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The two main causes of market failure

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Published: Mon, 5 Dec 2016

1.Explain the two main causes of market failure and give an example of each case.

Market failure occurs when a market is unable to manage its resources efficiently due to the breakdown of price mechanism caused by externality or market power. An externality is an impact of one’s action into another bystander. The influence could be positive or negative. An example of positive externality is when a father buys a television will bring benefit to other family members to watch movie or show aired. In another case like driving a car creates air pollution can be classified as negative externality. This is external cost; it tends to bring losses into a community/society. The driver himself does not have to pay for the social cost as he only pays for driving (private) cost. In this case, society pays the cost of dealing with air pollution. Therefore, the car pollution is the negative externality. Negative externality occurs only when the social cost is greater than private cost. As a result, the driver does not take into account the externality by ignoring the social cost. Hence, market failure occurs.

Market power holds the control over demand and supply. It is capable to alter the market price of a good or service. Those firms who are the leader in the market also known as “price makers”; they have the power to decide any change in price. Thus, those firms who have no market power have to accept and they are “price takers”. For instance, in such case as oligopoly, a group of firms form a ‘cartel’, formal agreement among competing firms to set the price. The objective is to increase all the members’ profits and to eliminate competition. Eventually, new firms who decide to enter the market face barriers of entry from the oligopolists. Such oligopolistic competition creates market failure as market should be equilibrium, demand equals to supply.

2.Why is Productivity important?

Productivity is an indication to efficiency of an individual or group of people in a firm or nation. It is a measurement of the number of output produced by each workforce or machinery. Efficiency determines the success of any individuals or firms as it refers to how well resources such as raw material, labor and capital can be used to produce a product or service.

Consider, for instance, ABC private limited company is a family business using manpower skills to produce keychain whilst XYZ public limited, large scale business uses machinery to manufacture the same product. In this case, XYZ public limited will produce more keychain than ABC private limited. This is due to the use of technology in making of the product. Technology such as machinery leads to increased productivity, more will be produced with fewer resources used. Thus, result a reduction of wastage like time and material. Consequently, XYZ public limited earns higher profit and its employees enjoy higher wages; lower price will be offered to the customer. XYZ public limited tends to produce at full capacity in shorter time compared to ABC private limited company. In addition, using technology as its based force, XYZ public limited firm will eventually grows bigger and obtain economies of scale, reducing its costs and producing more output. The more efficient a firm is, the lower the cost per unit and vice versa.

To conclude, productivity is vital as it indicates the efficiency of an individual or group of people. Furthermore, efficiency determines the success of any individuals or firms. As the business is productively efficient, all stakeholders: owner(s), employees, customers and so on will enjoy greater benefit such as better standard of living. This directly shows that productivity and standard of living are related with each other. In other words, higher productivity means greater efficiency in a firm leading to better standard of living of a nation. However, in order to attain better standard of living by raising the productivity, a firm or nation should make sure workers are well-trained and to choose the best technology.

3. Discuss: “Water is necessary for life”. Is the marginal benefit of a glass of water large or small?

Water is an essential element for life. People need water for cleaning, showering and most important is drinking. Marginal benefit defines as an extra enjoyment that an individual will gain from consuming an additional good or service. The marginal benefit of a glass of water can be large or small. The reason is due to the enormous supply of water in our life. Thus, it is easy to find and to be obtained; the marginal benefit would be large. However, from my point of view to drink a glass of safe and clean water, the marginal value will be little because of the lack of sanitation in a few countries around the globe.

Marginal benefit will go down as consumption goes up. The first glass of water is enough to quench thirst. Hence, the marginal benefit is higher. In spite of this, 7th or 8th consumption do not quench thirst anymore so the marginal benefit is decreasing and turn to be lower. The reason is because the benefit will decline as the quantity consumed rises up. In other words, the marginal benefit increases rapidly with the first few units consumed and then the benefit of every additional unit consumed dives steadily.

Furthermore, paradox of value could also help to identify the marginal benefit of a glass of water as it differentiates the value of water and diamonds. Since diamonds are rare and difficult to be obtained as it can be unreasonably expensive, its satisfaction of having one of them is greater than drinking water. Thus, the marginal benefit of diamond is large.

4. Discuss: Why is not trade among countries like a game – i.e some winners and some losers.

Trade can make everyone better off. Simplest reason is people would not burden themselves for instance by making a shirt when they can just buy it from the market. People usually buy things (necessities and wants) not only from domestic market but also from international market. One of the reasons for this case is unavailability of resources. It could be that one country specializes in producing woods and the other one expert in transforming wood into another product such as wooden furniture.

Another example, to eat complete set of beef burger, people needs several ingredients to make it. Consider a restaurant specializes in producing beef burger. The ingredients needed would be the bun, beef patty, slice of cheese, margarine, cucumber and all. Therefore, the restaurant will have to import beef from Australia, Italian cheese, Canadian margarine, cucumber from India and purchase bun from local bakery shop in order to make a beef burger. This clearly shows that trade among countries is interdependence, each country rely on other countries. Subsequently, there is no such loser or winner as every country would gain profit from the trade.

This applies to comparative advantage as there is low opportunity cost of producing a good in one country compared with its trading partners. International trade involves international specialization. Examples of international specialization are Malaysia with tin and rubber, Brazil with coffee and Ghana with cocoa. Therefore, again, each country is interdependence with its trading partner. Thus, trade is not like a game, with some winners and some losers.

5. Discuss: How are inflation & unemployment related in the short run?

Inflation can be defined as a rise in price level of goods or services. The relationship between inflation and unemployment in the short run can be seen in the Philips Curve (declining curve). It shows that when unemployment is decreasing, inflation increases. Similarly, when unemployment rises up, inflation declines.

When the government spends too much rather than earning revenue, an individual income will climb up and too many people get employed. In this case, government spending is referring to an extent to expand national economy and its income for instance creates new industry. Every individual will eventually enjoy higher income which will contribute to more expenditure. Firms will take an advantage of this situation by producing more output due to high spending of an individual (demand is rising rapidly). However, inflation goes up due to the increase in money supply. Price of a product increases because of indirect taxes and high tariffs imposed. As a result, employees demand higher wages.

On the other hand, in order to reduce the inflation, government spending is decreasing while earning more revenue by increasing interest rates of credit cards, raising productivity by using more technology and increase direct tax such as income tax. As the government reduces it’s spending, the economy contracts leading to an increase of unemployment. Technology has become widely available in the country and being used to replace workforces in order to remain productively efficient. Due to the unemployment, high interest rate for credit card and greater income tax, the individuals’ expenditure has become less. Firms will face low demand and thus reduce its output. As the company produced less output, it would not need extra or more workers leading to more unemployment. Therefore, to solve the shortage of demand, the firm will reduce the price of the goods or services. Correspondingly, inflation decreases.

6. Discuss: What does the ‘invisible hand’ of the market place do?

In a free market, an entrepreneur aims to allocate scarce resources effectively through competition. This directly will be beneficial to the society. Without any regulations or government intervention, the market is actually assisted by the invisible hands. Firms in the free market are competing to promote their goods or services for their own good. Unknowingly, these firms’ helps maximizing the world output and enhancing the economy of the world. Unlike the governments who only aim to achieve the national goals and objectives.

Invisible hands are related with demand and supply. When there is excess supply, the invisible hand guides to decrease the price so that stocks are sold. On the other hand, if there is little demand, the invisible hand assists on reducing production and increase price.

7. Discuss: Equity VS Efficiency: Everyone in society should be guaranteed the best healthcare possible.

This is the tradeoff society faces, efficiency and equity. Efficiency tells us that the scarce resources are being used effectively or at its fullest. Equity means fairness, distribution of equal proportion among the members of the society. Everyone should be guaranteed the best healthcare possible but in this case it is quite far-reaching statement.

There are two types of people in the society, those who work hard to earn money for survival and those who do not work and earn money but still survive. For instance, consider Mr A, middle aged man who work as executive have to pay for his income tax to help the government funding on society’s welfare. Mr. B is one of them, who have retired from working due to his age. The government’s distributions of direct taxes obtained from people like Mr. A to Mr.B who do not have to work anymore demotivate and reduce the efficiency of Mr. A. Mr. A tends to work slow and does not being productive as he knows his income is deducted for someone’s else welfare. The purpose of the government doing this is to improve the nation’s education, healthcare and so on. Nevertheless, this would not solve the tradeoff.

From my point of view, we should ignore the opportunity cost, the next best alternative choice. The ultimate choice in this case is to reduce Mr.A income. By doing this, it will help to expand the growth of the nation’s economy as education, healthcare and so on are enhanced and upgraded. Level of standard of living would eventually increase due to the improved condition of the country.


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