Roles of the Government in a Market Economy - Coursework Example

Name: ID: Lecturer: Date: Semester: Introduction In a free market economy, all activities in the economy are determined by forces of demand and supply with no control of the government. The buyers and sellers are allowed to transact freely based on a mutual agreement about the price with no government intervention in terms of subsidies or taxes. However, in the real world, it is no economy that can operate without the intervention of the government. This is due to the market failures which would mean that public goods are not provided, there is over consumption of demerit goods such as alcohol and cigarettes, there is no provision of merit goods such as schools and hospitals and monopolies would exploit customers. In general, there is need for the government to intervene so as to regulate the market transactions (Kates, 2011). The following are roles of the government in a market economy: 1) Controlling the labour market using Minimum Wage The main aim of the employers is to maximize profit while minimizing cost. They seek to reduce all costs of production including the cost of labour. For this reason the government comes in to protect these workers who cannot be able to support themselves with such low wages. The government intervenes by setting minimum wage which is the lowest wages that an employer can pay an employee. The minimum wage is a wage set above the equilibrium wage. Equilibrium wage is determined where supply of labour is equal to demand of labour. When the minimum wage is set above the market equilibrium, it would mean that the supply of the willing labour force is more that what the producers are demanding (Karam ,2011). This is as illustrated in the diagram below: 2) Correcting Market A market failure occurs when a free market fails to efficiently allocate resources. Some of the market failures include: Inefficient production and allocation where markets fail to efficiently produce and allocate resources(Salanié, 2000). Monopoly power where markets fail to control exploitation by the monopoly firms Missing markets -these are markets that fail to form and are therefore unable to meet the wants and needs of the public such as providing roads, public roads, street lights and defense (Salanié, 2000). Incomplete markets- these are markets that fail to provide adequate merit goods such as healthcare and education (Salanié, 2000). De-merit goods where markets may fail to control the production and sale of goods like alcohol and cigarettes which have no less merit to consumers (Salanié, 2000). Negative externalities- this is a situation where the transactions between consumers and producers affect third parties who are not part of the transaction. An example is water and air pollution by industries to the surrounding community who may not even be users of that product (Salanié, 2000). Property rights-markets work efficiently when producers and consumers have the right to own property. Failure to assign consumers the right to own property limits the market formation ability (Salanié, 2000). Information failure where markets fail to give adequate information to the other party during a market transaction (Salanié, 2000). Unstable markets- at times markets are very unstable which makes it impossible to have a stable equilibrium such as with foreign exchange, credit markets and agricultural markets. This instability requires government intervention (Salanié, 2000). Inequality-markets may also fail to bridge the gap between the low income earners and high income earners. Market transactions reward producers and consumers with profits and income but they may only be concentrated on the hand of the rich (Salanié, 2000). Government Remedies to market failures: In order to correct the above market failures, the government uses two main mechanisms: i. Price mechanism This is where the government uses pricing policies to change the behavior of producers as well as consumers. For instance, so as to control production of demerit goods, it could increase prices of such goods so as to discourage consumption through taxation. It can also induce production of merit goods by giving subsidies. Therefore, the government changes behavior using financial incentives to allocate resources efficiently (Salanié, 2000). ii. Legislation and force The government can also use legal force to change behavior. For instance, introducing penalties on pollution e.g. carbon tax which seeks to pollution that lead to emission of carbon or banning cars from the town centers or having a licensing system to control alcohol and cigarettes sales. In most cases, the government uses both mechanisms to correct market failures(Salanié, 2000).. 3) Provision of Public Goods and Services Public goods and services are provided by the government because the market cannot provide them. It is in the interest of the public that the government provides them instead of private companies because they are needed by all members of the public. For example police, public education and defense are provided by the government since they would be less desirable if they were provided by private companies. Public goods are therefore economic products that are collectively consumed by all and may include highways, sanitation facilities, schools, the national defense, the fire fighters and the police force. All members of the public benefit from provision of such commodities (Salanié, 2000). 4) Distribution of income to create equality The government uses taxation to create equitable distribution of income or wealth by taxing those who earn much highly and using the taxes to provide public goods and services to better the standards of living of low income earners. The government creates a tax regime that seeks to distribute wealth equitably (Salanié, 2000) 5) Price Control This is the government action to artificially set (impose) prices on certain goods and services in the economy through its legislation. Such imposed prices by the government are known as fixed or flat prices, a flat price can either be a maximum price control or minimum price control (Galbraith, 2010). The main reasons for price control by government include; For cheapness which aims at consumer protection where essential goods and services are made affordable to most people in the economy especially to the low income earners Producers protection where their commodities are fetching poor prices in the market, the government sets a higher price to assure producers that their commodities will fetch relative higher prices To fight inflation To ensure price stability in the economy To ensure an equilibrium in the balance of payment There are two types of price control which the government uses; i) Maximum price control (price ceiling) This refers to the government action to impose a price on a good or a service beyond which it cannot be sold (Mankiw, 2009). It is therefore set below the equilibrium price when the government feels that the price set by the forces of demand and supply is too high If the government set price at below the equilibrium price (pc) i.e. maximum price, the immediate effect will be an excess demand. The other effects will be making the necessities to be affordable to most people in the economy, bring rice to a black market, shortages will become chronic, and producers of commodities under maximum price control may incur losses (Galbraith, 2010). ii) Minimum price control (price floor) This refers to the price set by the government below which a good or a service cannot be sold. It is normally set above the market equilibrium price when the government feels that the price set by forces of demand and supply (Galbraith, 2010) . The diagram below shows an illustration and implication of minimum price control; If the government set a minimum price (pf), its effect will be an excess supply under a normal circumstance, and producer of commodities fetching poor price in the market will be assured of high income compatible to the cost of living in the economy. 6) Solving macroeconomic problems These problems arise when the macroeconomic does not attain the goals of stability, full employment, and economic growth. Inflation exists when the economy falls short of the stability goal and unemployment results when the goal of full employment is not achieved. Therefore, these problems are caused by too much or too little demand for gross production as inflation emerges with too much demand nab unemployment results from too little demand. To solve unemployment and inflation in the market economy, the government regulates supply of money in the economy through the use various types of monetary policies tools such as; i) Open market operations This type of monetary policy tool involves selling and buying of government security in the market by the central bank (Lane & Philip, 2003). By selling securities to the public, the government will reduce the money supply and this will solve the problem of inflation as consumers will not have excess money to spend. On the other hand, the government can decide to buy the securities through the central bank from the public. This will increase money supply in the economy which means that investors can easily access money and start businesses which in turn creates employment reducing the problem of unemployment. ii) Interest rates This is the interest rate charged by a country’s central bank to banks and other depository institutions for borrowing reserves (Yakhin, Yossi, 2008). To solve the problem of inflation, the government through the central bank can raise the interest to discourage. This means that banks and other depository institution will also raise the interest rates for lending money to their customers which discourages them not to borrow money from them. This will reduce the money circulating in the economy which means that the people will have excess money to spend which in turn affects demand and supply in the market economy. On the other hand, the central bank can reduce its borrowing interest rates which in turn will enable banks to offer loans to their customers at a lower interest rate. Since investors can get capital from bank at a cheaper cost, they will be willing to borrow and invest and these investments will create employment. iii) Bank Reserve Requirements The central bank requires bank and other depositary institutions to deposit a certain amount of money with it (Lane & Philip, 2003). The government through the central bank can reduce supply of money to control inflation by increasing the reserve needed to be deposited by banks and other depositary institution. This will make banks not to have enough money to lend to its customers since most of their money has been held by the central bank. To increase money supply in the economy, the central bank can reduce the reserve needed to be deposited by banks and other depositary institution which mean that banks will have more money at their disposal to lead to customer who will invest in businesses. Therefore, this will solve the problem of unemployment as these investments will create employment. References Economicsonline (2013) Types of market failure. Retrieved on 16th March 2013 from http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html Karam G (2011) Are the Proposed Minimum Wages Too High? Retrieved on 16th March 2013 from http://www.yalibnan.com/2011/12/23/are-the-proposed-minimum-wages-too-high/ Kates S (2011) Free Market Economics: An Introduction for the General Reader. Edward Elgar Publisher: UK Salanié B (2000) The Microeconomics of Market Failures.4TH edition, library of congress: USA http://www.hanseconomics.com/2012/01/16/romney-is-wrong-on-minimum-wage/ http://www.econlib.org/library/Enc/MinimumWages.html Lane, Philip (2003) "Business Cycles and Macroeconomic Policy in Emerging Market Economies "International Finance, 6 (1), pp. 89-108 Yakhin, Yossi (2008) "Financial Integration and Cyclicality of Monetary Policy in Small Open Economies," Monaster Center for Economic Research Discussion Paper No. 08-11 Mankiw G (2009) principles of macroeconomic, 2nd Edition, Harcourt Brace Publishers: USA Galbraith (2010) A theory of price control, 3rd Edition: Harvard University Press Read More