Economy: Capitalism and Price Mechanism

1. What are the vital functions of an Economy? Explain the price mechanism. Economies whether simple or complex; developed, undeveloped or developing; or capitalist, socialist or mixed economies differ in their organization but all perform the following three vital functions: i. Production

ii. Consumption
iii. Growth

i. Production:
The first vital process of an economy is production. Sir John Hicks defines production as any activity directed to the satisfaction of other people’s wants through exchange. Thus, production includes all consumers’ goods, producers’ goods and the services of all kinds which are exchanged for money. Production is a continuous process and consists of final consumption goods, services of all types, products in different stages of production and so on. The production is not complete unless the product is taken to the hands of consumer. The term ‘production’ is broad one and includes various kinds of production: Production may involve transformation of a commodity with lower utility to a commodity with higher utility.

Thu, manufacturing of goods and extraction of mines is also production. Transportation is a means of production when a commodity is shifted from one region to another (low utility region to high utility region). Production also takes place when a commodity is stored over time, from a period of lower utility to higher utility period. These three different types of production are generally known as form utility, place utility and time utility. These three collectively called as production. Thus, a farmer, manufacturer, trader and banker- all are producers. ii. Consumption:

The second vital process of an economy is consumption. Consumption means the use of economic goods and services in the satisfaction of human wants. Consumption implies the using up of material goods and of immaterial services. Consumption may be of different types. There are many goods which are used up or destroyed when they are consumed, e.g. food. There are some goods which are produced and consumed simultaneously, e.g. services of doctors, waiters, etc. In many cases there are intermediate stages between production and consumption, e.g. the raw material stage, semi-finished stage, wholesale stage and retail stage. The goods in the intermediate stage are known as investment goods. There are some goods which are not consumed away and continue to provide services for long periods. These are called durable consumer goods. These are also included in category of consumption as it is difficult to estimate service a person secures from the consumption of durable goods in any given period. iii. Growth:

The economy grows by using its resources to their fullest extent. In the growing economy, the rate of output steadily increases. The rate of growth should exceed the rate of increase in population of the country. Thus, a growing economy will ultimately mean an increase in the country’s per capita income. A developing economy allocates part of the resources for the production of capital goods which in turn will produce other goods. The greater the size of the capital stock of the country, the larger will be the income of the community. A developing economy should devote its resources not only to maintain capital but also to accumulate capital. Every economy has these three vital processes, though they may differ with regard to the volume of production, consumption and the rate of growth. In the capitalist economy, these functions are performed by individuals and institutions without the interference or guidance from government. In the socialist economy, these processes are organized and planned by the government.

PRICE MECHANISM
Every commodity has its own price determined by its demand and supply in a free market. There are many prices as there are goods and factors of production. All these prices are collectively called the price mechanism or the price system. The price mechanism requires the existence of free market forces of demand and supply. The price mechanism, also known as market mechanism, helps to solve the central problems in capitalist economy. Choice of techniques

The first function of prices is to resolve the problem of what to produce and in what quantities. Every producer tries to minimize the cost and maximize his profit. The producer who adopts the most efficient method of keeping the cost of production to minimum can hope to secure high profits. The price system indicates to the producers which factors of production must be chosen to make production cheapest. It works using the following method: No factor unit will be wasted in production

Every factor unit will be put to that use in which its productivity will be highest. Every factor will be employed up to the point at which the revenue from the last unit employed is equal to the cost on that unit.

If factor units are underutilized or wastefully used, total product will not be maximum and cost per unit will rise and profit will come down.

Method of distribution

Goods and services are produced for those who have effective demand, i.e., one who can afford to pay for these services. Effective demand depends upon money incomes which constitutes the part of price mechanism. Thus, the distribution of goods and services, i.e., the problem for whom to produce, is solved on the basis of effective demand which also depends upon the price mechanism. Price mechanism brings about an ideal allocation of economic resources and the most efficient production and distribution. Hence, the consumer welfare is maximized under the system of price mechanism.

Effectiveness of price mechanism

The price mechanism is most efficient if following essential conditions are fulfilled: There should be free enterprise, perfect competition and no interference of market forces of demand and supply by the consumers, producers or government Extreme inequalities of income should not be allowed to come into existence

When the above conditions are present, production of goods will reflect the needs of all the consumers. Profits will be kept at minimum but even then production will be carried on very efficiently. Distribution of goods and services will not be according to income but according to need.

In practice, however, the above conditions do not prevail and thus, the price mechanism may not help to produce goods efficiently or distribute them equitably. If price mechanism cannot allocate resources adequately, an alternative system must be found. In the socialist system, central planning and government direction of resources are resorted to and this system is claimed to be superior to the price mechanism.

3. Describe the kinds of Economic Systems.
The economic system refers to structures in society within which we make decisions about: what to produce (goods and services)
how to produce the goods and services
where to produce them
how to allocate and distribute them to meet the demands

There are 4 main types of economic systems:
i. Subsistence system
ii. Capitalist system
iii. Socialist system
iv. Mixed economic systems

i. Subsistence system:
It is also called as traditional economic system. Under this system, people produce just enough goods to feed their household with very little left for sale or exchange in the market.

Characteristics of subsistence system:
Production is geared towards subsistence and basic survival
Trade is mainly by a barter system, i.e., direct exchange of goods Market an money are of little importance
Customs and traditions are the driving forces for what is produced and how it is allocated.

ii. Capitalist system:
It is also called as market or commercial system. Under this system, the decisions about what to produce, how to produce and where to produce are determined by market conditions such as supply, demand and price.

Characteristics of capitalist system:
Production is large scale and geared towards markets
The market determines the allocation and use of society’s resources The price mechanism determines supply and demand of goods and services Competition among producers works to ensure stable and lower prices for consumers

Drawbacks of the capitalist system:
Since market does not exist for some resources, only some environmental resources might be used and exchanged in the society. The long cycle of production of some crops does not allow for rapid adjustment of demand and supply so gluts and shortages often follow in succession Market forces do not relieve resource problems when prices decreases spur on demand but shortages of the commodity fail to stimulate immediate increase in supply. Strong demand and high prices may encourage supply to the point that a resource would be depleted beyond its critical limit. environmental side effects result from market operations

part of the cost of production is borne by the society
cartels and monopolies manipulate supply to influence prices the market system separates consumers from producers and hence responsibility for consequence of production is weakened

iii. Socialist system
It is also called as centrally planned system. Under this system, decisions regarding what commodity to produce, how and where to produce and how to distribute are made by the government.

Characteristics of socialist system:
Central government takes over decisions about production and marketing of goods price control keep prices low but discourage production
attempts are made to allocate goods and services according to needs of the individuals private ownership of resources is restricted
the role of market in determining prices, allocation of goods, etc. is limited. Drawbacks of socialist system:
Government control creates little incentive to work hard to produce goods and services serious resource problems including severe hunger and famine are rampant there can be extensive environmental damage

there is a question that who will guard the government if something goes wrong individual initiatives are discouraged and people look up to the government for the solutions to their problems

iv. Mixed economic system
It is currently the most common economic system. Under this system, elements of both capitalist and socialist economic systems are combined.

Characteristics of mixed economy:
It is mainly capitalist in nature where Government often intervenes to modify the market economy, preventing monopolies, influencing prices and offering incentives to increase production.

Reasons for Government intervention:
There are no markets for public goods such as clean air and water, wildlife. These are often wasted. Externalities are passed on to others and society as a whole. The market may encourage over-exploitation of resources beyond critical limits. Consideration of national security such as food production under war condition to protects groups such as farmers whose productions are essential but may not be able to compete and survive the market when left alone. The desire to promote social justice and equity in a country by providing sufficient access to resources.

4. Price mechanism also known as the market mechanism that helps to solve the central problems in Capitalist Economy. Explain. The central problems in economic system are:
what goods and what varieties should be produced and in what quantities they should be produced how they should be produced
for whom are these goods and services produced
Under capitalist economic system, the decisions about what to produce, how to produce and where to produce are determined by market conditions such as supply, demand and price. Price mechanism:
Every commodity has its own price determined by its demand and supply in a free market. There are many prices as there are goods and factors of production. All these prices are collectively called the price mechanism or the price system. The price mechanism requires the existence of free market forces of demand and supply. The price mechanism, also known as market mechanism, helps to solve the central problems in capitalist economy. Choice of techniques

The first function of prices is to resolve the problem of what to produce and in what quantities. Every producer tries to minimize the cost and maximize his profit. The producer who adopts the most efficient method of keeping the cost of production to minimum can hope to secure high profits. The price system indicates to the producers which factors of production must be chosen to make production cheapest. It works using the following method (how to produce): No factor unit will be wasted in production

Every factor unit will be put to that use in which its productivity will be highest. Every factor will be employed up to the point at which the revenue from the last unit employed is equal to the cost on that unit.

If factor units are underutilized or wastefully used, total product will not be maximum and cost per unit will rise and profit will come down.

Method of distribution
Goods and services are produced for those who have effective demand, i.e., one who can afford to pay for these services. Effective demand depends upon money incomes which constitutes the part of price mechanism. Thus, the distribution of goods and services, i.e., the problem for whom to produce, is solved on the basis of effective demand which also depends upon the price mechanism.

In a free economy, there is no visible authority that controls and directs the economic systems. All the three economic problems are solved with the help pf the price mechanism.

The capitalist system of production and distribution based on the market forces of demand and supply, is considered the best and the mist efficient system. It brings about the most efficient allocation of resources in the country. Only those goods and services are produced which consumers want and they are produced in the required quantities. Secondly, production though undertaken by thousands and millions of independent producers is maximized and the cost of production is minimized. Hence, economic resources are not wasted. Finally, goods and services are distributed among all on the basis of their effective demand. Price mechanism brings about an ideal allocation of economic resources and the most efficient production and distribution. Hence, the consumer welfare is maximized under the system of price mechanism.

5. What are the factors governing Price Elasticity of Demand? Explain. The price elasticity of demand (PEoD) measures the rate of response of quantity demanded due to price change. The concept of price elasticity was given by Alfred Marshall in 1890. The formula for PEoD is: PEoD = (% change in quantity demanded) / (% change in price)

The following are the main factors which determine the price elasticity of demand for a commodity: i. The number and kinds of substitutes:
Of all the factors determining price elasticity of demand the number and kinds of substitutes available for a commodity is the most important factor. If for a commodity close substitutes are available, its demand tends to be elastic. If the price of such a commodity goes up, the people will shift to its close substitutes and as a result the demand for that commodity will decline. The greater the possibility of substitution, the greater the price elasticity of demand for it. If for a commodity substitutes are not available, people will have to buy it even when its price rises, and, therefore, its demand would tend to be inelastic. For instance, if the price of Campa Cola was to increase sharply, many consumers would turn to other kinds of cold drinks, and as a result, the quantity demanded of Campa Cola will decline very much.

On the other hand, if the price of Campa Cola falls, many consumers will change from other cold drinks to Campa Cola. Thus, the demand for Campa Cola is elastic. It is the availability of close substitutes that makes the consumers sensitive to the change in the price of Campa Cola and this makes the demand for Campa Cola elastic. Likewise, demand for common salt is inelastic because good substitutes for common salt are not available. If the price of common salt rises slightly the people would consume almost the same quantity of salt as before since good substitutes are not available. The demand for common salt is inelastic also because people spend very little part of their income on it and even if its price rises it makes only negligible difference in their budget allocation for the salt. ii. The position of commodity in a consumer’s Budget:

Another important determinant of elasticity of demand is how much it accounts for in consumer’s budget. In other words, the proportion of consumer’s income spent on a particular commodity also influences the elasticity of demand for it. The greater the proportion of income spent on a commodity, the greater will be generally its elasticity of demand, and vice versa. The demand for common salt, soap, matches and such other goods tends to be highly inelastic because the households spend only a fraction of their income on each of them. When the price of such a commodity rises, it will not make much difference in consumer’s budget and, therefore, they will continue to buy almost the same quantity of that commodity and, therefore, the demand for them will be inelastic.

On the other hand, demand for cloth in a country like India tends to be elastic since households spend a good part of their income on clothing. If the price of cloth falls, it will mean great saving in the budget of many households and, therefore, they tend to increase the quantity demanded of the cloth. On the other hand, if the price of cloth rises many households will not afford to buy as much quantity of cloth as before, and, therefore, the quantity demanded of cloth will fall. iii. The number of uses of a commodity:

The greater the number of uses to which a commodity can be put, the greater will be its price elasticity of demand. If the price of a commodity having several uses is very high, its demand will be small and it will be put to the most important use and if the price of such a commodity falls it will be put to less important uses also and consequently its quantity demanded will rise significantly. To illustrate, milk has several uses. If its price rises to a very high level, it will be used only for essential purposes such as feeding the children and sick persons. If the price of milk falls, it would be devoted to other uses such as preparation of curd, cream, ghee and sweets. Therefore, the demand for milk tends to be elastic. iv. Complementarily between goods:

Complementarily between goods or joint demand for goods also affects the price elasticity of demand. Households are generally less sensitive to the changes in price of goods that are complementary with each other or which are jointly used than in the case of changes in the prices of those goods which have independent demand or used alone. For example, for the running of automobiles, besides petrol, lubricating oil is also used, now, if the price of lubricating oil goes up it will mean a very small increase in the total cost of running the automobile, since the use of oil is less as compared to other things such as petrol. Thus, the demand for lubricating oil tends to be inelastic. Similarly, the demand for common salt is inelastic, partly because consumers do not use it alone but along with other things. It is worth mentioning here that for assessing the elasticity of demand for a commodity all the above three factors must be taken into account. The three factors mentioned above may reinforce each other in determining the elasticity of demand for a commodity or they may operate against each other. The elasticity of demand for a commodity will be the net result of all the forces working on it. v. Time and elasticity:

The element of time also influences the elasticity of demand for a commodity. Demand tends to be more elastic if the time involved is long. This is because consumers can substitute goods in the long run. In the short run, substitution of one commodity by another is not so easy. The longer the period of time, the greater is the case with which both consumers and businessmen can substitute on commodity for another. For instance, if the price of fuel oil rises, it may be difficult to substitute fuel oil by other types of fuels such as coal or cooking gas. But, given sufficient time, people will make adjustments and use coal or cooking gas instead of the fuel oil whose price has risen. Likewise, when the business firms find that the price of a certain material has risen, then it may not be possible for them to substitute that material by some other relatively cheaper one. But with the passage of time they can undertake research to find substitute material and can redesign the product or modify the machinery employed in the production of the commodity so as to economies in the use of the dearer material. Therefore, give the time; they can substitute the material whose price has risen. We, thus seen that demand is generally more elastic in the long run than in the short run.