ECONOMICS
STUDY NOTES
#MATRIC
Chapter 5: PROTECTIONISM AND FREE
TRADE
PROTECTIONISM AND FREE TRADE
EXPORT PROMOTION
INTRODUCTION


Industrial development and growth depend on trade.
"When goods do not cross borders, soldiers will." - F. Bastiat
DEFINITION

An outward-looking policy where governments pay incentives to encourage the production of
goods & services that can be exported.
REASONS






The idea is to eventually achieve significant export-led economic growth.
It enlarges the production capacity of a country as more manufacturing industries are being
established.
Much bigger markets become available.
The greater volumes of production will require more employment.
The use of mass production will reduce cost per unit and therefore leads to lower prices.
Foreign exchange will be earned.
METHODS
Incentives
 The idea is to make the effort of exporting less daunting in order to get producers to export an
increasing amount of their production.
 Provide producers with information on export markets.
 Research is done with regard to new markets.
 Concessions on transport charges are given to producers.
 Credit facilities are made available specifically for exports.
 Publicity when successful exporters are being commended.
Subsidies
 The idea is to help reduce production cost of producers (artificially).
 Cash payments are made to exporters.
 Refunds are given on import tariffs.
 General tax rebates are given to producers.
 Tax concessions on profits made from exports or on capital invested to produce export goods.
 Employment subsidies are provided to producers.
 Assistance is provided in financing exports.
ADVANTAGES






There is no limitations of size and scale since the world market is very large.
Production is based on cost and efficiency considerations and is organised along the lines of
comparative advantage.
Domestic production is also stimulated in related industries.
Foreign exchange will be earned, positively affecting the trade balance.
Increased levels of production reduce unemployment levels.
The production capacity of a country is enlarged allowing for higher GDP.
DISADVANTAGES




The real cost of production is hidden by subsidies and incentives.
There is less competition as other businesses are forced out of the market.
There may be increased tariffs and quotas from other countries in retaliation.
Developed countries protect their labour-intensive industries and developing countries that
might have the comparative advantage simply can't compete.
IMPORT SUBSTITUTION
INTRODUCTION


Expenditure on imports is a leakage and countries need to make sure they only import those
goods that are really necessary.
The rest needs to be produced domestically, especially if there is a comparative advantage
present.
DEFINITION


An inward-looking policy where governments reduce the imports of goods & services by
replacing them with domestic production.
This won't be possible without establishing or expanding domestic manufacturing industries.
REASONS





Developing countries can diversify their economies through industrialisation.
Infant industries are protected during times of establishment.
It creates an opportunity to eventually export manufactured goods in stead of raw materials.
Balance of Payments problems can be solved or at least addressed more efficiently.
Import substitution is easier to implement in the short run.
METHODS
Tariffs
 It is also known as customs duties or import duties and is basically taxes on imports.
 They can be ad valorem (percentage of the value) or specific (amount per unit).
 The desired effect is to make imports more expensive and force consumers to shift their
demand to domestically produced goods & services.
Quotas
 It is a limit on the supply of a good or service
 There is a restriction on the quantity of a product that may be imported into a country.
 The desired effect is to reduce supply of a product and to push up the price.
Subsidies
 Subsidies on transport costs or subsidies on employment, used for export promotion, may also
be used to protect them indirectly.
 These producers will then be able to undercut foreign businesses in the domestic market.
Exchange control
 Governments can limit the amount of foreign exchange made available for importers.
 This will require that all foreign exchange earnings be handed over to the central bank.
 Those who need to make foreign payments will then need to apply to the central bank.
Physical controls
 This will take the form of a complete ban on the import or export of a certain good or service.
 Also known as an embargo or a boycott.
 This is the most extreme form of protection.
Diverting trade
 The idea is to make importing more difficult.
 Import deposits may be required by governments before they allow a country to import to their
country.
 Time-consuming customs procedures may be imposed.
 Unnecessarily high quality standards may be imposed on imported goods.
ADVANTAGES






There will be increased domestic employment and GDP growth.
As certain imports decrease, more foreign exchange becomes available for other imports and
this will increase the variety that consumers can choose from.
There is diversification of the domestic economy as a bigger variety of goods & services are now
produced domestically.
Infant industries are protected from foreign competition.
The trade balance should improve.
Less foreign exchange will be demanded, strengthening the rand.
DISADVANTAGES






Capital and entrepreneurial talent are drawn away from the areas of comparative advantage.
Technology is often borrowed from abroad and may not be suitable for the country's production
structure.
It lowers the competitiveness of sectors where a comparative advantage does exist.
Businesses may become too dependent on protection.
The stronger rand will make our exports less competitive.
We can't afford to reduce imports on certain capital goods.
SCEPTICISM



Domestic producers are isolated from foreign competition and never fully develop as there is no
real need to strive for maximum efficiency.
Industrialisation does not necessarily advance and a country may be left with only adding the
finishing touches to imported products.
Consumers may end up paying higher prices for goods of inferior quality.
PROTECTIONISM
INTRODUCTION
Protectionism is the economic policy of restraining trade between countries through methods such as
tariffs, quotas and a variety of other government regulations designed to allow fair competition
between imports and goods & services produced domestically.
ARGUMENTS FOR





It creates an opportunity for industrial development of the economy.
It will help countries to become more self-sufficient.
The dangers of dumping will be prevented.
There is protection of infant industries.
It will lead to more government revenue.
FREE TRADE
INTRODUCTION
 Free trade occurs when there are no barriers to trade or at least no artificial barriers to trade.
ARGUMENTS FOR
 There is reduced production cost per unit as economies of scale are being maximised.
 There is bigger variety available for consumers as they are not limited to what is supplied
domestically.
 Free trade implies more competition providing a strong incentive to innovate and to pursue best
practice.
 Better foreign relations are often an unintended result of free trade.
 Consumers experience welfare gains.
DESIRABLE MIX
INTRODUCTION



Countries may decide to diversify step by step.
Depending on the stage of development and other macroeconomic objectives, the government
will adopt a trade policy that best suits the country's needs.
There are very often trade-offs where a trade policy solves one economic problem, but creates
another.
IMPORT SUBSTITUTION AND EXPORT PROMOTION


These two policies should not be regarded as unavoidable opposites.
Import substitution almost inevitably leads to export promotion.


A dual strategy of combining import substitution with export promotion is also feasible.
Outward-oriented countries outperformed inward-oriented countries.
GLOBALISATION




Restrictive practices from import substitution and from export promotion have the same effect.
They reduce the potential volume of world production.
The World Trade Organisation (WTO) pursues the objective of free trade as an independent
facilitator.
They have four main functions
- Administration and implementation of multilateral trade agreements.
- Acting as a forum for multilateral trade negotiations.
- Seeking to resolve trade disputes.
- Supervising the review of national trade policies.
TRADE PROTOCOLS
Free Trade Areas



Member countries agree to remove all tariffs and quotas amongst each other.
They still use protectionism against non-member countries.
Examples - COMESA, EFTA, SADC
Customs Union



Member countries agree to remove all tariffs and quotas amongst each other.
They also have the same level of protectionism against non-member countries.
Example – SACU
Common Market




Member countries agree to remove all tariffs and quotas amongst each other.
They also have the same level of protectionism against non-member countries.
There is free movement of factors of production between member countries.
Example - Mercosur
Economic Union



This is the highest form of economic integration.
Member countries adopt a single currency, monetary policy and fiscal policy.
Example – EU
EVALUATION OF SA's POLICIES
INTRODUCTION

We need to keep in mind that South Africa did not enjoy normal economic and political
conditions between 1961 and 1994.
SOUTH AFRICA's TRADE HISTORY





The traditional forms of import substitution and export promotion require protection measures
which are no longer allowed under the WTO.
Maintenance, expansion and modernisation of infrastructure is an approved method to
promote manufacturing, exports and economic growth.
BRICS is our newest trade agreement.
South Africa's biggest trade partners are China and the EU.
Both relationships are heavily skewed with massive trade deficits.
CHAPTER 6: PERFECT MARKETS
PERFECT COMPETITION
INTRODUCTION





Markets owe their origin to the interaction between buyers and sellers.
Markets are at the center of economic activities and provide the dynamics for the performance
of economies.
Market behaviour involves the things that businesses do in their role as suppliers and buyers.
Market behaviour also involves the things that consumers do in their role as households and
sellers.
Price changes cause ripple effects in markets and we are very interested in the changes in
consumption and production.
DESCRIPTION




Perfect competition is a market structure with a large number of participants who are all price
takers.
We are not talking about the local flea market or fresh produce market, but rather sophisticated
markets where the equilibrium price is determined by the interaction between buyers and
sellers.
o Stock markets
o Foreign exchange markets
o Commodity markets (Both agricultural products and mining products)
The most important aspect of perfect competition is its impersonal nature where individual
participants act completely independent of one another.
Individual businesses are not concerned with what their competitors are doing at all, but only
worry about how the market price fits into their own cost structure.
CHARACTERISTICS








The number of buyers and sellers in the market is so large that every participant is insignificant
in relation to the market as a whole. Individual buyers or sellers are not able to influence the
market price.
All the products that are sold are homogeneous so no buyer cares about where or from whom
to buy the product.
There is complete freedom of entry into and exit from the market.
All factors of production are completely mobile and can move freely between markets.
Both buyers and sellers have full knowledge of all the prevailing market conditions.
There is no collusion between sellers.
There is no government intervention that could influence buyers or sellers.
Sellers are price takers and can't dare to deviate from it.
INDIVIDUAL BUSINESS AND INDUSTRY
INTRODUCTION


An individual business is part of a market/industry.
The demand curve of the individual business is derived from the market.
DEMAND OF THE INDIVIDUAL BUSINESS

In a perfectly competitive market the market price is determined by the interaction between
market demand and market supply.





The individual business has to accept the market price as a given.
Any amount can be supplied by the individual producer.
The individual business receives the same price for every unit sold.
This causes average revenue (AR) to be equal to the market price.
The marginal revenue (MR) will also be equal to the market price.
Market price = Demand = AR = MR
Economic cost = Opportunity cost = Explicit cost + Implicit cost
MARKET STRUCTURE
INTRODUCTION

A distinction is made between four broad types of markets
o Perfect competition
o Monopolistic competition
o Oligopoly
o Monopoly
CHARACTERISTICS
OUTPUT
INTRODUCTION


Production is also known as output.
In the final analysis output is decided by profits.
THE INDIVIDUAL BUSINESS


We try to determine how much the individual business will produce and supply at the market
price.
Remember that the individual business under perfect competition only takes into account the
given market price and his own cost structure in order to determine his production quantity.
Total cost = Fixed cost + Variable cost


Each one of these curves has to touch the y-axis at those specific places.
The shapes of the MC and AC are important to remember.


The MC is now also the supply curve of the individual producer.
The market price that every producer has to take then also becomes his demand curve.


By using typical data we can see how D, MR and AR end up on the same level.
It also shows us how the slope of all three curves are zero.


By matching TC with TR, MC with MR and AC with AR these curves come to their full right.
It is important for the individual producer to know exactly how much to produce and the three
graphs don't give enough information yet.
Important points on graphs


The points where cost and revenue intersect on the different curves indicates normal profit.
The point where MC = MR is called the profit maximisation point.
PROFITS AND LOSSES
INTRODUCTION




When the business is making a profit the average cost is lower than the price.
When the business is making a loss the average cost is higher than the price.
When the average cost is equal to the price the business breaks even.
It is important to distinguish between the short term and the long term.
SHORT TERM





This is the period during which a business is confronted with at least one of its factors of
production being fixed.
This will mean that at least one of its inputs can't be increased, so then production can't
increase either.
In the short term the individual business can't change anything regarding its cost and it has to
take the price that the market gives.
There are several profit and loss possibilities for the perfectly competitive business in the short
term.
Everything depends on the location of the AC-curve in relation to the market price.






By comparing the AR and AC of the individual business at the profit maximisation point we can
see that
the total income is equal to the total cost of the individual
business.
Part of the total cost of an individual business is the remuneration that the entrepreneur pays
himself.
Normal profit is thus the minimum earnings required to prevent the entrepreneur from using
the factors of production elsewhere.
By comparing the AR and AC of the individual business at the profit maximisation point we can
see that
the total income is more than the total cost of the individual
business.
Economic profit is the profit made on top of normal profit.
By comparing the AR and AC of the individual business at the profit maximisation point we can
see that
the total income is less than the total cost of the individual
business.

Economic loss is made, but it doesn't necessarily mean that the individual business has to close
its doors yet.
LONG TERM



This is the period during which the factors of production of a business are completely mobile.
This will mean that inputs can be increased, so then production can also increase.
In the long term the individual business can change its cost although the market price still has to
be taken.
SHUT-DOWN POINT

The individual producer will be able to come back from an economic loss.

As soon as the market price falls to under the AVC the individual producer will have to close
down.
COMPETITION POLICIES
INTRODUCTION



Markets can only function effectively if healthy competition is taking place.
The first step to increasing competition is to open up a country's economy for imports.
Lowering of import tariffs and removal of import control will also increase competition.
GOALS



To prevent the abuse of economic power.
To regulate acquisitions and mergers.
To prevent restrictive practices.
COMPETITION ACT

Provision has been made for
o Competition Commission
o Competition Tribunal
o Competition Appeal Court
CHAPTER 7: IMPERFECT MARKETS
IMPERFECT COMPETITION
INTRODUCTION





The dynamics of economies start in markets.
Change in prices cause a change in demand & supply.
Cost and revenue determine the level of production for producers.
This will ultimately also have an effect on economic growth and economic development of a
country.
Under imperfect competition producers limit supply and higher prices will result in less demand.
CHANGE IN SUPPLY AND DEMAND



Under imperfect competition supply will most likely be reduced intentionally.
Less production takes place, less income is earned and less expenditure takes place.
This is bad for economic growth and economic development.



Under imperfect competition higher prices will cause demand to be less.
Once again production, income and expenditure suffers because of this.
This is also bad for economic growth and economic development.
REVENUE AND COST

R is calculated by price x quantity
We don't need to draw the TR-curve though.









AR is calculated by TR / Q
MR is calculated by TR / Q
We can clearly see that the AR-curve is more elastic than the MR curve.
The AR-curve therefore lies above the MR-curve.
TC is calculated by VC + FC
Alternatively it is calculated by cost per unit x quantity
We also don't need to draw the TC-curve.
AC is calculated by TC / Q
MC is calculated by TC / Q
COMPARISON BETWEEN PERFECT AND IMPERFECT MARKETS

Perfect competition is the one extreme, the other market structures move further away from it,
with monopolies being the other extreme.
MONOPOLISTIC COMPETITION
INTRODUCTION



Monopolistic competition has a hybrid structure and is a mixture between competition and
monopoly.
The element of competition can be seen in the fact that many sellers are fighting for market
share of the differentiated product.
The monopoly element can be seen in the fact that product differentiation causes every
producer to be the only one with that specific variant of the product.
CHARACTERISTICS





A large number of buyers and sellers are active in this market and their turnover is enormous.
Products that are produced are similar, but not identical. Producers therefore make use of
differentiated products to create brand loyalty. Different types of packaging also play a role.
Producers have little control over prices, but their control grows as brand loyalty becomes
stronger.
Demand therefore becomes more inelastic and creates an opportunity for a small monopolistic
profit.
There are no barriers that limit entry into the market. It is also easy for producers that leave the
market to recover their capital.



Buyers and sellers have incomplete market information. There are simply too many different
brands and price differences to be aware of everything at all times.
No collusion is possible, sellers will not even make an attempt.
Non-price competition takes place in the market and producers have to build brand loyalty and
ensure that they have the best location.
SHORT TERM


Producers under monopolistic competition have a more inelastic demand curve compared to
perfect competition.
The AR and MR are also not on the same curve anymore.

By comparing the AR and AC of the individual business at the profit maximisation point we can
see that the total revenue of the individual business is equal to total cost.

By comparing the AR and AC of the individual business at the profit maximisation point we can
see that the total revenue of the individual business is more than total cost.

By comparing the AR and AC of the individual business at the profit maximisation point we can
see that the total revenue of the individual business is less than total cost.
LONG TERM


Just like with perfect competition economic profit that is made in the short term attracts more
producers to the market and then there is a return to normal profit.
Economic loss that is made in the short term chases away certain producers and then there is a
return to normal profit as well.
COMPARISON WITH PERFECT COMPETITION


We can clearly see that even though both market structures are making a normal profit over the
long term, less is being produced and prices are higher with monopolistic competition.
This is of course not good for economic growth and economic development.
OLIGOPOLIES
INTRODUCTION

An oligopoly is a market structure in which a few sellers dominate the market.

This means that each seller doesn't only influence the other sellers, but also has to consider
them.
CHARACTERISTICS







There is a small number of big firms that dominate the market (2-5 firms) and there is an
interdependence between the relevant businesses.
Products that are produced can be homogenous or differentiated. We therefore refer to pure
oligopolies or to differentiated oligopolies.
There is considerable control over prices, but any change in prices will result in price wars.
Entry into the market is difficult and brand loyalty once again plays a big role
Buyers and sellers have incomplete market information.
Collusion is possible and abnormal profits can be made when oligopolies act as a cartel.
Non-price competition takes place to try and gain market share.
THEORIES ON PRICING AND PRODUCTION DECISIONS
Non-price competition


Because price competition can lead to destructive price wars oligopolies usually prefer to
compete on the basis of product differentiation and efficient service.
Participants in an oligopoly market watch each other closely. If the one business starts
something, the other businesses soon follow with the same thing.
- Product differentiation
- Special offers
- Extended shopping hours
- Business over the internet
- After-sales service
- Offering additional services
- System of loyalty points
- Door-to-door deliveries
Collusion




There is a lot of uncertainty in this market around how the other businesses will behave, so
oligopolies usually collude.
This means that they agree on quantities that are going to be produced and on prices that are
going to be asked.
Then there will be less uncertainty for businesses and higher profits can be made.
There are two ways in which collusion takes place.
- Cartels (When collusion occurs openly and formally.)
- Price leadership (When collusion occurs tacitly and informally.)
Prices and cost of production



Oligopolists are price makers, but are usually careful not to start a price war.
There are cases where businesses are willing to start a price war.
The business with the lowest cost of production will win the fight.
Prices and levels of production





The model is based on the assumption that if an oligopolist increases its price the others won't
follow.
If the oligopolist decreases its price the others will follow.
This causes the demand curve to be kinked and to have two different elasticities.
The oligopoly has a stage where a change in MC won't cause it to change the price.
The best place to determine the price is therefore at the point where the demand curve is
kinked.
COMPARISON WITH PERFECT COMPETITION




We don't draw cost and revenue curves for oligopolies, because there is not one fixed price
theory for this market structure.
We do recognise that oligopolies are able to make an economic profit that can even be
sustained over the long term.
Oligopolists also don't produce at the lowest turning point of the AC-curve, which means
consumers will pay higher prices.
Like with the other forms of imperfect competition there is less production and higher market
prices that is not good for economic growth and economic development.
MONOPOLIES
INTRODUCTION



A monopoly is a market structure in which there is only one seller of a product or service with
no close substitutes.
Consumers can therefore only buy the product or service from this monopolist.
This is the other extreme that is exactly the opposite of perfect competition.
CHARACTERISTICS





There is only one seller in the market and consumers don't have any other options.
The product that is produced is unique and has no close substitutes to compete with.
Producers have great control over prices and are price makers. They also have a very inelastic
demand curve to work with.
There are many barriers that limit entry into the market. Leaving the market will be very
expensive and painful.
Monopolists are confronted with demand curves, but they can decide where they want to be on
the demand curve.
Their demand curve is also the demand curve of the whole market.



They decide on the level of production for the whole market. Their supply curve is also the
supply curve for the whole market.
Monopolists are still exposed to market powers.
Monopolists enjoy favourable circumstances in terms of geographical location and legal
requirements.
REVENUE

The AR-curve and MR-curve of the monopolist have a negative slope the same as with imperfect
competition in general.

It is important to notice where the MR-curve intersects with the x-axis in relation to the ARcurve.
The monopolist will determine the price on the AR-curve in such a way that it will be left of the
quantity where MR = 0.

Implications of a downward-sloping demand curve



The MR-curve runs below the AR-curve.
The monopolist can have his own pricing policy.
The monopolist won't determine the price past the middle point of the demand curve.

The income curves of a monopoly are much more inelastic than those of monopolistic
competition.
This enables them to increase prices without loosing too many consumers.

SHORT TERM

The demand curve of a monopoly is more inelastic than under monopolistic competition.

The AR and MR are still not on the same curve anymore.

By comparing the AR and AC of the individual business at the profit maximisation point we can
see that the total revenue of the individual business is equal to total cost.

By comparing the AR and AC of the individual business at the profit maximisation point we can
see that the total revenue of the individual business is more than total cost.

By comparing the AR and AC of the individual business at the profit maximisation point we can
see that the total revenue of the individual business is less than total cost.
LONG TERM


A monopoly is in the position to keep on making an economic profit even in the long term.
A monopoly is not guaranteed of an economic profit, but over the long term the following can
happen
- Economic profit from the short term can be enlarged over the long term.
- Normal profit from the short term can be changed into economic profit.
- Economic loss from the short term can be changed into economic profit.
- The negative sense is also possible, a monopoly can weaken over the long term and then close
down.

A monopoly that can't manage to make an economic profit over the long term should rather
close down.
COMPARISON WITH PERFECT COMPETITION



We can clearly see that less is being produced and prices are higher with a monopoly.
There is also not only a normal profit that is being made over the long term, but an economic
profit.
This is obviously still not good for economic growth and economic development.
CHAPTER 8: MARKET FAILURES
CAUSES OF MARKET FAILURES
INTRODUCTION



Market failure means that the best available production outcome has not been achieved.
There needs to be productive efficiency as well as allocative efficiency in order for markets not
to fail.
Market failure will be evident in consumption and production levels being wrong.
o Too much production of an item or too little production of an item.
o Too much consumption of an item or too little consumption of an item.
MISSING MARKETS


When a product or service is not being produced at all because of the absence of certain
conditions.
The private sector won't be providing these goods & services.
- It can't be withheld from non-payers.
- Consumption can't be measured, so a market price can't be established.
- There is no profit to be made.

Public goods & services are provided by the government because if they don't provide it nobody
will.
- Collective goods (parks, roads, bridges, refuse removal, etc.)
- Community goods (street lighting, police, defence, prison, etc.)
- Merit goods (healthcare, education, inoculations, car seat belts, etc.)
- Demerit goods (cigarettes, alcohol, non-prescription drugs, gambling, etc.)


With merit goods the government needs to make sure enough is being produced and consumed.
With demerit goods the government needs to curb production and consumption.
IMPERFECT COMPETITION



In market economies competition is often impaired by the fact that more power lies in the
hands of producers than in the hands of consumers.
Producers are able to restrict output, raise their prices and prevent new businesses from
entering the market.
There is less production in the economy and consumers pay higher prices.
LACK OF INFORMATION


Participants in the economy need information to be able to make rational decisions.
Consumers don't have perfect information at all times, which causes them to
- Buy items that are too expensive.
- Consume too much harmful products.

Labourers don't have perfect information at all times, which causes them to
- Be unaware of other job opportunities.
- Get training for a job that is not in high demand.

Entrepreneurs don't have perfect information at all times, which causes them to
- Use their factors of production inefficiently.
- Produce the wrong quantities of certain products.
IMMOBILITY OF FACTORS OF PRODUCTION





Most markets don't adjust rapidly to changes in demand & supply
Labour will take time to increase and to move into the areas where it is needed.
Capital will take time to acquire and can't be moved easily once fixed assets are bought.
Natural resources are scarce and won't increase just because there is more demand for it.
Entrepreneurship is something that can't be taught and won't increase overnight.
INEQUALITY IN WEALTH AND INCOME DISTRIBUTION



In a market economy the market is neutral in the issue of income distribution.
The market will not try to correct inequalities in wealth and income distribution.
The rich will continue to get richer and the poor will become poorer.
The impact on consumption and ultimately on production needs to be kept in mind.
EXTERNALITIES

The costs and benefits that convert private costs and benefits into social costs and benefits.
Also known as spill-over effects or third-party effects.
Private costs

The costs of producing goods & services which translates into the prices that consumers pay.
Private benefits

Benefits that come to those who buy the goods & services as well as those who produce and sell
the goods & services.
Social costs


The total costs incurred by society as a whole.
Private costs + external costs
Social benefits


The total benefits experienced by society as a whole.
Private benefits + external benefits






The society as a whole is experiencing a welfare loss because of the negative externalities
caused by the production of a certain product. (Pollution is only one example of a negative
externality)
It would have been much better if there was less production taking place.
The market failure is that there is too much production of a certain product and this will
continue to happen because the market mechanism can't include external costs.
The society as a whole is experiencing a welfare loss because of the negative externalities
caused by the consumption of a certain product. (Cigarettes is only one example of a product
with negative externalities)
It would have been much better if there was less consumption taking place.
The market failure is that there is too much consumption of a certain product and this will
continue to happen because the market mechanism can't include external benefits.






The society as a whole is experiencing a welfare loss because of not realising the positive
externalities caused by the production of a certain product. (Training is only one example of a
positive externality)
It would have been much better if there was more production taking place.
The market failure is that there is too little production of a certain product and this will continue
to happen because the market mechanism can't include external costs.
The society as a whole is experiencing a welfare loss because of not realising the positive
externalities caused by the consumption of a certain product. (Education is only one example of
a service with positive externalities)
It would have been much better if there was more consumption taking place.
The market failure is that there is too little consumption of a certain product and this will
continue to happen because the market mechanism can't include external benefits.
CONSEQUENCES OF MARKET FAILURES
INTRODUCTION

When markets fail there will be three main consequences
- Inefficiencies will occur.
- Externalities will be present.
- The government might need to intervene.
INEFFICIENCIES

When inefficiencies occur consumers will either pay prices that are too high or goods & services
will be available in the wrong quantities.
Productive inefficiency
- Producers will then not be producing at the lowest possible cost.
- Factors of production could have been used more efficiently.
- This wastage will result in prices being higher.
Allocative inefficiency
- The correct combination of goods & services that consumers want are not available.
- Factors of production are allocated towards producing the wrong quantities of certain products.



At point C the economy is functioning under Pareto inefficiency, meaning that neither
productive efficiency nor allocative efficiency has been achieved.
At points A and B productive efficiency has been achieved, but not necessarily allocative
efficiency.
We would have to include an indifference curve on the graph to see where allocative efficiency
will be.
The economy needs to find ways to expand its PPC outwards so that production at point D can
become possible.
EXTERNALITIES

Positive externalities and negative externalities occur because producers have too much power
and individuals are uninformed.
Negative externalities

The government can use the following to ensure that production and consumption decrease
- Campaigns
- Laws and regulations
- Indirect taxes
Positive externalities

The government can use the following to ensure that production and consumption increase
- Advertising
- Provide for free
- Subsidies
GOVERNMENT INTERVENTION

Government intervention is necessary because markets won't be able to correct these market
failures on its own.
Externalities

Discussed in the section above.
Missing markets



The fact that the government steps up and provides public goods & services is addressing the
market failure.
That doesn't mean that the government will always achieve Pareto efficiency.
Taxes and subsidies can also come in handy in trying to solve this market failure.
Imperfect competition




We know that imperfect competition is not good for an economy.
Competition policies can help to ensure more competition in markets.
Taxes on economic profits can limit imperfect competition.
Price controls can be used to correct market failures.

Notice how the quantities produced change when price controls are implemented.
Lack of information




Government can ensure that the necessary information is made available so that rational
decisions can be made.
Certain products need to go through quality regulations done by SABS.
Certain information on packaging is made compulsory.
Certain advertising regulations are set in place.
Immobility of factors of production

The government can't do much about this, that is why wastage is so unacceptable.
Inequality in wealth and income distribution







The government can do quite a few things to improve wealth and income distribution in the
economy.
They can levy various kinds of taxes and make use of a progressive tax system.
They can provide certain services for free.
They can make transfer payments to the poor.
They can pay subsidies to consumers and producers.
They can use price controls.
They can make use of redress methods like BBBEE, land redistribution, preferential
procurement, RDP housing, etc.
COST-BENEFIT ANALYSIS
INTRODUCTION



In both the private sector and public sector project evaluations need to be done in order to find
out which projects would be more beneficial.
The private sector will simply compare private costs and private benefits.
The public sector will need to compare social costs and social benefits.
REASONS FOR CBA




In a market economy resources are allocated through the interaction of demand & supply.
Most of the public goods & services either don't have price signals or it is ineffective.
Without firm market signals the decisions on the desirability of a project may rest mainly on
subjective political views.
Cost-benefit analysis brings greater objectivity to decision making.
APPLICATION
A cost-benefit analysis is done by



Identifying and quantifying all private costs
Identifying and quantifying all external costs
Calculate the social cost (private + external)




Identifying and quantifying all private benefits
Identifying and quantifying all external benefits
Calculate the social benefits (private + external)
Subtract social cost from social benefits and make a decision.