Economics for Business and Management - Essay Example

? Topic: Lecturer: Presentation: Introduction Adam Smith described an efficient market as one that is guided by free market forces which he referred as “Invisible Hand” (Griffiths & Wall, 2008). This is to mean that a market is guided by the forces of demand and supply without government intervention. The price acts as a signal to buyers and producers and acts as an incentive to buy or sell. For example, in fig. 1, when the price is high (P1) sellers get more profit hence increase supply but buyers opt not to buy as they don’t get value for money. There is thus surplus in the market which forces sellers to accept lower prices until equilibrium is reached at P. At price P2, buyers are willing to buy thus creating excess demand in the market which in turn pushes the prices up to P where quantity demanded is equal to quantity supplied thus clearing the market. . Excess demand Fig. 1.0 Price Mechanism by Adams and Periton 2009 Resource Allocation The allocation of resources in a country is determined by the economic system in place. The pure market system has many sellers and buyers and sellers act as price takers. The consumers and producers act based on self interest and have perfect knowledge of the market conditions. The products sold are homogenous thus there is no non-price competition or control over market prices. Firms enter freely in the market and the factors of production are privately owned (Anderton, 2000). Profits act as a sign for producers to increase supply and in effect they employ the best combination of resources that can give them maximum profits (Myers, 2004). Low prices acts as a signal for consumers to buy. Lipsey and Chrystal (2007) argue that when demand is more than supply, the prices rises and falls when supply is more than demand. Allocation of resources is though supply and demand forces. The pure command market is run by one producer selling unique products. There is no competition hence the producer determines the price. The producer can decide whether to raise prices by decreasing the supply in the market or operate at supernormal profits. Entrance to the market is restricted by scarcity of resources, government regulations, and monopolist anti competitive behaviour. The consumer choice is restricted as the government provides what it deems fit for the population. The factors of production are owned by the state hence resource allocation is the duty of the state through a planning process (Anderton, 2000). Arguments in Favour of Free Market The free market economy is considered as the most efficient in allocation of resources. The welfare of the society is maximised when demand equals supply or social marginal benefits equals social marginal costs (Gillespie, 2007). All individuals are driven by self interest and thus the consumers determine the demand for products, the sellers produce the goods to satisfy the demand driven by profit motive and thus combine factors of production in an efficient way to achieve the goal or be pushed out of the market. This results in low cost production and provision of high quality goods at a low price to the consumer. There are no barriers to entry in a free market thereby allowing competition between sellers. If the sellers earn abnormal profits, this acts as an incentive for competitors to enter the market thus sharing the profit and pushing the prices down (Baumol, 2002). As supply becomes more than demand and the many sellers have to attract customers by selling at low price since consumers are guided by the law of demand; the lower the price, the higher the demand. The consumers also have a variety of alternatives to choose from due to presence of many sellers. Baumol (2002) argues that a free market is engaged in a continuous process of innovation. Competition leads sellers to engage in research and development so as to come up with new ways of producing a product which are efficient and differentiate it from other competitors. This leads to innovations of technology and more advanced production methods leading to improved quality and low prices. The entrepreneurs have perfect information on market conditions thus are able to decide how to combine factors of production for efficiency. They can move factors of production from an unprofitable good to produce a more profitable good. For example, if the price of coke falls relative to price of Pepsi, the sellers concentrate on producing coke which is more profitable and stop production of Pepsi. There is no government intervention in resource allocation hence no market distortions. The government’s role in the market is to provide infrastructure needed for market activities and ensure the welfare of the society. Market Failure Market failure is as a result of misallocation of resources. The market assumes that sellers and buyers have perfect information to make informed choices but this may not be the case. A low price for a product signals buyers to make purchases but information on the benefits derived from consuming the good is not available. Consumers thus under consume merit goods while over consuming demerit goods such as cigarettes and tobacco (Griffiths & Wall, 2008). There is missing markets for unprofitable goods such as defence, education and health since producers are driven by self-interest. These goods are consumed by all irrespective of income as they are beneficial to the individual and the society at large. Restriction of consumer choice results in market failure (Riley, 2005). Self interest also leads firms to engage in malpractices such as crime, fraud and corruption. Externalities may arise as production takes place. Kirzner (2007) notes, that benefits derived by individuals are not what the whole society derives. There is difference between private and social benefits in the market; if benefit to society exceeds private benefit a positive externality is created. For example, taking a drug to prevent communicable diseases is more beneficial to the society. The costs incurred by a producer do not cater for negative externalities such as pollution. The social costs to the society are thus more than private costs Price P2 P1 0 Q1 Fig 1.1 A negative externality by Gillespie Andrew 2007. Some sellers collude through mergers and acquisitions to form cartels so as to increase market share and take advantage of consumers since the market is not regulated (Anderton, 2000).Some grow in size to become monopolies and oligopolies to enjoy of economies of scale. A monopoly is formed where producer acquires a large market share. He determines the resources to be used in production and the amount of output to produce. He can also increase supply and sell at a higher price than would be in a competitive market thus get abnormal profits. Monopolists also carry out price discrimination to bar entry of other sellers into the market. This can be done through offering huge discounts to some consumers especially if one buys large quantities (Griffith & Wall, 2008). An oligopoly consists of many firms selling unique products or differentiated products hence making it hard to efficiently allocate resources. Correcting Market Failure The UK government is involved in direct provision of goods and services. It collaborates with private sector to provide health, education, and transport among others. It is also involved in advertising through television to give information to consumers on alternatives available and promote merit goods which are under consumed and has in place advertising laws such as compulsory labelling on cigarettes (Adams & Periton, 2009). There are regulations on the acceptable amount of pollution and firms given licences to pollute to a certain level. The Clean Air Act stipulates the level of pollution that firms should keep (Gillespie, 2007). To curb monopoly power and encourage competition, various legislations have been enacted. The Competition Act of 1998 prohibits abuse of a dominant position in the market (Rodger & MacCulloch, 2009). The Office of Fair Trading (OFT) is entrusted with the work of carrying out investigations under the competition Act and fine those firms found guilty of the offence. For example, Napp pharmaceuticals was fined ?3.21m for predatory discounting of drugs sold to hospitals and high prices to community customers (142). The Enterprise Act 2002 deals with public interests cases such as when a consumer group complains. It deals with all industry issues as opposed to competition commission which deals with dominant firms. The treaty of Rome was the basis for foundation of the European Economic Community to break trade barriers (Riley, 2005) Conclusion The free market is the most efficient in resource allocation. There is no government intervention unless where the welfare of the society is undermined. The forces of demand and supply allocate the resources and each actor in the system is guided by self interest. It is favoured because of lack of bureaucracy, non-regulation and profit maximization by sellers. However, it has short comings in that public goods miss markets, misinformation leads to under consumption of merit goods, monopolies which exploit consumers are formed and existence of externalities. References Adam, S., Periton, P (2009) Fundamentals of Business Economics. UK: Elsevier. Anderton, A. (2000) Economics, 3ed. London: Pearson Education. Baumol, W (2002). The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism. UK: Princeton University Press. Beattie, A (2011) “Adam Smith and the Wealth of Nations” Investopedia. http://www.investopedia.com/articles/economics/09/adam-smith-wealth-of-nations.asp 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. Kirzner, I (2007) Market Theory and the Price System. NY: D Van Nostrand CO, Inc. Lipsey, R., Chrystal, A (2007) Economics. New York: Oxford University Press Myers, D (2004) Construction Economics: A New Approach. London: Spon Press. Riley, G (2005) OOR As Economics, Course Companion. Yorkshire: Tutor2u. Rodger, B., MacCulloh, A (2009) Competition Law and Policy in the EC and UK. 4ed. UK: Routledge. Problems with Global Banking The global financial crisis which began in 2007 was as a result of credit crunch brought about by sub prime mortgages. The banks reduced lending activities due to lack of confidence on borrowers. Credit borrowing by investors became difficult due to high interest charged leading to reduced investments and consequently unemployment. Banks like Lehman bought low interest mortgages to securitize from poor and bad debtors (Shah, 2008). The interest was to be high after 2years. When the mortgage owners were asked to repay, they couldn’t afford hence mass repossessions leading to decline in housing prices, shares and collapse of the bank. The countries most affected by the global financial crisis are the rich nations such as; USA, UK and Japan. They have spent billions in trying to bail out the collapsed financial institutions. USA opted to buy debts from banks while UK opted to buy shares in the affected financial institutions. Monetary Policy Monetary policy targets full employment, output, price stability and exchange rates. An expansionary monetary policy involves increasing the amount of money supply by increasing the loanable funds to the banks. Investors borrow money for investment stimulated by low interest leading to increase in real GDP (Gali, 2008). Contractionary monetary policy involves reducing amount of money in circulation by raising interest rates. The monetarist economists like Friedman advocate control of money supply in the economy hence control the rate of inflation (Handa, 2009). He emphasizes the need to maintain equilibrium between money demand and money supply where money demand is constant. This impacts the level of national output in the short run and the level of prices in the long run. Friedman argues that by reducing money supply, people reduce spending and hold the money for future use. When money supply is increased, people spend the money thus stimulating aggregate demand hence a specific level of inflation is targeted. Keynesians advocate for injections of money into the economy so as to increase output and employment since output is not always at full employment as depicted by Friedman. He argues that money demand is not constant as it depends on current income thus expansionary monetary policy causes inflation (Cliffsnotes, 2011). The UK government monetary policy committee (MPC) duty is setting interest rates so as to control money supply and keep an inflation target of 2% (Bank of England, 2009). In the year 2009, the BOE decided to inject money directly in the economy through quantative easing as the bank rates were approaching zero thus could not have impact on inflation target. According to the BOE, the following were the interest rates in corresponding years. In 2006 from January to July, interest rate was 4.5%, August - October 4.75%, Nov - Dec 5.0%. In 2007, the rate was 5.25% from Jan to April, May & June 5.5%, July - Nov 5.75%, Dec 5.5%. In 2009, Jan 1.5%, Feb 1.0%, the rest of the year until 2011 is 0.5%. Fiscal Policy A government can use fiscal policy to influence the level of economic activity especially after recession by stimulating aggregate demand. The government can do so by increasing its expenditure, taxation and government borrowing. Government expenditure includes; provision of education, health, and infrastructure (Riley, 2006). If a government increases its expenditure, more money is injected into the circular flow of income leading to more investments, income and consumption. The result is increased output and employment. If the government cuts on expenditure, income flows out of the circular flow hence reduced investments, employment and income. A government can stimulate demand by cutting taxes; income tax, corporation tax, excises duties. A cut in income tax increases the disposable income of individuals leading to increase in aggregate demand. Taxes are withdrawals from the circular flow of income thus a reduction in tax leads to more consumption and investment hence increase in output, employment and aggregate demand. Tax policy is concerned with tax structure and tax incidences (Cordes et al. 2005). Individuals contribute in funding government expenditure on essential services according to the ability to pay. Income tax as a form of direct tax is progressive in nature thus ensuring fairness. It is adjusted every fiscal year due to changes in dependants’ expenses. The gross income is adjusted to come up with a taxable income by reduction of tax deductions related to business expenditure; health plans contributions, and personal exemption. The taxable income bracket is different for different family types. For example in USA, single families and married couple filing returns individually start paying tax on income above $8375. A married couple filing jointly pays income tax on income above $ 16750 and household heads at income above $ 11950 (Perez, 2010).Value added taxes are a form of consumption tax and are regressive in nature as they overburden the poor. Government spending and taxation are measures used to correct the economic crisis resulting from global financial crisis. Debt The governments involved in bailing out financial institutions incurred huge debts. The banks had no deposits left after securitizing loans and most of them collapsed. However, the UK government decided to invest in shares in those banks such as the Northern rock so as to redeem them while the US opted for taking up the debts. To fulfil this obligation, the government employs fiscal policy measures thus borrows from the domestic market as well as international markets for bail out. During this period of recession, the economic activities are slow hence low output and unemployment. The aggregate demand declines leading to low GDP since it is the total output in the economy. Revenue also declines during this period thus causing a deficit on government budget. According to Pettinger (2011) the budget deficit stands at 13% of GDP thereby scaring away potential investors and instilling fear on policy makers. The UK public sector net debt was ?875.8 or 58% of GDP. The UK government interest rates according to the Bank of England are nearing zero (0.5%) and hence could not keep inflation on check. In 2009, the monetary policy committee embarked on new monetary policy of quantative easing to inject money directly in the economy (BOE, 2011).For this purpose, the government needs funds thus prompting more borrowing. The national debt to GDP ratio has therefore been increasing sharply since 2008. Improving National Debt Various measures can be taken to reduce or eliminate the national debt problem. The government can expand the economy by increasing taxes and reduction of spending on benefits. This will lead to increased revenues from tax and reduction in borrowing thus reducing the budget deficit. The UK government cut back on all social spending and blamed past governments for inducing the crisis. Engaging in nationalization controls the freedom of the banks and hence the crisis would not have occurred if there were regulations (Shah, 2008). Welfare benefits such as child benefits, job seeker benefits among others can be eliminated or reduced to control government spending. Improved performance by the bailed out banks can help to restore the lost glory and encourage investors by instilling confidence in them. The UK government hopes that by investing in those banks, they will redeem themselves and in future it can sell the shares (Shah, 2008). The banks can also lend more to other banks leading to increased investments and consequently output and income. A cut in government expenditure may have adverse effects on the economy. Though there will be reduction in borrowing, there would be reduced economic activity thus further recession and unemployment. Loss in employment leads to reduction in consumption hence the level of aggregate demand. Improving tax revenue could also be hampered by economic growth. Pettinger (2011) enumerates several problems likely to occur. He states that in future, interest rates could raise thus reduction in consumption of goods which are related with interest. High interest rates discourage investors from borrowing credit to increase investments. There could be crowding out of private investors leading to low investments and consumption. The exchange rate may lose value as interest rates encourage money supply in the economy leading to inflation. Economic growth could also lead to higher future taxes thereby reducing disposable income and prompting fall in consumer spending and aggregate demand. Conclusion During the first quarter of 2010, the UK economy expanded by 4.4%. The growth may prompt inflationary pressures in the economy due to increased interest rates. As Keynes noted, increase in money supply prompts people to spend hence increased demand reflected in high prices. A government that keeps on raising taxes to bail out the banks which consist of wealthy individuals is unpopular with the people hence may lack support. Reduced government spending leads to low output and unemployment. Negative exchange rates prompts investors to import goods instead of producing locally hence imports exceed exports leading to unbalanced balance of payments. References Abbey, John (2009) “Credit Crunch Explained-How Subprime Mortgages and Securitization Has Led Us to Recession”’. http://www.johnabbey.co.uk/wsb4919660101/creditcrunch. Bank of England (2011) “Quantative Easing Explained”http://www.bankofengland.co.uk Cliffsnotes (2011) “Monetary Policy”. http://www.cliffsnotes.com/study-guide/Monetary-Policy.topicArticled-9789.articled-9750.htm Cordes, J., Ebel, R., Gravelle, J (2005) Encyclopedia of Taxation and Tax Policy. 2ed. Washington, D.C: Urban Institute Press. Gali, Jordi (2008) Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. New Jersey: Princeton University. Handa, Jagdish (2009) Monetary Economics. 2ed. Oxon: Routledge. Investopedia (2011) “Case Study: The Collapse of Lehman Brothers”. http://www.investopedia.com/articles/economics/09/leyman -brothers-collapse. asp Perez, William (2010) “Tax Planning: US”. About.com Pettinger, Tejvan (2011) “Economy: UK National Debt”. http://www.economicshelp.org/blog/uk-economy/uk-national-debt. Riley, Geoff. (2006) “Fiscal Policy” tutor2u. http://www.tutor2u.net/economic/revision-notes/as-macro-fiscal-policy.html Shah, Anup (October, 2008) Global Financial Crisis. Global Issues. http://www.globalissues.org/article/768/global-financial-crisis. Read More