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Enow Kima
Title: Business Economy & Manegerial Decision Making
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Table of Contents
Chapter 14: The Boundaries of the Firm
Questions and Answers
Pages 4 & 5

Chapter 15: The Growth of the firm
Questions and Answers
Pages 6 & 7

Chapter 16: Changing the Boundary of a Firm
Vertical Integration
Questions and Answers
Pages 8 & 9

Chapter 17: Changing the Boundary of a Firm
Questions and Answers
Pages 10, 11 & 12

Chapter 18: Changing the Boundary of a Firm
Divestment and Exit
Questions and Answers
Pages 13 & 14

Chapter 19: Changing the Boundary of a Firm
Questions and Answers
Pages 15 & 16

Chapter 20: Organizational Issues and Structure
Questions and Answers
Pages 17 & 18

Chapter 23: Public Sector Production
Questions and Answers
Pages 19, 20, 21 & 22

The Boundaries of the Firm

1. What do you understand to be the transaction cost using the market?

Transaction cost are cost incurred using the market other than management cost. For producers the transaction cost will include discovering the range of suppliers, the specification of the products and their prices, negotiating contract terms, monitoring performance and enforcing the terms of the contracts.

2. What do you understand by the term management or firm transaction cost?

Management cost is the cost arising from organizing the same transaction within the firm and includes any activities undertaken to manage consciously the use of resources.

3. Explain the concept of bounded rationality and asymmetric information and their role in determining the boundary between the market and the firm.

Imperfect markets are characterized by bounded rationality. Decision makers are not fully informed or have just partial information required to make a decision. Asymmetric information is when information is hidden from one party about a potential agreement. Example  is used car market, the seller knows more about the car than the buyer becomes reluctant to pay for the required price of the car and mat be forced to use an expert to evaluate the car; using the market.

4. What is the important asset specification in encouraging the avoidance of the market?

Asset specification is the degree to which resources, capital and labor are committed to a particular task. Such assets cannot be divided to other tasks without their significant fall in value. Asset specification is the key concept in organizational economics; it’s the major determinant of whether a transaction takes place in the market or within the firm. The greater the degrees of asset specification the more likely are the firm to internalized its activities and avoid the market.


5. Explain the concept of adverse selection and moral hazard.

The situation of adverse selection arises when information is both asymmetric and hidden from one party to a potential agreement. Moral hazard arises where parties to an agreement have different information about the action of the other party and the outcome. Example is where the employer cannot fully observe if the employee is fully complying with the contract; otherwise term hidden action. The results of moral hazard are an increase in probability of undesirable outcome for one party after the agreement or contract has been signed. Example is the sales of insurance policies cheaper to elderly people and more expensive to young and inexperience drivers. The insurance company cannot observe the buyer before selling the policy.

6. Many firms Contract out services and offer their supplies long-term contracts, what factor would encourage the firm to acquire its supplier?

A firm will be tempted to acquire its supplier in a situation where there is an imperfect knowledge or incomplete contract, it will be advantageous to acquire the supplier and gain better control over her.

7. In analysis of incomplete contracts what advantages does the owner have over a market contract?

The owner has a greater control over the supplier and obtains a greater share of the benefits.

8. Can a clear blue-line be drawn between the firm and the market as argued by Coarse?

No, market and the firm are alternative methods of coordinating products.













The Growth of the firm


1. Explain Baumol’s sales Maximum model of growth.

Baumol’s model assumes that the objectives of the firm are to maximize the rate of growth of sales revenue in the long run. Retain profits are used to finances growth, the higher the proportion of the profit retained the higher the rate of growth. The model is summarized in the formula; g = (#, R) the rate of growth of sales (g) is a function of profit (#) and current sales (R).



2. How does Marris reconcile the conflict interest of managers and shareholders?

Marris model assumes that the firm owners and mangers have different objectives. The owner is concern with maximizing profit while the manager’s concern is the growth of the firm. Managers want to maximize the growth of the firm and are prepared to sacrifice profits now for higher future growth. They would prefer to retain profit within the firm so that they can use the retained earning to pursuit growth opportunities. There is a trade off between retention and distribution of dividends and the growth rate that the firm can achieve. But the mangers pursuit of growth is restricted by needs to pay dividends to share holders, limiting the proportion of profit that can be retained to fiancé growth. Managers can only pursuit growth only when the keep shareholders happy in order to maintain their positions.

3. Explain how a firm finds optimal combination of growth and profit.

A schema developed by Radic (1971) can be use to show the impact of growth and profit on a firm. The two way relation between growth and profitability is captured by the demand growth curve and the supply of capital curve. From the curve, it can be seen that initially, the higher growth achieved the higher the rate of profit earned. The higher growth rates will only be achieved by lowering prices, increase expenditure ob advertising and developing and introducing new products. The growth and profit rate combination chosen by a firm depends on the preferences of owner and manager. The preferences of manager are between the growth rate and the valuation ratio. Utility can be maximized at point of transparency; a point between the managerial indifference and the valuation ratio.

 4. What factors encourage an endogenous growth process within a firm?

As per Penrose (1959), the key determinants of growth of the firm are internal process that increases the capacity of production. Since the change is within the firm, it is known as endogenous growth. Any resources within a firm that leads to increase I production capacity will encourage endogenous growth. These may include tangible resources; physical assets, plants, equipment and physical labor and intangible resources; skills and knowledge about the production and managerial processes.

5. Explain Penrose’s management constraint and explain why it limits the growth of the firm.

Penrose (1964) identified management as the main constraint on the growth of the firm which has been termed the Penrose effect. Firms wishing to grow can always raise the necessary finances and find new markets but they face difficulties expanding the size of the managerial team without reducing its effectiveness. Thus the limit to the size of the firm is the capacity of the existing team to manage an organization of a given size and complexity. Expansion of the management team may reduce its effectiveness because new members have to be trained and assimilated and may not perform at the same level of efficiency as the existing ones.
6. What are the factors that limit the growth aspiration of a firm?

The cost of growth prevents firms from moving instantaneously to any desire size. A growing firm faces two set of costs; those related to operation of the current business and those related to expanding of the business. Both costs may not be separable and may be jointly incurred, such that the cost of growth adversely affects the cost of existing activities. Example is the building of a new plant and the installation of new equipment to expand production capacity and potential output. These may require the redirection of other factors of production, disrupting current production, increasing the time needed to solve new problems associated with installation and commissioning the new facility. Additional opportunity cost of growth may include higher current production cost because of less stringent supervision and/or the loss of current production.

7. What are the main characteristics of the resource-based view of the firm?

According to Kay (1993) the main element of resources or competence-based theories of the firm are;

  1. Firms are essentially collection of capabilities.
  2. The effectiveness of the firm depends on the match between the capabilities and he market the firm serves.
  3. The growth and appropriate boundaries of the firm are limited by its capabilities.
  4. Some capabilities can be purchased or created and are available to all firms.
  5. Other capabilities are irreproducible or producible with substantial difficulties by other firms and it is on these capabilities that the competitive advantage of the firm depends.
  6. Unique capabilities are generally irreproducible because they are a product of history of the firm or their nature is not fully understood by the firm itself.




Changing the Boundaries of a Firm
Vertical Integration


1. What is Vertical Integration?

Vertical integration involves joining together under a common ownership a series of separate but linked production processes.

2. Explain and evaluate the saving of production cost argument for Vertical integration.

The traditional argument for firm adopting a strategy of vertical integration is associated with the technological imperative of the production process. Significant savings can be made by linking the production of a key input with a given production. Example is the smelting, rolling and fabrication of steel or aluminum. A significant saving on energy cost is realized when the process are linked together as compared to when they are operated separately and require reheating. Having a car body plant closer to the assembly plant saves on transportation and storage cost and avoids delay in scheduling delivery.
One disadvantages of vertical integration is that the firm is committed to technology set-up for the chain linked activities.

3. How does Vertical integration reduce cost?

A firm applying vertical integration can avoid the market and transaction cost but incurs additional managerial cost with increase in the size of the firm. But the cost of the combined management function for the two firms should be lower that than of the two independent enterprises linked by market transaction. Vertical integration will reduce the cost of transportation, energy cost, avoid contract uncertainty and opportunistic behavior that are associated with the market.

4. Explain and evaluate Williamson model of Vertical Integration.

Williamson developed a model that determines the optimal level of vertical integration and the size of the firm. The model distinguishes between;

  1. Technical efficiency; use of least cost production techniques.
  2. Agency efficiency; extent to which the firm minimizes or coordinates agency and transaction cost.

He argued that optimal vertical integration firms minimizes the sum of production and transaction cost compared with market alternatives. A Firm will gain more from Vertical integration where;

  1. The product market is lager. The more the firm produces the faster its growth and the more likely it will integrate.
  2. The firm has multiple products and fewer input.
  3. Assets specification is important, vertical integration will be more profitable than market transaction.


5. If a competitor buys a supply of a key input for your enterprise what factors should
    your firm consider integrating?

The enterprise should consider potential performance that could be improved on, skills and necessary resources to integrate the acquired company without disrupting the operations or causing problems.

6. In what circumstance does a strategy of vertical integration profits the firm?

Vertical integration will be profitable where there are;

  1. Strong technological linkage
  2. High transaction cost
  3. Problem relating to assets specification and incomplete contracts.

7. What alternative arrangement can give the firm the advantage of vertical integration without the disadvantage of ownership?

Firms should consider long term contracts of various kinds that tie the firm together in an exclusive relationship.

8. In what way does vertical integration increase the monopoly power of a firm?

Vertical integration increases the market power of that firm enabling it to raise prices above competitive levels in the production market. The more the firm produces the faster its growth and the more likely it will be to vertically integrate.

Changing the Boundaries of a Firm


  1. What do you understand by diversification?

Diversification occurs when a single product firm changes itself into a multi-product firm. Diversification involves starting a new activity or acquiring a new activity either related to the existing activity of the firm. The new activity can be widened to include selling of existing product in new geographical distinct market. A firm can diversify by developing a new product or entering a new market.

  1. Distinguish between related and unrelated diversification, why might the former be more successful than the later.


Related diversification occurs when a firm produces a number of products using some of the resources of the firm. Using production machinery to make different products and/or using the same marketing strategy to sell products that are not related.

Unrelated diversification occurs when new products or activities have little or no overlaps in terms of their required managerial competence or assets requirement. Making use of the firm’s existing assets and competence could lower unit cost and increase labor and capital productivity.

  1. Explain the main sources of economic gain a firm might expect from pursuing diversification.


The benefits of diversification give the firm cost advantages for a given range of output and revenue possibilities; example is the use of excess capacity to produce and additional product. Competences whose capacity expands with use would seem to have no limits to their exploitation. Synergy can also be derived from economy of scope which arises from the nature of the production function so that two or more products or activities can be produced more cheaply together than separately. The increase in firm that comes with diversification may also produce economy of size. A large firm may use it buying power to obtain lower cost input. Size may also allow the company to achieve lower management cost through organizational efficiency.

Diversification will lead to reducing the volatility of profits and risk spreading, it’s another way for a firm to reduce dispersion and offset the decline in profit, cyclic variation can be offset by the acquisition of products whose sales moves counter –cyclically to its existing product, while secular decline can be offset by product exhibiting long-term growth. Such diversifications are intended to stabilize and prevent the firm from making losses.

Diversification enables a fir to spread risk by offering a degree of insurance against unexpected changes in any one market for any one product. A given fall in sales may have  a bigger impact on  specialist airlines than a diversified company with an airline  division, leading to loses, retrenching and ultimately bankruptcy. A firm pursuing diversification may experience limit profit variation and hence variation in dividend payment to shareholders which may give the firm a cost of capital advantage compare to firms whose profit are more variable. The risk of no dividend payment to shareholders may also reduce. A diversified share portfolio enables them to stabilize their income. A large firm has the opportunity to utilize funds generated from one activity for investment in another. The use of internal funds negates the need for the firm to borrow from external sources. With their own resources the firm is able to finance new strategies and to back the superior knowledge of the proposed change.

Senior manages can secure their jobs by diversifying the activities of the firm in order to reduce the variability of the overall profit, dividends and share prices. Where the mangers rewards are tied to the size of the firm then growth by diversification satisfies both their needs to protect security of employment and the desire to see the remuneration increase. Diversified firms will also experience increase in market power, it does so by increasing the firm s ability to adopt other anti-competitive practices. The ability to do so come from the strength of the company to finance activities in one market with support of profit made in another. As per Hill (1985) diversified firms will thrive at the expense of non-diversified firms because they have access to conglomerate power which is derived from the sum of its market power in individual markets. A diversified firm might engage in predatory pricing to make life difficult for competitors and possibly drive them from the market.


  1. Explore and explain the following rationale for diversification.
    1. Unused resources
    2. Economic of scope
    3. Risk reduction for investment
    4. Management utility fulfillment
    5. Lower financial cost.

A. Unused resources
Making better use of the firm’s existing assets and competences could lower unit cost and increase labor and capital productivity. Great use could be made of;

  1. Using of the existing plant and equipment to make new products along side the existing ones.
  2. Use of distribution and logistic systems to distribute related goods to the same outlet.
  3. Use of existing promotion system to promote new products
  4. Use of existing brand name to sell new products
  5. Use of retained earning not required for current activities for future investment, rather than keeping them I non-interest earning form of cash.
  6. Use of managerial talent to extend to a range of activities.


B. Economic of scope
Synergy may be derived from economies of scope; two or more products or activities can be produced more cheaply together than separately. Increase in size of the firm that comes with diversification may also produce economy of size; the bigger firm can use it buying power to obtain lower cost input. Size may also allow the firm to achieve lower management cost through organizational efficiency. Diversification may also be a spur to a firm adopting more cost effective organizational form.

C. Risk Reduction for investment
Diversification enables a firm to spread risk by offering a degree of insurance against unexpected changes in one market for any one product. A market shock affecting a single product will have greater impact on a specialist firm profit that those of a diversified one. Example is a given fall in sales may have a bigger impact on a specialist airline company that a diversified company with an airline division leading to losses or, retrenchment and ultimately bankruptcy.

D. Management Utility fulfillment.
Only if the gain from utilizing the unused resources internally exceeds the gain made by arranging to sell the used resources to third party then can the efficiency argument hold. Grant (1995) argued that “for diversification to yield competitive advantage requires not only the existence of economies of scope but also the presence of transaction cost. The firm should always consider selling spare resources to outside user and therefore identify the core activities of a diversified firm.

E. Low Financial cost
Diversification may limit profit variability and hence variation in dividend payment to share holders which may give the firm a cost per capital advantage compared to firms whose profit are more variable. The greater stability of earnings reduces the risk of debt holders of not receiving their interest payment. Debt capital may also offer tax advantage to the firm, since the interest payments are treated as cost rather than element of profit. Dividends on a contrast are regarded as profit distributed to shareholders. The risk of dividend payment to shareholders is also reduced. A diversified share portfolio enables them to stabilize their income.

  1. Why is diversification a popular strategy with management


Managers may be pulled towards diversification where potential rewards for investment in new markets opportunity promise greater profitability than ploughing them back into the existing activities. The pursuit of diversification may be tempered by the need to make more profits to keep shareholders happy and maintain the valuation ratio of the firm. Diversification may be driven by the following factor;

  1. Limited size of the existing market
  2. The existence of underutilized assets that might be used to produce new products or manage new activities
  3. Surplus investment resources that could be used to finance new activities.

Changing the Boundaries of a Firm
Divestment and Exit


1. What factors might explain why a firm ceases to be viable?

A firm will not be viable because of the following factor;

  1. Demand is static and/or declining.
  2. Low earning or making losses in activities concern.
  3. Cash flow problem; unable to pay debts.
  4. Firm is inefficient in terms of productivity and cost compared with it market rivals.
  5. Strategy does not fit with current objectives of the firm.


2. Explain the concept of barrier exit, how do they explain the reluctance of firm to leave the industry or market?

Exit barrier are obstacles to firm leaving the market despite falling sales, narrow profit margins and declining profits. Porter and caves (1976) and Harrigan (1980) classified barriers into economic and strategic. Economic barriers are those factors that results in the facing of high opportunity cost if a firm decides to leave the market or industry; the cost associated with closing and dismantling plants and equipments and the absence of a market for used capital equipments. The significances of the economic factor are a function of the capital intensity of the production process, assets and the reinvestment requirement of the firm.
Strategic barrier arises from the reluctance of the firm to sacrifice the cumulative benefits of intangible assets created by previous investment and these include;

  1. High quality image created by previous expenditure on R&D, production and advertisement.
  2. Facilities shared with other products that are profitable
  3. Company recognition created by previous advertisement
  4. Business that are strategic important to the firm
  5. The potential damage in other markets of upset customers with significant business power.

Porter argues that the exit of a single product firm means the manager losing their jobs while in a multi-product firm it means redundancy.
3. How does game theory help to explain the reluctance of firm to exit the market?

The notion that the most inefficient firm will be the first to leave the market is unlikely because there may be some reasons for the firm to stay. An individual firm may behave strategically and wait on the decision of the other firm. The first firm to leave the market will make it easier for the remaining firms to survive, particularly if a significant amount of capacity is removed. Large multi-product firms may be able to finance losses while waiting for improved market conditions because the activities may be crucial to some other part of the firm. In practice the size of he firm affects its closure decision. Ghemawat and Nalebuff (1985, 1990) Argued that large firms may close plants or leave the industry before small firms. They suggested that survivability is inversely related to size. Smaller firms have lower incentives to reduce capacity in declining industries than do the larger competititors. Smaller producer may suffer less from unit cost as output declines, can operate more profitably with smaller level of output and their management may have more to loss if they leave the industry.

4. Explain the terms manger friendly and investor friendly used in bankruptcy procedure.

Manager friendly is the procedure for bankruptcy used by the United State of America. The provision allows the manger of the firm in financial difficulties but not necessary insolvent to seek protection against creditors. The existing manger continues to run the business, seize or sell any of the firm assets during the process.

Creditor friendly is the bankruptcy procedure used in the United Kingdom. The procedure involves banks that lent money to a company; agreeing not to take any action against the company to recover their debts. The second stage is for the lead bank to negotiate with the company on behalf of the lender to put in place arrangement to restore the company’s financial health. The procedure is initiated by the creditor not the company director.  

  1. Should UK introduce Chapter II type procedure to deal with companies in financial difficulties?


No, many more companies are declaring bankruptcy because of Chapter II procedure.









Changing the Boundaries of a Firm


1. Why should the management of a firm prefer;

  1. Internal growth to external growth through mergers?
  2. Growth through mergers to internal growth by organic expansion?
  1. A firm will prefer internal growth if it has a source of resources and the capacity to expand.
  2. Growth through merger is preferred to organic expansion because growth through merger is often considered les risky and more rapid way of achieving growth, achieving diversification and access to new markets.


2. Distinguish between horizontal, vertical and conglomerate mergers and give examples of each.

 Horizontal merger occurs when two firms in the same market are consolidated into a single enterprise. The new enterprise will have increased in market share and thus acquiring market power. Example is two small legal services merging to form one big firm.

Vertical merger occurs when two firms operating at different stages of a linked production process combined. Vertical mergers are described as either bringing about backward or forward integration. Backward integration involves a firm moving closer to raw material sources and forward integration is moving closer to the market. Example is a refinery merging with an oil and gas producing firm.

Conglomerate merger occurs when firm producing independent products for different markets merge. Conglomerate merger create larger diversified firms. Example is a legal firm merging with car manufacturing industry.

3. For what reason would a firm seek to be taken over?

The management of a firm seeks to merge for defensive reasons such as protecting their own position, to avoid bankruptcy or to avoid being taken over by unwelcome bidders.

4. What reasons will motivate a firm to acquire another?

A firm may be motivated to acquire another one because of the asset the target firm posses, particularly intangible assets or competences that cannot be purchased in the market; these may include knowledge of a particular market or particular technology and strong reputation for product quality.

5. What are the anti-efficiency arguments against merger?
A merger adversely affects profits and medium size growth. Pickering (1983) found that on an average merger do not have favorable effect on the relative profitability of the merged firm. In 1990, studies indicated that majorities of merger were unsuccessful and that merging was a high risk strategy. A failed bid or the repulsing of a bid has significant effect on the efficiency of the firm that exhibits substantial growth in net assets. Merger favors growth rather than profitability.

5. What are the pro-efficiency arguments in favor of mergers?

Mergers favor growth and long-term profitability of the firm. Greater market power can be achieved by increasing market shares through mergers. Merger will also permit a firm to acquire competence, knowledge of a particular product or market. Mergers are intended to produce cost savings from synergy between existing and acquired which may arise from reorganizing the production, selling, distribution and management function of the combined enterprises. Through the economic of scale as production is concentrated on fewer facilities and from economic of scope as administrative functions are shared and purchase of raw material are coordinated. And from economic of size which allows the larger firm to achieve lower cost that smaller firms.

  1. Why do merger fail to deliver the anticipated benefits?


Merger fails to deliver the anticipated benefits because little attention is paid to the problem of integrating two organization and disposing particular activities in pursuit of rationalization. Merger creates uncertainty for staffs of both companies and at most discontent and decline productivity.










Organization Issues and Structures


1. What do you understand by the term Agency theory?

The term agency theory is the alignment of the principal (Owner) interest with that of the agent (manager) such that both work together in the benefits of firm and shareholders. Same relation exist within a firm be it between executives and senior manger or manger and workers. The theory arises where the principal engages an agent to perform some services on their behalf which involve delegating some decision making authority to the agent.

2. What is the source Agency problem?

The agency problem is aligning the growth of the firm with the maximum profitability of the firm as required by the principal or owner. When both objectives are not reconciled then there will be a conflict of interest issue.
How might owner attempt to alleviate agency problem among senior mangers.

The principal or owner might attempt to alleviate the agency problem by introducing an incentive scheme that ties the efforts and outcome or performance of the agent to a reward. The nature of the incentive offered to the agent may be a financial nature and closely linked to the output. The agent may be paid a basic salary with bonus varying with output. Or the incentives may allow the agent acquire shares in the company at a preferential rate after meeting a set target.

4. If the efforts and outcome are not clearly measured what problems are created for incentives schemes?

If the principal cannot clearly measured agent’s efforts or out come then a situation of asymmetric information is created. The principal can offer the agent a fixed wage but the agent has no incentive to do a good job because he can reduce his efforts and still receive his wages. If the principal receives a fixed payment and the agent receives a residual and bears the risk attached, then the agent has an incentive to make an extra effort but the principal who does not share in any surpluses may not have any incentive to maintain the quality of the resources supplied to the satisfactory of the agent. The reward structure adopted will clearly depend on the attitude of the two parties bearing the risk.

5. Identify the main characteristics of the U- form firm. What are the advantages and disadvantages? How does the U-form structure limit the growth in size of the firm?

U-form structure is an organization structure that is hierarchical with the managing director and board of director at the top of the pyramidal structure. The firm is divided into functional areas covering each activity as sales, finance, production, R&D and personnel.

The advantages of the U-form structure are;

  1. The growth of functional specialization that provides the firm with more efficient performance through the effective division of labor and free the executive from undertaking many of it duties, giving him more time to consider the strategic and entrepreneur issues facing the firm.
  2. The U-form structure is very effective for small or medium-sized, single-product enterprises

The disadvantages of the U-form structure are;

  1. The unitary structure takes the form of a hierarchy or pyramid whereby the managing director gives orders to the functional director who also gives orders to the next layer of management down the line of control. Each level of hierarchy has its responsibilities for a particular aspect of function and will report its performance to the higher level that gives orders. The number of levels of management requires in a U-form firm is a function of the span of control of the manager and the number of operations at the lowest level. At some point the firm faces diminishing returns as the number of hierarchy layer keeps growing. Loss of control, information distortion and senior management making decision with incomplete information.
  1. Crowding out strategic decision making; the BOD may be made up of senior operating officers for each of the functional areas together with the CEO. Since the officers are primary concern with the efficiency of their functional area, such a board is said to spend too little time on the wider issues facing the enterprise. Each director may also behave opportunistically to favor his own department at the expense of the others. The function of the CEO is to give the functional director objectives and to co-ordinate their work. But each functional director may prosecute the interest of his particular group over the others. The functional director may cease to communicate with other and pursue conflicting goals making the work of the CEO to pursue the collective interest more difficult.


  1. Self interest and opportunistic behavior; if resources are allocated to functional areas led by a stronger and more powerful EXECO then the resources are misallocated. The problem is compounded by the different faces of U-form firms in measuring performance of individual functions.






Public Sector Production


1. Explain the concept or externalities, what are the sources of social benefits and social cost? Why do markets misallocate resources in the presence of externalities?

  1. Externalities arise when benefits and cost are not wholly received by the intended consumer or fully incurred by the producer. The producer provides an unpaid for benefits to another producer or consumer. Example is the construction of a damp that provides water, prevents floods and acts as a touristic site.


  1. External cost arises when the producer imposes cost on other who then receives no compensation. Example is generating electricity from coal which produces smoke, acid rain and other pollutants. Social cost of an activity are equal to private cost plus external benefits
  1. The market in the presence of externalities will misallocate resources where social cost exceeds private cost, the market overproduces and where the social benefits exceed private benefits the market under produces.


2. Explain the concept of excludability and rivalry in consumption and explain how they can be used to define private, public and merit goods.

  1. Excludability and rivalry arises where private good are produced only for those who have the ability to pay for and exclude those who cannot pay from consuming. Consuming of the product by one person deprives the other person from consuming the same product or services and the consumer’s benefits are private.
  2. Public goods are good that are non-excluded and non-rival in consumption, consumption by one individual does not reduce the amount available for the other person and the consumer cannot be excluded. The consumer cannot be excluded from consuming if he chooses to do so whether they have made a contribution or not towards the cost of supply.
  3. Merit goods are goods that have substantial social benefits; example is education and health care.


3. What problems does the concept of free ridding create for public sectors organization?

Free riding concept come into play when using public goods or good that are non-excludible and non-rival in consumption. And because they are non-excludible and non-rival they may become congested since no body can stop the other from using.



4. What are the main economic argument for certain goods and services to be produce in the public sector?
Goods may be produced by state owned or public organization because of the following reasons;

  1. Failure of market economy and disadvantage of private ownership.
  2. Inadequate private supply; neither the volume produced nor the quality meets the requirement of the society when production is lefty to private sector.
  3. Asymmetric and imperfect information; inadequate market supply because consumer and producer have incomplete information available to use in making decisions. One party to the transaction has information that is not available to the other parties, leading to a situation of adverse selection and moral hazard. Example is health insurance market where prices are bid up if the insurer does not know the risk associated to particular individuals leading to only the sick seeking insurance that they cannot afford and many people are left uninsured. The alternative is for the state to provide health services and insurance.
  4. Decreasing Cost Industries; where the demand cannot justify more than one economic or sustainable organization then efficiency requires a monopoly supplier who will exploit consumers raising prices and restricting output and may have no interest in investing in growth of capacity despite the desire of the state to see growth in supply capacity. Electricity supply is a good example of natural monopoly and is seen as an important factor for economic development. Consequently state or public ownership is the preferred option in many countries since the sate can regulate the prices better and also carry out objective management, investment and growth.
  1. Social Preference and Ideology; Socialist believe that public ownership of key sectors of the economy is superior to private ownership and necessary  not only to achieve increase in economic welfare but also to enable benefits to be more fairly distributed in a more equalitarian state. Public ownership is also thought necessary to help plan the economy so that the decision about the industry could be made to meet social and political objectives.


  1. Sovereignty and Ownership; public production is a concern over foreign ownership of sectors that the state might consider important for it efficiency running and survival. Example are the defense and infrastructure, cultural institutional and media. Aero manufacturing, ship building airlines, shipping and armament manufacturing, so to prevent the termination of supply at inappropriate time.




5. What factors determine whether a product or service produced by public sector organization should be available “free” or at a cost-related price?

The choice of organizational structure can be between government departments, independent agencies and independent public corporations.  Some factors influencing this choice include:

  1. Ownership
  2. Function
  3. Objectives
  4. Output
  5. Consumer charges
  6. Finance of  organization
  7. Market operational control
  8. Performance measurement.

Depending on a particular task the government wishes to carry out, then a particular structure will be selected. Local authority might be appropriate for social services. Public enterprise might be appropriate for electricity or railway.

6. Why should public enterprise be less efficient than private sector enterprise?

Comparative performance results for public and private enterprise are inconclusive. The results obtained are very much a function of performance at a particular point in time and the indicators used to measure the performance differ according to the objective of the public and private enterprise. Millward (1982) in a major survey conclude that there appear to be no general ground for believing that managerial efficiency was lower for public firms. Vickers and Yarrow (19998) suggested that private owned firms tend on average to be more efficient when competition in market is effective.

Kay and Thompson (1985) also concluded that privatization will tend to improve performance in a company if only supported by liberalization. Pryke (1982) examined comparative performance in airlines and cross-channel ferries where there was public /private competition. He also looked at the sales of gas and electricity appliances and examined productivity, profitability and output.  He concluded that private firms tend to be more profitable and exhibit a greater internal efficiency than their public sector rivals. Boarderman and Vining (1989) surveying empirical literature suggested that the literature provides only weak support for superior performance of private enterprises. They argued that the studies have been of natural monopolies and regulated monopolies and none has been set in competitive environments. Their statistics test showed that private companies were more significant more profitable than the other types and that mixed enterprises were less successful than state-owned enterprises.
Studies by Parker and Martin (1995) also failed to find improvement in performance in a number of cases. They found that significant improvement in performance came in periods before privatization because the public enterprise needed to improve its performance to help it salability to private owner. With the right objectives the performance of public and private enterprises might be similar
The conclusion from these studies is that the performance of an organization is as much a function of the competitive environment it operates in as its ownership status. The general perception that public enterprises are less efficient than public sector has led to the privatization and introduction of competition in many sectors through out the world.

7. Why are clearly specified property rights important in determining the performance of a public enterprise?
Senior managers in private firms have ownership stake in the enterprise. In order to ensure that they align their interest with that of the shareholders they are given ownership rights as part of their remuneration package. The proper right theory argues that public enterprises will be less efficient private sector enterprises because of lack of enterprise pressure on managers to operate efficiently since they are unable to benefit in the same way as their private sector counterparts.

  1. Is it possible to reconcile the concept of public and enterprise in a single organization

Yes, it is possible like in the notion of public enterprise as in the UK where the politicians set the long-term objectives and managers are responsible for day to day decisions. The aim is to combine the notion of publicness with the concept of enterprise to serve the public interest. The concept of publicness implies serving the interest of the community as a whole rather than the private interest of owner’s of capital. The government set the objectives that are fulfilled by the managers who have ownership stake and pressure to serve the public interest. The organization is accountable to the government and the society through democratic control rather than through shareholders.
The concept of enterprise implies that managers can take judgment decisions and incur risk in their decision about how to produce and how to innovate. The managers have the power to implement the existing plans and are allowed to change production to meet changes in demand, to introduce new products, to introduce cost saving production techniques and to undertake investment to ensure future production of goods and services. The board of public enterprise is appointed by the government to run the company. The board then appoints senior mangers. Neither the board nor the manger has the freedom to make full range of enterprise decision that are required of a private company. They are not allowed to diversify, make take-over bids or even set prices.

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