Market System Isnt Able To Allocate Resources Efficiently

5207 word (21 pages) essay in Economics

25/04/17 Economics Reference this

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Cliffs Notes defines an economy as a social system that produces, distributes, and consumes goods and services in a society. Three sectors make up an economy: primary, secondary, and tertiary. The primary sector refers to the part of the economy which engages in the production of raw materials, such as crude oil, timber, grain, or cotton. (CliffsNotes (n.d) [online])

The secondary sector, made up of factories, changes the raw materials into manufactured, finished or semi-finished goods, for example fuel, lumber, flour, or fabric. (CliffsNotes (n.d) [online])

And the tertiary sector which refers to the distribution of manufactured goods, food and hospitality services, banking, sales, and professional services like architects, physicians, teachers, doctors and attorneys. (CliffsNotes (n.d) [online])

Investor word also defines an economy as the “Activities related to the production and distribution of goods and services in a particular geographic region or it is the correct and effective use of available resources or as a system of allocating resources based only on the interaction of market forces, such as supply and demand. A true market economy is free of governmental influence, collusion and other external interference”.

Investopedia, explains a market system as “An economic system in which economic decisions and the pricing of goods and services are guided solely by the aggregate interactions of a country’s citizens and businesses and there is little government intervention or central planning. This is the opposite of a centrally planned economy, in which government decisions drive most aspects of a country’s economic activity”.

Business dictionary also defines a market economy as “an economy in which decisions regarding resource allocation, production, and consumption, and price levels and competition, are made by the collective actions of individuals or organizations seeking their own advantage. In all market economies, however, freedom of the markets is limited and governments intervene occasionally to encourage or dampen demand or to promote competition to thwart the emergence of monopolies”.

Investopedia further explains that “Market economies work on the assumption that market forces, such as supply and demand, are the best determinants of what is right for a nation’s well-being. These economies rarely engage in government interventions such as price fixing, license quotas and industry subsidizations. While most developed nations today could be classified as having mixed economies, they are often said to have market economies because they allow market forces to drive most of their activities, typically engaging in government intervention only to the extent that it is needed to provide stability. Although the market economy is clearly the system of choice in today’s global marketplace, there is significant debate regarding the amount of government intervention considered optimal for efficient economic operations”.

A market system according to Grigg C (n.d a) [online] has the following characteristics: “It is a type of economic system where the forces of supply and demand control the economy, rather than the government intervening or interfering. In a true free market economy all resources are owned by individuals. The individuals without the government intervention make decisions on the allocation of resources. There are no completely free market economies because there is need for government intervention in some cases. The United States is more of a market economy than a command economy, (where a government controls the market). In a market economy, the producer decides what to produce, how much to produce, what to charge customers for those goods, and what to pay employees. These decisions are influenced by the pressures of competition, supply, and demand; one of the most important characteristics of a market economy is limited government intervention. Most economic decisions are made by buyers and sellers, not the government. A competitive market economy promotes the efficient use of its resources; thus it is a self-regulating and adjusting economy. However, a number of limitations and undesirable outcomes associated with the market system result in an active, but limited role for government, and in a market economy, almost everything are owned by individuals and private businesses. Capital resources like equipment and buildings and the goods and services produced in the economy are not government-owned”. The private ownership, combined with the liberty to negotiate legally binding contracts, permits and people to obtain and use resources as they choose”. (EdHelper (n.d) [online])

For example, the clothing companies in the United States are owned and managed by private individuals and firms like Versace, Banana Republic and Marc Jacobs; these companies produce and supply various clothing at different prices in order to maximize profits. (Grigg C (n.d b) [online])

The evaluation of the market economy according to Alain A. (2008) states; “In a market economy there would be a wide range of choice for the consumers to chose from, however choice in not available to all, the rich however would have a great deal of choice compared to the poor, and the price range may be not be favorable to the poorest in society. In a market economy there are strong incentives built in the system to encourage the production of high quality goods in such cases, there is consumer sovereignty, but producers can manipulate the market through the use of marketing methods and advertising to exploit the consumers. A market economy encourages economic growth at a faster pace compared to a planned economy, in a market economy, risks are easily avoidable especially through insurances and there is un-even distribution of wealth and income in the economy”.

According to Pierce (n.d) [online] the compensation of a market economy are: “The market gives producers an incentive to produce goods that consumers want, the market provides an incentive to acquire useful skills and the price system encourages producers and consumers to conserve scarce resources.” Competition enhances a business’s productivity.

On the other hand, the disadvantages include; may sometimes enhance the unstability of the economy (unemployment, inflation, growth), consumers are exploited through advertising, prices may give false signals to producers and consumers, a market economy is cannot satisfy certain areas (public goods, such as national defense), output may be restricted thus inflating prices, and market economies tend to increase the gap between the rich and the poor.

Also it contributes to the negative effects on the third party (society) as a result of over production which leads to wastage and also pollution due to inappropriate means of disposing waste.

Preserve articles stated that, “In a free market economy where resources are privately owned, the decisions regarding what to produce or how much to produce, how to produce and for whom to produce are taken by private producers through market forces. Profit is the main motive of carrying out various activities. The government has little role to play in the functioning of the economic activities”.

Economy Detail (n.d) [online] stated that, “Scientific management of resources in the line of production, distribution, exchange and consumption is called simply allocation of resources. The allocation of resources discussed principle of right sharing of resources among competing sectors. Whatsoever, the type of economy be it capitalist, socialist of mixed decision has to be made concerning allocation of resources. In a capitalist economy decision about the allocation of resources are made through the free market price mechanism. A capitalist of free market economy uses impersonal forces of demand and supply to decide what quantities and thereby determining the allocation of resources. The producers in a free market economy motivated as they are by profit consideration take decisions regarding what goods are to be produce and in what quantity by taking into account the relative prices of various goods. (Economy Detail (n.d) [online])

What to produce?

This is based on what and how much to produce? Because resources are scarce production of all goods and services needed by a society are beyond its capacity. It is simply not possible for any economy no how develop it might be. So, it has to select a set among various alternatives production must meet the maximum social need. The first priority goes to the basic needs. However, production is guided by profit and profit knows social justice. An economy should put into consideration the effects on the society while reallocating resources. The social norms and values should guide to maximize social satisfaction so allocation is best which satisfies the most. The problem of what to produce and how much to produce, depends on the necessity of the citizens of the country. For example, United States of America having different rates in the groups of the population cannot allocate its productive resources to the provision of toys and children related products. (Economy Detail (n.d) [online])

How to produce?

This takes into consideration the method of to be used in producing the goods and services. In some cases, labor may play a major role. It is called labor intensive technology. In others, capital may play a major role. It is called capital intensive. Labour intensive methods create more jobs favouring more employment. It helps in mitigating unemployment problem. Capital intensive production goes for large volume of production. It commends rapid growth rate depending on the right decision on the current state of the economy. (Economy Detail (n.d) [online])

For whom to produce?

Production for masses or productions for profit are two major choices that every economy has to decide; of which the market economy centers it production based on production for profits. Basic needs of common people cannot be ignored. Of course, the priority goes to wage goods production. In the quality is determined by the level of living standard, which is the outcome of the development level of the economy. Therefore, as the development level of goods, higher production of superior goods proceeds towards fetching super profits. This issue is also related with maintaining social justice. Meeting the basic requirements of all segments of population is the main criteria of resources allocation. (Economy Detail (n.d) [online])

To quote from Hawken et al (2001) on the weakness of the market economy, “Churchill formerly remarked that democracy is the worst system of government, except for all the rest, the might be said of the market economy. Markets are remarkably good at what they do, harnessing such persuasive motives such as greed and envy indeed; as a result, the main importance of promoting economic growth is neglected” The market economy does not aim at economy growth , only maximization of profits. (Nat Cap (2001) [online])

A common response to the misuse, exploitation, or misdirection of market forces is to call for a retreat from capitalism and a return to heavy-handed regulation. But in addressing these problems, natural capitalism does not aim to dispose of market economics, nor reject its valid and important principles or its powerful mechanisms. It does suggest that markets should be employed vigorously for the appropriate ideas as a tool for solving the problems in the economy, while better understanding markets’ boundaries and limitations. (Nat Cap (2001))

Democracies require ceaseless political awareness and informed citizenship to prevent them from being subverted or distorted by the elites who wish to turn them to other ends to incorporate their ideas. Markets, too, demand an equivalent degree of responsible citizenship to keep them functioning properly despite those who would benefit more from having them work improperly. (Nat Cap (2001) [online])

For example; in the United States of America, those who get employed are mostly the high-classed graduates. Their creativity, their rapid feedback, and their diverse, dispersed, practical, and highly motivated agents give markets unequaled effectiveness. Many of the excesses of markets can be compensated for by steering their immense forces in more creative and constructive directions. What is necessary is diligence to understand when and where markets are dysfunctional or misapplied, and to choose the correct targeted actions to help them to function better while retaining their vigor and vitality. (Nat Cap (2001) [online])

It is often argued that most of the earth’s capital, which makes life and economic activity achievable, has not been accounted for by conventional economics. The goal of natural capitalism is to extend the sound ideology of the market to all sources of material value, not just to those that by accidents of history were first appropriated into the market system. It also seeks to guarantee that all forms of capital are as prudently seen as money is by the trustees of financial capital. (Nat Cap (2001) [online])

Also, the notion that the remedy for unsustainable market activities is the adoption that certain market activities may offend both those who deny that markets can be unsustainable and those who deny that markets and profits can be moral. Yet worldwide experience confirms an abundance of market-based tools whose outcomes can be environmentally, economically, and ethically superior. These tools include institutional innovations that can create new markets in avoiding resource depletion and abated pollution, maximize competition in saving resources, and convert the cost of a sulfur tax or a carbon-trading price into profits realized from the sale and use of efficient technologies. (Nat Cap (2001) [online])

Likewise, ensuring that markets fulfill their promise also requires the need to remember their true purpose. They allocate scarce resources efficiently over the short term. That is a vital task, especially as the logic of natural capitalism changes the list of which resources are genuinely scarce. Though, the continuity of the human experiment depends on more than just success in the short term, and efficiently allocating scarce resources does not embrace everything people want or need to do. (Nat Cap (2001) [online])

Furthermore, for all their power and vitality, markets are only tools. They make a good servant but a bad master and a worse religion. They can be used to accomplish many important tasks, but they can’t do everything, and it’s a dangerous delusion to begin to believe that they can, especially when they threaten to replace ethics or politics. For instance, America may now be discovering this, and has begun its retreat from the recent flirtation with economic fundamentalism. That theology treats living things as dead, nature as a nuisance, several billion years’ design experience as casually discard able and the future as worthless. (At a 10 percent real discount rate, nothing is worth much for long, and nobody should have children.) (Nat Cap (2001) [online])

The 1980s extolled a selfish attitude that counted only what was countable, not what really counted. It treated such values as life, liberty, and the pursuit of happiness as if they could be bought, sold, and banked at interest, because neoclassical economics is concerned only with efficiency, not with equity. It fostered an attitude that treated social justice as a frill, fairness as pass, and the risks of creating a permanent underclass as a market opportunity for security guards and gated “communities.” Its obsession with satisfying nonmaterial needs by material means exposing the basic differences, even contradictions, between the creation of wealth, the accumulation of money, and the improvement of human beings. (Nat Cap (2001) [online])

Economic efficiency is an admirable means only so long as one remembers it is not an end in itself. Markets are meant to be efficient, not sufficient as well as being aggressively competitive, not fair. (Nat Cap (2001) [online])

A good example can be related with the United States of America. Markets were never meant to achieve community or integrity, beauty or justice, sustainability or sacredness and, by themselves, they don’t. To accomplish the wider purpose of being human, civilizations have invented politics, ethics, and religion. Only they can expose worthy goals for the tools of the economic process. (Nat Cap (2001) [online])

Some market theologians promote a fashionable conceit that governments should have no responsibility for overseeing markets, for setting the basic rules by which market actors’ play. (Nat Cap (2001) [online])

Their attitudes for example is, let’s cut budgets for meat inspection and get the government off the backs of abattoirs, and anyone who loses loved ones to toxic food can simply sue the offenders, deregulate financial markets, and self-interested firms will police themselves, or let clear-cut telephone, cable TV, and airline competition substitute outdated regulatory commissions. Those convinced by the purity of such theories forget that the stern brand of market economics taught is only slightly related to how markets actually work. The latest illustrations of that principle include the Wild West wreck now looming in Russia, mad-cow disease, savings and loan fraud, phone scams, and crash-by-night airlines. By the time textbook simplifications get filtered into political slogans, their relationship to actual market behavior becomes remote. (Nat Cap (2001) [online])

Although, the main ones are: All participants have perfect information about the future, there is perfect competition, price signals completely reflect every cost to society: There are no externalities, there is no monopoly (sole seller), there is monopsony (sole buyer), no barriers to market entry or exit exist, there is no taxation (or if there is, it does not distort resource allocations in any way), everyone is motivated solely by maximizing personal “utility,” often measured by wealth or income. (Nat Cap (2001) [online])

On the contrary, no one could make more than routine profits, because all the good ideas would already have been had, all the conceivable opportunities exploited, and all the possible profits extracted or, as the economists put it, “arbitraged out.” It’s only because actual markets are so imperfect that there are exceptional business opportunities left. (Nat Cap (2001) [online])

Just how imperfect are the markets in which we all actually live? For instance examining the perfect information about the future? If anyone had it, he or she’d be barred from elections and stock markets and probably not given any credence by the voters who cast votes on them, competition is so imperfect that exceptional profits are commonly earned by exploiting either one’s own oligopolistic power or others’ oversights, omissions, and mistakes, markets know everything about prices and nothing about costs, most harm to natural capital is not priced, and the best things in life are priceless, no monopolies? For example, Microsoft, airlines’, and managed-health- care providers come close, no monopsonies? Consider your utility, the Coca-Cola Marketing Board, and the Federal Aviation Administration; thirty percent of the world’s people have no work or too little work. (Economists justify this by calling them “unemployable”, at least at the wages they seek. (Nat Cap (2001) [online])

Actually, the market works even less perfectly than the above counter-examples imply, for two reasons. First, corporations that benefit from subsidies, externalizing their costs, avoiding transparency, and monopolizing markets tend to ignore market realities and lobby for making new rules, or overlooking old ones, that will best achieve their private benefits. Secondly, people are far too complex to be perfectly rational benefit/cost maximizes. They are often irrational, sometimes devious, and clearly influenced by many things besides price. (Nat Cap (2001) [online])

For example, suppose you put a group of individuals in hot, humid apartment with air conditioners and tell them that both the air conditioners and that electricity is free, what would you expect them to do? Would they not just turn it on when they feel hot and set it at a temperature at which they feel comfortable? That is what an economic theory would predict; if cooling is a free good, people will use lots of it whenever they want. However only about 25 to 35 percent of individuals actually behave that way, many others won’t turn on the air conditioner at all. Most do run it occasionally, but in ways that are essentially unrelated to comfort. Instead, their usage depends largely on six other factors: household schedules; folk theories about how air conditioners work (many people think the thermostat is a valve that makes the cold come out faster); general strategies for dealing with machines; complex belief systems about health and physiology; noise aversion; and (conversely) wanting white noise to mask outside sounds that might wake the baby. (Nat Cap (2001) [online])

Theoretical constructs are, after all, just models. The economy that can be described in equations is not the real economy. (Nat Capinc (n.d) [online])

The world that is based on unreal assumptions about how every economic transaction works is not the same in real world. (Nat Cap (2001))

A market system may not be very productive in actuality, of which they were identified.

According to bized, (n.d) [online] on the strengths of a market system, “The economy relies on a number of factors to make certain that it works efficiently, these are;

The profit motive – the incentive for a reward for enterprise

Good levels of information being available to both producers and consumers

Price accurately reflecting the costs and benefits of consumption and production

The ease with which resources can move to different uses

At the heart of the market system is the profit motive. Entrepreneurs (those who organize resources into production) are stimulated to take risks and produce goods and services by the prospect of seeing some return on their efforts. The extent to which they achieve this success is dependent on identifying the level of demand for the good or service, as well as their ability to manage production efficiently. If the costs of providing the good or service is less than the revenue that they receive from selling those goods and services, they will make a profit. If they can maximize revenue whilst reducing costs to a minimum, the level of profit they make will be higher. (bized, (n.d) [online])

To maximize revenue and reduce costs, producers rely on high quality information to enable them to access supplies at minimum cos; the producers find ways of organising production in the most efficient way and finding resources at minimum cost. Equally, consumers rely on information to give them the guidance about what is available and what they are getting for their money. (bized, (n.d) [online])

To enable this to happen, price has a central role. It acts as a signal to both consumers and producers. For consumers, it tells them whether what they are being asked to give up in terms of money to reflect the value or the level of satisfaction that will be gained from consumption of the product. For example, If I buy a CD priced at £12.99 but do not like the music on it, I might decide that I was not getting £12.99 worth of value, I could have used that £12.99 to better effect by buying something else that would have given me more satisfaction. (bized, (n.d) [online])

For producers, price tells them something about the relationship between the cost of production and the level of profit they are making. If prices are falling then this suggests demand is also falling, and as a result, the revenue being received from sales set against the cost of supplying the good will narrow or decrease. There will come a point where that difference is so small that the producer might decide that they would be better placed moving onto some other line of production. (bized, (n.d) [online])

Price will only act as an accurate signal to consumers and producers, if it properly reflects the costs and benefits of production and consumption. This implies that prices will include all the positive and negative externalities that are associated with production and consumption – in many cases, this does not occur. When this happens, we get what is called market failure – an inefficient allocation of resources. (bized, (n.d) [online])

If we assume that prices accurately reflect costs and benefits, decisions made by both producers and consumers will lead to an efficient allocation of resources. This can only happen if resources are able to move from one use to another. The ease with which resources can transfer from one use to another is therefore important. How does this work? (bized, (n.d) [online])

Imagine a company that used to produce typewriters before computers and word processors came along. There was high demand and this resulted in high price, this situation enabled the firm to make healthy profits. As PCs and word processing software became more accessible, the demand for typewriters started to fall. As demand fell, prices also fell. The profit margins (the difference between price and the cost of production) also narrowed. The firm can continue but things are would get more difficult. This process may continue and eventually it will be not worth the firm’s while to continue to produce typewriters, since profit would no more be actualized. After this the company starts to look instead at moving into production of PCs where there is clearly demand and profits to be made. If they are able to transfer their resources relatively easily, then they can switch production and move into a new area. (bized, (n.d) [online])

Equally, we can see similar things happen when a business hits upon a new winning idea for a product. As the only producer, they command the entire market share. Demand is high and sales revenue strong and as a result, profits are very healthy. Other businesses start to notice that there is a demand for this product and profits to be made, they will look at moving resources to producing a competing product, and as more firms move into the industry lured by the prospect of profit, supply will increase. Consumers will now have more choice and firms in the industry have to adjust prices to compete. If prices start to fall as a result, profit levels start to shrink. The process will continue until the market becomes saturated. Some firms will barely survive in this competitive setting and may leave the industry. Equally, it is likely that other firms and businesses will be looking to develop new and better products and services that will make this product obsolete, and so the whole process starts again. (bized, (n.d) [online])

Consumer decisions about what to buy and what not to buy are crucially important to the market system. A decision to choose a can of Fanta rather than a can of Mirinda is a small signal to the two companies about the relative value placed on the consumption of the drinks in relation to the price being charged. If enough people choose Fanta rather than Mirinda, Mirinda has to do something about their product or their price, or possibly both. This is how competition and the profit motive provides the mechanism through which the market system operates and which is absent in the planned market system. (bized, (n.d) [online])

From the explanation above, the whole market system is extremely dynamic i.e it is constantly changing and evolving as products and services come and go and new ideas and innovations take over. The speed of change can be mystifying at times and, if there is a lack of information, market failure occurs. The constant appeal to of the chance to strike it rich is what drives individuals and makes the system so dynamic and relatively efficient in allocating scarce resources”. (bized, (n.d) [online])

Prenhall (n.d) [online] defines market failure as when resources are misallocated, or allocated inefficiently. Market failure results from the assumptions of the market economy. (prenhall (n.d) [online])

A monopoly is a market with one seller and many buyers. A monopoly may exist because of special government regulation or because the monopolist is the sole owner of a resource. An airline is an example of an oligopolistic industry, one that is dominated by a few large firms. (prenhall (n.d) [online])

Monopolistic competition is a market organization where large numbers of monopolists each produce a distinctive product, but all products are substitutes. An example is sharwarma stores. They each make a unique sharwarma, but when it comes right down to it, eating at one store is not all that different from eating at another store. (prenhall (n.d) [online]) [online]

Where MC is Marginal Cost, AC is Average Cost, MR is Marginal Revenue, D is Demand and AR is Average Revenue.

Prenhall states that none of these markets are efficient. In general, the firms do not produce the socially optimal quantities (they tend to under-produce) and the price is higher than it would be under perfect competition. The condition P = MC does not hold, and the system does not produce the most efficient product mix. (Prenhall (n.d) [online])

According to bized (n.d) [online] “A market can fail in various ways if: The provision of public goods – public goods are goods that could not be provided under a market system because it is not possible to charge a price for them. This is because it is not possible to exclude those who do not pay from getting the benefits. For example, how could the provision of a defense system that by definition protects all citizens be charged for individually? If just one person pays then it would not be possible to exclude all others from the protection – what reason do they have to pay if they are all being protected anyway?, The provision of merit goods – merit goods are goods and services that could be provided by a market system but if they were, there is a possibility that some people who need these services would either not be able to afford to pay for them or would not believe that they need them. There is a danger, therefore, that such goods and services would be under-consumed. Examples of merit goods are health services and education, Income inequalities – market systems tend to focus on individuals who become very rich whilst there are others that struggle to survive. Such wide income inequalities may lead to a range of social and economic problems and tensions like the; Existence of shortages and surpluses – imperfect information tends to lead to shortages and surpluses not being erased. A standard example is unemployment. In theory, unemployment should not occur because wages would adjust to get rid of the surplus labor; in reality, wages may not adjust in this way. In addition, there may be a number of factors preventing labor resources moving from one type of job to another, the existence of externalities – externalities is the effects of decision making on third parties (individuals and groups who are not involved in the initial decision)”. It could be positive or negative. (biz/ed, (n.d) [online])

Alain A. (2008) “A positive externality is when the social benefit is greater than the private benefit e.g a health care center. ( (n.d) [online])

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