Economics for Business and Management - Essay Example

? Topic: Lecturer: Presentation: Q1 (a Arguments in Favour of Free Market System of Resource Allocation A free market system is whereby resource allocation is determined by price mechanism. There are four actors in this system namely; consumers, producers, owners of factors of production, and the government and each actor is inspired to act by self interest (Anderton, 2000).The consumers aim at maximizing utility while producers are motivated by profit maximization. The owners of factors of production get wages, interests, rents and profit. The role of the government in the system is to ensure the welfare of the society is not compromised. The free market is characterized by competition by various players’ hence free allocation of resources. According to Anderton (2000), the consumers are the ones who determine what is to be produced hence determine allocation of resources leading to allocative efficiency. The demand for goods and services by consumers triggers the producers to increase production thus engaging more factors of production in the process. The income earned by the factors determines the amount of consumption by individuals; the more the income, the higher the consumption or demand. At the initial stage, competition by consumers for scarce resources pushes the prices up. The law of supply states that the higher the price, the higher the quantity supplied thus the producers increase production and get more profit. Since there are no barriers to entry in a free market, more producers may enter the market attracted by the abnormal profits (Griffiths & Wall, 2008). In the long run, supply will increase more than demand and the firms will start competing for the few buyers pushing the prices down. A fall in price means the profits also decline leading to reduction in production by firms and exit from the market by others. An optimum allocation of resources occurs where demand by consumers interacts with supply by producers. The resources are used to produce the goods that are most in demand by consumers hence resources are transferred from one use to another which is more profitable. As such, some people are made well off while others are made worse off. For example, if a firm decides to change the technology used in production it will employ individuals who have such skills and those who don’t possess the required skills are declared redundant and lose their wages. The firm can also use new equipments. High prices make some consumers to afford goods while others cant due to amount of income held by individuals. According to the law of demand, the lower the price the higher the quantity demanded. A reduction in production by producers may force prices up as consumers compete for the goods. The high prices in turn lead to cut in consumption. The producers therefore must innovate ways of producing goods at low cost hence low prices for goods and increased demand. This leads to productive efficiency of the economy (Griffiths & Wall, 2008). Competition by firms leads to innovation as firms try to gain competitive advantage. They thus produce high quality goods to the advantage of consumers. Lipsey & Chrystal (2007) argue that the free market gives better information on changing market conditions thus allowing buyers and sellers to make informed decisions. For example, when prices are low it signals that there is high supply in the market and an incentive for buyers to buy more. High prices indicate scarcity of goods and hence an incentive for sellers to sell more and make profit. High prices also induce firms to employ more factors of production. Due to availability of information, decision makers respond quickly to changes in consumer demand (Vidler & Grant, 2003). The free market system also allows consumers to have a variety of choices from different firms. Q1 (b): How Market Failure Occurs and how Government can Correct Market Failure Market failure is due to inefficient functioning of the markets. A market should be able to resolve the questions of what, how and for who the production is and how well the available resources are used to achieve desired output (Anderton, 2000). There are various causes of market failure; lack of competition, externalities, missing markets, factor immobility, inequality in distribution of income and wealth, and information failure. Free market system is advocated for due to competition between firms which leads to innovation and production of high quality goods at low cost and prices. However, some firms are involved in mergers and acquisitions so as to enjoy economies of scale and bar the entry of new firms in the market. Sometimes there is one supplier in the industry due to natural cost advantage or resource and legal barriers. These monopolies regulate production and prices leading to low output and high prices. The competition in the market is limited and the welfare of the society is compromised through high prices and reduced product choice thus allocative inefficiency. Externalities in production and consumption lead to market failure (Riley, 2006). The cost of environmental pollution as a result of production cannot be quantified and there are no individual rights to such effects. The prices and profits which act as signals of market conditions are misleading thus resources are misallocated and economic efficiency is not achieved. Producers are driven by profit maximization objective in a free economy. They thus offer only the goods and services that are profitable. Public goods such as defence and merit goods such as health care and education are not profitable to the private sector and therefore are not provided in the market. The market is supposed to be allocatively efficient by producing the goods needed by customers and since such goods are needed and not available there is market failure due to allocative inefficiency (Riley, 2006). The free market allows for factors of production to be transferred to more profitable use for productive efficiency to occur (Griffiths & Wall, 2008). However, some factors are difficult to transfer to different use. For example, transport facilities are used for transport and not any other use. Labour can also be immobile if labourers do not have the skills to perform certain tasks especially due to technological advancements. Market failure is also a result of inequitable distribution of income and wealth. The free market creates inequalities in distribution as consumption is directly related to income. People have different skills and different levels of wealth hence the income they get from wages, rent, interests and profits vary. Those with higher income can buy more goods than those with low income creating a gap between the rich and the poor (Griffiths & Wall, 2008). The consumers also lack information as to the benefits and costs associated with particular products. They therefore end up buying more of a good that is not useful such as cigarettes and forego important products. This is due to profit maximising objective of firms where they attract more demand to increase sales and eventually profit by giving wrong information to consumers (Riley, 2006). Government intervention in the market is required in order to correct market failures. The United Kingdom government has undertaken several measures to that effect. The government through legislations, deregulations and privatization aims at curbing monopoly power and introduce competition in the market. British telecom and Gas were privatized. Sectors such as water, electricity, gas and rail are regulated through price controls. The freedom to increase prices in these firms is limited by a formula (Vidler & Grant, 2003). It also has a competition policy in line with EU requirements to eliminate anti-competitive behaviour. The UK government also has managed to curb monopoly by breaking up monopolies. For example, the British rail was split into three; railway and station network, rolling stock provision and rail operating companies. To ensure equitable distribution of income and wealth, UK government has put measures such as taxation. Income tax is high for the rich people and tax is levied on inheritance to reduce wealth. Those who earn income below a certain level are given family credit and part groups are given child benefits. The government also provides health care and education and has set minimum wages to avoid trade union pressure on firms and ensure individuals are not paid unfairly by firms through the minimum wage Act of 1999 (Vidler & Grant, 2003). The state also is involved in direct provision of goods and services to resolve market failure due to missing markets. It collaborates with the private sector to provide such services; NHS is an example. To deal with externalities, the government offers subsidies to consumers to encourage consumption of merit goods and indirect taxes to discourage de-merit goods. It also has laws governing the level of pollution such as the Clean Air Act and the market must operate within this level. There is a market for pollution whereby firms’ trade pollution permits (Gillespie, 2007). Information is made available to consumers through advertisements on television, advertising campaigns and compulsory labelling of products among others. Q2: W/J Approach to Circular Flow of Income in the Economy The circular flow of income shows how income circulates in the economy between households and firms. The firms produce goods and services which are consumed by the households and use factors of production in the process. The firm thus pays for the production inputs provided by households and other firms in form of wages, interests, rents and profits. The income received by households is used to purchase more goods and services and the cycle continues. However, not all income received by households is consumed. Households save some of the income especially if the income is high. Firms also save some of its profits in the financial sector and the rest is used for further investments. The government also plays a role in the circular flow of income. It buys goods and services from firms and engages labour from households hence is a source of income to households. The government on the other hand, gets revenue by taxing the income of households and firms in form of income tax and corporation tax respectively. The national income in the economy is the total market value of all final goods produced hence is the total of private consumption (c), investments (I), government expenditure (G) as well as the net exports (X-M). Y=C+I+G+(X-M) (Arora, 2008). Not all income earned by households is consumed; some is saved for future use thus withdrawal of income from the circular flow. The government also imposes taxes on households and firms further withdrawing income from the economy. Government expenditure is an injection of income in the circular flow. Other investments that do not arise from transactions between firms and households are also termed as injections in the economy as they add to the national income. Withdrawals therefore denoted by letter W are payments received by firms and households but not through consumption or spending (Lipsey & Harbury, 1992). They include; savings (S), tax (T), and imports (M). Injections on the other hand denoted by letter J are additions to planned expenditure and includes exports (X), Investments (I), and government expenditure (G). For equilibrium income in the economy to be achieved, the injections are equal to withdrawals. The simple equation would thus be; S +T+M=I + X +G. Fall in Government Spending The government injects money in the economy through its spending activities. It provides essential services such as education, health and transport. To provide the services, it employs labour from households and pays wages as rewards. It also purchases goods from firms thus source of income for the firms as they increase production. Government expenditure in the circular flow of income is an injection and therefore leads to an increase in national income which comprises of all final goods produced in the economy (Griffiths & Wall, 2008). The government borrows money to finance its expenditure from financial institutions and from donors so as to stimulate growth in the economy. To have a balanced budget, the government income must be equal to expenditure. The government may decide to cut its expenditure hence public borrowing in order to maintain a balanced budget and avoid deficit though its fiscal policy. It thus cuts its spending on health, education and transport. A cut in government expenditure leads to a decline in injections into the circular flow creating disequilibrium (Bluedorn, 2005). The income by households from government employment will decrease as government cuts expenditure. Consumption by households is determined by the amount of disposable income they have. A reduction in income therefore means the households will have to cut consumption of goods and services. The households also start spending on health care and education which was previously provided by government further decreasing their income. The reduction in consumption by households have a direct impact on firms; the firms will be forced to cut production due to reduced demand by households and the government leading to low output and employment. The firm is the source of income for households and as it cuts production, it cuts on factors of production hence reduction in income for households. The reduction in income leads to decline in savings which is a withdrawal from the circular flow of income hence in the long run withdrawals will equal to injections. The overall impact of a cut in government expenditure is a decline in output and employment leading to decline in the national income. Marginal Propensity to Save (MPS) The MPS shows the proportion of each unit of income that is saved and is the slope of the saving curve (Lipsey & Harbury, 1992). It is inversely related to the multiplier which indicates the change in national income for each unit change in desired investments and is always less than one. As income increases, the households increase their savings as they have more money at their disposal to consume and save hence an increase in marginal propensity to save. When the economy is at recession, there is a decline in economic activity in the economy (Griffiths & Wall, 2008). The households and businesses thus save their income to spend when recession is over thus the marginal propensity to save is high. If the public begins to gain confidence that the worst economic recession is over, they will begin to use the savings they had kept during recession to buy goods and services hence disaving takes place and consumption increases. The marginal propensity to save declines and the marginal propensity to consume increases so as to maintain a balanced equation; MPS + MPC=1 and is always positive (Pailwar, 2008). Savings are withdrawals from the circular flow of income hence disaving reduces the withdrawals from the flow and consequently disposable income increases leading to increase in consumption. The increase in consumption by households results in increase in production of goods and services by the firm and consequently increased use of factors of production provided by households leading to high output and employment and consequently an increase in income for households. Value Added Tax The government stimulates the economy though use of its fiscal policy. It can either do so through government expenditure which is financed by tax revenue which can be direct or indirect. Taxes are withdrawals from the circular flow of income as they reduce the income of households and businesses (Pailwar, 2008). VAT is an indirect tax imposed on goods and services hence is paid by the final consumer of goods and adds to the withdrawals. If the government wishes to increase tax revenue, it can increase VAT on goods and services. Additional VAT will lead to increase in prices of goods and services in the economy that means households will have to spend more to buy the same bundle of goods they were buying previously. Since the income of households remains the same, it means the households will cut on consumption expenditure since some of the income is withdrawn from the flow due to VAT. A cut in consumption by households will lead to cut in production by firms due to reduced demand hence reduced profits and consequently to cut costs, the firms will cut on inputs leading to loss of employment and reduced income for the households and the cycle continues. The output and employment will decline. In the long run, the government will spend the tax revenue received by purchasing goods and services hence injecting money in the economy. The injections will increase to counteract the increase in withdrawals due to VAT to return the economy back to equilibrium. Initially, the economy will operate at low output and employment but in the long run the economy will be balanced as the government expenditure will stimulate demand hence output and employment. Exports Exports add to the national output of the economy hence increase the national income. The income from exports adds to the planned expenditure and does not arise from the spending of households and firms hence it is an injection into the flow. The value of exports in a country is determined by the exchange rate (Arora, 2008). If the exchange rate is favourable, the country will export more to earn more foreign exchange and increase the volume of output in the economy and consequently the national income since national income is equal to the total output in the economy. Increase in exchange rate means the businesses can now produce more goods and services for export as opposed to local consumption. The firms will employ more factors from households to help in the production process thereby creating more income for households. Increased income will stimulate consumption and as income increases further households will increase their savings hence withdrawing income from the circular flow. Increase in exports will also create a surplus in balance of payments as exports are more than imports. The aggregate demand in the economy will be stimulated leading to high output and employment. References Anderton, A. (2000) Economics, 3ed. London: Pearson Education. Arora, K (2008) Introductory Macroeconomics for Class XII. New Delhi: Tata McGraw-Hill. Bluedorn, J (2005) Macroeconomics II: The Circular Flow of Income. Nuffield College. Gillespie, A. (2007) Foundations of Economics. New York: Oxford University Press. Griffiths, A., Wall, S (2008) Economics for Business and Management, 2 ed. England: FT/Prentice Hall. Lipsey, R., Chrystal, A (2007) Economics. New York: Oxford University Press. Lipsey, R., Harbury, C (1992) First Principles of Economics, 2ed. NY: Oxford University Press. Pailwar, V (2008) Economic Environment of Business. New Delhi: PHI Learning Private Ltd. Riley, G (September, 2006) ‘Market Failure: Government Intervention in the Market’ tutor2u. March 9, 2011 from http//www.tutor2u.net/economics/revision-notes/as-marketfailure-government-intervention-2.html. Vidler, C., Grant, S (2003) Heinemann Economics A2 for AQA. Oxford: Heinemann. Read More