Market Efficiency and Free Market System in Kenya

1)

A free market system is an economic system in which prices for goods and services are determined and set liberally by approval between the buyers and sellers, and where the demand and supply for those goods and services are free from any interference or regulation by any authority including the government (Wikipedia, n.d.).

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The free market system runs under the principal of supply and demand, where decisions on what, when and how much to produce, what resources to allocate, and what prices to set, are made by producers and consumers of the goods. It is also known as capitalism.

The attributes of a free market system include:

• Freedom to choose – individuals are free to choose what to buy or sell, and there is cooperation between buyers and sellers
• Private ownership – individuals own goods and property, not the government or some other regulatory authority, and are therefore free to buy and sell private property
• Self motivation – individuals are motivated due to self interest: It also encourages entrepreneurship where people are free to invest and free to earn profits from their investments
• Competition in the market – companies compete freely in the market thus giving consumers more variety, better quality of goods and services, and also reasonable low prices
• Freedom to set the prices of goods, services, and also the wages being paid for labor and other work
• No regulation (Lameiro, n.d. & Mayerson, 2013)

To determine whether the free market system is really the best alternative for determining the allocation of resources in an economy, it is important to understand the pros and cons of the system.

The lack of any regulation or government control means that the free market system has various advantages and a range of freedoms that benefit both the producer (investor) and the consumer. Consumers are free to choose how they want to spend, and because of this, the market is responsive to the needs (demand) of the customers, thus a wider variety of goods and services are produced (supply) to meet those needs. The market forces (consumer demand and producer supply) of the free market system determine what goods are produced, the quantity, what prices to set, and the target consumers. This gives rise to strong competition and drives the companies to produce better goods and service, through innovation, use of better production methods, and technology, ultimately leading to better pricing for the benefit of the consumers (Hanks, n.d.).

A good example of the benefit of having a free market system is demonstrated in the case of AT&T. AT&T, a telephone company in the US, was a regulated company and had a national monopoly, which meant it set the prices to maximize profit, was in the 1980s deregulated thus allowing competition and consumers benefited from the resulting competitive rates (Seabury, 2008).

However, the free market system also has some drawbacks which can lead to severe negative consequences. Although companies would produce goods that are in demand by consumers, without any regulations in place, harmful products can end up in the market. The companies’ focus would be profit maximization, thus the needs of a company are put above the needs of consumers; this would lead to a tendency for companies to neglect the negative impact of their goods and services. There is a high risk of unethical practices being carried out to gain more profit and for self-interest. As the main motive of companies would be profit maximization, merit goods and services such as education, roads, street lighting and such, may not be well-catered for because companies may not find it profitable enough. A free market economy in its pure form would lead to unfair competition whereby companies can create price fixing monopolies thus benefiting certain companies or individuals, and because there are no mechanisms to ease the inequality between the rich and poor, a free market system would further increase the inequality between people.

The dangers of having a completely free market system are clearly evident in the case of companies such as Enron and WorldCom where the motive of profit led to unethical practices (Hanks, n.d.).

In the case of Enron, the leaders and other employees used unethical financial practices to deceive investors and employees by making false entities to which a substantial amount of debt was transferred to thus showing that the company was making good profit (Jennings, 2006). The scandal was eventually revealed and the company’s stock went from US$90 to less than a dollar thus devastating the many investors and employees, and the financial market as well (Betz, 2002). This clearly shows that the individuals involved in this scandal were motivated by the greed for money.

The case for WorldCom was similar. Through accounting malpractices, the company showed revenue growth by acquisition of their competitors. By listing acquisition losses and debt as goodwill, and not reporting operating expenses, the company portrayed a strong financial and credit rating. This led to investors believing that the company was making a good profit whereas it was running into losses. An audit and investigation later revealed billions of dollars of undisclosed debt. As was in the case of Enron, the investors and employees lost their hard earned saving.

Had there been regulatory processes and business ethics code of conduct in place, then the story of Enron and WorldCom could have been different, and the investors and employees could have been in a better position than what they had to go through (Szjbf31, 2014).

A free market system without some regulatory authority or government intervention can be a dangerous economic playground.

2)

Kenya is an agricultural country, meaning that the major economic activity is farming and the majority of the population survives on agriculture related income. Crops like tea and coffee, and horticulture crops like flowers are the main goods to be exported out of the country for foreign income.

Since Kenya relies a lot on its exports to generate most of its foreign income for the economy, priority is given to agricultural and horticultural crops to ensure efficient and sustainable production to meet foreign demand for these goods. Income earning export goods are produced in the highest quantities and are allocated more resources in terms of land, processing facilities, transport, and tax benefits. An organization called Export Processing Zone Authority (EPZA) has established seven Export Processing Zones (EPZ) across the country that offer incentives and attractive investment opportunities to export-oriented companies in Kenya. The scheme offers lower investment and setup costs with higher profit returns (Embassy of Republic of Kenya in Japan, n.d.).

Kenya is also home to the second largest venue for tea auction in the world. The Mombasa Tea Auction Centre provides direct feedback of market prices to the tea factories and tea farmers thus enabling them to adjust their prices according to the demand and supply thus ensuring that the tea industry remains competitive and amongst the top in the world. This would ensure that the tea farmers also benefit through better pricing and constant supply to meet demand (Kibe and Kimenyi, 2014).

The government implements its economic tool, the public budget, which transforms the government’s policies and goals into decisions aimed at developing and sustaining economic policies and growth. The general public is directly affected by the government budget which determines the production levels and prices changes, for example, of basic common goods such as bread, milk, sugar and fuel, and also of the various taxes that are to be levied on goods and services. Ultimately, the government budget influences how the public resources are raised and allocated (International Budget Partnership, n.d.).

The population growth in Kenya surpasses the economic growth rate, and that translates into budget shortfalls and unemployment. The pressure on the available resources has been high resulting in a rise in rural poverty, and thus non-availability of appropriate technology (especially for small farmers), lack of access to funding, inadequate infrastructure, and high cost of farm inputs (United Nations, n.d.).

To tackle this, the government has implemented procedures in order to increase reasonable access to production support services by the rural population such as: inspection of farm inputs, quality control, technology development for farming, participation of the private sector, training of farmers especially women, providing physical infrastructure such as rural feeder roads, electricity provision to rural areas (United Nations, n.d.).

The poor population can barely afford basic goods, and make their purchases on a daily requirement basis. This has led to the producers making goods in smaller packaging quantities such that the poor are able to buy these goods on daily basis.

3)

Market efficiency can be defined as the level to which the price of a stock or market or asset reflects all information available about that particular stock or market or asset, and the prices adjust immediately when any new information is available (Harvey, 2012).

When investors invest money into a particular stock or market, they do so with the aim of generating profitable return by trying to beat the market using the all available information.

According to the efficient market hypothesis (EMH) that was devised by Fama (1970), market efficiency advocates that at any particular time, prices completely reflect all available information about a particular stock or market. Consequently, no investor has the upper hand in forecasting a return on a particular stock or market since no one has access to some particular information that is not already accessible to everyone else in the market This means that the way investors perceive available information will be reflected in the prices of the stock or market, and because all investors will be having the same information available to them, no investor will have an upper hand to make more profit than anyone else. For this reason, an efficient market will be having prices that are random and unpredictable such that no particular investment pattern can be determined. A market becomes efficient when investors see the market as being inefficient and the potential to beat the market exists. Thus they implement investment strategies to try and gain from the perceived inefficiencies, but they actually end up keeping the market efficient. For this to happen, it is necessary for the market to be large and accessible, and information must be made available to all the investors at the same time (Heakal, 2004).

Samuelson (1965) observed that “in competitive markets there is a buyer for every seller. If one could be sure that a price would rise, it would have already risen” and also asserted that “arguments like this are used to deduce that competitive prices must display price changes… with no predictable bias.”

Types of market structures and their characteristics

The collection of all companies making similar or identical products is called an industry. The market structure of an industry is determined by the number of companies in that industry, how they position themselves to compete (Flynn, n.d.), the number of buyers and sellers, existence of any entry or exit barriers, size of the company, market share, existence of competition, transparency of information and type of product: homogenous or differentiated (Sen, 2011).

The four common and basic market structures along with their characteristics are outlined below:

• Perfect competition – In this market, the companies are the price takers whereas the market forces (demand and supply) are the price makers. The companies therefore have no control over the prices. As the companies are small, their behavior has no influence on other companies in the market (Thrasher, 2011).
• Number of buyers: many
• Number of sellers: many
• Buyer entry barriers: no
• Seller entry barriers: no
• Size of the firm: small
• Product: homogenous product; very good substitute products
• Market share: small
• Competition: very strong; pricing based
• Pricing power: none; no influence on other companies
• Transparency of information: transparent and freely available
• Demand curve: perfectly elastic

(Sen, 2011 & Thrasher, 2011)

In the real world, a true perfect competition market does not exist. Instead, there exists a near perfect competition market, for example, the vegetable market that we buy vegetables from.

• Monopolistic competition – In this type of a market, there are many firms that produce similar products, and it is relatively easy for a new company to gain entry into the market. The market share that each company holds is small, so competition is strong with a lot of marketing activities to attract consumers.
• Number of buyers: many
• Number of sellers: many
• Buyer entry barriers: yes: very low
• Seller entry barriers: no
• Size of the firm: relatively small
• Product: substitute products but differentiated; different branding
• Market share: small
• Competition: very strong; marketing and pricing
• Pricing power: little; a company’s decision may not influence another
• Transparency of information: fairly transparent and available
• Demand curve: downward sloping (but more elastic compared to monopoly)

(Sen, 2011 & Thrasher, 2011)

Monopolistic competition markets are found almost everywhere. In fact it is the most common type of market that exists today because it enables small firms to survive. Examples would be restaurants, hotels, specialist retail outlets; they all provide similar goods and services but with some differentiation like physical appearance, packaging, size, marketing differentiation and distribution differentiation (Economics Online, n.d.).

• Oligopoly – in this market structure, a few companies dominate and make up the industry. These companies together can have some control over the output and prices and are interdependent on each other such that if one company makes certain decisions or changes to the prices and product output, the other companies respond by following suit. The characteristics of an oligopoly market structure are:

• Number of buyers: many
• Number of sellers: few
• Buyer entry barriers: no
• Seller entry barriers: yes: high capital requirements, economies of scale
• Size of the firm: average
• Product: differentiated products
• Market share: average
• Competition: high; marketing and pricing
• Pricing power: average; companies stick to rigid pricing to avoid price wars
• Transparency of information: slightly transparent but not easily available
• Demand curve: indeterminate

(Sen, 2011 & Thrasher, 2011)

An example here would be the automobile industry in many countries whereby there are few companies that produce and sell but there are many buyers and competition is high (Sen, 2011).

A second example would be the fuel selling companies. There are few companies that sell the fuel but the buyers are numerous. In Kenya, the main companies that sell fuel are Shell, Oil Libya, Kobil, Kenol, and Total. Competition does exist, but there is a price regulation that has been put into place to protect consumers from artificially inflated prices. Without this regulation, it would be possible for these companies to mutually agree on price-fixing to maximize profits.

• Monopoly – in this type of a market structure, one company dominates the market by providing a product that has no substitute available and therefore no competition, and thus profits are also very high since the company is the price maker and sets the pricing so as to reap maximum profits. The company is the industry. There are several barriers and restrictions, such as high costs, state regulations, and control over resources, making it impossible for another company to enter this type of a market. The characteristics of such a market structure are:

• Number of buyers: many
• Number of sellers: one
• Buyer entry barriers: no
• Seller entry barriers: yes: very high, almost prohibited
• Size of the firm: large
• Product: in most cases single product; no substitute available
• Market share: highest
• Competition: no competition; advertising
• Pricing power: significant; company is the price maker
• Transparency of information: minimum, barely available
• Demand curve: downward sloping

(Sen, 2011 & Thrasher, 2011)

An example would be state owned companies, such as Indian Railway in India where there is no other contributor to that market. This means that the company sets its own transport fares and the buyers, in this case the passengers, have to pay the stated price without being allowed to bargain (Sen, 2011).

Another example, here in Kenya, would be the Kenya Power and Lighting Co (KPLC) which solely distributes electricity throughout the country. There is no other company that is in the same market due to government regulations and high costs of investment especially infrastructure. Electricity costs in Kenya are high, and because it is a necessity especially in urban areas, KPLC is enjoying good margins since it determines the prices that the consumers will pay. The effect on consumers is that since they have no alternative choice, they have to accept the terms set by KPLC. Yes, there is an option to use solar power systems but then the investment for equipment is very high.