how to
produce? and for whom to produce? are addressed by the forces of demand and supply sometimes
referred to as the “invisible hands”. In this economic system, factors of production are owned and
managed by private individuals and institutions. However, when the invisible hand of the market
place produces a mix of output that is different from the one society most desires, then the market
has failed. Hence, market failure implies that the forces of demand and supply have not led
us to the best point on the production possibilities curve. It is an imperfection in the market
mechanism that prevents optimal outcomes. Market failure is used to refer to less than perfect
(suboptimal) outcomes. This has been discussed in our previous lectures.
Sources of market failure.
Three sources of market failure will be considered and these are:
• Public goods
• Externalities
• Equity.

Public goods
Public goods are goods or services whose consumption by one person does not exclude
consumption by others. A public good must satisfy two criteria. First unlike private good, more
than one individual can simultaneously receive benefits from a public good. That is, public good
exhibits no rivalry in consumption, thus allowing one person to increase his or her consumption
of the good without diminishing the quantity available for others. Second, it is costly to exclude
non payers from receiving the benefits of a public good. A good example of public good is national
defense. In this sense, public goods generate “free ride”. Free ride is a situation whereby an
individual reaps direct benefits from someone else’s purchase (consumption). Due to the high cost
of excluding non-paying individuals, private firms are unwilling to produce and sell public goods;
thus, the private sector fails to provide public goods and government intervention is necessary.

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Externalities
A second type of inefficiency arises when there are spillovers or externalities, which involve
involuntary imposition of costs or benefits. The term externalities refer to all costs or benefits of
a market activity borne by a third party, that is, by someone other than the immediate producer or
consumer. Externalities (or spillover effects) occur when firms or people impose costs or benefits
on others outside the market place. In other words, externalities are the difference between the
social and private costs (benefits) of a market activity. Social costs are the total cost of all the
resources that are used in a particular production activity while private costs are the resources costs
are incurred by the specific producer. For instance, airports produce a lot of noise; they generally
do not compensate the people living around the airport for disturbing their peace. On the other
hand, some companies which spend heavily on research and development have positive spillover
effects for the rest of society. Hence, external costs exist when social costs differ from private
costs.

Equity
Another source of market failure is high income inequality produced by free market enterprise
whereby few privileged individuals control the greatest amount of resources in the economy.
Markets do not necessarily produce a fair distribution of income. A market economy may produce
inequalities in income and consumption that are not acceptable to the electorate. Hence,
government steps in to alter the distribution of income. Government redistributes income through
taxes and transfers. Redistribution involves taxing one group and using the resulting tax revenues
to provide subsidies to another group. However, for a distribution scheme to be considered
equitable, the two principles of vertical equity and horizontal equity must be satisfied. Vertical
equity means that “unequals are treated unequally”. That is, vertical equity is satisfied when people
with higher incomes are treated differently than those with lower income. In practice, vertical
equity is achieved when the net tax system is sufficiently progressive. A redistribution scheme is
considered to be progressive if the net taxes as a fraction of income increase with income.
However, when the net taxes as a fraction of income fall with income, we have a regressive tax
regime. Also, if the net taxes as a fraction of income remain constant, such redistribution is said to
be proportional. On the other hands, horizontal equity means that “equals should be treated

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equally”. This implies that people with the same amount of income should pay the same amount
of net taxes

Roles of government in an economy

Sources of market failure discussed above provide the justification for government intervention in
an economy to provide public goods, correct for externalities and achieve equity in income. The
expected functions of government are discussed below:
1. Providing the economy with a legal structure: This is the first and most important function a
government should provide and without it an economy may collapse. This function requires the
government to provide for the legal status of business enterprises, ensure property rights, provide
enforcement of contracts, act as a referee and impose penalties for foul play. In order to perform
this function, the government should furnish the economy with regulations, legislations, and means
that ensure product quality, define ownership rights and enforce contracts. For instance, the
Federal government of Nigeria established the Corporate Affairs Commission (CAC) to register
both limited and non limited business enterprises in Nigeria, thereby providing their legal status.
Government also establishes courts to adjudicate on such as matter as breach of contracts, maintain
police-force to ensure the prevalence of effective law and order.

2. Maintaining competition: Since competition is the optimal and efficient market mechanism
that encourages producers and resource suppliers to respond to price signals and consumer
sovereignty, the government should fight monopoly power and non-competitive behavior.

3. Redistribution of income: The government should strive to provide relief to the poor,
dependent, handicapped, and unemployed. Welfare, Social Security and Medicare programs are
examples of programs that support the poor, sick and elderly. These programs are built on
transferring income from the high-income groups to the limited income ones, through progressive
taxes. Other means of redistribution might include price support programs such as the farm subsidy
and low interest loans to students based on their family incomes.

4. Provision of public goods and Creation and maintenance of social and economic
infrastructure: When the markets fail to provide the needed goods or the correct amounts of
certain goods or services, the government fills in the vacuum. One legitimate function of
government is to provide public goods. Examples of public goods that the markets do not provide

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are defense, security, police protection and the judicial system. Education and health services are
examples of quasi-public (merit) goods that the market does not provide enough of. The
government should provide the first, and help in the provision of the second. Government should
also provide goods such as roads, bridges, electricity, pipe-borne water and sanitation. These are
generally referred to as social overheads which private sector will not want to undertake because
of lack of resources to undertake them.

5. Promoting growth and stability: The government (assisted by the Central Bank of Nigeria)
should promote macroeconomic growth and stability (increasing the GDP, fighting inflation and
unemployment) through changes in its fiscal and monetary policies. The fiscal refers to the use of
taxes and spending and it is managed by the executive branch of government. The monetary
policies signify the use of interest rates, money supply, reserve requirements, etc. and it is managed
by the Central Bank of Nigeria.
6. Reallocation of resources: Public action is required to redress the consequences of negative
externalities especially welfare loss associated with environmental pollution. For instance,
companies producing goods such like cement, asbestos, crude-oil and chemical often cause
environmental pollution in their production activities thereby inflicting costs upon the society.
Government makes legislations and establishes specialized agencies to ensure that such companies
bear the cost of environmental pollution. This will affect their costs of production and determine
the amount of goods they can supply at any given alternative prices.
Instruments use by government to intervene in an economy
These are various policy instruments used by government to direct the pace of the economic
activities. Some of these instruments are:
1) Fiscal policy: This refers to the use of government taxes and spending to regulate
economic activity. Fiscal policy can be in form of expansionary or restrictive policy. For
instance, during inflation, government can employ restrictive fiscal policy such as
curtaining the growth of government expenditure, raising taxes especially for middle- and
upper-income group to reduce their disposable income. However, if an economy is faced
with high unemployment, government can employ an expansionary fiscal policy such
increase in government spending and tax reduction to boost aggregate demand.

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 2) Monetary policy: Government also intervenes directly in the economy through the Central
Bank by managing the amount of money available in the economy. The basic tools of
monetary policy are:
• Reserve requirement through cash reserve ratio
• Discount rate
• Open-market operation.

Hence Y= C + I + G economic agents in the national output.

THE CONCEPT OF INSTITUTION

According to Hodgson (2001) institutions are durable systems of established and embedded social
rules and conventions that structure social interactions. Udah and Ayara (2014) define institution
as the rules of the game while economic agents are the players. Institutions comprise norms,
regulations and laws that establish the “rule of game”. That is, institution condition and modify
the behaviour of individuals and groups so that their actions become more predictable to others.
There are various types of institutions which include legal, political, economic, social and so on.

Economic institutions: These refer to the network of commercial organizations (such as

manufacturers, producers, wholesalers, retailers, and buyers) who generate, distribute, and
purchase goods and services. In other words, economic institutions refer to those institutions that
perform economic function. Essentially, economic institution can be categorized into three and
these include

a) Institutions that establish and protest property right

b) Institutions that facilitate exchange
c) Institutions that permit economic cooperation

Examples of economic institutions in Nigeria

i) Banks (commercial and Central Bank)

ii) Insurance companies
iii) Nigeria Deposit Insurance Corporation (NDIC)
iv) The Security and Exchange Commission (SEC)
v) The Nigerian Stock Exchange (NSE)
vi) Corporate Affairs Commission

Functions of economic institutions

1) The educate society about how to make sound financial decisions

2) An economic institution may provide business inventory financing and indirect consumer
loans
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 3) Other economic institutions, such as insurance companies, provide cover for various risk
factors in addition to providing investment opportunities and loans.
4) Economic institutions, such as commodity markets, stock exchanges, help in creating and
providing ownership of financial claims
5) Economic institutions also help to promote macroeconomic growth and stability

Globally, there are three recognized economic institution and these are:

1) The General Agreement on Tariffs and Trade (now World Trade Organisation)
2) The world Bank
3) The International Monetary Fund (IMF).