Free Market Economy - Assignment Example

Introduction to Economics: A1. A free market economy is one in which the prices of goods and services are ascertained by the market forces i.e. bydemand and supply. Although the free market economy operates by itself i.e automatically devoid of any government / public sector intervention, such an economy does not exist in the real world. This is because a free market economy is controlled by private enterprises which operate to maximize their own profits. Hence they will provide only those goods in which they can earn maximum profits. This will harm the consumer or the common citizen in the long run since the basic public amenities such as roads, transportation, defense equipments etc would not be available to them. Hence such free market economies use some form of mixed market economies where there is government control and / or intervention in order to protect the rights and interests of the common citizens. Most of the economies today are examples of mixed economy where there is a co-existence of public as well as private institutions. The U.S. is one such example. Furthermore, many countries opt for the mixed economy model owing to the various advantages it offers. For instance, a mixed economic system allows both the public as well as private sectors to work side by side, whereby full freedom is afforded to the private enterprises to pursue their profit motives as the public sector acts as a controller and governs the activities, thus together working for the growth and development of the country as a whole. Mixed economy also allows a better and efficient allocation of resources as compared to any other form of economic system. In a mixed economy the private sector can make the best possible use of the resources since such optimum utilization of resources will guarantee them higher productivity, and higher returns and hence enable them to achieve their private goals of profit maximization. While on the other hand, the public sector is interested in social welfare and catering to the broader needs of the citizens. Hence there is a good and effective coordination between the private and public sector enterprises, where both are able to accomplish their goals of public benefit and private profits respectively. Furthermore such a system allows for accelerated growth of the country thereby benefiting everyone in the process (Lipsey, Chrystal, 2007). Resources are limited and hence its equitable and optimum allocation is of extreme significance, regardless of the economic system of any nation. All the economic agents are required to allocate these limited resources in such a way that it ensures best possible gains to them. From the perspectives of the consumers, optimum allocation of resources is done to achieve maximum utility; from the perspective of producers, the allocation of resources is done in a manner which ensures maximum returns or profits; and from the perspective of the government - the allocation of resources is done in order to ensure and increase welfare and economic growth of the nation. Such allocation of resources requires proper planning at various levels. At the national level, the allocation of resources is planned to attain national priorities, which includes the economic as well as social development of the country. It involves a thorough review and assessment of various factors such as the current state of the economy, the level of development at the national level, the existing resources as well as national wealth, etc in accordance with which the resources are allotted (Lipsey, Harbury, 1992). Thus in a mixed economy, the allocation of resources is done in a fair and equitable manner, which benefits both – the private enterprises as well as the government. A: 2.1 The price of metal palladium fell on news of the technological breakthrough in the production of catalysts for cars because of the following reasons: 1. The catalyst developed by the company entailed lower use of the basic raw materials i.e 90% reduction in the use of platinum and palladium. This is likely to cause a major fall in demand for these products. 2. Since the demand for the raw materials is likely to fall drastically, the suppliers of these raw materials would be compelled to reduce their supply, simultaneously, as they are no longer required. There is a direct relationship between price and quantity supplied, thus with every fall in price the quantity supplied falls, and vice versa. Thus, the prices of raw materials fell with the news of technological breakthrough. The following graphs depict the above mentioned scenario. The market functions at an equilibrium, where the quantity demanded is equal to the quantity supplied and any change in the conditions of demand or supply is likely to shift the demand and supply curve. The fall in quantity demanded will lead to an inward shift in the demand curve which is shown below: Figure 1: An inward shift in the demand curve Price Supply P1 P2 D2 D1 Q2 Q 1 In the above diagram, there is a fall in demand of the product as well as the price; hence there is an inward shift in the demand curve, whereas the supply curve remains unchanged, in the short run. Since there is a sudden fall in price, because of expected news of a likely fall in demand for these products, the demand curve shifts inward while the supply curve remains unchanged since it takes time for the suppliers to adjust to the sudden change (in this case, fall) in the market demand for the products supplied. However, in the long run, the producers may increase their output, on account of technological developments, fall in prices of raw materials, reduced cost of production – which will eventually lead to higher demand of the product and hence higher profits for the firms, and this will eventually increase the demand of the raw materials, in the long run, and the markets will again function at equilibrium price. A: 2.2 Firms in automobile industry operate in an oligopolistic market, where two or three major producers compete for market space. Since, firms in this industry do not compete on the basis of prices, no producer will increase the price of their product, because if they do so, the others may not follow, and even a small price rise is likely to cost several customers, and the firm will ultimately end up losing a considerable share of their customers. On the other hand, if one of the producers lowers the price, the others will have to follow or else, risk losing a significant portion of market share. Since in this case, the two producers Mazda and Nissan, are likely to face competition from low cost producers such as Tata Motors, the firms will face two market demand curves shown below: Figure 2: The Kinked Demand Curve Price Marginal Cost A D Profit Average total cost B C Demand Marginal Revenue Q Units of output In such a market, which is controlled by very few players, the competition is likely to be non-price based. Hence any upward change in price by one firm is hardly likely to bring about major changes in the prices of the other rival firms, and the demand for the product will be relatively price elastic. However if firms with lower priced products enter the market, (in this case, Tata Motors) then there is likely to be a huge shift in the demand as well as market share for the other firms Mazda and Nissan. But if Mazda and Nissan reduce their prices to retain market share, and when the demand is inelastic, then the total revenue would fall leading to little or no impact on the market share. The above graph shows that a firm can attain stable profits (shown by the area ABCD) by maximizing the equilibrium price. A: 3 If the new technology is not adopted in the car industry, in this case, then there will be no change in the demand or supply of the raw materials, hence no change in the prices of raw materials, (which fell ever since the announcement, of the development of a catalyst) as well. Since the new technology is likely to drastically reduce the usage of the relatively expensive raw materials, such as palladium, the cost of production will fall, leading to an overall reduction in the price of the product, higher demand (owing to fall in prices), and higher profits for the firms. However, if the breakthrough in technology is not adopted by the firms, then the existing firms, in this case – Mazda and Nissan, are likely to face stiff competition from low cost producers such as Tata Motors, and subsequently lose their market share. If other firms are not able to cope with the low price model, then there are chances that Tata Motors may enjoy monopolistic market conditions, all things remaining the same. References: Lipsey, R. G., Chrystal, A. K., (2007). Economics, Oxford University Press, Pp. 10 - 15 Lipsey, R. G., Harbury, C., (1992). First Principles of Economics, Oxford University Press, Pp. 20 - 23 Read More