Free Market Economy - Research Paper Example

? Assessment TABLE OF CONTENT. RESPONSE TO QUESTION A). INTRODUCTION......................................................................................................................3 MAIN DISCUSSION.....................................................................................................4, 5, 6 &7 RESPONSE TO QUESTION 1(B) INTRODUCTION......................................................................................................................8 MAIN DISCUSSION. ....................................................................................... 8, 9, 10, 11 &12. RESPONSE TO QUESTION 2(A). INTRODUCTION. ............................................................................................................... 12. MAIN DISCUSSION. ..........................................................................................12, 13, &14. RESPONSE TO QUESTION 2(B). INTRODUCTION..................................................................................................................14 MAIN DISCUSSION. ............................................................................................. 14, 15 &16. CONCLUSION......................................................................................................................17 REFERENCES. ........................................................................................................... .18 &19. Response to Question Q 1(a). Introduction. This assessment examines the statement put forward by Adam Smith in light of the free market economy. Arguably, in words of Adam smith, free market system supports growth of monopolies, cartel-type activities and mergers. Free market, in this respect, is an economic system in which prices, wages etc are controlled by supply and demand rather than government. It is in total contrast of controlled market in which the government indirectly or directly controls demand, supply or prices. Whether Adams Smith is right or not, remains the subject of this discussion. Gregory and Stuart (2003) note that free market system of resource allocation is based on the principles of supply and demand. They assert that the term ‘free market’ should be taken to mean the freedom from governmental control and regulations. In this respect, resources are allocated based on demand of those resources and their supply. More often than not, free markets are closely associated with capitalism with socialists advocating for it. This has made them, on many occasions, to utilized free markets in proposals where the capital allocation of the market is intertwined with self-management within the enterprises alongside the ownership of cooperatives owned by employees. According to Adman Smith, an invisible hand balances supply and demand forces and maintains equilibrium (Smith, 1776, Book IV). Invisible hand refers to the ability of the market to balance itself without government intervention, and which might occur in a free market system of resource allocation. Supply refers to the quantity of product that can be supplied by firms. Demand, on the other hand, refers to the quantity of product demanded by the consumers. Equilibrium occurs for cases where demand and supply curves intersect. This is illustrated in fig 01 below. Fig 01 shows equilibrium position of a demand and supply curve. Source: www.learngoldcoins.com This, if taken from this approach, implies that in a free market, monopolies and cartels cannot exist because monopolies are created mainly by government help and, therefore, are more likely to co-exist in a controlled economy than in a free economy. Monopolies and cartels thrive well when supported by governments. In such cases, the government notably, provide help to large firms in the form of lower tariffs or taxation. A free economy is characterized by tight competitions. For instances, where businesses sprout with maximum profits following the discovery of some thrilling items of demand, other firms often enter into that business driving the profits down. In this case, monopolies do not have a chance in such free market system. There are various advantages attributed to free market economy. First, free market economy is characterized by free resource allocation with lacking monopolies and cartels. Secondly, free market system has improved efficiency, as opposed to controlled market system. It is quite apparent that whenever price setting is left to market forces, firms operate efficiently exhausting all their resources to produce at lowest possible prices. Firms in the free market system are often free to enter into any business while consumers access a wide range of products and services. In such a system, no government help or intervention exists. Firms work out a production system that maximizes output and lower costs. Thirdly, in the free market system consumers are made to access products and services. In such cases, existence of demand necessitates the existence of supply. Occasionally, consumers are allowed to get a wide range of products and services. Research shows that when production and investment decisions are made by market forces instead of government, resource allocation is done in a way that that benefits the whole society. Most notable, is the fact that in the free market system represents economic freedom for all customers (Friedman & Friedman, 2002, 15). The chart below (chart 02) is the evidence for the worldwide support of free market system. Chart 02. Shows the worldwide support for free market. Source: Global Scan (2012) There are other market systems other than the free market system. They include mixed economy, and command economy. Mixed economy is a market system involving the economic system where both the government and the private sector are all involved in directing the economy. This reflects the market and planned economies characteristics. Diagram 06 illustrates movement of goods and services in a mixed economy. Figurer 06 shows movement of goods and services in a mixed economy. Source: Reddy (2011). A command economy is the economy in which the state is responsible for making virtually all decisions that deal with allocation. Response to Q1 (b). This assessment seeks to examine how market failure occurs with a major focus on how the UK has sought to remedy such occurrences. Market failure, in this respect, takes place whenever freely-functional markets end up failing to deliver the amount of allocation of resources that is efficient. This results to loss in both the economy, as well as the social welfare. It happens for cases where the outcome of the competition fails to be efficient from a point of view of a society. Market failures are often associated with non-competitive market, externalities, information asymmetries, as well as principal-agent problems. Their existence justifies the intervention of the State in a certain market. The principal causes of market failure are the government policy interventions, which cut across bailouts, taxes, price control, subsidies, and other inherent regulations that attempt to correct the failures of the market, thereby leading to insufficient allocation of resources. As far as economics is concerned, an externality also called a transaction spillover is that benefit incurred by a person who was not part of either as a seller or a buyer of services that cause the benefit or cost. It is the cost or the benefit not often transmitted through prices. The negative externality is the cost of an externality, while a positive externality is the benefit of an externality. It is worth noting that for both positive and negative externalities, the prices in any competitive market fail to reflect the actual full cost of producing and consuming a product. The graphs 03 and graph 04, show the positive and negative externalities. Diagram 03 showing negative externalities of consumption. Source: Lloyds Baking Group (2009). In a free market, it is clear that consumption shall be at Q1. This is because Demand = Supply. However, it is socially inefficient since Social Cost < Social Benefit. This implies under consumption of positive externality. Social Efficiency occurs at Q2 where the Social Cost = Social Benefits. Diagram 03 showing positive externalities of consumption. Source: Lloyds Baking Group (2009) ? In a free market, it is clear that consumption shall be at Q1. This is because Demand = Supply. ? However, it is socially inefficient since Social Cost < Social Benefit. This implies under consumption of positive externality. ? Social Efficiency occurs at Q2 where the Social Cost = Social Benefits. The term monopoly refers to an enterprise, which is the only sole seller of goods and services. In cases where there is no government intervention, he or she is often free to set any prices of his/her choice. Monopoly is disadvantageous to the consumer in many ways. This includes exploiting the consumer, restricting the choice of the consumer, inefficiency because of lacking competitors, increased product prices, and exploitation labor whenever prices are more than the marginal cost. Additionally, with monopoly risks of overproduction are often reduced. It is also worth noting that monopoly market has various advantages. These include the capital for research is always available, established control on the whole market, and monopoly enjoys producing certain limited resource production. Rationally, the monopoly would on many occasions set prices that provide him/her the largest profit. The fact that one enjoys monopoly, does not guarantee the enterprise maximum profits as opposed to the enterprise facing competition. On some occasions, the market might be quite restricted that is hardly support one enterprise. However, for cases where the monopoly becomes more profitable, it is expected that other entrepreneurs would join the business and take the higher returns. Joining of competition drives the prices down, thereby eliminating monopoly. It is, in fact widely cited that monopoly is one of the causes of market failure. Graph 05 shows how a monopoly thrives in a market system. Diagram 05 shows a Monopoly Graph. Source: www.ecomishelp.org. A Monopolist makes price alone without facing any competitors. Hence demand is always price inelastic. A monopolist seeks to maximise profits through setting output MR = MC This shall be at the output Qm and the Price Pm. For cases where the market is competitive the price becomes lower and output higher. There are various notable solutions put forward by the UK government towards market failures. They includes addressing externalities such as social sanctions, voluntary organizations such as charities, moral or ethical values, contracts among parties that seek to address any arising externalities, and internationalization, which encompass teaming up all the possible activities with possibilities of externalities in one firm to reduce chances of their occurrences. Response to Question 2 (a). This assessment seeks to examine how the government of UK had to make adjustment in its fiscal, as well as its monetary policies as a response toward the world downturn. It is notable that understanding the terms fiscal and monetary policies can help explain the reasons behind the adjustments. Monetary policy refers to the policy of the country’s central bank policy regarding interest rates and supply for money. Monetary policies are used to control inflation, unemployment, and growth of the economy. More often than not, Central banks use monetary policies to dictate the economic outlook of the economy. This happens when government decides to promote and encourage growth of businesses. In such instances, the government sets new interest rates, in which case, interest rates are often lowered in ensuring people have less incentive to keep their money in bank accounts. In this regard, lower interest rates tend to lower the cost of borrowing. This in effect, encourages people to impress borrowing necessary to kick start their businesses. It is also worth noting that Central bank does control the money supply for purposes of increasing or decreasing liquidity in an economy. One most notable case happened in 2008, where the world over was got in a web. The global economic crisis experienced in 2008 prompted the global banks and governments around the globe to revisit their monetary, as well as their fiscal policies in order to kick start their economies again. United Kingdom was not to be an exception for this case. It put in place policy measures to help curb the effects of economic recession. The government had to center its monetary policy on lower interest rates and injection of money to the economy to increase public consumption and job creation. The global banks together with the United Kingdom central bank had to adopt the monetary policy of expansion after the crisis of 2008. In essence, the government tried to lower interest rates and increased the money supply in helping create avenues for economic growth. Moreover, the government had to adopt a quantitative easing policy (Moulds, 2012, 1), a technique through which central banks inject more money into the economy through buying bonds issued by governments and corporations (BBC, 2011, 1). It is through the quantitative easing that the Central banks were able to provide cash stimulus within the economy with hopes of improving the economy. Fiscal policy is a term used to refer to efforts of the government to influence the economy of a country through spending and taxation. One of the main reasons for the existence of fiscal policies is to help enhance equal distribution of income among all members of the society for realization of economic growth and prosperity. It is worth mentioning that it is the work of the government to increase its expenditure on projects of public benefit like health and infrastructure. This helps the government attract economic progress. In this respect, taxes are vital sources of government revenue. This implies that lowering taxes affect the foreign direct investment. It is worth noting that the UK often fights to reduce its public spending in an effort to decrease its debt. Fiscal deficit contributes immensely to the government debt and, therefore, government always works out to reduce its expenditure. There are cases where the government expenditure decreases following the efforts by the government to shift costs to people instead of offering subsidies. This has a significant effect on the countries interest rates such that it alters the rate of interest. The UK interest rates were maintained at 0.5 % by the Bank of England. It is noted that the Bank of England faced difficult choices either to try and keep interest rates as low as possible to help the economy to recover or to go ahead and raise them in trying to cool inflation. Most notable is the fact that raising the demands is such that it causes slowing down of inflation. However, increasing the cost of borrowing might as well tip the economy into recession. The purchasing manager Index for the service went down from 57.1 to 54.3 relative to the modest drop of 55.7. This came up following similar drop in the purchasing manager Index for construction, as well as in the manufacturing. It was noted, as well though inflation was well beyond the target, led to a fall of 0.4%. The chart below shows UK interest rates of 2010/12. The chart showing UK interest in years 2010/12: Source: www.ecomishelp.org. Response to Q 2 (b) Introduction This assessment examines the inherent problems that the government gets into while seeking to avoid any deeper recession. In order to achieve the set objective, it would be paramount to get to understand key terms such as inflation, monetary and fiscal policies as a way of getting to the bottom of addressing the subject. Inflation is a term used to refer to the persistent rise in the prices of goods and services. It involves economic crises that are created by poor monetary policies. Acting in certain capacity as to limit inflation, the central banks can lower or increase interest rates in order to encourage or discourage borrowings. This can clearly be seen from the interest rate chart labeled 06 below. It can be noted that unregulated money supply resulting in increased money supply, in the economy, propagating inflation. United Kingdom decreased its interest rates on a consistent basis from 2008 stretching to date. This was made in ensuring that people can afford borrowing at a lower rate. Research has clearly shown that due to inflation, the current interest rate went as low as 0.5 percent (BBC, 2011, 1). This implies that for the government to be able to kick start the economy, a lot had to be done in all sectors of the economy. It is widely cited that whenever supply shifts to the right, the interest levels are expected to fall proportionally. This clearly demonstrates the monetary policy of the UK as can be confirmed from the figure 04. Figure 04 shows the monetary policy of the UK. Source: University of North Carolina (2009). Inflation tax, on the other hand, is the term used to refer to a sort of financial value loss that is suffered by the holder of the fixed-rate bonds, as well as cash. In essence, it is represents the loss of purchasing power. In a move to cut down on inflation, which is directly linked to economic recession, in 2011, the government had to cut on huge expenditure in order to lower the national debt by more than 15 percent over the next few years (Reddy, 2011, 1). Governments, when implement such budget often do so by compromising on social welfare projects such as health care benefits, social welfare, transportation, and housing projects. United Kingdom has been forced to slice its expenditure in order to safeguard its national debt. In the long run, such decisions often have a far reaching implication on unemployment rates, which is often reflected as increased inflation. The charts 08 and chart 09 clearly illustrates both unemployment rates, as well as the inflation rates for the UK, in the years 2008/2012 and 1971/209 Chart 08 showing the UK unemployment rates. The charts 08 showing inflation rates for the UK in the years 2008/2012: Source: www.ecomishelp.org. The chart 09 showing unemployment rates for the years 1971/2009: Source: www.ecomishelp.org. Monetary and fiscal policies are tools through which central banks use to control the money flow, interest rates, and overall economic activity. After the economic recession, of 2008 government of UK lowered interest rates and injected money in the economy. The government also decreased public spending and increased taxation. The government injected around 400 billion pounds in the economy in order to restore the confidence to investors and to avoid a total market collapse (BBC, 2008, 1). This was a huge drain on tax payers’ money; bailout package played a great role in increasing the already large fiscal deficit of the country. The government of United Kingdom has been trying to lower its public spending and increasing its taxes, at the same time. This has created crises because according to research, people in the government need to spend more finances on the public sectors of economy instead of slashing government spending (Smith, 1776, I). Due to the policy of lowering government spending, government is not effectively supporting programs of social welfare of its citizens. In addition, the government passive in creating jobs as it capitalizes on reducing expenditure on capital hence a rampant unemployment (Krugman, 2010, 1). Experts suggest that the government’s focus should be on job creation and capital spending for better economy (Mirror, 2010, 1). In conclusion, monetary and fiscal policies are essential components in cushioning the economy of any nation. Inflation is detrimental affecting citizens directly by affecting and raising the living standards. Fundamentally, it is the responsibility of central bank, and the government to formulate and implement these policies to create a favorable environment for economic growth and prosperity. References. Bized UK., 2001. Good with Negative Externalities, [online] Available at: < http://www.bized.co.uk/reference/diagrams/Good-with-Negative-Externalities> [Accessed July 23, 2012] Friedman, M., & Friedman, R., 2002. Capitalism and Freedom. Chicago: University of Chicago Press. Gregory, P. & Stuart, R., 2003. Comparing Economic Systems in the Twenty-First Century. New York: South-Western College Pub. 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George Osborne has exaggerated and it could cost us 1 million jobs, [online] Available at: < http://www.mirror.co.uk/news/uk-news/george-osborne-has-exaggerated-and-it-could-cost-256103>[Accessed July 23, 2012] Moulds, J., 2012. Bank of England debated ?75bn of quantitative easing. The Guardian UK, [online] Available at: < http://www.guardian.co.uk/business/2012/jul/18/bank-of-england-minutes-more-qe?newsfeed=true> [Accessed July 23, 2012] Reddy, M., 2011. New UK Fiscal Policy Implements Large Spending Cuts. International Business Journal, [online] Available at: < http://nyuiba.com/ibj/2011/09/new-uk-fiscal-policy-implements-large-spending-cuts/>[Accessed July 23, 2012] Smith, A., 1776. The Wealth of Nations. London: Penguin Classics. University of North Carolina. 2009. Interest Rates, [online] Available at: < http://www.unc.edu/depts/europe/euroeconomics/Interest%20Rate.php> [Accessed July 23, 2012] Read More