Does the Market System Best Allocate Resources?
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Published: Tue, 12 Dec 2017
In order to accurately examine the belief that the market system best allocates resources and encourages positive investment climate we must look at the functioning of the market system, resource allocation and the criterion within a positive investment climate.
A Market System is a system where buyers and sellers interact without the intervention of government regulations. Inherent in this system is the concept that sellers want to gain maximum price for the goods, services and resources offered and buyers want to receive value for the lowest price. The balance of this relationship leads ultimately to the market equilibrium price. However, important to note in this system is that all factors external to the “Market” have no effect on this relationship that is government regulations or policies. Resources are therefore strictly allocated to the production of those goods which give the sellers maximum return and correspondingly give the consumers the maximum satisfaction of their wants at a market price.
Within the” Market system” resource allocation is heavily dependent on the variations of the price of the resources themselves. Price acts as an indicator to both the consumers and the sellers within the market (Price Signals as Guides for Resource Allocation, Anon, n.d.)
To be explicit given accurate price information the sellers will use high priced scarce raw materials, (e.g copper market) or resources to produce goods of high value. Likewise only those consumers who see benefit in consuming those higher valued goods will demand them therefore achieving balance within the system. Similarly where the price of a readily available resource is low it will be allocated by the resource users for use to produced goods in a lower valued tier and consumer behavior will also react accordingly.
To summarize, the shifts in the price of privately owned resources within a free market results from the shifts in the demand and supply of the resource i.e. capital, labor, raw material. This is believed to lead in turn to efficient resource allocation by the resource owners through:
- (Expanding the supply) Reallocating resources to the production of high priced goods.
- (Contracting supply) Reallocating resources away from the production of low priced goods.
- Reallocating resources to production of goods in high demand by consumers in order absorb excess demand.
- Reallocating resources away from the production of goods in low demand in order to absorb excess supply.
Therefore efficient allocation of scarce resources is based on private consumption, production decisions or a combination of both at the market equilibrium price.
The investment climate itself is determined by several factors which affect the investment choices, opportunities and the resultant benefits gained by a firm or investor. A good investment climate encourages efficiency and productivity in order to increase profits and therefore increase capital available for investment (Investment Climate, Anon, n.d.). We must recall that the market system itself encourages producers to allocate resources such that they are put to use where there will be no wastage at the market price i.e. Pareto optimal allocation (Griffiths and Wall 2008 p. 212). Therefore we can say that the market system fosters efficiency within the business environment through full utilization of investment capital, machinery and labor. Essentially this indicates that the market system encourages a positive investment climate.
It can be said that the creation of employment and market expansion is an indicator of a positive investment climate. As established, the market system is such that, where opportunities exists for both expansion into new markets or producer output to be increased, the private owner of the resources will act in response . For example, all things being equal, increased consumer demand for natural gas converted cars in Trinidad and Tobago would lead to increased production of scarce natural gas and new suppliers followed by increased job opportunities.
From our examination of the market system and scarce resource allocation within it we have seen why it is believed by some that the market system is the best mechanism for allocating scarce resource. This is justified through accurate market price signals and the resultant efficiencies created and the positive effects these have on the investment climate.
PURE MARKET ECONOMY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2010. [Accessed: November 10, 2010].
Why do some people believe that not everything can be left to the free market, but that governments also have a role to play in encouraging a positive ‘investment climate’? Explain your reasoning.
In order to explore why some may believe that everything cannot be left up to the free market but government has a role to play in fostering a positive investment climate we must first look at what constitutes a good investment climate.
The World Bank Report (2005) declared that a good ‘ investment climate’ is not one only centered on profit generation but one which cultivates benefits to society as a whole. Taking into consideration the free market system and its characteristics it is established that in this system exists:
- Private ownership of the scarce resources.
- The private needs and wants and or production decisions influence the allocation of scarce resources.
- Profit maximization as aim of producers.
That is to say the free market system does not factor in the needs of society in pricing or distribution of scarce resources. The market system is such that scarce resources are allocated to the production of those goods whose market price yields maximum gain. However, in the production of these goods in the pure market system will to certain effects. These effects are known as Externalities. It is known that externalities occur when economic decisions create costs (negatives) and benefits for people other than the decision taker (Griffiths & Wall, 2008). Externalities often lead misallocation of the scarce resources (Griffiths &Wall, 2008, p. 35). These misallocations of scarce resources in the free market may occur where:
- The social benefit of production is not maximized as opposed to the private benefit of the production (profit maximizing firm).
- The social cost of production is less than the private cost.
Where these situations are left unchecked, as will occur in a free market system, they will lead to over production and under production respectively (Griffiths & Wall, 2008, p.283 & p.284). There are other ways in which the free market will lead to misallocations such as in the provision of ‘public goods’, These would not be produced by the market system since no private benefit would be gained. Additionally where imperfect information exists within a market it can lead to misallocations (Griffiths & Wall, 2008). This is especially important since the consumer and producers within a free market depend on information in order to allocate their resources i.e. capital. For example where a firm will make false claims about the high quality product which have not been verified by a government agency, this will lead to consumers using this product based on these claims. This will in turn signal to producers to elevate to higher production levels.
The market system also has inherent failures for example natural monopolies and externalities. Where monopolies
We must now consider what role the government plays in offsetting these inefficiencies and encouraging a good investment climate. As discussed previously a positive investment climate is one which considers the needs of the society. Therefore one important role the government plays in fostering this climate is in the provision of public goods, for example the police force for maintaining order in society. This also leads to trickle down benefits to the firm in terms of a stable society and deterrent to crime which is a cost to the firm (World Bank Report, 2005).
The government can also seek to create opportunities for employment which is hallmark of a good investment climate. This may be done by providing incentives, financial or otherwise, to firms who introduce youth apprenticeship programs.
The World Bank Report (2005) says that government has to control the markets’ through macro and micro economic policy. This may occur specifically in the form of regulations and also taxation. Consider where an environmental tax is introduced for firms producing a product with a dangerous chemical byproduct. This passes on the true costs of production to the firm. These capital gains by government can then be reinvested into society. Whilst the free market may allocate resources it is important to remember this allocation is based on profits and price signals. The government must therefore control the direct factor markets to some extent to bring fairness and stability. This may be achieved through minimum wage legislation or controls on the trade union powers.
As we have seen the free market system on its own will lead to inefficiencies and misallocation. If a positive investment climate is to be fostered the government must interject in the form of macro and micro economic policies. Ideally this intervention results in a duality of benefits to both the firm and the society in the form of expanded growth and opportunity for all (The World Bank, 2005).
Suggest some actual government policies that might be used in your country (name the country) to improve the ‘investment climate’. Explain your reasoning.
The World Bank (2005) suggests that a good investment climate benefits society as a whole, not just firms. And it embraces all firms, not just large or politically connected firms. The government plays a central role in furnishing the improvement of the ‘investment climate’ through use of policies and regulations. Let us examine some government policies that might be used in Trinidad and Tobago to facilitate the improvement of the ‘investment climate’.
In Trinidad and Tobago there exists a problem within the land market of unregistered residential properties, with most residential properties being unregistered. As a result transactions within the property market have become an extremely complex and expensive process. This has resulted in a small supply of registered lands being available for purchase, as a consequence, property ownership and even rental in some cases, is only within the reach of the rich. I suggest that the Trinidad government adopt a housing policy that promotes property ownership for all. Through rapid programs of registration of title the supply lands readily available would increase sending market prices down. In so doing, in the medium to long run this would
- Raise living standards by potentially placing wealth in the hands of all.
- Secure future property rights of citizens.
- Reinvigorate the stagnant financial market for loans.
- Potentially create thousands of jobs within the construction and trades sectors.
We must remember that the business environment must also benefit if an improved investment climate is to be realized. Therefore another policy that could be adopted is one of zero percent corporation tax for a fixed period for newly incorporated firms within the manufacturing sector. This would result in creation of new firms, jobs and creation of new business opportunities within the capital market. Additionally, these incentives would lead to expansion of the manufacturing sector, and improvements in the trade deficit position. For the benefit of existing firms the government could also drastically reduce the tax on profits gained from exports as was done in India during the 80’s (World Bank, 2005). This would lead to stimulation of the manufacturing sector, increase of the country’s GDP and investments in new technology to improve production efficiency.
Trinidad and Tobago suffers from the plagued of crime and a painfully slow justice system. The social policy areas of crime and justice must be looked at urgently by the government in conjunction with the above stated policies. Through reform of the crime and justice policies, improvements in the’ Investment Climate’ will be seen and would be advantageous to both society and firms. It is known that crime places additional costs on firms’ through hiring of security and losses from robberies (World Bank, 2005). Also the risk to investment associated with corruption poses a constant threat to investors, both foreign and local. Likewise crime affects the society as a whole corroding the investment climate. Therefore the policy should seek to:
- Focus on shortening the process time for serious violent crimes.
- Significantly increase the severity of punishment for violent crimes and public dissemination of information of such.
- Strengthen the anti corruption laws to reduce investment risks.
There are numerous policy tools available to the government to intervene and improve the investment climate. The policies explored will improve the investment climate since both the firms and society will be benefactors.
Q2. It is said that the main aims of macroeconomic policy are to achieve sustainable economic growth, a low rate of inflation, low unemployment and a balance of payments equilibrium
For ONE country of your choice (name the country)
a) Consider to what extent these aims have been achieved over the last 10 years
b) Choose ONE of the aims and discuss the policies which the Government might use to achieve this aim over the next 10 years
c) Recently it has been suggested that “increasing the happiness of the population of the country” should replace these 4 aims as the key objective of government policy. Discuss the difficulties the Government might encounter in trying to achieve this objective.
a) The Trinidad and Tobago government, like most countries, intervenes into the working of its economy through the use of its macroeconomic policy. In order to assess their success over the past 10 years in doing so, we must first look at what macroeconomic policy entails. Macroeconomic policy can be described broadly as the range of strategies used by a government to influence the workings of the economy or economic business cycle. Traditionally a government can influence the macro environment of an economy through the use of fiscal and monetary policies. Fiscal policies are aimed at controlling government revenues and monetary policies are geared towards controlling the supply and demand for money (Griffiths & Wall, 2008).
Low inflation may be considered to occur where prices rise steadily as oppose to periods of high inflation where consumer prices rise sharply. During the last ten year period the Trinidad government to a degree failed to achieve low inflation rates. Over the period 1999-2009 Trinidad and Tobago had varying rates of inflation as shown in Table 1.Trinidad and Tobago is often considered to have relatively low inflation however during the period 2004 to 2005 it experienced a relatively sharp increase in consumer inflation. Thereafter a sharp increase in the price of consumer goods resulted. During this period the government adjusted its fiscal policy decreasing the tax base and increasing their expenditure on large infrastructure projects. The periods that followed also showed increases in inflation in line with the increases in aggregate demand within the Trinidad and Tobago economy.
During the last ten year period the government achieved relatively low unemployment figures primarily through the government driven infrastructure program, community employment programs and investment in downstream energy projects. The government also sought to achieve balance of payments equilibrium through investments large manufacturing projects, increasing the availability of acreage for oil exploration and contraction of car imports market. Additionally they increased their savings base by offering bonds and financial instrument on the open market during the period.
Trinidad and Tobago experienced marked economic growth over the last ten years, seen by the consistent yearly increase in the GDP. This can be attributed to the increase in foreign currency reserves from Oil and Gas exports. Also, from the supply side, the government sought to expand the supply of labor through the tertiary level financial assistance programs. However sustainable growth is concerned not only with expansion of the economy but also with low inflationary growth and resource issues (Pettinger, 2008). In this regard, Trinidad have not been successful since there have been upward inflationary pressure in the economy coupled with lax environmental regulations during the period. In Addition to these facts the oil and gas reserves are being exhausted at a rapid rate though the ‘One Horse’ economy.
Trinidad and Tobago has done comparatively well in achieving the aims of macroeconomic policy. However, its success can be misleading since the government benefitted from windfalls from the oil and gas industry. Also the corresponding issues of growing inflation, resource exhaustion and environmental degradation still prevail.
b) Sustainable economic growth can be thought to be manifest by the expansion of the Gross Domestic Product of a nation. However it is also thought to include low inflationary growth and productive sustainability (Pettinger, 2008). In order for Trinidad and Tobago to achieve sustainable growth in the next ten years the government must look at the following policy initiatives:
1. Diversification of the economy by investing in the agricultural sector.
2. Pursue the establishment of local ‘Economic Zones’ or Free trade to encourage investment in manufacturing; to include removal of import duties on purchases of new capital equipment.
Trinidad and Tobago has the climate, acreage and resources available for the expansion of its agricultural sector. The enhancement of this sector would lead to increases in exports, inflows of foreign currency and increases in the employment base. The improvement of this industry would also result in lower food prices resulting in lower consumer inflation (Sankar, 2010).
The establishment of an economic zone would lead to increases in foreign direct investments and economies of scale for local producers who stand to benefit from foreign ‘know how’ (World Bank Report, 2005, p.167). The government must also include tax breaks for exporters in the economic Zone which should encourage further investment.
These initiatives when grouped would ensure sustainable economic growth in Trinidad in the next ten years since they would lead to increased exports, productive output and curb price inflation. Additionally the problem of resource exhaustion would be aided through diversification of the economy. From these facts it is conclusive to say that through a policy liberalization and expansion of the agriculture sector Trinidad can achieve sustainable economic growth in the next ten years
c) Increasing the ‘happiness’ of a people is purported to be able to replace the four aims of macroeconomic policy. It is often argued that by increasing happiness that output and national income will be increased whilst high unemployment and inflation will not occur.
Veenhoven (2005) describes happiness as the personal enjoyment one gains from his life as a whole. However, there exists no standard measure for the happiness of a nation. A government would first face a dilemma in choosing measures of happiness since it is a subjective topic. Additionally happiness has been seen to be relative such that measures of happiness may have to differ based on class or even race (Layard, 2005 cited by Griffiths and Wall, 2008, pp. 78, 79).
It is important to remember that man has unlimited wants. Therefore it follows that another dilemma which would face governments with an objective of happiness is the utilization of scarce resources. Are they to allocate resources to produce more luxury items?
Happiness as a replacement for the aims of macroeconomic policy is a utopian ideology of modern economists. The implementation of such an objective would call for massive shifts in thinking, policy and regulatory structure of the Trinidad government. These shifts call for long term planning which is always a problem for small emerging economies like Trinidad and Tobago. However the idea of happiness of the population is one that warrants further research.
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