OSHWAL ACADEMY

NAIROBI CAMPUS
SUBJECT: ECONOMICS
TOPIC 1: THE BASIC ECONOMIC PROBLEM
YEAR: 10
TERM: I

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 1.0 THE BASIC ECONOMIC PROBLEM
Economics is a social science which studies human behaviour as a relationship between ends
and scarce means (resources) having alternative uses. Ends means wants and wants are
unlimited. Means refer to resources, and resources are limited in supply / scarce. Therefore the
concept of choice arises. Resources are chosen or put into use for the satisfaction of people’s
wants. More and more urgent wants are satisfied first and less and less urgent wants are
satisfied later. The central problem in economics is scarcity and choice.

1.1 The nature of the economic problem

The fundamental economic problem is that there is a scarcity of resources to satisfy all human
wants and needs. There are finite resources and unlimited wants. This is applicable to
consumers, producers, workers and the government, in how they manage their resources.

 Resources: are the inputs required for the production of goods and services. These are
factors of production.
 Scarcity: a lack of something (in this context, resources).
Resources are chosen or put into use for the satisfaction of people’s wants. More and more
urgent wants are satisfied first and less and less urgent wants are satisfied later. Therefore the
central problem in economics is scarcity and choice.
Economic and free goods
Economic goods are those which are scarce in supply and so can only be produced with an
economic cost and/or consumed with a price. In other words, an economic good is a good with
an opportunity cost. All the goods we buy are economic goods, from bottled water to clothes.
Free goods, on the other hand, are those which are abundant in supply, usually referring to
natural sources such as air and sunlight.

1.2 The factors of production

Resources are also called ‘factors of production’. They are:

 Land: all natural resources in an economy. This includes the surface of the earth, lakes, rivers,
forests, mineral deposits, climate etc.
 The reward for land is the rent it receives.
 Since, the amount of land in existence stays the same, its supply is said to be fixed. But in
relation to a country or business, when it takes over or expands to a new area, you can say
that the supply of land has increased, but the supply is not depended on its price, i.e. rent.
 The quality of land depends upon the soil type, fertility, weather and so on.
 Since land cannot be moved around, it is geographically immobile but since it can be used
for a variety of economic activities it is occupationally mobile.

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 Labour: all the human resources available in an economy. That is, the mental and physical
efforts and skills of workers/labourers.
 The reward for work is wages/salaries.
 The supply of labour depends upon the number of workers available (which is in turn
influenced by:
 Population size – a high population means the workers are likely to be many.
 Number of years of schooling – raising the school leaving age reduces the number
of workers.
 Retirement age – the higher the retirement age, the more the number of people
available for work.
 Age structure of the population – a country with a higher proportion of people of
working age will have more workers than another country with less.
 Attitude towards women working – a country where women are allowed to work
will have more workers.
 The number of hours they work (which is influenced by number of hours to work in
a single day/week, number of holidays, length of sick leaves, maternity/paternity
leaves, whether the job is part-time or full-time etc.).
 The quality of labour will depend upon the skills, education and qualification of labour.
 Labour mobility can depend up on various factors. Labour can achieve high occupational
mobility (ability to change jobs) if they have the right skills and qualifications. It can achieve
geographical mobility (ability to move to a place for a job) depending on transport facilities
and costs, housing facilities and costs, family and personal priorities, regional or national
laws and regulations on travel and work etc.
 Capital: all the man-made resources available in an economy. All man-made goods (which help
to produce other goods – capital goods) from a simple spade to a complex car assembly plant
are included in this. Capital is usually denoted in monetary terms as the total value of all the
capital goods needed in production.

 The reward for capital is the interest it receives.
 The supply of capital depends upon the demand for goods and services, how well
businesses are doing, and savings in the economy (since capital for investment is financed
by loans from banks which are sourced from savings).
 The quality of capital depends on how many good quality products can be produced using
the given capital. For example, the capital is said to be of much more quality in a car
manufacturing plant that uses mechanisation and technology to produce cars rather than
one in which manual labour does the work.
 Capital mobility can depend upon the nature and use of the capital. For example, an office
building is geographically immobile but occupationally mobile. On the other hand, a pen is
geographically and occupationally mobile.
 Enterprise: the ability to take risks and run a business venture or a firm is called enterprise. A
person who has enterprise is called an entrepreneur. In short, they are the people who start a
business. Entrepreneurs organize all the other factors of production and take the risks and
decisions necessary to make a firm run successfully.
 The reward to enterprise is the profit generated from the business.

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 The supply of enterprise is dependent on entrepreneurial skills (risk-taking, innovation,
effective communication etc.), education, corporate taxes (if taxes on profits are too high,
nobody will want to start a business), regulations in doing business and so on.
 The quality of enterprise will depend on how well it is able to satisfy and expand demand in
the economy in cost-effective and innovative ways.
 Enterprise is usually highly mobile, both geographically and occupationally.
All the above factors of productions are scarce because the time people have to spend working,
the different skills they have, the land on which firms operate, the natural resources they use
etc. are all in limited in supply; which brings us to the topic of opportunity cost.

1.3 Opportunity cost

The scarcity of resources means that there are not sufficient goods and services to satisfy all our
needs and wants; we are forced to choose some over the others. Choice is necessary because
these resources have alternative uses- they can be used to produce many things. But since
there are only a finite number of resources, we have to choose.

When we choose something over the other, the choice that was given up is called the
opportunity cost. Opportunity cost, by definition, is the next best alternative that is sacrificed/
foregone in order to satisfy the other.
Example 1: the government has a certain amount of money and it has two options: to build a
school or a hospital, with that money. The govt. decides to build the hospital. The school, then,
becomes the opportunity cost as it was given up. In a wider perspective, the opportunity cost is
the education the children could have received, as it is the actual cost to the economy of giving
up the school.
Example 2: you have to decide whether to stay up and study or go to bed and not study. If you
chose to go to bed, the knowledge and preparation you could have gained by choosing to stay
up and study is the opportunity cost.

Influence of opportunity cost on decision making

1. Consumers make decisions on which products to buy based on price and value they get
when they buy the product.

2. Workers make a decision on which profession to study for. This may be influenced by
several factors such as likely wages in the future and chances available.

3. Producers make decisions on what to make e.g. farmers may use their fields to grow
coffee, or grow a different crop based on yields/ returns from the crops. May even
convert the farmland into flats/ apartment blocks.

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 4. The government carefully considers how to use tax revenue received for maximum
benefit of its citizens. When taxes rise, they provide an opportunity cost of what the
citizens could have spent their incomes on.

1.4 Production possibility curve diagrams (PPC)

Because resources are scarce and have alternative uses, a decision to devote more resources to
producing one product means fewer resources are available to produce other goods. A
Production Possibility Curve diagram shows this, that is, the maximum combination of two
goods that can be produced by an economy with all the available resources.
It is also known as a production possibility frontier.

The PPC diagram above shows the production capacities of two goods- X and Y- against each
other. When 500 units of good X are produced, 1000 units of good Y can be produced. But
when the units of good X increases to 1000, only 500 units good Y can be produced.

Let’s look at the PPC named A. At point X and Y it can produce certain combinations of good X
and good Y. These are points on the curve- they are attainable, given the resources. Th
economy can move between points on a PPC simply by reallocating resources between the two
goods.
If the economy were producing at point Z, which is inside/below the PPC, the economy is said
to be inefficient, because it is producing less than what it can.

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 Point W, outside/above the PPC, is unattainable because it is beyond the scope of the
economy’s existing resources. In order to produce at point W, the economy would need to see
a shift in the PPC towards the right.

Movements along a PPC

All the points that are on the PPC (A, B, C as shown) are possible combination of the 2 goods
using all the resources available in the country.

For an outward shift  to occur, an economy would need to:

 discover or develop new raw materials. Example: discover new oil fields
 employ new technology and production methods to increase productivity
 increase labour force by encouraging birth and immigration, increasing retirement age etc.
An outward shift in PPC, that is higher production possibility, will lead to economic growth.

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 In the same way, an inward shift can occur in the PPC due to:
 natural disasters, that erode infrastructure and kill the population
 very low investment in new technologies will cause productivity to fall over time
 running out of resources, especially non-renewable ones like oil or water
An inward shift in the PPC will lead to the economy shrinking.

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How is opportunity cost linked to PPC?
Individuals, businessmen and the government can calculate the opportunity cost from PPC
diagrams. In the above example, if the firm decided to increase production of good Y from 500
to 750, it can calculate the opportunity cost of the decision to be 250  units of good X (as
production of good X falls from 1000 to 750). They are able to compare the opportunity cost for
different decisions.

2.0 THE ALLOCATION OF RESOURCES

What is an economy?
Economy: an area where people and firms produce, trade and consume goods and services.
This can vary in size- from your local town to your country, or the globe itself.

2.1 Microeconomics and Macroeconomics

 Microeconomics is the study of individual markets. For example: studying the effect of a
price change on the demand for a good. Microeconomic decision makers are producers and
consumers (who directly operate in markets)
 Macroeconomics is the study of an entire economy, as a whole. Examples include studying
the total size of the economy or the unemployment rate, among other things.
Macroeconomic decisions are made by the government of the particular economy – a town,
state or country)

2.2 The role of markets in allocating resources

 Resource allocation is the way in which economies decide what goods and services to
provide, how to produce them and who to produce them for.
 These questions- what to produce
 how to produce, and for whom to produce – are termed ‘the basic economic questions’.
In short, resource allocation is the way in which economies solve the three basic economics
questions.
 Market is any set of arrangement that brings together all the producers and consumers of a
good or service, so they may engage in exchange. Example: a market for soft drinks.
 Goods and services are bought and sold in a market at an equilibrium price where demand
and supply are equal.
 This is called the price mechanism. It helps answer the three basic economic questions.
Producers will produce the good that consumers demand the most, it will be produced in a
way that is cost-efficient, and will be produced for those who are willing and able to buy the
product. The answers to the above questions differ in different economic system. An
economic system covers the institutions, organizations and mechanisms that influence
economic behaviour and determine how resources are allocated.

There are three economic systems:

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 1. Planned economy: an economic system where the government makes the crucial
decisions, land and capital are state owned and resources are allocated by
directives.
Directives – state instructions given to state owned enterprises
2. Market economic system – economic system where consumers determine what is
produced, resources are allocated by the price mechanism and land, and capital is
privately owned.

Price mechanism – is the way the decisions made by households and firms interact
to decide the allocation of resources. In such a system, resources move
automatically in response to prices. This leads to market equilibrium. Market
equilibrium is the price at which demand and supply are equal. Any other price is
known as market disequilibrium. Such a situation leads to demand and supply not
being equal.
3. Mixed economy – It combines elements of the planned economy ( public sector) and
the market economic system ( private sector).

2.3 Demand
Demand is the willingness and ability of consumers to buy a good or services at a given
price. Demand is effective if the willingness to buy is backed by the ability to pay. For example,
when you want a laptop but you don’t have the money, it is called demand. When you do have
the money to buy it, it is called effective demand.

The effective demand for a particular good or service is called quantity demanded.

(Individual demand is the demand from one consumer, while market demand for a product is
the total (aggregate) demand for the product, or the sum of all individual demands of
consumers).

THE LAW OF DEMAND 

 The law of demand states that an increase in price leads to a decrease in demand, and a
decrease in price leads to an increase in demand (it’s an inverse relationship between price
and demand. However, it’s worth noting that an increase in demand leads to an increase in
price and a decrease in demand leads to a decrease in price. The law of demand is
established with respect to changes in price, not demand, hence the difference).

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This is an example of a demand curve for Coca-Cola.

 Here, a decrease in price from 80 to 60 has increased its demand from 300 to 500.
The increase in demand due to changes in price (without changes in other factors) is called
an extension in demand. Here the extension in demand is from A to B.
 In the above example, an increase in price from 60 to 80, will decreased the demand from
500 to 300. The decrease in demand due to the changes in price (without changes in other
factors) is called a contraction in demand. The contraction in demand will be from B to A.

Shifts in Demand

In this example, there is a rise in the demand of Coca-Cola from 500 to 600, without any change
in price. A rise in the demand for a product due to the changes in other factors (excluding
price) causes the demand curve to shift to the right (from A to B).

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 In this example, there is a fall in demand of Coca-Cola from 500 to 400, without any change in
price.
A fall in demand for a product due to the changes in other factors (excluding price) causes the
demand curve to shift to the left (from A to B).

Factors that cause shifts in a demand curve:

 Consumer incomes: a rise in consumers’ incomes increases demand, causing a shift to right.
Similarly, a fall in incomes will shift the demand curve to the left.
 Taxes on incomes: a rise in tax on incomes means less demand, causing a shift to the left; and
vice versa.
 Price of substitutes: Substitutes are goods that can be used instead of a particular product.
Example: tea and coffee are substitutes (they are used for similar purposes). A rise in the price
of a substitute causes a rise in the demand for the product, causing the demand curve to shift
to the right; and vice versa.
 Price of complements: Complements are goods that are used along with another product. For
example, printers and ink cartridges are complements. A rise in the price of a complementary
good will reduce the demand for the particular product, causing the demand curve to shift to
the left; and vice versa.
 Changes in consumer tastes and fashion: for example, the demand for DVDs have fallen since
the advent of streaming services like Netflix, which has caused the demand curve for DVDs to
shift to the left.
 Degree of Advertising: when a good is very effectively advertised (Coke and Pepsi are good
examples), its demand rises, causing a shift to the right. Lower advertising shifts the demand
curve to the left.
 Change in population: A rise in the population will raise demand, and vice versa.
 Other factors, such as weather, natural disasters, laws, interest rates etc. can also shift the
demand curve.

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2.4 Supply
Supply is the willingness and ability of producers to supply a good or services at a given price

 The amount of goods or services producers are willing to make and supply is called quantity
supplied.
 Market supply refers to the amount of goods and services all producers supplying that
particular product are willing to supply or the sum of individual supplies of all producers.

The law of supply

The law of supply states that an increase in price leads to a increase in supply, and a decrease
in price leads to an decrease in supply (there is a positive relationship between price and
supply.

However, it’s also worth noting that, an increase in supply leads to a decrease in price and a
decrease in supply leads to an increase in price. The law of supply is established with respect to
changes in price, not supply, hence the difference).

Supply curve

 This is an example of a supply curve for a product. Here, an increase in price from 60 to
80, has increased its supply from 500 to 700.
 The increase in supply due to changes in price (without changes in other factors) is
called an extension in supply.
 A decrease in price from 80 to 60, will decrease the supply from 700 to 500. The
decrease in supply due to changes in price (without the changes in other factors) is
called a contraction in supply.

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 Shifts in supply
a) Shift to the right

 In this example, there is a rise in the

supply of a product from 500 to 700,
without any change in price. 
 A rise in the supply for a product due to
the changes in other factors (excluding
price) causes a shift to the right.

b) Shift to the left

 A fall in supply from 700 to 500, without any

changes in price is shown. 
 A fall in the supply for a product due to the
changes in other factors (excluding
price) causes a shift to the left.

Factors that cause a shift in supply

 Changes in cost of production: when the cost of factors to produce the good falls,
producers can produce and supply more products cheaply, causing a shift in the supply
curve to the right. A subsidy*, which lowers the cost of production also shifts the supply
curve right. When cost of production rises, supply falls, causing the supply curve to shift to
the left.
 Changes in the quantity of resources available: when the amount of resources available
rises, the supply rises; and vice versa.

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 Technological changes: an introduction of new technology will increase the ability to
produce more products, causing a shift to the right in the supply curve.
 The profitability of other products: if a certain product is seen to be more profitable than
the one currently being produced, producers might shift to producing the more profitable
product, reducing supply of the initial product (causing a shift to the left).
 Other factors: weather, natural disasters, wars etc. can shift the supply curve left.

2.5 Price determination

The interaction of the market forces of demand and supply determines the equilibrium price and the
sales in a market.

Market equilibrium and Market disequilibrium

Market equilibrium

 Market equilibrium is when quantity demanded is

equal to quantity supplied
 Market equilibrium is also when there are no
surpluses or shortages of a product.
 Equilibrium price is the price at which quantity
demanded is equal to quantity supplied.
 In this diagram, P* is the equilibrium price and Q* is
the quantity sold.

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Market disequilibrium

 Market disequilibrium is when quantity demanded

is not equal to quantity supplied
 Market disequilibrium is also when there are
surpluses or shortages of a product.
 Disequilibrium price is the price at which quantity
demanded is not equal to quantity supplied.
 In this diagram, two disequilibrium prices are
marked- 2.50 and 1.50.

2.6 Price changes

 At price 2.50, the demand is 4 while the supply is 10. There is excess supply relative to the
demand. 
 When the price is above the equilibrium price, a surplus is experienced. (Surplus means
‘excess’).
 At price 1.50, the demand is 10 while the supply is only 4. There is excess demand relative
to supply. 
 When the price is below the equilibrium price, a shortage is experienced.
 Shortage means demand for a product exceeds supply (or supply is less than demand)
 Surplus means supply of a product exceeds demand (or demand is less than supply)

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2.7 Price elasticity of demand (PED)
 The PED of a product refers to the responsiveness of the quantity demanded to changes in
its price.
PED (of a product) =   % change in quantity demanded / % change in price

i.e.

Price Elasticity of Demand = Percentage Change in Quantity Demanded

Percentage Change in Price
PED = % ΔQD ÷ % Δ P
The percentage change in quantity demanded is obtained as follows:
New Quantity Demanded – Original Quantity Demanded × 100
Original Quantity Demanded
The percentage change in price is obtained as follows:
New Price – Original Price × 100
Original Price
The elasticity of demand for a product can be:
 Perfectly elastic
 Perfectly inelastic
 Elastic
 Inelastic
 Unitary

Price elastic demand

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For example, calculate the price elasticity of demand for the product.
PED= [(500-300/300) *100] / [(60-80/80) *100]
= 66.67 / 25   = -2.67
In this example, the PED is -2.67, that is, the % change in quantity demanded was higher than
the % change in the price. This means, a change in price makes a higher change in quantity
demanded. These products have a price elastic demand.  Their values for price elastic demand
are always above 1.

Price inelastic demand

When the % change in quantity demanded is lesser than the % change in price, it is said to have
a price inelastic demand. The values or price inelastic demand are always below 1. A change in
price results to a smaller change in demand.

Unitary price elastic demand

When the % change in demand and price are equal, i.e. the value of PED is 1, it is
called unitary price elastic demand as shown below.

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Perfectly elastic demand

When the quantity demanded changes without any changes in price itself, it is said to have
an infinitely price elastic demand. The value of price elasticity of demand is infinite (∞).

Perfectly inelastic demand

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When the price changes have no effect on demand whatsoever, it is said to have a perfect
price inelastic demand. The value of price elasticity of demand is 0.

Determinants of price elasticity of demand

1. The availability and number of substitutes: goods that have close substitutes will tend
to have elastic demand because consumers can easily switch from one product to
another. On the other hand, if there are few or no real substitutes for a product,
demand will be inelastic.
2. Whether the Good is a Necessity or a luxury: goods considered to be ‘essential’ by
consumers will have inelastic demand. This is because if the prices of essentials such as
food and fuel increases, consumers cannot reduce their purchase significantly – they are
necessities. While the demand for luxury products like boats, sport cars and holidays –
will have more elastic demand. If a product is a habit forming it may become necessity
and therefore it will have inelastic demand.
3. The proportion of income spent on the good: goods that take up a large proportion of
consumers’ incomes have an elastic demand, while those that take up only a small
proportion of income have an inelastic demand.
4. Time period – in the short run, goods have an inelastic demand. This is because it can
often take time for consumers to find substitutes when price rises for example. In the
long term, demand is more elastic because consumers can search for alternatives and
more prepared to switch.
5. Goods which can be stored or whose use can be postponed: these have an elastic
demand. A fall in price will lead to a more than proportionate extension of demand
since people can store them until when they need to use them. Similarly, a rise in their
price will cause a large contraction of demand as people postpone their demand until
when prices are favorable.

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 6. Advertising: successful advertising creates brand loyalty. Consumers identify with the
product and are willing to consume it at whatever the price. This makes the demand for
the good inelastic.

Significance of PED
1. For the Government: governments must consider PED when determining their tax policies.
Taxes cause prices to rise. A tax on good whose demand is elastic will cause a more than
proportionate fall in quantity demanded, thereby reducing tax revenues. It is important for
governments to select products which have an inelastic demand to tax. This is because
consumers will avoid heavily taxed products if demand for them is elastic.

2. For producers/ Business -Producers can calculate the PED of their product and take a
suitable action to make the product more profitable. Revenue is the amount of money a
producer/firm generates from sales, i.e., Quantity sold * Price. So, as the price or the
quantity sold changes, those changes have a direct effect on revenue.
 If the product is found to have an elastic demand, the producer can lower prices to
increase revenue. The law of demand states that a price fall increases the demand.
And since it is an elastic product (change in demand is higher than change in price),
the demand of the product will increase highly. The producers get more revenue.
 If the product is found to have an inelastic demand, the producer can raise prices
to increase revenue. Since quantity demanded wouldn’t fall much as it is inelastic,
the high prices will make way for higher revenue and thus higher profits.

3. For Trade Unions: when trade unions are bargaining for increased wages for their
members, they consider the PED for the goods produced by that labor. This is because a rise
in wages leads to a rise in prices. If the demand is elastic, it means that the rise in price due
to a rise in wages will have a negative effect on the industry, as sales will fall. This in turn
may lead to job losses. But if the demand for the goods is inelastic, then the trade unions
can comfortably bargain for higher wages, knowing that the resulting increase in price will
neither reduce total revenue nor employability of its members.

2.8 Price elasticity of supply (PES)

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The PES of a product refers to the responsiveness of its quantity supplied it to changes in its
price.
PES of a product=   %change in quantity supplied / %change in price

PES = Percentage change in Quantity Supplied

Percentage change in Price

Example:1
Calculate PES when the price falls from $5 to $ 4 causing a contraction in supply from 10 000
units to 4 000 units.
PES = %ΔQS
%ΔP
%ΔQS = New supply – old supply × 100 = 4000 – 10000 × 100 = -6/10×100 = -60%
Old supply 10000
%ΔP = New price – old price × 100 = $4 - $5 × 100 =-1/5×100 = -20%
Old price $5
PES = -60% ÷ -20% = 3

Since supply varies directly with price, PES is always positive.

Example 2

A firm’s market price increases from £1 to £1.10, and its supply increases from 10m to 12.5m.
Calculate PES

Degrees of price elasticity of supply

The supply of a commodity can be:

 Perfectly elastic
 Perfectly inelastic
 Elastic
 Inelastic
 Unitary

Perfectly Elastic Supply

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This is when a change in price causes a complete change in quantity supplied. PES=infinity Due
to spare capacity that exists, suppliers are able to raise output at the current price level.
Price

P S

Q1 Q2
Quantity
A change in price would drop quantity supplied to zero. Supplied

Perfectly Inelastic Supply

This is when quantity supplied does not change when price changes. PES = zero. This suggests
that there is absolutely no spare capacity for suppliers to raise output irrespective of increases
Price

in prices.
P1
P
O
Q
Quantity Supplied

Elastic Supply

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This is when a change in price brings a more than proportionate change in quantity supplied.
The PES is greater than one but less than infinity (1<PES<∞).

Provided firms have spare capacity the supply of many manufactured products is elastic.

S
Price

P1

Q Q1 Quantity Supplied

Inelastic Supply

This is when a change in price brings a less than proportionate change in quantity supplied.
PES is less than one (1>PES) S

Price

P1

Determinants of price elasticity of supply

Q Q1
Quantity Supplied 23
  Number of firms (1)- Supply will be elastic in competitive a market as there are more
firms supplying the market and responding to price changes than in less competitive
markets (1)
 Existence of spare capacity (1)- if a firm has spare or excess capacity, will be able to
respond to a price increase quickly making supply elastic (1) If the firm is operating
at full capacity supply will be inelastic.
 Ease of accumulating stocks (1)- producers that hold stocks of goods can respond
quickly to price changes so supply will be elastic (1) However, where it is impossible
or expensive to hold stocks, supply will be inelastic.
 Ease of entry into the market (1)- supply will be inelastic if it’s difficult for new firms
to enter the industry as supply is restricted. (1)
 Time (1) -Supply will be elastic in the long run as firms have greater ability to adjust
to price changes than in the short run (1).
 Ease of factor substitution (1) – Supply will be elastic if factors of production can
easily be shifted/ switched from one use to another (1)
 Length of the production period (gestation period) (1) a good that takes a long time
to produce (e.g. agricultural commodities) has an inelastic supply while one that
takes a short time to produce (e.g. manufactured goods) has elastic supply. (1)
 Availability of resources: More resource (land, labour, capital) will make way for an
elastic supply. If there are not enough resources, producers will find it difficult to
adjust to the price changes, and supply will become price inelastic.

Significance of PES

The price elasticity of supply can affect consumers, producers and government

PES and consumers

Consumers benefit from supply being elastic. This is because it means supply is responsive to
consumer demand. If demand increases, price will rise. If supply is elastic, the quantity supplied
will rise by a greater percentage than the change in price. This means sales may rise
significantly without there being a large increase in price.

PES and producers

Producers want their supply to be as elastic as possible. If suppliers can quickly adjust their
supply in response to changes in demand (and hence price), their profits will be higher.

PES and Government

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Elastic supply can be used by the government to increase output. One way the government can
help firms increase the supply of product is by giving a subsidy. A subsidy is a payment by a
government to encourage the production or consumption of a product.

2.9 Market economic system

The market economic system is a system where resources are owned, planned and allocated
privately. In such a system, resources move automatically as a result of changes in price. These
price changes are determined by interaction of demand and supply. Resources will be allocated
more on goods with high and demand and less to those with decreasing demand.

Features
 Private property: All resources are privately owned by people and firms.
 Profit motive: Profit is the main motive of all businesses; hence they produce those
products that offer them high profit.
 There is no government interference in the business activities.
 Freedom of choice Consumers are free to choose what they want. Workers are free to
choose which occupations they will enter. Producers are free to produce what they
want, how much they want and for whom they want to produce.
 Prices are decided by the Price mechanism/market mechanism, i.e. the demand and
supply of the good/service.
 A very limited role of the government. Its activities may include establishing law and
order, coming up with a form of money and ensuring competition continues to exist in
business.
 Competition forces the firms to be efficient. This may result into production of quality
good at cheaper price.

Advantages
i. Consumer control: consumers have the power to influence what is produced. By
purchasing more of some goods and less of the others, they influence what producers
supply.
ii. Free market responds quickly to the people’s wants: Thus, firms will produce what
people want because it is more profitable whereas anything which is not demanded will
be taken out of production.
iii. Wide Variety of goods and services: That is available in the market to suit everybody’s
taste.
iv. Efficient use of resources encouraged: Profit being the sole motive, will drive the firms
to produce goods and services at lower cost and more efficiently. This will lead to firms
using latest technology to produce at lower costs.
v. Economic growth encouraged. This is because free-market system offers a reward-and
penalty signaling system to its participants. There is incentive to increase productivity
because of the reward (profit). Because of the penalty of losses or reduced profits,
resources do not stay in areas where consumer demand no longer exists.

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 vi. Low costs and prices. The profit motive and competition promotes efficiency. This in
turn allows firms to charge lower prices due to low costs achieved by efficiency.

Disadvantages
i. Unemployment: Businesses in the market economy will only employ those factors of
production which will be profitable and thus we may find a lot of unemployment as
more machines and less labour will be used to cut cost.
ii. Certain goods and services may not be provided: Those which people might want to
use but don’t want to pay may not be available because the firms may not find it
profitable to produce. For example, Public goods, such as, street lighting and merit
goods such healthcare and education may be under produced or consumed because of
the free rider problem, which means people can benefit from the service even if they do
not pay for them. Such goods are also non-excludable, which means it is not possible to
restrict those who do not pay from using the good.
iii. Consumption of harmful goods may be encouraged: Free market economy might find it
profitable to provide goods which are in demand and ignore the fact that they might be
harmful for the society.
iv. Ignore Social cost: In the desire to maximize profits businesses might not consider the
social effects of their actions. As a result, an individual or firm making a decision does
not have to pay the full cost of the decision.
v. Pollution created by firms due to production activities is an example of negative
production externality.
vi. Unequal distribution of income and wealth: in a market system few who own resources
such as land and capital might be very rich compared with majority of the people who
would probably own just one resource – their labour.
vii. Economic instability: there exist cyclical pattern of booms and slumps. During periods of
boom, output and employment rises and vice versa during a slump
viii. Existence of monopoly – because of the limited role played by the government, it is easy
for large businesses to run smaller ones out of business and remain as monopolies in
the market. This may allow them to exploit customers.
N/B
There are two other economic systems:
 Command/ Planned economy.
 Mixed economy.

2.10 Market failure

Market failure occurs when market forces fail to produce the products that consumers demand
in the right quantities and at the lowest possible cost.

Causes of market failure

i. Existence of externalities

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 ii. Missing markets-Due to lack of public goods, such as defence, street lighting, and
highways. the free-rider problem; non-provision of public goods
iii. Incomplete markets- Under provision of merit goods such as education and healthcare.
Overprovision of demerit goods- like cigarettes and alcohol.
iv. Environmental degradation.
v. Immobility of factors of production.
vi. Problems of information-Information failure.
vii. Abuse of monopoly power.

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Definition of key terms in market failure
a) Private Benefit (PB) is the benefit which is derived by private individuals in the consumption
or production of a good or service.
Examples of Private Benefit include profit, salary, medical schemes, experience, job security,
education allowance, retirement benefits and entertainment benefits.
b) External benefit (EB) is the benefit from consumption or production of a good or service
that people other than the consumer enjoy.
Examples of External Benefit include a bee keeper produces honey, but as an external benefit,
his bees help to fertilize nearby fruit trees; Vaccination against communicable diseases; Cycling
to work helps to reduce the level of pollution and congestion, therefore other road users have
quicker journey times.
c) Social Benefit (SB) is the benefit enjoyed by the entire society, both by the consumer and by
everyone else.
SB=PB+EB
d) Private Cost (PC) is the cost of producing a good or service that is paid by the producer
Examples of Private Cost include wages paid to workers, salaries paid to workers, plant,
machinery, transport, equipment, vehicles.
e) External cost (EC) - the cost of producing or consuming a good or service that falls on other
people other than the consumer or producer.

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Examples of external Cost include greater congestion and slower journey times for other
drivers, cause of death for pedestrians, cyclists and other road users, pollution e.g. noise and air
pollution, health related problems.
f) Social Cost (SC) is the total cost to society as a whole for production of goods and services SC
= PC + EC
i. Externalities
Economic activity, such as building a new factory or transporting a tanker full of oil from Qatar
to Japan, will affect those inside the business. However, economic activity can also have an
impact on the outside. There are spillover effects that may be positive or negative.
Social cost
The production or consumption of a good will have costs. These are divided into private costs
and externalities.
Private costs are met by those who consume or produce a good. Externalities are the spillover
effects of production or consumption. They affect others and can be positive or negative.
Negative are the costs that are not met by those who impose them. Social costs are the costs
that the society as a whole has to meet and are the sum of both private and external costs
(negative externalities).

SOCIAL COST = PRIVATE COST + EXTERNAL COST

Social benefits
The production or consumption of a good will also have benefits. These are divided into private
benefits and positive externalities. Private benefits are enjoyed by those who produce consume
a good. Positive externalities include the removal of an eyesore and creation of employment.
The benefits to the society as a whole of an economic activity, the social benefits, are made up
of private benefits and external benefits (positive externalities).

SOCIAL BENEFIT = PRIVATE BENEFIT + EXTERNAL BENEFIT

Examples of externalities are traffic congestion, noise pollution, air pollution, water pollution,
overcrowding and resource depletion.
Social costs and social benefits of consumption
The consumption of a good can also result in externalities. For example, a college student who
buys a small car for $2,000. The social costs and benefits are;
i. Private cost = $ 2,000 + any other running costs such as fuel and insurance.
ii. External cost = the pollution resulting from exhaust fumes and the contribution of
congestion.
iii. Private benefit = the convenience and flexibility which car – owning provides
iv. External benefit = the possible free lifts given to friends and family in the car.
Types of Externalities
Externalities can result either from consumption activities or from production activities. There
are four types of Externalities
 Negative externality
 Positive externality

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Negative externalities
 Negative spill-over effects of production or consumption that affect people or
organizations that were not part of decision making.
For example
 Road congestion.-As individuals 'consume' road-space they reduce available road-space
and deny this space to others.
 Smoking-by smoking in public places, the consumer is creating negative externalities, in
the form of passive smoking, for non-smokers.
 Using fossil fuels that pollute atmosphere
 Playing loud music and disturbing neighbors
 Discarding garbage in public places
 Also if individuals consume alcohol, get intoxicated and do harm to the property of
innocent third parties, a negative consumption externality has arisen.

Demerit goods
Demerit goods are goods which are deemed to be socially undesirable, and which are likely to
be over-produced and over-consumed through the market mechanism.
Examples of demerit goods are cigarettes, alcohol and other addictive drugs such as heroin and
cocaine.
The consumption of demerit goods imposes considerable negative externalities on society as a
whole, such that the private costs incurred by the individual consumer are less than the social
costs experienced by society in general:
For example,
Cigarette smokers not only damage their own health, but also impose a cost on society in terms
of those who involuntarily passively smoke and the additional cost to the National Health
Service in dealing with smoking related diseases.

Positive externalities
Positive spill-over effects of production or consumption that affect people or organizations that
were not part of decision making. Third-parties include any individual, organization, property
owner, or resource that is indirectly affected. While individuals who benefit from positive
externalities without paying are considered to be free-riders, it may be in the interests of
society to encourage free-riders to consume goods which generate substantial external
benefits.

ii. Merit goods – Incomplete market

Most merit goods generate positive consumption externalities; which beneficiaries do not pay
for. For example, with healthcare, private treatment for contagious diseases provides a
considerable benefit to others, for which they do not pay. Similarly, with education, the skills
acquired and knowledge learnt at university can benefit the wider community in many ways.
The market for merit goods is an example of an incomplete market.
Merit goods have two basic characteristics:

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 
Firstly, unlike a private good, the net private benefit to the consumer is not fully
recognized at the time of consumption. In the case of education, which is widely
considered to be a merit good, pupils and students cannot possibly know the specific
private benefit to them of getting good grades at school, college or university. They will
be well aware of the sacrifice required to study, but will not know the benefits to them
in terms of a future job, salary, status and skills. Therefore, with education, as with
other merit goods, there is a significant information failure in terms of expected
benefits.
 Secondly, while consumption of a merit good also generates an external benefit to
others, from which society gains, this is unlikely to be known or recognized at the point
of consumption. Given that decisions to consume are driven by self-interest, it is
unlikely that this external benefit will be taken into account when the consumer of a
merit good evaluates its worth.
For example, an individual student is generally not motivated to study hard in order to benefit
others later in life, although everyone associated with them will benefit from their education in
some way. Beneficiaries include future employers and all those who consume the products
supplied their employer, their family, and friends. The better job they obtain, the more tax they
will pay, and the greater the benefit to those who receive welfare benefits and transfers.
However, putting a value on these external benefits is impossible, especially at the point of
learning.
Healthcare : Healthcare is also regarded as merit good. For example, although it is not possible
to know exactly when the benefit will arise, inoculation against a contagious disease clearly
provides protection to the individual, and yields a private benefit. There is also an external
benefit to other individuals who are protected from catching the disease from those who are
inoculated. However, few would choose inoculation simply to protect others.

Private goods
Goods consumed by someone and not available to anyone else. Most goods consumed on a
daily basis are private goods. They have two characteristics:
a) They are excludable – only people willing to pay their price will consume the goods.
b) They have rivalry – the consumption by one person reduces their availability to another
person.

iii. Non-provision of public goods

Public goods are those the private sector would underprovide by the private sector because
they are difficult to charge to individuals because of their non-rivalry and non-excludability.
Their consumption results in people consuming them without paying. Such individuals are
known as free riders. For this reason, they are provided by the public sector and paid for
through taxes.
Non-excludability means that once the good is provided for one consumer, it is impossible to
stop all other consumers from benefitting from the good, while non-rivalry means that as more
people consume the good, the benefit to those already consuming the good will not diminish/

31
reduce. When combined, these three characteristics deter potential suppliers because it would
be impossible to charge users at the point of use.

Why will suppliers not be able to charge?

Suppliers cannot charge at the point of consumption or use because of the free-rider problem.
No one would pay because the first person to pay for supply creates a free supply for everyone
else! No one can be excluded from the market and prevented from consuming, and hence they
are encouraged to become free-riders.
Because of this, suppliers are not able to generate any revenue, or make a profit, so a necessary
condition for the formation of a market is absent, namely the absence of a profit incentive.
With no incentive, entry into the market is deterred, resulting in a missing market.
Common examples
 Defense,
 Public fireworks,
 Lighthouses,
 Clean air,
 Street light.

iv. Abuse of monopoly power.

Monopoly power occurs when a firm has market dominance in an industry for example, more
than 40% market share. Abuse of monopoly power could involve setting higher prices or
limiting output. Abuse of monopoly power can lead to deadweight welfare loss, less choice, and
problems for suppliers.

Deadweight loss is the cost to the

society due to the market inefficiencies

Evidence of Abusing Monopoly Power

 Charging excessively high prices. This might be difficult to judge, but if they are making
high profits then this is an indication that prices are higher than in a competitive
situation.
 Predatory Pricing. This involves cutting prices and selling below average cost to force
rivals out of business.
 Exclusive distribution. Some retailers will only buy from some particular manufacturers.
 Tie in sales. E.g. if you buy a printer the company will try and make you buy their own
brand ink.

The costs of monopoly

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1. Less choice: Clearly, consumers have less choice if supply is controlled by a monopolist – for
example, the Post Office used to be monopoly supplier of letter collection and delivery services
across the UK and consumers had no alternative letter collection and delivery service.
2. High prices: Monopolies can exploit their position and charge high prices, because
consumers have no alternative. This is especially problematic if the product is a basic necessity,
like water.
3. Restricted output: Monopolists can also restrict output onto the market to exploit its
dominant position over a period of time, or to drive up price.
4. Less consumer surplus: There is asymmetric information – the monopolist may know more
than the consumer and can exploit this knowledge to its own advantage.
5. Productive inefficiency: Monopolies may be productively inefficient because there are no
direct competitors a monopolist has no incentive to reduce average costs to a minimum, with
the result that they are likely to be productively inefficient.

Monopoly is a single seller.

Price fixing refers to when two or more firms

agree to sell a product at the same price.

v. Immobility of resources
It occurs when it is difficult to move resources between different areas of the economy. The
resources in this case are both geographically and occupationally immobile e.g. demand for a
country’s financial services may be increasing while the demand for its steel is decreasing.
There may be a shortage of financial services, unemployment of workers and under-utilization
of capital equipment if resources cannot easily move between the two.

vi. Short termism

A high allocation of resources to consumer goods may result to high living standards in the
short run, but a shortage in the future. Such a situation is known as short termism. The interest
to make quick profit may result in little or no ivestment for the future. This may result in little
capital goods investment and government may have to cut taxes or give services to private
sector firms to encourage them to invested.

2.11 Mixed economic system

A Mixed economy is a market composed of the private and public sector. Public sector is a part
of the economy owned and controlled by the government while the private sector is owned
and controlled by individuals. Private sector covers organizations owned by individuals and
shareholders while the public sector covers government run services and state-owned
enterprises (SOEs).
All economies are mixed to a certain extent because there is some level government
intervention in all economies, and some private sector production. Some countries are however

33
more of market economies where the public sector has very little roles. Such countries include
the USA.
In such an economic system, both the government and the consumers influence what is
produced.
The following are benefits of government intervention in a mixed economy:
 Government considers cost and benefits before arriving at a decision. This means even if
consumption of a product will not be profitable but it has a greater benefit to the
society, then the government will provide it.
 Government can discourage consumption of demerit goods by taxing them, passing
legislation or providing information.
 Government can encourage consumption of a product that is more beneficial for
consumers such as merit goods by granting subsidies, providing information or passing
legislation.
 Government can finance production of public goods.
 Government can prevent private sector firms from exploiting consumers by charging
higher prices.
 Government will seek to maximize use of resources.
 Government will plan for the future hence allocates enough resources to acquire capital
goods.

Government policies to deal with externalities

A government will want to discourage economic activities that result in negative externalities
and encourage those that result in positive externalities. The government uses following
measures to deal with negative externalities,
1. Taxation
If a tax is imposed on a firm that produces damaging emissions, production costs will
increase and the prices charged by the firm will rise. This should result in a fall in
demand for the firm’s product and therefore a reduction in pollution.

2. Subsidies
The government can offer grants, tax allowances and other subsidies to firms as an
incentive to reduce externalities. For example, a firm may receive a subsidy if it builds a
plastics recycling plant. This might encourage households and firms to recycle their

34
 plastic waste instead of dumping it. The government can also give subsidies to firms that
generate positive externalities.

3. Fines
In some countries fines are imposed on those who damage the environment.
4. Government regulations.
Pressure has grown on government in recent years to pass more legislation to protect
the environment. Much of the pressure has emerged due to growing concerns about
global warming. In UK, for example, the Environment Act 1995 was set up to monitor
and control pollution. It also laid down regulations relating to contaminated land,
abandoned mines, national parks, air quality and waste.

5. Tradable permits.

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 Tradable-permit system in which a greenhouse gases (carbon) emitter can buy/sell
permission to emit a certain amount of emissions from/to other emitters (who are
below/above their limit). Tradable permits provide an incentive to polluters to
‘internalize' the externality. Tradable permits to pollute involve the government, or an
appointed agency, selling the right to generate a given quantity of pollution to firms in
an industry. These can be bought, and traded, with the result being:
 The high polluters have to buy more permits, which increases their costs, and makes
them less competitive and less profitable.
 The low polluters receive extra revenue from selling their surplus permits, which
makes them more competitive and more profitable.
 There is clearly an incentive to be a non-polluter!
6. Maximum and minimum prices
A maximum price/ price ceiling occurs when a government sets a legal limit on the price of a
good or service with the aim of reducing prices below the market equilibrium price.
In some markets, governments intervene to keep prices of certain items higher or lower than
what would result from the market finding its own equilibrium price
A price ceiling occurs when the government puts a legal limit on how high the price of a product
can be. In order for a price ceiling to be effective, it must be set below the natural market
equilibrium. It is also known as maximum price. If the maximum price is set above the
equilibrium price, then it will have no effect.

Reasons for maximum price

Maximum prices involve the government making a normative judgment that the market
clearing price is too high, and needs to be reduced. The government may impose a maximum
price for a variety of reasons.
The good is essential for daily living – without a maximum price some people may be unable to
afford the good. By reducing the price, it can help reduce relative poverty.

36
Monopoly exploitation. If firms have monopoly power, they can charge high prices to
consumers – higher than the marginal cost of production and higher than in a competitive
market.
However, if supply is very inelastic, then a maximum price will not reduce the supply of the
good, therefore, there will be no fall in the quantity supplied.
Examples of maximum prices
 Maximum prices for train tickets. With monopoly power, train companies could increase
the peak tickets, but governments may impose a maximum price for rent. Governments
have tried different types of rent control – keeping the cost of renting below a certain
level.
 Maximum price for food. In some developing economies, there are maximum prices for
certain foodstuffs to keep them affordable.
Problems of maximum prices
 Existence of black market: Due to demand exceeding the supply, there will be buyers
who will be willing to purchase the good at a higher price. This will lead to existence of
black market.
 Shortage. A maximum price distorts the market and leads to disequilibrium. The
demand is greater than supply meaning many consumers will be unable to get the
product at all. Cheap rents are no good, if it leaves many people homeless.
 Queues. One consequence of a maximum price is that people will end up queuing to try
and get the good before it sells out. This will encourage people to spend longer and
longer in queues before it runs out. This time spent queuing represents a significant cost
in terms of time.
 The market will become less profitable for firms. In the long-term this may lead to less
investment and also decrease supply in the long-term. For example, rent controls may
be a way to deal with the short-term problem of expensive housing. But, reducing rents
will discourage some landlords from letting out property. It may also discourage people
from building houses.

Minimum prices or price floors

A price floor is a government imposed price limit on how low a price can be charged for a
product. A price floor must be higher than the equilibrium price in order to be effective.
A minimum allowable price set above the equilibrium price is a price floor. With a price floor,
the government forbids a price below the minimum Price Floors are minimum prices set by the
government for certain commodities and services that it believes are being sold in an unfair
market with too low of a price and thus their producers deserve some assistance.

37
Government might set Minimum prices to raise incomes for producers such a farmers and
protect them from frequent fluctuations in the commodity market. To protect workers and
ensure that they get a enough wages to sustain a reasonable standard of living.
Examples of price floors
In many countries governments assist farmers by setting price floors in agricultural markets.
Setting Minimum wages for certain occupations is also an example of price floors.

7. Competition policy
Competition policy is the structures governments have in place for the regulation of markets
and monopolies.
Competition policy generally aims to:
 Prevent growth of Monopoly power
 Prevent abuse of Monopoly power and restrictive trading practices
 Investigate suspected abuses of monopoly power and recommend policy decision.
 Reduce barriers to entry and keep markets contestable.
8. Environmental agencies
Environmental agencies are responsible for taking action against companies who don’t abide by
regulations pertaining to the benefit of the environment. They can help firms by looking after
wildlife, reducing waste, working with farmers and giving advice on how to protect the
environment.

9. Road pricing and charges

Causing congestions and pollution can result in charges to the road user(s) causing it. For
example, in London, Drivers were charged with a fixed rate for entering a designated central
London zone. 12 months later it was claimed that traffic had been cut by 18% and delays were
down 30%

10. Nationalization and privatization

Privatization is the transfer of public sector resources to the private sector.

38
Form of privatization
1. Sale of nationalized industries
Nationalized industries: public corporations previously part of the private sector which were
taken into state ownership
 Natural monopolies (more efficient under state control) but sold off and owned by private
shareholders
2. Contracting out
Where private contractors are given a chance to offer for services previously supplied by the
public sector
Government and local authority have been ‘contracted out’ to private sector business
3. The sale of land and property
Tenants have their own right to buy their own houses
WHY DOES PRIVATIZATION TAKE PLACE?
i. To generate income
Sale of state assets make income for the government
ii. Nationalized industries/Public sector organization were inefficient
- Lack of incentive to make a profit and often made losses
- In private sector, would have to cut cost, improve services and return profits to shareholders
- In private sector it would also be more accountable
iii. To reduce political interference
In private sector, the government could not use these firms for political aims. Firms would be
free to determine their own investment levels, prices, product ranges, growth rate etc.

Effects of privatization on Consumers

Higher competition means lower prices, increased quality and innovation. Prices have fallen (for
example telephone services, gas and electricity).
However, exploitation may occur. Prices have risen sharply too (for example rail travel and
water).
More unemployment as focus on efficiency means introduction of machinery hence cutting
back on staffing levels
In effort to improve efficiency, workers may have been pressurized to raise their productivity
(For example, have been asked to adopt more flexible working practices).

Effects of privatization on Firms

 Objectives have changed to maximize profit
Profit increased after privatization
 Increased investment levels
For example, water companies after privatization raised investment level to fund new sewerage
system and purification plants
Effects of privatization on Government
 No longer responsible for running the privatized firms - focus more sharply on the
government business
 Money earned from privatization is huge. However, often governments sell them off too
cheaply.

39
  Increase in company profits means greater tax revenue.
 Privatized firms do not have to be subsidized.
 Governments no longer take profits from firm.
Effects of privatization on The Economy/economy
Businesses in the economy will run more efficiently because of increased competition. Increase
in efficiency results to higher growth.
Privatization would lower costs and improve quality of services
However;
 Unemployment may rise.
 Inflation may become unstable.
 Negative externalities may increase.
 It may be difficult to evaluate the overall effect of privatization on the economy.

11. Nationalization
Refers to moving ownership and control of an industry from the private sector to the
government. The firm becomes a public corporation.

A public corporation is a business organization

owned by the government and designed to act in
public interest.

Advantages of nationalization

40
12. DIRECT PROVISION

41
GOVERNMENT FAILURE
Government failure is a situation where government intervention in the economy to correct a
market failure creates inefficiency and leads to a misallocation of scarce resources.
Government failure’ as intervention that results in a net welfare loss.
Government intervention to resolve market failures can also fail to achieve a socially efficient
allocation of resources. Government failure is a situation where government intervention in the
economy to correct a market failure creates inefficiency and leads to a misallocation of scarce
resources.
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 providing 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.
4. Information failure is also an issue for governments, given that government does not
necessarily ‘know’ enough to enable it to make effective decisions about the best way to
allocate scarce resources. Many economists believe in the efficient market hypothesis, which
assumes that the market will always contain more information than any individual or
government. The implication is that market prices and market movements should be free from
interference because markets cannot be improved upon by individuals or governments.
5. Lack of incentives: In the public sector, there is limited or no profit motive. Because workers
and managers lack incentives to improve services and cut costs it can lead to inefficiency. For
example, the public sector may be more prone to over-staffing. The government may be
reluctant to make people redundant because of the political costs associated with
unemployment.
6. Political interference e.g. politicians may take the short term view rather than considering
long term effects

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Overcoming government failure
There are various things the government can try and do to overcome government failure:
 Give performance targets / profit incentives
Competitive tendering – where public sector bodies face competition from the private sector
for the right to run a public service. Employing outside private sector consultants to make
decisions about how to cut

43