BASIC ECONOMIC IDEAS &

RESOURCE ALLOCATION
TOPIC objectives:
•Explaining the concept of economics
•Describing a Production possibility curve/
frontier
•Explaining the functions of money &
resource allocation
•Describing the classification of goods
 Intro: What is economics?
• Discussion point:
• It’s a social science that deals with
the study of how to allocate scarce
resources in the most efficient
way.
• Task:  Give examples to illustrate
that resources e.g. money are
never enough!! 
• Human needs & wants are always
unlimited while the means of
providing them (resources) are
scarce.
• Thus choices must be in order of
priority of how to satisfy them
• Task:  draw the illustration..
 Economic analysis

• It follows a scientific framework in

studying the behaviour of
economic agents.
• Task  Draw the diagram on page
3.
• Give examples of how economists
study unemployment….
• There are 3main economic
agents/players in a
market/economy
Firms- producers
Households- consumers
Government- regulator.
 Top tip 

• The complex structure within which

these agents lie is called the Economy
• The road to economic explanation
follows 2 main approaches
• 1. positive statements (Objective)
• These are factual statements that can
be verified and/or falsified by looking
at the known facts
• Such statements are acceptable to
all economists eg the rate of
inflation in 2009 in Kenya was
4.23 %
• 2. Normative statements
(Subjective)
• They are personal opinions that
reflect value judgements which can
not be verified by looking at the
facts.
• They are personal views about what
ought to happen.
• Eg the government should cut fuel
tax to reduce the rate of inflation.
• Q 4. 9708/11/M/J/11
• Which is a normative statement?
• A An increase in the rate of inflation
will lead inevitably to an increase in
unemployment.
• B A reduction in unemployment below
a certain level will lead to higher
inflation.
• C Inflation can be reduced only by
increasing the level of unemployment.
• D Unemployment is more harmful than
inflation.
 Q3 9708/01/M/J/09
What must be true of a positive
statement?
A It is one that can be shown to be
correct or incorrect.
• B It is one that deals with positive
changes in economic well being.
• C It is one that is true by definition.
• D It is one with which everyone is in
agreement.
Classification of economics;

Economics

Microecono Macroeconomics
mics
 1. Microeconomics;

• It deals with the study of

individual economic agents e.g.
person, household, firm, or
industry)
• Eg how a consumer allocates his
income among various uses.
 2. Macroeconomics:

• It involves the study of aggregate

economic principles which affects
the whole economy.
• Eg unemployment, inflation,
national income etc.
• Macro economics vs
microeconomics video
 The economist tool kit

• It refers to the skills & techniques

for the analysis of economic
problems.
• It consists of 2 main skills;
• 1. Ability to interpret and use
data
• 2. to write in a clear way.
 Data skills

• task:  Summarize the bullet

points on page 4.
• Types of data
• 1. time series data
• Its data recorded over a long
time period Eg. UK
unemployment data for 10years
  
• 2. cross sectional data
• This is data in snapshots or
piecemeal
• 3. discreet data
• This is data in whole numbers
• 4. continuous data
• This is data that is not in whole
numbers but in decimals eg
economic growth
 How to write clearly
& effectively
• This is useful especially in
examinations….hand out
• 1. Be clear and precise in your writing:
• Use simple language avoiding jargons
which you don’t understand
• 2. Write impersonally avoiding first
person singular [ I or we] when
writing economic essays.
• 3. Match your writing to your
audience- use appropriate
economic terms and concepts.
• 4.Be careful with sentence
structure and punctuations- avoid
spelling mistakes.
• 5. Use one idea per paragraph&
develop your ideas & arguments
• 6. Support your arguments-
elaborate and develop your
arguments.
• 7. Avoid humour & jokes in exam
essays.
• 8. Be professional: do not insult or
offend
 Data & graphical skills

• This involves being able to read

and interpret data from graphs.
• i.e. ability to pick out main
features in a data set.
• Also involves ability to interpret
economic information in a visual
form.
 Example
• Use the graph below to answer the
following questions;(handout)
• Describe the behavior of oil prices
between 1965 to 1974 [2]
• Explain the trend in oil prices
between 1975 to 1982.[2]
• Suggest what would have caused
constant price fluctuations
between 1970-1980s [4]
• What does the graph indicate
about oil prices between 1985-
2000 [3]
• Why do you think oil prices are
rising from year 2000 onwards[6]
• Explain the difference between
nominal and real prices.[4]
• C:\The basics of graphing video 00
: 7: 21.
 The basic economic problem
• AKA fundamental economic problem.
• Problem of scarce resources relative
to unlimited human wants.
• It’s a problem of ‘scarcity & choice’.
• Task:  copy the key terms: page 13
• It causes economic agents to make
choices of what to consume and to
sacrifice/forego
 Top tip: 
• The economic problem refers to
scarce resources in relation to
unlimited wants.
• It forms the basis of other economic
problems facing individuals and
governments e.g. unemployment
How do economic agents react to this
problem?
• They seek to answer the three basic
economic questions:
• 3 economic questions video
1. What to produce:
• since resources are never enough
producers must decide the quantity of
goods and services to produce from
the bulk of scarce resources available
 2. How to produce;

• Refers to a choice on the best

method of production in order get
maximum benefit from the resources.
• Method used could be labour
intensive (man power) or capital
intensive(machinery).
 3.For whom to produce;

• It’s the determination of consumers

since its not possible to satisfy the
wants of all the people in the economy.
• Firms will invest in R &D to determine
consumer preferences.
• Target market could be a niche or mass
• C:\Users\pnduati video. Economic
scarcity
 Students tasks

• Draw fig 1.1 pg 13

• Prep task: Self assessment task
1.2_China: the challenges of an ageing
population: pg 16-17
• Due on Monday
 The meaning of ceteris paribus

• This is Latin phrase for: other things

being equal or holding other factors
constant:
• Assumption that economic agents will
consider one variable when making
economic decisions
• E.g. A consumer may consider price only
when buying an iPod ceteris paribus!
 The margin and
decision making
• Economics involves making
decisions of what to consume and
what to sacrifice.
• The margin refers to the utility or
value of one additional unit of an item.
• Decision making “at the margin”
• It means making economic choices
based on the value of the additional
amount of costs & benefits
 Example
• Give practical examples of the cost
& benefits of oil exploration in
‘Ngamia 2 well’ in Turkana .
• The decision maker looks at the
additional or marginal cost(MC) of an
action, & the additional or marginal
benefit(MB) of the decision.
• If the incremental benefit/MB is
greater than the incremental
cost/MC, the action is taken
 Top tip  

• If MB > MC Take the decision since

the incremental benefit is more than
the incremental cost
• If MB < MC reject the decision since
the incremental benefit is less than
the incremental cost.
 Choice and opportunity cost
• Opportunity cost is the cost/benefit
foregone in order to consume the
next best alternative.
• Since resources are scarce compared
to the unlimited wants, choices
must be of which wants to satisfy
before the others
• E.g. A student decides to stay in her
room and study instead of going to
the cinema.
 Task

• Identify the opportunity cost facing

her…………….
• Its used by various economic agents
for decision making
• Opportunity cost video
• C:\Users\pnduati.
Opportunity cost video 00:07:41
 Production possibility
curve (PPC)
• AKA production possibility frontier
(PPF).
• It’s a graphical representation of the
basic economic problem &
opportunity cost
• It represents the maximum level of
output an economy can achieve
when using its existing resources in
full.
• It can be a straight line or a curve
• .
 Make observations

• Production within the ppf shows

underutilization/unemployment of
resources.
• On the boundary: …….efficient
resource
• Above the curve….
• Calculate the opportunity cost of
making 8 hammers
 Observations

• All points on the PPF represents

combinations of two goods an
economy can produce at a given
technology when all resources are
fully engaged.
• Production within the PPF shows
inefficient utilization of resources
(underutilization)
• Prodn above the PPF is not possible
with the present bulk of resources
  Top tip: 
• 1. The PPF is concave to the origin
because of increasing opportunity
costs as resources are switched to
produce the alternative product.
• 2. A linear (straight line) PPF
implies constant opportunity cost
in the prodn of the two products &
its hypothetical.
• 3. The resources available together
with the technical know-how
determines an economies
production possibility.
• i.e. how many goods & services to
be produced
• 4.The PPF is also called product
transformation curve since along the
curve different combinations are
produced due to increasing
opportunity cost.
• PPF video
• C:\Users\pnduati. PPF I & II
 Shifts in the PPF:

• The PPF assumes that technology

and resource levels of an economy
are constant but they may change
overtime
• It can either shift upwards or
downwards.
 An expansion in production
possibilities
• Shown by an outward shift of the
PPF
• It represents economic growth.
• Draw the diagram.
• Reasons behind the upward shift
• Discovery of new resources
• Improvement of technology
• immigration in to a country
• Capital inflows to a country e.g.
foreign loans etc
• NB: All this is due to economic
growth and expansion
 A reduction in production
possibilities
• Shown by an inward shift of the
PPF
• It represents economic recession.
• Draw the diagram.
• Reasons behind the downward
shift
• Adoption of an inferior technology
• Exhaustion of some resources e.g.
oil
• Emigration outside the country
• Regulations requiring adoption of
green production methods. etc
• NB: All this could be due a
declining economic growth rate
 9708/1 Jun03

• 2 The diagram shows a production

possibility curve LM.
• What might cause the curve to
shift to NP?
• A technological progress
• B unemployment of resources
• C the depletion of natural
resources
• D a reallocation of resources
 9708/01/M/J/07
• 1 The diagram shows a production
possibility curve for an economy
that produces only two goods, X
and Y.
• The economy produces 400 of
good Y and produces on its
production possibility curve.
• Which quantity of good X is given
up?
• A 600 B 800 C 1200 D 1600
 9708/01/M/J/09

• 2 The diagram shows two

production possibility curves (EF
and GH), before and after
technological progress has taken
place.
• After technological progress has
taken place, what is the opportunity
cost in capital goods of producing
OX consumer goods?
• A MH B OH C OM D YF

• Q2.9708/13/O/N/2012
 Applications of the PPF
• The choice between production of
capital and consumer goods:
• Consumer goods are used to satisfy
wants directly while capital goods
are used to produce other goods eg
machinery
• Capital goods are created through
investment & are subject to capital
consumption/depreciation which is
the process of wear and tear
• Gross investment - depreciation=
net investment
• A choice has to be made btn.
producing consumer goods or
producing capital goods.
• More consumer goods will imply high
living conditions but this may reduce
in future if capital goods are not
produced to replace those worn out.
• This implies a hard choice so as to
balance out the two goods
• Hard choices for developing
economies
• They are faced with low living
standards hence they must
increase their capital stock
investment
• They must devote more resources
from current consumption to
investment so as to grow while
producing enough consumer goods to
feed their high populace.
• The issue of high population causes
lots of resources to be committed for
subsistence at the expense of capital
investment.
• This problem is referred to as ‘jam
today or more jam tomorrow’.
• Task: draw fig 1.11 from page 31
• Observations:
• o-a is the capital
consumption/depreciation
• O-b is the quantity of consumer
goods
• Producing o-b units of consumer
goods will improve welfare today
only.
• This is because depreciation rate
will be higher than the quantity of
capital goods produced.
• Self assessment task: page 30
 Economic resources:
• These are the factors of production
or the factor inputs necessary to
create goods and services.
• They are always limited/scarce in
supply since human wants are
insatiable and recurrent in nature.
Categories of resources
1. Land;
  
• It’s a natural resource, free gift of
nature.
• It includes the earths surface, water
bodies, forests, atmosphere and
mineral deposits.
2. Labour;
• It’s the human effort used in
production.
• No production can occur with out
labour.
 3. Capital
• These are man made aids to
production.
• Capital goods assist land and labour to
produce more output e.g. machinery,
• 4. Enterprise/entrepreneurship-
business skills
• The entrepreneur, business person,
organizes other factors of production
for maximum productivity.
• The enterprise involves risk taking in
undertaking various production
activities especially in a free
enterprise economy.
• Top tip: 
• Economies with abundant resources
are said to have good factor
endowment
Factor rewards- earning to factors
of prodn
Factor input Factor reward

labour Salaries/wages

Land Rent

Capital Interest

Entrepreneurship profit
 Economic resource video
• C:\Users\pnduati.
• Production and consumption
• Production is the process of creating
goods and services, from economic
resources, to satisfy human wants.
• Process of creating utility(usefulness of
goods & services)
• Consumption is the process of using goods
and services to satisfy human wants
 Note 
• Production occurs in 3 distinct
periods.
• 1. short run (SR)
• Time period during which a firm
can only change some and not all
factor inputs.
• E.g. in the SR a firm can increase
production by hiring more workers
ceteris paribus.
 2. Long run (LR)
• Time period during which all factor
inputs can be varied.
• E.g. in the LR a firm can hire more
capital
• 3.Very long run
• Time period during which all key
inputs in to production are variable
• E.g. govt regulations, tech etc
SPECIALIZATION AND EXCHANGE

• Specialization refers to the process

whereby economic agents concentrate
on one economic activity
• e.g…Japan specializes in the
production of technology & cars
• It leads to creation of surplus/excess
output which can be exported abroad.
• This allows world living standards to
rise
• It also contributes to unemployment
since specialized workers lack
flexibility to work elsewhere
• .
C:\Users\pnduati.Specializatin vide
o.
 Division of labour:

• Breaking down of a production process

into a sequence of individual tasks
where different workers concentrate
according to their levels of skills and
experience
• It was introduced by Adam smith in
his book an inquiry in to the nature
and causes of wealth of nations (1776)
• He suggested that production of
pins could be split in to 18
operations so as to increase output.
• Apart from raising factory output,
this process leads to monotony due to
constant repetition of similar tasks.
• Merits & demerits handout
 Examples

• Henry Fords use of the conveyor

belt in car manufacture in the US.
 Economic structure

• It refers to the way in which an

economy is organized in terms of
sectors:
Primary sector
Secondary sector
Tertiary sector
Quaternary sector
 1. The primary/extractive sector-

• It deals with extraction & use of

raw materials in their natural form
• It includes the production of raw
material and basic foods.
• Occupations here include- fishing,
quarrying, farming etc
 2. Secondary Sector
• This sector manufactures finished
goods from raw materials.
• This sector includes all of
manufacturing, processing, and
construction .
• occupations here include: automobile
production, textile production,
aerospace manufacturing etc
 3. Tertiary Sector
• This is the service industry.
• It provides services to the general
population and to businesses.
• Occupations here include; tourism,
insurance, banking, healthcare, hair
dressing etc.
 4. Quaternary sector
• It consists of intellectual activities
especially in the provision of info.
• E.g. ICT, R &D, Libraries&
universities etc
• Task: identify the sectors in
which the following occupations
lie…
• \self assessment task page 21: do
in class
 DIFFERENT ALLOCATIVE
MECHANISMS
• The basic economic problem leads to
different economic systems.
• An economic system describes the
means through which economic agents
make choices of resource allocation
• Types of economic systems:
• They are 3 main types
 ECONOMIC SYSTEMS

Comma Market Mixed

nd/ econom econom
planned y y
 1. The market economy
• AKA free market economy, free
enterprise economy or capitalism.
• It was advocated by Adam
smith(1776) & can be
represented by the USA
• The system is an ideal case not
present in today’s modern
economies.
 Features
• No government regulation in a
pure market economy
• Profit maximization is the main
goal of buyers & sellers.
• All resources are privately owned
by the firms and the households.
(private sector) who make
decisions on how to allocate
resources.
• Many buyers & sellers who
interact freely.
• Prices are determined by the
market forces of demand and
supply.
• i.e. invisible hands of the
market/market mechanism
• Consumer sovereignty- freedom of
what to consume
 Advantages

• Consumers are free to choose what

they want to buy.
• No taxes charged. This is a
motivation as workers can keep all the
profits
• Businesses compete with each other
freely and this could keep prices low.
• Freedom of enterprise- New
businesses are encouraged to set up.
• Efficient allocation of scarce
resources according to market
forces.
• Disadvantages:
• Public services e.g. health and
education are not adequately
provided
 Disadvantages: contd’

• Production of harmful goods due to

absence of govt regulation
• Monopolies can develop and hence
lead to consumer exploitation
• Possibility of high inflation as market
demand rises
• There lacks fair play in the market
since there is no govt regulation
 Research task

• Read and make short notes on functions

of price mechanism in a free market
economy [10]
Reference
• S-cool
• Tutor2u
• DineshBakshi
• Economicsonline.com
• Any other online source
 Command/planned economy.

• AKA socialist or communist

economy.
• It was advocated by Karl Marx
(1818)
• A pure planned economy does not
occur in practice.
• Examples: former USSR, Cuba,
North Korea etc
 Features

• All resources are owned and

controlled by the government
• Public sector dominates the
economy.
• Resource allocation decisions are
made centrally by the govt or some
state agency on behalf of the govt.
• The government determines
collective market preferences in
a planned economy.
• Central govt is responsible for: ..copy
the bullet point from page 22.
 Advantages

• Government decides what should be

produced, how much and for whom
• Decreases inequalities between the
rich & poor.
• Both public & merit goods are
adequately provided
• Enhances balanced regional
development
 Disadvantages:
• Its expensive to run a government
structure
• Centralised decision making may
conflict the market forces of dd & ss.
• Government systems may have excess
red tape
• Govt controls may reduce
innovations & inventions
 Video 00:09:13

• C:\Users\pnduati Capitalism vs
Socialism
 The Mixed economy

• It’s a combination of both the market &

command economy as in present day
countries.
• Features
• The private sector & public sector are
actively involved in resource
allocation thru PPP’s
• Some resources are owned by the State
and some by private individuals
• Businesses make decisions & the
Government tries to influence and
control some areas such as Taxes &
Laws.
• Degree of govt control varies from
country to country
• However some public sector business
may be inefficient leading to
privatisation.
• Advantages;
• Government control eliminates
unhealthy business competition.
• It may lead to high economic growth
due to freedom of enterprise thru PPP
 Advantages: contd’

• Govt ensures uniform resource

distribution to benefit all.
• It controls production of harmful
products eg narcotics
• Disadvantages;
• There is less incentive to work as the
government fixes wages and taxes
• The government may not produce
goods which people want to buy.
• The lack of absolute freedom of
enterprise may discourage production.
• Task:
• Draw the diagram from page 24
 The transition economy

• it is one that is changing from

central planning to free market
• i.e. moving from command to free
enterprise economy.
• The problems of transition
economies
• Q1/9708/11/M/J/2012
 1. Rising Unemployment-

• A command economy employs more

pple due to active govt regulation in
the public sector.
• Under a free market, private
sector may adopt capital intensive
prodn at the expense of labour
intensive prodn
 2. Rising inflation

• This is due to the removal of price

controls imposed by governments.
• Private firms charge high prices,
due to pursuit of profit motive,
leading to inflation
 3. Corruption

Its possible that under free market

corrupt business activities may
thrive.
This leads to production of harmful
products eg narcotics
 4. Lack of a sophisticated
legal system

• Market-driven economies will only

develop when citizens are granted
extensive property rights, and can
protect these rights through the
legal process.
• This was large absent in the
former communist transition
economies. 
 5. Lack of infrastructure

• The transition economies also

suffered from a lack of real capital
and technology.
• This was partly because of the
limited development of financial
markets and the little foreign
direct investment
 Reading task:

• Role of enterprise in a modern

economy
• china’s radical moves…page 26
 BARTER TRADE

• A system of exchange by which

goods or services are directly
exchanged for other goods or
services without money.
• The limitations of barter
• 1.Need for presence of double
coincidence of wants:
• For barter to occur between two
people each would need to have
what the other wants.
• 2. Absence of common measure of
value:
• There lacks a standard ‘measure of
value’ of the worth of products being
exchanged
 3. Indivisibility of certain goods
Its not possible to divide/breakdown
commodities in to smaller units
Eg you can’t divide a live cow in to
smaller pieces.
4. Lack of standards for deferred
payments:
To ‘defer payment’ means to make it
happen in the future (financing credit)
 5. Difficulty in storing wealth

• If a society relies exclusively on

perishable goods, storing wealth for the
future may be impractical.
• Research Task
• Read & make short notes on the
advantages of barter trade
 Money

• What is money?..................
• It s an important aid to trade and is
anything that is generally acceptable as
a means of paying for goods and services.
• It includes notes & coins, cheques, debit
cards, credit cards or other valuable
items
• Money as a resource is scarce in supply
 Near money
• Non cash assets that are highly
liquid.
• E.g. savings accounts, bonds etc.
• Assets that are cash or cash
equivalent are called liquid assets.
 The origin of money

• Before the invention of currency,

people relied on barter trade
• Money was invented due to the
impracticability of barter system.
• Characteristics/ qualities of money
• General acceptability
• https://www.google.co.ke/?gws_rd
=ssl#q=legal+tender
• Durability
• Portability
• Divisibility
• Cognizability
• Scarcity- most important
• Malleability
 Functions of money

1. Medium of exchange
• It’s a medium that buyers use for
purchases and that sellers are
willing to accept in exchange for
products bought.
• It’s a means of paying for goods
and services
 2. unit of account:

• It’s a unit by which prices are

established e.g. $, £ , Kshs etc.
• It applies for current and future
transactions (eg loan repayment)
• 3. Store /measure of value
• It can be accumulated for a long
time (bank) to form a source of
wealth.
• It can also be held in form of
financial securities [stocks, bonds,
treasury bills, etc ] assuming that its
value will not be wasted by inflation.
• 4. Standard of deferred payment
• Money is used to finance credit
transactions.
• It settles future payments at an agreed
date.
• Eg rent and utility bills paid at the end
of the month
• Top tip: if these functions break down,
people will lose confidence in money &
the economy will collapse
• Q4/9708/11/O/N/2013
• Q4/9708/12/M/J/2012
 Q4/9708/W/11/2013

A website compares the prices of

groceries. Which function of money
is illustrated by this?
• A medium of exchange
• B standard of deferred payment
• C store of value
• D unit of account
 CLASSIFICATION OF GOODS

• There are four categories of goods;

Capital/producer versus Consumer
Free versus economic
Private versus public
Merit versus demerit
 Capital/producer goods

• They are used to produce

consumer goods eg plant
machinery in a factory
• Consumer goods
• They are produced for
immediate consumption by end
users. Eg TV’s, food etc
 Free goods
• They are abundant in supply
and have no opportunity cost.
• They have no prices e.g. air
• Economic goods
• They are scarce in supply and
have an opportunity cost and a
price attached to them.
 Private goods.
• This is one where consumption by one
person results in the good not being
available for consumption by another.
• Give an example…
• Characteristics
• 1.Excludable-
• Consumers are excluded from using
the product if they are not willing or
able to pay for it. E.g. A movie ticket.
 2.Rivalry
• One persons’ consumption reduces the
amount left for others to consume.
• Scarce resources are used in
producing and supplying the good or
service.
• 3.Rejectability-
• One can chose to buy/use it or not. Eg
you can choose the type of ice cream
flavour to buy
 Public goods
• Goods that are non rival and non
excludable and difficult to charge a
price.
• E.g. defence, fishing light house &
street lighting.
• Characteristics
• Non excludable:
• Once provided, no person can be
stopped from benefitting from it
 2. Non rival:
• Consumption of the good by one
person does not reduce the benefit
to others.
• i.e. as more consume, the benefit to
those already consuming is not
diminished.
 3. Non-rejectable

• There is no choice as whether to use

it or not e.g. defence
• Note: 
• Quasi public goods have some but not
all the characteristics of public goods.
• E.g. seaside beach & roads.
• Task: explain how a beach can be made
exclude and rival….
 The problem of public goods
• In a free market, they will not be
provided at all!
• This is because of the ‘free rider
problem’: consumers will wait for
others to purchase them and then use
them for free!
• In the lighthouse case, the fishermen
will wait for one ‘foolish’ fisherman’ to
provide it then enjoy the benefit
 Task
• Copy the definition of the free
rider from page 34.
• Solution
• Public goods need to be provided by the
government and force everyone to its
cost through taxation.
• Video on private and public goods
 Q16/9708/11/M/J/2013
• A good is more likely to be
supplied by the government rather
than a private company if it is
• A excludable and non-rival.
• B excludable and rival.
• C non-excludable and non-rival
• D non-excludable and rival
•  Check out for more quizs in the
booklets
 Merit goods
• Goods that have positive side
effects associated with them.
• i.e. they provide more benefits than
the consumer perceives.
• They are under produced & under
consumed due to info failure hence
they are provided by governments
e.g. education and health.
• E.g. inoculation against Polio. It
not only protects the individual
but the whole community!
• https:// free Rotavirus vaccine
• Task: draw Fig 3.5 on page 132 (2nd
edition bk)
• Observations:
• If consumers know the true value of
the product, the correct demand
would be D1 leading to higher dd.
• Since consumers undervalue the
product, demand is registered at D2,
leading to underprodn & under
consumption at Q2.
• This is below the optimum level: The
market has failed.
 Demerit goods:
• Goods that have adverse side effects
associated with them when consumed.
E.g. junk foods & cigarettes.
• They are worse for the individual
than he /she realises.
• They are overproduced and over
consumed due to info failure
• E.g. smoking cigs is not only harmful
to active but also to passive smokers.
 Task: draw figure 3.6 page 132

• Observations
• The ‘correct’ dd should be at D1
which leads to less quantity being
demanded.
• Because consumers over-value the
product, dd is registered at a higher
level
• This leads to overprodn and over
consumption.
• The market has failed because too
• much resources are devoted to the
production of this demerit good.
• Information failure
• Occurs where pple lack full info
about the benefits and harmful
effects of certain goods.
 Discussion point; 

• Why do people consume demerit

goods yet they are knowledgeable
about their side effects?
• Addiction, value judgment etc
 Moral Hazard

• Why do you go to see a doctor

when unwell?
• Occurs when people misallocate
resources due to lack of info
• A doctor may prescribe some
expensive drugs for a trivial case so
as to extort a patient who has no
option but to pay.
• This causes misallocation of resources &
market failure since the Dr. has more
info than the patient!
• NB: seller has more info than the buyer.
• Adverse Selection
• Refers to a market process in which
bad results occur due to information
asymmetries between buyers and
sellers
• NB: Buyer has more info than the seller
• The buyers have information that
sellers don't about some aspect of
product quality.
• Eg when buying medical insurance, one
may provide inaccurate medical info
so as to avoid high premiums.
• When the risk occurs, the premiums
for healthy people will have to be
raised so as to compensate many
claimants.
Many ‘bad risk’ customers will cause
the insurer to allocate lots of
resources for compensation which is
market failure.
XXXXXXXXXXXXXXXXXX
• Read the summary from page 37
• Prep questions = page 37
End of topic test: Monday
09/11/2015.
 Students tasks
Further reading:
Read about the market for lemons
by George Akerlof online

•  The end 