Explain the Workings of Market Mechanism

Economists have to deal with a range of economic problems when studying an economy. But the basic economic problem is: “Scarce resources in relation to unlimited wants” – Bamford, 2001 Because there are unlimited wants and limited resources, societies have to confront three basic questions What to produce? Everything cannot be produced so we need to decide what goods should be produced and in what quantities. Here comes the concept of Opportunity Cost . How to produce? Economics demands the most efficient use of resources, hence the concept of economic efficiency was introduced. Here we need to consider how we can get the maximum use out of the given resources and use them efficiently. For whom to produce? Because of scarce resources, all wants cannot be satisfied so again choices need to be made. A market is where buyers and sellers interact to exchange goods and services. “The essence of any market is trade. So, whenever people come together for the purposes of exchange or trade, we have a market.” – Bamford, 2001 These markets work on the basis of demand and supply. Demand refers to the quantities of a product that consumers are willing and able to buy at a given price, ceteris paribus.

The diagram shows that there is an inverse and causal relationship between price and quantity demanded. P QD

P QD
Price is one determinant of demand. Others include changes in tastes and fashion, prices of substitutes and complements and expectations of further price changes. Changes in these factors cause shifts in the demand curve.

“economic equilibrium is simply a state of the world where economic forces are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal” – http://en.wikipedia.org/wiki/Economic_equilibrium

The market equilibrium, price determination, shifts and movements in the demand and supply curves are collectively known as the market mechanism which is a distinctive feature of the market economy. “A market structure is the description of the behavior of buyers and sellers” – http://www.lse.co.uk/financeglossary.asp?searchTerm=&iArticleID=2126&definition=market_structure There are 4 common types of market structures:

* Perfect Competition
* A large number of numerous firms
* homogenous product
* firms and consumers have perfect knowledge about the product
* firms are price takers therefore PED = infinity
* market mechanism
* only normal profit
* no barriers to entry or exit
* in the long run, some firms may exit the industry causing a rise in market price and new firms may enter causing a fall, thus supernormal profit or loss can be made, assuming no change in the cost curves.

* Monopolistic Competition
* Many producers
* consumers have defined preferences
* heterogeneous products
* no barriers to entry and exit.

The difference between monopolistic competition and perfect competition is that of heterogeneous products which enables the company to raise prices without losing all customers, owing to brand loyalty. This means its demand curve is downwards sloping in contrast to perfect competition.

* Oligopoly
* market dominated by a small number of firms
* homogenous products
* interactivity
* interdependence between firms
* imperfect competition
* firms can form a cartel illegally in which they agree to coordinate prices, marketing and production.

MC
Price
Quantity
AR
MR

The kinked demand curve reflects inelasticity below market price and elasticity above it. The products and services offered are all different and there are major barriers to entry. Firms utilize non-price competition in order to accrue greater revenue and market share due to the price competitiveness created by this upward demand curve.

* Monopoly
* single dominant seller of a product with substantial demand * consumers do not have perfect knowledge
* PED = 0, perfectly inelastic demand therefore the demand curve is vertical * firm earns supernormal profit since there is no competition, AR>AC * strong barriers to entry.

The theory of economic efficiency is made up of two sub theories: Allocative efficiency and Productive efficiency. Economic efficiency = Allocative efficiency + Productive efficiency “It has been established that for economic efficiency to exist products must be made using the least possible resources or generating the lowest possible cost of production. This is productive efficiency.” – Keith Bruskill, 2001

To get to the lowest cost of production, first production must take place on the lowest possible average cost curve and second, it should take place on the lowest point of that AC curve. This second condition is known as technical efficiency.

Quantity
On the other hand, allocative efficiency is allocating the right amount of resources to the right products. It is to with producing that combination of products which will yield the greatest level of satisfaction of consumer wants.

Market failure exists when the operation of a market does not lead to economic efficiency. There are 5 main causes of market failure:
1- Externalities
An externality is said to arise if a third party is affected by the decisions and actions of others. It can also be seen as a divergence between private cost and social cost. Private cost is the cost to the decision maker of a certain decision while social costs are all the related costs of that particular decision. Another form of cost is external cost which is a real cost to society. Social cost is made up of private and external costs.

Social cost = Private cost + External cost

Similarly, there are private, social and external benefits.

Externalities are of 2 types: Positive and negative.
A positive externality is when the social benefits of a decision may exceed the private benefits. The problem with positive externalities is of underproduction.

If only the private benefits of producing the good are registered then demand is at D 1 with a price of P1 and an associated quantity of Q 1. However, if the social benefits are considered then demand would be at D 2 with a price of P 2 and an associated quantity of Q 2. In this way insufficient resources are being devoted to the production of this good/service. With negative externalities, the problem is over production. When making a business decision only the private costs will be considered and not the external costs. This means that the price will be lower than if all social costs were considered. In turn, demand and production will be higher than if the full social costs had been considered. Thus, a negative externality will lead to overproduction.

The diagram shows the market for a product where supply (S 1) is equal to demand (D). If all the social costs (which are greater than private costs due to the existence of external costs) were considered then the supply would be at S 2 and price at P 2 and the quantity associated at Q 2. Over production is taking place therefore, the market fails.

2- Merit goods, de-merit goods and information failures
A merit good is one which has positive externalities. A de-merit good is any product that has negative externalities associated with it. However, the problem here is that consumers have a lack of knowledge about the effects of a good. With this lack of information, a merit good is one that is better for the person than they realize, e.g. consumers do not realize all the benefits of education such as those to society. Due to lack of information about how good the consumption of a product is, insufficient demand will be generated for that product. This means that there will under provision of that good leading to market failure. De-merit goods are worse for the consumer than they realize, e.g. if people did realize all the harmful effects of smoking there would be greater reluctance to smoke. Hence excess demand for de-merit goods leads to over provision and market failure.

3- Public goods
Public goods are described as non-excludable and non-rival. The problem that may be caused in a free market is that it may fail to produce them at all.

“The essence of the problem is summed up in the phrase ‘free riding’.” – Bamford, 2001

Consumers attempt to gain a free ride on the back of other consumers (since it is non-excludable) by not paying for the good themselves, e.g. all fishermen need a light house. Once one fisherman provides it for his benefit, all the others will also benefit equally but their advantage will be that they will not pay for it. The logical thing would seem to be for all fishermen to sit back and wait and this way it will never be provided. The absence of public goods leads to market failure because resources are not being allocated to their production, generating allocative inefficiency.

It can be seen on the diagram that the AR schedule is the same as demand schedule and the MC schedule is the same as supply schedule. The equilibrium level of output is Q 1 selling at price P 1. However, in a monopoly, the firm has the power to set the price and the profit maximizing monopolist will choose to set it where MC is equal to MR – the point of profit maximization. This is indicated by price P 2 and quantity Q 2, suggesting a higher price and lower quantity. The problem is that price is above marginal cost which means there is no allocative efficiency and demand/production is too low. Insufficient scarce resources are being devoted to this product. It is also possible that the cost indicated on the diagram may rise since the monopolist does not have any competitive pressure and costs might not be as low as possible. This is known as x inefficiency which is a tendency of costs to drift upwards in monopolies. Thus costs tend not to be at their lowest level and there is productive inefficiency. Market failure can also be understood through deadweight loss which can occur in a monopoly market when comparing it with a perfectly competitive market. In the above diagram, it is shown by the triangle made of lined pattern. This indicates the loss of net consumer and net producer surpluses due to the increased price and reduced quantity in monopolies.

5- Factor immobility
“Even under conditions of perfect competition, factors may be very slow to respond to changes in demand or supply. Labour, for example, may be highly immobile both occupationally and geographically.” – John Sloman

This can lead to a large number of changes to the structure of a market in the long run. There will be price changes, changes in profits, wages and in the meantime, changes in demand and supply. Thus the economy is continuously in disequilibrium. Resources are never allocated properly and the costs are instable too, leading to market failure.

As discussed, market mechanism plays a big role in free market economies as well as mixed. Even though in some cases price determination is not followed, producers like to have knowledge about the demand of their products and try to supply accordingly. Market failure on the other hand is a major issue in economics and has a number of causes. It is very dire for any market since scarce resources are wasted. However, government intervention may seek to correct for the distortions created by market failure and to improve the efficiency in the way that markets operate: Pollution taxes to correct for externalities; taxation of monopoly profits; regulation of oligopolies/cartel behavior; direct provision of public goods (defense); Policies to introduce competition into markets (de-regulation); Price controls for the recently privatized utilities.

Bibliography

* Bamford, Bruskill, Cain, Grant, Munday & Walton, Economics * M Parkin, M Powell et al Economics 7th edition
* J Sloman Economics 4th edition