Transcript (A) The Market Mechanism

SMART Classes
First Year
Chapter (2)
The Modern Mixed
Economy
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Learning Objectives
This chapter represents the basis or
foundation for the analysis of a market
economy, through the following points:
(A) The Market Mechanism
(B) Trade, Money, and Capital
(C) The Visible Hand of Government (The role
of government in the market economy)
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(A) The Market Mechanism
• A market economy is a mechanism for
coordinating people, activities, and businesses
through a system of prices and markets. So, in
a market economy, no single individual or
organization is responsible for production,
consumption, distribution, or pricing.
• A market “is a mechanism through which
buyers and sellers interact to determine prices
and exchange goods, services, and assets”.
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(A) The Market Mechanism
• In a market economy, prices serve as signals
to producers and consumers. If consumers
want more of any good, the price will increase,
sending a signal to producers that more supply
is needed. This is true in both product markets
and factor markets.
• So prices coordinate the decisions of
producers and consumers in a market. Higher
prices discourage and encourage production.
Lower prices encourage consumption and
discourage
production. Prices are the
balance wheel of the market mechanism.
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(A) The Market Mechanism
• Markets achieve equilibrium the market
mechanism by balancing supply and demand
forces, at those prices for which buyers desire
to buy exactly the quantity that sellers desire
to sell, that is the quantity demanded is
equal to the quantity supplied.
• Markets also can solve the three economic
problems (what, how, and for whom) through
the market mechanism.
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How Markets Solve the Three Economic
problems?
• The way in which markets solve the three
economic problems (trio of economic
problems) can be illustrated by the circular
flow of economic life.
• This diagram provides an overview of how
consumers and producers interact in the
product markets and factor markets to
determine prices and quantities for both
outputs and inputs. In this circular flow, there
are two fundamental forces that shape the
market economy: tastes and technology.
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How Markets Solve the Three Economic
problems?
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How Markets Solve the Three Economic
problems?
• In this circular flow, the three problems are
solved in the following way:
1- What goods and services will be produced
is determined by the dollar votes of consumers
that interact with the business supply in the
product markets and determine prices. This is
because tastes of consumers are expressed in
the dollar votes of consumer demands.
Firms, in turn are motivated by the desire to
maximize profits (the difference between total
sales and total costs).
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How Markets Solve the Three Economic
problems?
2- How things are produced is determined by
the competition among different producers. The
best way for producers to compete and
maximize profits is to keep costs at a minimum
by using the most efficient methods of
production, and this will depend largely on the
resources and technology available to a
society.
3- For whom things are produced depend
largely on the factor prices (wages, rents,
interest rates, and profits) that are determined
by household supply and business demand
in the factor markets.
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The Invisible Hand
• Adam Smith was the first who recognized how
a market economy organizes the forces of
supply and demand, through what he called
the invisible hand.
• The invisible hand “states that private interest
can lead to public gain when it takes place in a
well-functioning market mechanism”. But the
functioning of the invisible hand requires a
perfectly competitive economy with no market
failures. Market failures like monopolies or
pollution will require government interference.
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(B) Trade, Money, and Capital
• Modern economies have enjoyed rapid
economic growth as increasing specialization
has allowed workers to become highly
productive in particular occupations and then
to trade their output for the goods they need.
• Specialization “occurs when people and
countries concentrate their efforts on a
particular set of tasks”. In this way, there will
be a division of labor dividing production into a
number of specialized tasks or steps.
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(B) Trade, Money, and Capital
• Each country will specialize in the production
of the goods in which it has advantage, and
then international trade will allow different
countries to exchange what they produce for
what they need. So trade can benefit all
countries by increasing the range and quality
of consumption and raising everyone’s living
standards. But trade will require a lubricant.
• Money can be considered the lubricant of
exchange, as it allows people and countries to
trade their specialized outputs for those
produced by others.
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(B) Trade, Money, and Capital
• Money “is the means of payment in the form
of currency and checks used to buy things”.
• Money acts as a matchmaker between buyers
and sellers matching their interests billions of
times everyday.
• But the increase in the future productivity
requires decreasing current consumption to
increase the country’s capital and also the
future consumption. The benefits from this
capital will depend on the ability of individuals
to own (have private property of capital) and
profit from capital.
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(C) The Visible Hand of Government
• In reality, no economy conforms totally to the
idealized world of the invisible hand. There are
flaws in the market mechanism that requires
government intervention such as pollution,
unemployment, and extremes of wealth and
poverty.
• Governments operate by requiring people to
pay taxes, obey regulations, and consume
certain collective goods and services.
• Therefore, Governments have three main
economic functions in a market economy: to
increase efficiency, promote equity, and
foster macroeconomic growth and stability.
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(C) The Visible Hand of Government
1- Efficiency:
• Adam Smith recognized that the benefits of the
market mechanism are achieved only when
perfect competition is present and so the
economy is efficiently producing.
• Perfect competition “refers to a market in
which no firm or consumer is large enough to
affect the market price”. For example: the
wheat market.
• There are many ways that markets cannot
achieve perfect competition such as: imperfect
competition, externalities, and public goods.
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(C) The Visible Hand of Government
• Imperfect competition “occurs when a buyer
or seller can affect a good’s price”. In this case,
the society may move inside its PPF.
• Imperfect competition leads to inefficiencies as
it results in too high prices and too low output.
Monopolies such as Microsoft are the extreme
case of imperfect competition.
• Governments can face imperfect competition
by regulating the price and profits of
monopolies, antitrust laws, and opening of
markets to competitors (deregulation).
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(C) The Visible Hand of Government
• Externalities (spillover effects) “occur when
firms or people impose costs or benefits on
others outside the market place”. That is ,
externalities mean that there was an economic
transaction without an economic payment.
Examples of externalities are pollution
(negative) and research and development
(positive).
• Government regulations such as antipollution
laws can be used to control externalities.
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(C) The Visible Hand of Government
• Public goods “are commodities which can be
enjoyed by everyone and from which no one
can be excluded, such as national defense”.
• In providing public goods, governments behave
exactly like any other large spender.
2- Equity:
• The market economy may not produce fair
distribution of income, even if the market
system worked perfectly. In this case,
government can use progressive taxation and
make transfer payments or subsidize
consumption.
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(C) The Visible Hand of Government
• Governments can engage in progressive
taxation by taxing large incomes at a higher
rate than small ones. Then, governments can
make transfer payments (money payments to
people) to the elderly, blind, disabled, and
unemployed.
• Sometimes, the governments subsidize the
consumption of low-income groups by
providing food stamps, subsidized medical
care, and low-cost housing.
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(C) The Visible Hand of Government
3- Macroeconomic growth and stability:
• Since its origins, capitalism has experienced
periodic fluctuations of inflation (rising prices)
and recession (high unemployment). These
fluctuations are known as the business cycle.
• Governments can stabilize economic growth
and face these fluctuations by using fiscal
policies (taxing and spending) along with
monetary policies (interest rates and credit
conditions).
• Such government intervention in the market
economy explains why most economies are
now mixed economies.
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