Market’s Flaws

 

   Market system has many positive characteristics, but there are also some things that make it to failure. This failure may occur when market produces the wrong quantity of goods or even fails to allocate resources to produce some goods and services. First failure results from spillovers but second one is related to public goods.

  Spillover
   When we talk about efficiency of a market, we thinks that all costs and benefits related to the production of it are showed on PPC, indeed sometimes certain benefits and costs aren’t showed by PPC. A spillover situation may happen when the benefits or costs are passed to someone else than immediate buyer or seller. Spillover is also called externality.

 

Spillover Costs
   Spillover costs are some costs that are related to a third person or group of people, and they are not compensated by initial seller or buyer. An example can be the harsh sounds produced by a factory to environment. So the habitat of some organisms may be destroyed.
So what are the economical effects? Since these costs aren’t included to PPC then this curve lies further to the right. So the price of the product is too low, but output is too large to achieve allocative efficiency. Then there happens an over-allocation of resources.

Eliminating Spillover Costs
   There are two ways by which government can correct this over-allocation of resources:

• Legislation– Government is adopting some laws which enforce factory owners to pay for the disturbing of animal’s habitat, by installing better isolation materials or buying better equipment.
• Specific taxes-Government might include levy specific taxes from factory owners. So this will be included in the total cost of production. Then the amount of this tax will be equal to the spillover tax.

       Spillover Benefits
   Sometimes, spillovers can be turned into benefits to the third person or group of people. These benefits aren’t paid to the immediate producer or consumer of that good and services. An example can be education. More educated people receive higher wages. But education has an impact over society. Education lowers crime possibility and promotes fast growing economy.
Spillover benefits make demand curve lie farther to the left, because benefits are underestimated, so a smaller amount of good or service will be produced, then an under-allocation of resources will occur.

Eliminating Spillover Benefits.
   Again government has to solve this problem of under-allocation of resources. Here are two solution subsidize consumers(increase demand), subsidize producers(lower the price) or in other case government has to produce it.

• Subsidize consumers. To correct the problem of under-allocation of resources government has to give some loans or grants to students, so they will be able to afford more education.
• Subsidize producers. Sometimes government finds it more useful to subsidize producers what means that they will be able to increase budget places at colleges and universities. Such subsidies reduce the price of “producing” higher education.
• Provide goods by government.  The last solution for government is to own these industries.

Public Goods.
   Certain goods are private goods because they can be divisible. However, public goods are indivisible. Private goods can be subjected to exclusion principle, so demanders who are willing and able to pay obtain it, others are excluded from getting this product and its benefits. Exclusion principle isn’t applied to public goods since you can’t exclude someone from using this good. To get benefits from private good you need to buy it, but to get benefits from public goods then it just should be available. For example acquiring the Eiffel Tower isn’t economically justified. Since its ratio of total utility over price is very small in comparison to total utility gained from all people who see it. Also if you buy it you can’t stop everyone to see it. In economics this is called free-rider problem, when a group of people receive benefit from a good without paying for it.
Because services of Eiffel Tower can’t be bought or sold there is no reason to buy it. So here is a service which could yield benefits for a nation as a whole but no reason for someone to allocate resource for it. Other public goods are public health, national defense. Society wants like these goods that’s why it supports some political parties.

Quasi-Public Good
   However, there are some public goods for which exclusion principle may apply, they are called quasi-public goods. Such goods may be education, streets, police, and museums. They could be provided by private firms.

Production of Public Goods
   From where government takes resources to produce public goods? As you may guess, it collects money by levying taxes to firm, businesses and households. With less money households and businesses must buy and produce fewer goods. So, demand for goods and demand for resources diminishes. So by decreasing purchasing power, taxes remove resources from private usage. Governments spend these money on purchasing public goods and quasi-public goods, so it changes the composition of economy’s total output.

Key Terms:
Spillover Costs-A cost imposed without compensation on third parties by the production or con­sumption of sellers or buyers.
Spillover Benefit-A ben­efit obtained with­out compensation by third parties from the production or consumption of sellers or buyers.
EXCLUSION PRINCIPLE-The ability to exclude those who do not pay for a product from receiving its benefits.
Public Good-A good or service that is indivisible and to which the exclusion principle does not apply.
Free-rider problem- The inability of potential providers of an eco­nomically desirable but indivisible good or service to obtain payment from those who benefit, because the exclu­sion principle is not applicable

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“Invisible hand” in economics

“Invisible Hand” in Economics
Firms and resource suppliers want to increase their revenue and seek their own self-interest, so that they are like guided by an “invisible hand”. In this environment businesses are the least costly producers of goods and services, because this is their interest is to get higher revenues. In the same way, using few resources to produce goods is in interest of demanders.
Businesses want to make higher profits; resource suppliers want higher rewards, so both of them manipulate resources usage order to get best allocation of them for the entire society.
Competition of self-interests unintentionally furthers fulfilling of society’s needs. The “invisible hand” maximizes profits of firms and also it maximizes the output and wish-fulfillment.
Most important characteristics of market system are:

• Efficiency– Market system produce only that goods and services that are most demanded by society. It forces using the most efficient techniques of production, so that in increases the total output.
• Incentives– Market system requires hard-work and innovation. So ones who are working a lot, get better results and efficiency, so that they also get higher revenues. Implementation of new efficient production techniques also offers higher revenues.
• Freedom-Firms and industries can enter or leave the industry when they want. Entrepreneurs and labour force are free to seek their own self-interest, so that they may get better results or big losses.

Key Terms:
Invisible Hand-The ten­dency of firms and resource suppliers seeking to further their own self-interests in com­petitive markets to also promote the interests of society as a whole.

Market System part II

There are two important components of market system: households (consumers) and firms (producers). The main roles of households are to sell resources and to purchase goods and services. In free market system households are able to buy the goods they want, so that they are dictating the demand. This kind of system don’t collapse, because firms produce the kind of goods and services that demanders need and the latter ones provide resources and labour force  that firms need.
You may ask “from where firms know what to produce?”.  The answer is quite easy. Suppliers seek profit and try to avoid losses, so they will produce the goods and services that continue to offer them profit.
Consumer register their needs on the demand side of the market, so firms and products suppliers respond to this demand by completing this demand.

Dollar Votes
Consumer sovereignty is represented by consumer demand, which is crucial for determining the type and quantity of goods to be produced. They spend their wages on the goods they are willing and able to buy. By these dollar votes consumers registers their needs on the demand side of the market. If a dollar vote for a certain good is high enough to produce a profit, the industry will expand so will production quantity of it. Otherwise, if there exist a decrease in demand, or fewer dollar votes cast for that good, industry will contract. We may say that the consumers are sovereign, because they collectively direct the market, in sense to produce more goods of some type or not.

Freedom of Market
Actually, firms don’t produce the goods and services they want, they rely on consumer’s buying decision and demand. Ones which don’t obey the rule of the market may face great losses or even bankruptcy.

This fact remains true also for resource suppliers. The demand for resources is called derived demand, derived from demand for goods and services. Consumers register their wants on the demand side of the market, producers and resource suppliers respond to these wants by creating supply for these goods.

Production Techniques
In each industry the firms which are able to survive are the most profitable. Competition eliminates producers which are not profitable and efficient, and ones that require less production costs survive.
Least-cost production means that these producers must have the most economically efficient production technique.  Efficient production depends on:

• Available technology
• Prices of resources

Economic efficiency means obtaining a particular output by using least input of scarce resource, while both input and output are calculated in the same currency.

Changes
Let’s suppose that buyers change their taste and don’t want to buy apple but they are willing to buy cherries. These changes are communicated to producers by an increase in demand of cherries, so the price of apples will decrease and that of cherries will increase. Some of these firms that activated in apple production may leave this industry, because they don’t seek losses. In contrast, in cherries industry some new firms will enters, because they seek self-interest. Higher profit will make cheery industry to expand. Firms will pay even more money to resources producers, who will find some alternatives to get more cherries. So demand can contract or expand an industry.

Technological Advances
New capital permits firms to spend less money on production of a good. So the costs are decreasing which offers suppliers higher revenue. Market system is conducted by a very fast spread of technological advances through industries. Rival firms must follow these technological advances elsewhere they may suffer losses or even a total failure. Creative destruction is destruction of market positions of firms that are using older ways of production, by creating new products and new production methods.
Entrepreneurs sometimes spend their revenue on purchasing capital goods. This yields higher revenue in future if new technology is more effective.  By selling ownership shares the firm casts dollar votes for buying new capital goods.

Key Terms:
Consumer Sovereignty-Determination by consumers of the types and quantities of goods and serv­ices that will be produced with the scarce resources of the economy.
Dollar votes- The “votes” that con­sumers and entre­preneurs cast for the production of consumer and capi­tal goods, respec­tively, when they purchase them in product and resource markets.
Derived Demand-The demand for a resource that depends on the demand for the products it can be used to produce.

Capital Goods,Specialization…

Technology and Capital Goods
   Market system needs extensive use of capital goods. Supplier’s self-interest, competition, willingness for high-revenue and freedom of choice create a motivation for using technological advantage. In order to have high income an economic unit should grow very fast and have a high efficiency at output production, that’s why suppliers are building capital goods like: machineries, tools that create facilities for goods storage and transportation.
The only way to acquire a high efficiency at production is to rely on roundabout production.

  Division of labour
   Human specialization, which is also called division of labour, contributes society’s output in several ways.

• Specialization helps us to take advantage of our differences. For example one which are better at math will be an accountant, so this person will do his/her job faster than one which is good at writing poems.
• Specialization helps to improve our abilities by doing. If we devote our time to a single task, we will be able to do it faster and more efficient than if we would do multiple actions in the same period of time.
• Specialization saves time. By using all our time to a single task we don’t have losses in time, in contrast to when we shift among more jobs.

Because of this reasons specialization help a society to create more output from the same scarce resources.

   Money
   In economics money has diverse functions, but the most important of them is using it as a medium of exchange. It makes trade easier.
Let’s take a case in which money doesn’t exist. So the only way some countries can exchange their goods is by barter-exchange of one good by another one. But, here some problems arise. One of them is coincidence of wants between demanders and suppliers. Let’s take one case. Country one (excess potatoes, needs carrots), country two (excess carrots, needs apples), country three (excess apples, need potatoes). In this case trade can occur, but what if country three had excess potatoes and demanded apples? For sure, barter would be very difficult or even impossible. That’s why using money is so convenient. One important property of money is that it should be accepted by sellers in exchange for their goods. The fact that different countries have different currencies makes international trade a little bit difficult, but we shouldn’t forget that there are right now currency exchangers that are very useful if we want to buy some goods from a country that has a different currency. Money helps countries to get some amount of goods that are even impossible without international trade, because that point lies outside of PPC.

Key Terms:
Roundabout Production-The construction and use of capital to aid in the produc­tion of consumer goods.
Specializa­tion-The use of the resources of an individual, a firm, a region, or a nation to produce one or a few goods and services.
Division of Labour-Divid­ing the work required to produce a product into a number of different tasks that are per­formed by different workers.
Barter- The exchange of one good or service for another good or service.