The Workings of the Market Mechanism - Coursework Example

Type here Market Failures: A graphical Analysis Here Market Mechanism is a system through which changes in demand and supply bring about changes in output and brings the economy towards equilibrium. Adam Smith writes in his famous work that it is the invisible hand of price mechanism that leads the economy towards equilibrium, even if everyone is pursuing their own self-interest. This was a particularly important development as it tells us how changes in demand and supply which in turn changes the price leads to the most efficient point output. In order to understand the concept better, let’s look at the following illustration. Figure 1: Demand and Supply The above diagram clearly shows how the plans of buyers and sellers interact at point e and equilibrium is determined at the point Q. The price at which the quantity demanded and supplied are equal is “P”. This price will always bring the market to the quantity “Q”. This mechanism of determining quantity, in accordance with the price is also called as price mechanism. Any price fluctuations will bring about new changes in the equilibrium at a new price. Whenever demand and supply changes, prices also fluctuate bringing about new equilibrium in the market. For e.g. in the above diagram we can see that following a change in demand (fall in demand to D1) has resulted in fall in prices and has brought about changes in equilibrium quantity leading the efficient allocation of resources to a good and efficient production. The price mechanism in the above case of new demand has changed the equilibrium from Q to Q1, following a change in price. This is how price mechanism works and many consider that presence of market mechanism on its own is going to lead the market toward efficiency and there will be no need for government intervention. This may at first look like the right statement, but going deeper into analysis one can say that even price mechanism may not always lead to efficient production and equilibrium. Whenever Price Mechanism fails to lead the market into producing most efficient output and allocating efficient amount of resources to production of good, it is said that the market has failed. The following situation may lead the market mechanism in not leading to the most efficient output and market will fail. These situations can be classified under the following head: 1. Externalities 2. Presence of Merit Goods and De-Merit Goods 3. Private Goods and Public Goods Externalities is a situation when a particular business transaction affects other parties that are not directly involved in the business decision process or business operation. Since, buyers and sellers take into account only their own costs and benefits and not the third-party affect (externalities), which can be both positive and negative, there can be under and over production of goods. The examples of externalities are, suppose that a person is suffering from a contagious disease. He considers that by going to a doctor, his costs will be the fees paid to doctor and benefits will be the cure of the disease. However, he will not take into account the fact that if he does not go to the doctor, other people might catch the same disease. This will result in less-urgency for him to go to the doctor. This shows how ignorance of negative externalities can lead to over production or irrational response. Now, let’s look at the example of negative externality in the context of a business or economic decision. Suppose you want to buy a car. The main consideration for the purchase will be the cost of the car and possible benefits attained from the car. However, market mechanism will ignore the impact of car purchase on the environment and other parties such as pollution, road congestion and accidents. This ignorance may tempt you into purchasing the good and hence there will be an over-production of good due to negative externalities. We look at the following situation from the demand and supply analysis aswell. e1 Figure 2: Negative Externality Suppose that initially, the decision does not take into account the third party affects or externalities and looked only upon the personal costs and benefits. In this case, equilibrium occurred at a point shown in the above diagram, “e”. At this point, the quantity demanded equaled quantity supplied at point “Q”, at price “P”. However, soon it was realized that there were some externalities associated with the buying or purchase of the good. When third parties affect were recognized, the cost of third parties affects were taken into account, and supply curve move to the left to S1. S1 is the sum private and social costs and hence the production and allocation decisions based on this will be efficient. As a result of this decision our Quantity will be reduced to Q1 and prices will rise to P1. This shows how the market fails in the presence of externalities and lead to over production by the amount Q-Q1. Similarly in the case of positive externalities, there is an underproduction as possible external benefits are not taken into account. In our analysis if we take into account the positive externalities; obviously we will want to produce more. As a result of this our supply curve will move to right and supply will be greater than if we are oblivious to the benefits. e Figure 3: Positive Externality The above diagram clearly shows how the ignorance of social benefits or third-party benefits leads to underproduction of goods by the amount Q1-Q, in the above diagram. Like in the previous analysis, e is a point prior to realization of social benefits. But, once these benefits were realized, supply of goods was increased from S to S1. As a result of this production was increased to Q1 from Q, at a higher price P1. This clearly shows that ignorance of even positive externalities can cause markets to fail due to under production. In simple words, there should be more goods production, which the market is producing, because of positive externalities. Thus, presence of any third-party affect, whether positive or negative, results in market failure which is beyond the control of market mechanism and there is need for government intervention when this happens, in order to produce at allocatively and productively efficient points. Like third-party affects, there is another type of goods which cause the markets to fails. These goods are called merit and de-merit goods. Merits goods are those goods that are under-produced because society does not appreciate their full benefits and hence demand less. For example, Education, people think that it will only result in good jobs for them. But, instead they fail to realize that educated society will enjoy many other benefits as well. Hence, the demand registered for such goods is less than the actual that should have been registered. Figure 4: Merit Good The above diagram clearly shows how a low demand being registered leads to equilibrium at a point below actual production at ‘e’. This point is far below the point at which full benefits of education are being taken into account, e1. The demand at the efficient point is D1 and hence there should be more production in order to arrive at the market clearing quantity and hence failure to realize the merits of particular goods may result in under production, by the amount Q-Q1. Similarly, de-merit goods are those goods that pose more hazardous affects on people than they realize, such as smoking. People just consider about personal costs smoking and not how society is going to be damaged from it. For example, a person may realize that smoking may cause cancer. What he may fail realize is that the whole society is going to suffer from it in form of pollution, deaths etc. As a result the demand for such goods is higher than if the potential harms are realized by the individuals. Taking the example of diagram below, we can see the once people realize that smoking is a demerit good, they will demand less of it at the point D1. This point is lower than a point which is established by market mechanism, e1, and hence the market fails if there is no government intervention or people become more aware about the issues. Figure 5: Demerit Good Similarly, the presence of public and private goods also results in market failures. Public goods are those goods which benefit all, but no one wants to pay for them. One example of a public good is street lights. Since, people know that everyone needs it, someone is going to pay for it and they want to free-ride on the back of a person who pays for it. However, no one is foolish and hence in the free market, price mechanism fails to provide these goods. This is a problem and cause markets to fail because despite of the fact, the good has a good demand, no one pays for it and the good is never provide by the forces of price mechanism. Therefore, in order to counter this market failure, government intervenes, takes taxes from people and provides them the goods which are not provided by price mechanism, such as street lights, light houses, police etc These were some cases, where market forces of price mechanism fails to provide the people with right quantity of goods and results in market failures. However, a new way adopted by most governments to counter market failures is by adopting a mixed economic system, where there is both price mechanism and government control. Whenever price mechanism fails to provide a good or service, or over or under provides it, the government comes forward and takes care of the market. For example, to counter the over production of demerit goods, it increases the taxes on those goods. Similarly, in order to increase the production of merit goods, it usually provides subsidies on them, so that these goods are provided more in the market. Thus, we can conclude from this essay that even the most efficient system of allocation of resources can sometimes fail to allocate the resources in most efficient way. This situation is known as market failure, and if not dealt properly, it will lead the market towards inefficiency and hence there is a need for good government control to counter the problem. References: 1. John Sloman (2001). Economics. Pearson Publishing 2. Collin Bamford. (2003). As and A Level Economics. Cambridge University Press. 3. Lipsey and Chrystal. (2002). Economics. Oxford University Press. 4. Manuel G. Velasquez (2001). Business Ethics: Cases and Concepts. Prentice Hall Read More