The Free Market System - Essay Example

?Free market system is considered to be the only economic system which encourages efficient allocation of resources. In the case of Laissez-faire or the absolute capitalist economy, the resources are privately owned and households have the liberty to invest anywhere they can. This is more of a hypothetical situation as no economy in the world is in a total Laissez-faire state. As opposed to planned economy, the free-market economy allows households and private firms and businesses to own land and other resources and use them to invest in any part or sector of the economy which seems lucrative and profitable to them (Rao, 1998). THE FREE MARKET SYSTEM In order to understand the benefits of free-market economy, one needs to understand how the planned economy works. In a planned economy, also known as command economy, all the resources are state owned. Its’ allocation is decided by the government in order to maximize the society’s welfare regardless of the profit motive. This means that even if the venture does not earn profit for the government and if the venture is good for the society’s welfare, the state would continue to allocate its resources to the latter. For example, if a government sets up a state-funded hospital in a remote are with state-of-the-art facilities, it cannot expect a fair return of revenue from its investment. However, this venture would increase the life expectancy of the people in the area and improve their standard of living. The government, operating in a command economy will not withdraw the investment. Likewise, operating a state-owned Postal Service in a remote area would incur losses as there would hardly be enough posts to break-even. Despite a venture’s disability to earn profit, a planned economy would continue to invest if a venture is maximizing the society’s welfare. Examples include building roads, infrastructure, merit and public goods etc. As there is no profit motive, the government will not invest as per market forces and the demand of the consumers. For example, if there is a high demand of luxury goods in the metropolitan city of an economy, the government would rather invest in those areas which would satisfy basic necessities of people in different parts of the country. Likewise, the government would not be interested to produce variants of any category. For example, there would be a limited range of cars produced in the economy. Some critiques argue that this economic system maximizes the society’s welfare and there is more even distribution of income in the economy as opposed to free market system. This is true to some extent however, like the case of Laissez-faire, there is no economy in the world which is entirely command economy. There is some level of international trade or some or some level of production in an economy which is driven by profit motive. However just for the sake of argument, planned economies fail to meet the consumers’ demand in an economy. Besides this, as there is no profit motive, the workers get de-motivated and as they are not allowed to own assets or factors of production, the economy’s GDP would be restricted to what a free-economy could otherwise have achieved. Besides this, the resources tend to be misallocated as they will not be yielding a fair return which it otherwise would have if the respective end product had a demand. The government would just be injecting more resources with no return as reimbursement at the expense of other people who would deserve a fair return for their taxes in the form of a diverse range of commodities to choose from (Rao, 1998). In a free-market economy, the resources are not just state-owned. Individuals and firms have the liberty to invest in whatever which is in demand. The market-forces would move in to stabilize the prices automatically and bridge the gap between demand and supply. Market forces will only come into play when the resources have some mobility and the consumers are free to choose from a range of products. Besides this, in the free market economy, there is a profit motive amongst the producers which in turn encourages them to sell more of what is in demand. Not only this maximizes their output, but also satisfies the wants and demands of the consumers. Resources yield more income/revenue and hence, firms and households are encouraged more to invest in order to maximize their revenue. This directly reflects on a country’s GDP as when more people own assets and factors of production, more economic activity takes place which further boosts the GDP and leads to economic growth (Rao, 1998). However, the free-market economy has its own limitations. No firm would be willing to produce those goods which yield no income like public goods. Public goods such as street lights, roads, pavement etc elevate public welfare but are also fruitless from the business point of view. Besides this, as stated above that the free market economy raises investments and leads to an efficient system of resource allocation, also has some limitations. For example, if an economy has a high demand of smart phones, capable firms would start producing them to reap benefit. However, some brands may remain unsold because of consumer preferences. These unsold brands would be a loss on investment and therefore, be considered as dead-weight loss. The free-market economy may not be the ultimate choice of resource allocation but is definitely leads an economy towards a higher GDP because of increased economic activity driven by the autonomy of owning factors of production and conducting business (Bhalla, 2001). MARKET FAILURE IN CHINA Operating in a free-market economy gives the firms full autonomy to produce whatever is in demand and also, however way which would help them cut down costs. This may involve using cheap raw materials and cheap production methods which cause pollution. As the businesses are only concerned with their profits, they will not pay heed to the environment and the negative externality which they are causing. This externality will cause a market failure (Tyler, 2010). China is the world’s fastest growing economy of the world. With the economic reforms which lead China from the socialist economy to the free-market economy, the country has become the second largest economy after the United States. However, no matter how well the free-market economic system has worked for China, it has also lead to experience one of the worse market failures: pollution and negative externalities. Besides being the second largest economy and the most populated economy of the world, China also tops the list of countries with most carbon dioxide emissions along with being one of the world’s most polluted countries. The economic revolution which hit China became a strong backbone of the Chinese economy but all the industries, factories and mills operating in China polluted the air which the Chinese breath. Gauging the cost of pollution is next to impossible. However, it could be reciprocated by the firms causing them in the forms of taxes, fines etc. The economy has undoubtedly grown at a fast pace to become the world’s second largest however, this has inevitably caused a market failure of climatic damage simultaneously which cannot be reversed (Tyler, 2010; Gallagher, 2006). China has become intensely polluted owing to recent economic change. Because of a growing population and heavy industrialization, the country reports to have about 300,000 approximate annual deaths caused wither by lung cancer or heart diseases. Studies have found that these diseases and deaths are primarily caused by air pollution, with the air containing those compounds which can most commonly be found in car exhausts and emissions produced by burning coal. Coal is a significant source of power which is used to operate factories in China (Gallagher, 2006). The Chinese government however, has been taking bold steps to minimize the greenhouse gas emissions if not eradicate them completely. For example, it has passed laws previously to impose heavy taxes on firms which cross a certain level of greenhouse gas emissions. This incorporates all other waste products of a manufacturing plant. These limits were set separately in different industries accordingly. On the other hand, it has also ordered vehicle manufacturers to produce vehicles with a certain level of gas emissions, failing to meet the standards of which, the firm would either be taxed heavily or the vehicle will not be allowed to be launched in the market. This has lead to major manufacturers like Toyota and Honda to introduce the technology of Hybrid in its cars. Running the car on Hybrid technology greatly reduces emissions to minimal levels and therefore, is known to be the most environmentally friendly alternative source of fuel besides being efficient too. Apart from this, the government has also noticed increasing number of vehicle consumption which has leaded it to restrict vehicle use and limit it to bicycles. One of the most prominent movements which China has sponsored to fight pollution is its steps to cut back pollution during 2008 Olympic Games in Beijing. It is claimed that if China continues to implement these steps to eradicate pollution, it will be successful to drastically reduce the risk of heart diseases and lung cancer in a resident’s life (Murray et al, 2003; Faure et al, 2008). DEPRESSION IN THE UNITED STATES AND ITS END Owing to sub-prime mortgages in the United States, majority of the citizens of the country were under some debt one way or the other. The economy was primarily dependent on banks to finance these debts and mortgages taken out by the people for real estate. Eventually, when the debts rose to an extent where they couldn’t be paid off by individuals, there came the most feared financial crunch which enveloped the whole world. Big financial institutions like the Lehman Brothers go a spiral downward and eventually collapse. The economic slowdown began to occur somewhere around in the summer of 2007. This eventually lead into a recession by about 2008 in the United States, affecting almost every big financial institutions. The United States was losing about 750,000 jobs on a monthly basis and the annual GDP fell about 6%. This recession is considered as the biggest since the 1930s. As the economy had taken a downturn, the U.S policy makers had to act immediately to prevent the economy from going into a deeper recession and to steer it towards economic growth again. One of the important steps taken by the government was to reduce interest rates aggressively and create lucrative credit policies for firms to start borrowing in order to invest. As the opportunity cost of saving and not investing was high because the benefit from investing would outweigh the benefit of saving and gaining on interest, firms started to re-invest however at a smaller magnitude. Simultaneously, the government increased money supply in the economy by purchasing Treasury Bonds and mortgaged-backed securities. This aggressive monetary policy adopted by the economy helped the banking sector to regain its confidence. Special programs were launched to inject more money in the economy. One of these programs includes Troubled Asset Relief Program (TARP). Through TARP, more money was infused in the nation’s banks. Along with this, 19 of the country’s biggest banks were to conduct “stress tests” to gauge the financial endurance of the banks and the ability to raise more capital if financial circumstances worsened. The results came out favorable (Blinder et al, 2010; Janszen, 2010). Alongside this, the US also launched a fiscal policy which included tax cuts. Middle and lower level income groups received cheques for tax rebates as a measure to elevate their purchasing power. As, the real estate is attributed to the financial crises primarily, the government tried to bring the real estate market to a recovery level by increasing confirming loan limits, reducing mortgage rates and by subsidizing homebuyers along with preventing foreclosures in the economy. The financial crises also reflected into the other sectors of the economy. The auto industry was in turmoil as well. General Motors and Chrysler went bankrupt but through the government’s subsidies, General Motors is back to its status of being a publicly trading company again (Blinder et al, 2010; Janszen, 2010). All in all, the economy is still recovering from the financial blow which started in mid 2007. Employment level in the United States is still lagging to get where it was before the recession struck. Besides this, the economy has great budget deficits owing to its borrowings from the banks to finance its fiscal and monetary policies. However, the worst is over and the economy has moved towards growth again (Blinder et al, 2010). AVOIDING DEEP RECESSION AND ITS COSTS Greater the economy reaches its boom, deeper would be the slumps. It is inevitable for an economy to avoid the cycle of booms and recessions. It is only the matter of when for an economy to reach to its peak and then move towards a recession. The policy makers can just control this time frame and the wavelength of these booms and slumps in an economy. If an economy is experiencing a slowdown, this would be mainly because of lack of economic activity owing to low investment, falling incomes and falling purchasing power. On the contrary, when the economy is going towards a boom, this would be because of an increasing economic activity with more investment coming in the economy. Households will have more purchasing power. However, an economy at its boom is also harmful. This can be explained by starting with an economy which is between a boom and a recession. In other words, it is moving towards steady growth. At this point, investment is coming in to the economy as businesses see a potential in the market. This is mainly because the purchasing power of the households is rising as firms are expanding to meet the rising aggregate demand. As firms employ more labor, GDP per capita would further rise, giving leverage to the purchasing power. This is solely dependent on the investment which the government wants to make in the economy wither through its spending or by lowering taxes or interest rates.(monetary and fiscal policy) As aggregate demand rises, cost-push inflation occurs in the economy. This raises the general price level. At this point, the economy would be at its peak. The employment would be high but so would inflation (Mcconnell et al, 2005). Eventually, there will come a point where firms will consider employing labor too expensive because of high wages demanded by the labor to cope up with high inflation. Firms will cut back on production as they will have unsold output in the market owing to inflation. As firms lay off workers, incomes start to fall causing an automatic drop in the aggregate demand. This leads the economy to a recession where demand keeps on falling and firms keep on reducing the head-count. Economic activity comes to a low level along with the aggregate demand which also brings down inflation. With inflation low, along with government intervention which brings in its investment though which, aggregate demand is generated. The government plays a vital role in the economy’s cycle of booms and recession by making use of its tools i.e. monetary and fiscal policy. By controlling investment when the economy is going towards a boom and primarily by controlling the money supply, interest rates and taxes, the government can prolong the period of boom and quickly steer the economy out of the recession (Mcconnell et al, 2005). Monetary policy has to do with controlling the money supply and the interest rates to keep the economy’s spending and investment controlled. In case of a recession where investment is at its lowest and the economy is expected to go into a deeper recession, the money supply will be increased by the government, causing the interest rates to fall. This will attract firms to borrow money for investment as borrowing would now be cheap. Simultaneously, as the firms and households will earn more in investing rather than earning a lower interest rate, opportunity costs of saving would rise and hence firms and households would start investing and this way, more money will begin to circulate in the economy. This is not as easy as it sounds. Increasing the money supply would also need some backing of the currency. Banks would be advices to raise their reserves. On the other hand, the Central Bank can purchase back bonds and securities from the households in order to release more money in the economy. However, if there is no money in the central reserves (which is likely when the economy is in deep recession), the government will need to borrow from International Monetary Fund or the World Bank, in order to buy back issued bonds or either to enable banks to raise their reserves. Both would put more debt burden on the nation (Allen, 1999). In contrast to this, fiscal policy is when the government uses taxation and its’ spending to control aggregate demand in the economy. When the government lowers its taxes, it is increasing the disposable income of households in order for them to be able to spend more. Likewise, when government increases its spending and starts to subsidize firms in order to encourage more investment, aggregate demand rises as firms employ more labor. These tools can be used in deep recessions to lead the economy towards growth however there are some impediments as well. When the government would lower taxes, it will generate lesser revenue for itself, leading to a negative outflow of money. Besides this, in the period of a recession, the state might not have enough money to invest. It will again be compelled to borrow from banks or from international organizations and further indebt the nation. However simultaneously, it can advice the banks to increase their loan reserves and lower discount rates to encourage borrowing amongst the households and the firms to raise investment and aggregate demand (Allen, 1999; (Mcconnell et al, 2005). REFERENCES RAO, C. P. (1998). Globalization, privatization and free market economy. Westport, Conn, Quorum Books. BHALLA, A. S. (2001). Market or government failures?: an Asian perspective. Houndmills, Basingstoke, Hampshire, Palgrave Top of Form MURRAY, G., & COOK, I. G. (2003). Green China seeking ecological alternatives. London, RoutledgeCurzon. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=92375. GALLAGHER, K. S. (2006). China shifts gears: automakers, oil, pollution, and development. Cambridge, Mass, MIT Press FAURE, M., & SONG, Y. (2008). China and international environmental liability legal remedies for transboundary pollution. Cheltenham, UK, Edward Elgar. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=24816 TYLER, B. A. (2010). The Chinese economy. New York, Nova Science BLINDER, A. S., & ZANDI, M. M. (2010). How the great recession was brought to an end. West Chester, Pa, Moody's Economy.com. http://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf. Bottom of Form JANSZEN, E. (2010). The postcatastrophe economy: rebuilding America and avoiding the next bubble. New York, Portfolio Penguin MCCONNELL, C. R., & BRUE, S. L. (2005).Macroeconomics: principles, problems, and policies. Boston, McGraw-Hill/Irwin ALLEN, R. E. (1999). Financial crises and recession in the global economy. Cheltenham, UK, Edward Elgar. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=716110. Read More