Removal of Imperfections in the Market Impact

Assignment question

1. The removal of imperfections in the market leads to an increase in efficiency in the allocation of resources. Discuss whether you agree with this view.

(25 Marks)

2. Explain what is meant by normal and abnormal profit and when such profits might occur

(12 marks)

3. Discuss the three reasons as to why people demand money, according to the liquidity preference theory.

(13 marks)

Table of Contents (Jump to)

Assignment question

List of figures

QUESTION 1: The removal of imperfections in the market leads to an increase in efficiency in the allocation of resources. Discuss whether you agree with this view.

QUESTION 2: Explain what is meant by normal and abnormal profit and when such profits might occur.

QUESTION 3: Discuss the three reasons as to why people demand money, according to liquidity preference theory.

References

List of figures

Figure 1: A perfect competition diagram.

Figure 2: Normal profit in a perfect competition and in monopoly market.

Figure 3: Abnormal profit in a perfect competition and a monopoly market.

Figure 4: Combination of Transactionary , precautionary , speculative demand forming the liquidity preference graph

QUESTION 1: The removal of imperfections in the market leads to an increase in efficiency in the allocation of resources. Discuss whether you agree with this view.

Efficiency is about how effectively the resources such as time and materials are used to produce an end result. In economic terms, it is concerned with the relationship between scarce inputs and outputs. Different forms of efficiency need to be considered.

Allocative efficiency is achieved upon good resource allocation; when no one can be made better off without making someone else worse off. It occurs when the value the consumer puts on a good or service is the same as the cost of the resources used in producing it. The main condition required for allocative efficiency in a given market is that the market price is equal to the marginal cost of supply.Total economic welfare is capitalized in this stance.[1]

Productive efficiency strikes in the lead of the lowest production cost against a minimal wastage of resources. A minimal long run unit cost of production leads to productive efficiency also.

Dynamic efficiency focuses on changes in the options undertaken in a market together with the quality/performance of products ought to be bought. Economists often link dynamic efficiency with the pace of innovation in a market.

In figure 1, at the output Ot, where the Marginal cost (MC) = Marginal revenue (MR) for the firm, the allocative efficiency exists since the firm’s price (P) isthe marginal revenue (that is, it is able to sell any amount at the unchanged price where each extra unit sold at that price provides the marginal revenue), so MC = P. In fact, at that point more equalities subsist, for instance when MC = P= MR = AR. This means clearly to make use of the least resources possible. In turn, the minimum average cost = the bottom of the AC curve. Hence, this proves that both productive and allocative efficiency are potential occurrences in the long run only under perfect competition.[2]

Inequity may still prevails in a country despite encompassing allocative efficiencyandproductive efficiency. This negates the odds perfection.

Figure 1: A perfect competition diagram.

In Figure 2, Imperfect competitions like monopolistic competition, monopoly and oligopoly, when producing profit maximising output, that is where MR=MC, the firm is not at its productive efficient output. That is, there is no productive efficiency since AC is not minimum. Neither is there allocative efficiency since MC is below price.

Figure 2: An imperfect competition diagram

The market economy and market system (price mechanism) will normally lead to efficiency in terms of lowest cost, minimum price, innovation and quality products (reliable).

Efficiency should increase and markets shall boom their performance with the elimination of imperfections. However, removing all imperfections is virtually impossible due to the existence of market failures. The Market mechanism and the price mechanism do not apportion resources efficiently.

Unfortunately for markets to achieve efficiency, a few conditions must be satisfied: the market must be competitive with no benefits or costs external to the market and the market buyers and sellers must be aware of all the information concerning prices and alternatives. This is however impractical to achieve and leads to market failure.[3]

Market failure is a situation in the free Market system that foils the most efficient allocation of economic resources; For example when a market having being left on its own has failed to allocate resources efficiently in the case of freely-functioning markets operating without government intervention. Therefore, economic efficiency welfare cannot be maximized. This leads to a loss of economic efficiency. The government policy interventions are able to potentially remedy the problem and increase economic efficiency in case of market failure. This can also cause an inefficient allocation of resources. Market failure is a situationwhere the free market fails to pull off an optimum allocation ofresources which is possibly the outcome of market imperfections, externalities and public goods and merit goods.[4] Market imperfection describes a situation in which the market behaviourdiffers from what it would be under perfect competition. A monopoly oran oligopoly may control the market and prevent other firms fromentering the market, restricting supply, the monopoly and oligopoly firm may be able to fix higher prices than they would be under a freemarket.In imperfect competition, there is likely to be market failure since firms who dominate their markets will attempt to charge high prices in order to make greater profit.

An externality exists if a benefit is not included in the demand price or a cost is not included in the supply price. As such, market equilibrium does not achieve an efficient allocation. Positive externalities exist where a society acquires more than the producer. The latter thus produces less than the optimal social amount. Examples are health and education. Examples of negative externalities are smoking and alcohol consumption. Government interventions are vital to adjust or counteract market failure scenarios caused by negative externalities. The government opts to tax those producing in excess. Legal help also is sought in some instances. Despite that market failures can be fixed, Governments are also imperfect since their interventions are also occasionally unable to warranty a remedy or provide an efficient allocation of resources. [5]

Even when the market appears to be working perfectly, we can have a problem with some goods. These are the public goods which are collectively consumed and the market may simply not supply them (e.g. street lighting) and the merit goods which areprovided by the market but in smaller amounts than are needed for the good of the state. Health and education are the most obvious ones. These may all be supplied in the “wrong” amounts, or even not supplied at all. When this occurs, it renders the market system inefficient and it is failing in this area.

The free market system is able to allocate scarce economic resourcesefficiently if private costs are the same as social costs, and privatebenefits are the same as social benefits. But in the most cases, theyare not the same. It is then argued that the price mechanism fails totake into account social cost and social benefits, and therefore failsin its role to allocate resources to their optimum use. Market failureis the result of a sub optimal allocation of resources in a country.

The market can fail also because of factor immobility (land, labour and capital) and the distribution of wealth and income. Increasing economies of scale may push all producers out of a market if none can charge enough to cover costs. In that case, production ceases even if it benefits society. Hence, markets fail under increasing economies of scale.[6]

Hence, it can be said that the removal of imperfections do lead to an increase in efficiency in the allocation of resources. One can try to achieve this concept but can only approach close to perfection and cannot remove all the imperfections in a market system. A market where efficiency is achieved in terms of lowest cost, minimum price, innovation and quality products (reliable) is difficult to obtained and there will always exists some degree of imperfections.

QUESTION 2: Explain what is meant by normal and abnormal profit and when such profits might occur.

The difference between the Total Cost (TC) and Total Revenue (TR) amounts to the profit of a firm. The payment to factors of production makes up the TC. The sales of the finished good breed the TR. When TR exceeds TC, the firm makes a profit termed in economic theory supernormal or abnormal profit (ANP). When the TR is less than TC, the firm is subject to a loss termed as a sub-normal profit. When TR equals to TC, then the firm makes normal profit (NP).[7]

The NP is the minimum level of profit to keep factors in their present employment. It is also equal to the opportunity cost of being in business; the profit that could have been reaped in the next alternative business. Figure 2 illustrates respectively firms in a perfect competition and a monopoly market situation earning only NP:

Figure 3: Normal profit in a perfect competition and in monopoly market.

The ANP is the profit in excess of NP. It is called producer’s surplus. Diagram 3 and 4 illustrates ANP in a perfect competition and a monopoly market:

Figure 4: Abnormal profit in a perfect competition and a monopoly market.

The principle characteristic factor between NP and ANP is that the former is the minimum requirement for factors to stay in their present employment. It also aims to competitive market situations: perfect competition and monopolistic competition. ANP points to non-competitive situations: monopoly and oligopoly. It is in fact the compensation for entrepreneur initiative and creativity.

In the short-run, both types of profits transpire in any market structure – perfect competition; monopolistic competition, oligopoly or monopoly. However, in the long-run, ANP can arise only in monopoly and oligopoly due to barriers to entry. Firms in perfect competition and monopolistic competition can make only normal profits in the long run again due to the freedom to entry.[8]

QUESTION 3: Discuss the three reasons as to why people demand money, according to liquidity preference theory.

One can use the theory of Keynesian Liquidity Preference to answer the determinants of the demand for money. The demand for money signifies the demand for money to expend. It is money to be exploited for the immediate exchange of goods and services. The common man demands money to pay one’s daily purchases of goods and services. The daily cash transactions for a person are expected to depend on the size of one’s money income and on institutional arrangements such as the sum remunerated or the bills to be paid. Institutional arrangements have a propensity to remain unaltered. It is thus anticipated that the total demand for money for transaction purposes to depend directly on money national income.[9]

Economists spot three motives to clutch money: the transaction motive, the precautionary motive and the asset (speculative) motive.

The transaction demand (T_m ) for money is perfectly interest inelastic, that is, it is not responsive to interest rate changes. Whether the interest rate changes, the amount of money a person, household, firm or country holds for transactions will remain more or less unchanged, assuming income and other variables remain constant. Hence, the graph of the demand for money for transactional purpose against the quantity of money demanded is a vertical straight line.[10]

The second reason is the precautionary motive. Money is here required to meet one’s unexpected expenditures. The money demanded for precautionary motive also tends to depend on the level of income, as in the case of the transactions demand. Similarly, the precautionary demand (P_m) is also interest inelastic and a vertical straight line graph.

The third reason is called the speculative demand for money. Usually the amount of money in existence is more than the sum called for transactionary and precautionary purposes. The excess must be held by someone somewhere. ‘People hold “idle” cash balances?’- Keynes challenged that it is for tentative purposes. This means being constantly in possession of a stash of cash to create profit at any given opportunity. For instance, it may be lucrative to buy shares or government securities (bonds) if someone is geared up with cash at the given instant. The speculative demand for money is inversely related to interest rate and is elastic. [11]

This demand for money will budge according to people’s speculation based on expectations. Secondly, it depends on business optimum. If speculators expect assets price to collapse, the demand of money will augment. Entrepreneurs will demand more money to invest in case of fruitful business.

Together the three motives make up the total demand for money in a country, called the liquidity preference (LP). The diagram below illustrates the concept of each motive in a graphical way.

Figure 5: Combination of Transactionary, precautionary and speculative demand forming the liquidity preference graph

References

Anderston, A., 2008. Economics. fifth ed. s.l.:Graficas Estella, Navarra Spain.

Anderton, A., 2000. “Economics”. third ed. s.l.:Causeway Press Limited.

Anon., 2013. “Short Run And Long Run Profits Trends Economics Essay”. [Online] Available at: http://www.ukessays.com/essays/economics/short-run-and-long-run-profits-trends-economics-essay.php?cref=1 [Accessed 26 March 2015].

Anon., 2013. “Theories Of Demand For Money And Empirical Works Economics Essay”. [Online] Available at: http://www.ukessays.com/essays/economics/theories-of-demand-for-money-and-empirical-works-economics-essay.php?cref=1 [Accessed 24 March 2015].

Anon., 2013. ‘What Is Market Failure And Its Causes Economics Essay’. [Online] Available at: http://www.ukessays.com/essays/economics/what-is-market-failure-and-its-causes-economics-essay.php?cref=1 [Accessed 24 March 2015].

Anon., n.d. “Profit”. [Online] Available at: http://www.economicsonline.co.uk/Business_economics/Profits.html [Accessed 18 March 2015].

Anon., n.d. MARKET FAILURES. [Online] Available at: http://www.AmosWEB.com [Accessed 19 March 2015].

Bækkeskov, E., 2013. Market failure. [Online] Available at: http://www.britannica.com/EBchecked/topic/1937869/market-failure [Accessed 07 March 2015].

Bamford, C. et al., 2006. AS Level and A level Economics. s.l.:University of Cambridge.

Grant, S. & Stanlake, G., 2006. “Stanlake’s Introductory Economics”. SJ Grant ed. s.l.:Pearson Education Limited.

Lipsey, R. G. & Hardbury, c., 2006. “First Principles of Economics”. second ed. s.l.:Oxford University Press.

Vernon, R. & Louis T. Wells, J., 1991. “The economic environment of international business”. fifth ed. s.l.:Englewood Cliffs, NJ : Prentice Hall.

Ward, D. B. a. D., n.d. “Economics for business”. s.l.:Mc Graw-Hill Higher Education.

[1] Anderton, A., 2000. “Economics”. third ed. s.l.:Causeway Press Limited.

[2] Lipsey, R. G. & Hardbury, c., 2006. “First Principles of Economics”. second ed. s.l.:Oxford University Press.

[3] Anon., n.d. MARKET FAILURES. [Online] Available at: http://www.AmosWEB.com [Accessed 19 March 2015].

[4] Anon., 2013. ‘What Is Market Failure And Its Causes Economics Essay’. [Online] Available at: http://www.ukessays.com/essays/economics/what-is-market-failure-and-its-causes-economics-essay.php?cref=1 [Accessed 24 March 2015].

[5] Anon., 2013. ‘What Is Market Failure And Its Causes Economics Essay’. [Online] Available at: http://www.ukessays.com/essays/economics/what-is-market-failure-and-its-causes-economics-essay.php?cref=1 [Accessed 24 March 2015].

[6] Bækkeskov, E., 2013. Market failure. [Online] Available at: http://www.britannica.com/EBchecked/topic/1937869/market-failure [Accessed 07 March 2015].

[7] Anon., n.d. “Profit”. [Online] Available at: http://www.economicsonline.co.uk/Business_economics/Profits.html [Accessed 18 March 2015].

[8] Anon., 2013. “Short Run And Long Run Profits Trends Economics Essay”. [Online] Available at: http://www.ukessays.com/essays/economics/short-run-and-long-run-profits-trends-economics-essay.php?cref=1 [Accessed 26 March 2015].

[9] Ward, D. B. a. D., n.d. “Economics for business”. s.l.:Mc Graw-Hill Higher Education.

[10] Anderston, A., 2008. Economics. fifth ed. s.l.:Graficas Estella, Navarra Spain.

[11] Anon., 2013. “Theories Of Demand For Money And Empirical Works Economics Essay”. [Online] Available at: http://www.ukessays.com/essays/economics/theories-of-demand-for-money-and-empirical-works-economics-essay.php?cref=1 [Accessed 24 March 2015].