Advantages and disadvantages of the market system

Advantages of market system

  1. Market system automatically responds and adjusts to the people’s wants
  2. As we know, in a market system, the price of goods and services are determined by the forces of demand and supply. If consumers want a particular good or a service, they simply demand for it and the prices go up, which gives signal for the producers to produce more of that good. If producers can produce the required amount of that particular good, the price automatically comes down to normal. Likewise, if people no longer wants a particular good, they simply stop demanding for it, so that it is no longer profitable for producers to produce that good, so producers stop producing that good.

  3. Wider variety of goods and services
  4. In a market system, producers compete with each other by offering wider variety of goods, therefore consumers have more choice, this may even lead to lower prices.

  5. Competition pushes businesses to be efficient: keeping costs down and production high.
  6. The aim of firms in a market economy is to make as much profits as possible. In order to do this, the firms need to be more efficient. Therefore they often use new and better methods for production, this leads to lower costs and higher output.

  7. Government does not have to take decisions on basic economic questions
  8. The market system relies on producers and consumers to decide on what, how and for whom to produce. Therefore it does not require the government to employ a group of people to take these decisions

The disadvantages of market system

  1. Factors of Production is not employed if it is not profitable
  2. In a market system, producers do not produce a good or a service if it is not profitable. But sometimes it may be necessary to produce some goods even if it is not profitable. Therefore Market system will fail in this aspect.

  3. Market system may not produce certain goods and services
  4. Private firms in a market system will not be willing to provide certain public goods like street lights because it is almost impossible to charge any payment from the consumers.

  5. Free market may encourage harmful goods
  6. If there are people in the market who wish to buy dangerous goods like narcotic drugs, the market will be ready to buy it since private firms will be willing to provide anything that is profitable

  7. Production may lead to negative externalities
  8. When firms are always trying to maximize their profits, they may ignore external costs like damages to the environment.

  9. Free market economy may increase the gap between the rich and the poor
  10. When firms and individuals are able to produce and consume freely, it may make the rich even richer because they have more decision making power, and the poor may become poorer because they have less decision making power in the market. The market system allocates more goods and services to those consumers who have more money than others.

Previous Topic: Types of economic systems

Types of Economic Systems

Traditional Economies

This is the earliest type of economies. Traditional economies existed in pre-historic age where hunter-gatherers relied on their environment to fulfil their needs, they bartered any excess meat or produce they collected. This type of economies are very rare in the modern world.

Command Economies

In this type of economic system, the government answers all the basic economic questions. Let’s see the typical answers to those questions by the government:

What to produce – The government decides what will and must be the needs of the citizens. The answer could be to produce only ‘Dettol’ soaps and no other variety of soaps. Citizens have no choice but to accept it.
How to produce – The government decides the method of production. A typical answer by a command economy could be to produce it in a labour intensive factory owned by the government.
For whom to produce – Again the government decides who will consume the products. Yes the answer is that the production is done for the people, so the people will use it and everyone gets the same price. Welfare is supposedly maximized.
Government controls everything. The factors of production are all owned by the state and production is done for the welfare of the state. And of course the choice of goods available to the people is much less, the people have to accept what is produced.

Market Economies

Market Economies is also known as capitalist economies. In this type of economic system, the questions facing the economy is answered by the forces of demand and supply. What to produce – What the customer demands. How to produce – By private companies, the companies decide the most efficient method and competes with each other to win customers. For whom to produce – The production is done for those who demand. It is for the customers willing to spend and buy it.

Everyone in a market economy acts in self-interest. The factors of production are owned by private individuals and companies. Government has a very minimal role in the production.

Mixed Economies

In a mixed economy, there are features of both the market and command economies. Some of the factors of productions are owned by the government, while others are owned by private sector. Almost all the economies today are mixed economies, however the degree of mixing varies. Some are more market oriented, while some are more towards government planning.

Next topic: Advantages and Disadvantages of the market system

Determinants of Demand

What determines the demand for a good or service in a market?
Demand refers to the amount that consumers are willing and able to buy at any given price. A demand curve shows this relationship between price and quantity demanded. It slopes downwards from left to right, because as price falls, people are more willing to buy a good.
demandcurve

Factors causing demand curve to shift to its right(increase in demand):
• an increase in income (for normal
goods)
• a fall in income (for inferior goods)
• successful advertising
• fall in price of complementary goods
• rise in price of substitute goods
• good becomes more fashionable.

Factors causing demand curve to shift to the left(decrease in demand):
• a fall in income (for normal goods)
• a rise in income (for inferior goods)
• rise in price of complementary goods
• fall in price of substitutes
• good becomes less fashionable.

A very important point: a change in the price of a good does not lead to a movement of the demand curve — it simply leads to a movement along the demand curve, since the demand curve shows the relationship between price and quantity demanded. Therefore, any change other than price will lead to a change of demand or a shift in demand curve.

Key terms:
Normal good — one for which demand increases as income rises.
Inferior good — one for which demand falls as income rises, eg bus travel, own-brand supermarket spaghetti sauce
Complementary good — a good that is bought with another good, ie the two go together well, eg cinema tickets and popcorn.
Substitute good — a good that is bought instead of another good ie consumers choose between one or the other, eg gold engagement rings or platinum engagement rings.

Source: Adapted from Edexel Tutor Support Materials with slight modifications.

Competitive Markets- How they work and why they fail

  1. What is the nature of economics?
  2. Production Possibilities Curve – illustrations of various economic concepts.
  3. Specialisation and division of labour
  4. Determinants of Demand
  5. Elasticity of Demand
  6. Determinants of Supply
  7. Determining the Price, Functions of Prices, Consumer/Producer Surplus
  8. Price Changes Explained
  9. Incidence of Taxation and Subsidies
  10. Wage rate determination in labour market
  11. Market Failure
  12. How governments attempt to correct market failure
  13. Government Failure

Unemployment

Meaning of unemployment

Unemployed are the people of working age group who do not have work to do and are actively seeking for work.
We have to note here that not all the people who are not working are counted as unemployed. For anyone to be counted as unemployed, he or she has to have the ability to work and must be willing to work and are actually searching for a job. Unemployment is measured as a percentage of total available workforce.

Types/causes of unemployment

Demand deficient unemployment
Falling demand for goods and services can have a downward multiplier effect on output, employment and incomes.
If the demand for a particular good falls, the firms that produce that particular good will be force to reduce output. In this case, the firm may have to lay-off workers to reduce losses.
If falling demand happens for the entire economy, which means the aggregate demand for goods and services falls, the negative effect will be seen on the whole economy. This often happens in a recession. If unemployment increases due to falling aggregate demand in a recession, it is called cyclical unemployment. Therefore cyclical unemployment is a type of demand deficient unemployment.

Structural unemployment
This type of unemployment arises from long-term changes in the structure of the economy. For example, changes in the taste of the people may lead to an entire industry to be closed down. Once those industries are closed down, the workers may not have skill to get a job from another industry.
For example, new technology (nuclear power) could make coal mines close down leaving many coal miners unemployed.
When structural unemployment happens due to the introduction of new technologies, it is often referred as ‘technological unemployment’.

Real Wage Unemployment / Classical Unemployment

Classical Unemployment

Classical Unemployment

This occurs when wages are artificially kept above the equilibrium. For example, powerful trades unions or minimum wages could lead to wages above the equilibrium leading to excess supply of labour (this assumes labour markets are competitive) Keynesian analysis suggests a fall in AD can lead to real wage unemployment as wages are sticky downwards and a fall in AD does not lead to wages clearing.

Frictional unemployment
Frictional unemployment is seen as the least serious of all the unemployment types. Frictional unemployment occurs when workers leave their current job to find better jobs or when the school leavers take some time trying to find work.

Seasonal Unemployment
Some goods have seasonal supply. For example, some agricultural produce can be grown only during certain weather conditions. Other goods and services may have seasonal demand, which means they are demanded only during certain periods of the year. When those goods and services are out of season, the workers who are employed in the industry may become unemployed.

The consequences of unemployment

Lost output
Having people who are willing but unable to work is a waste of resources. A country is therefore not maximizing its output so living standards and international competitiveness is lower than what it ought to be.

Lost tax revenue
Unemployment will result in lower revenue gained from income tax. The potential tax revenue could be spent on improving healthcare or education. Such spending would increase the productivity of the country and the general living standards.

Government spending on benefits
Spending on job seeker’s allowance will go up the more people there are that are unemployed. This represents a larger opportunity cost which could limit the spending on key areas such as health.

Pressure on other forms of government spending
Greater unemployment may also lead to more crime or mental health problems, which requires more government spending to solve.

Costs to the unemployed
The unemployed may suffer from social disadvantages and will suffer from loss of income. There may be increased arguments within households and/or a sense of worthlessness and aimlessness. Children of the unemployed will struggle at school because they may not be adequately provided with the resources as good as other kids whose parents are employed.

Hysteresis
This is unemployment causing unemployment. The longer someone is unemployed, the more likely that employers will see them as unemployable. This is because staying out of work for a long time indicates that they may not be good workers. Also, as someone stays away from work for a long time, he/she may not be able to keep in touch with the emerging technology and methods of work.

Negative multiplier effects
The closure of a local factory with the loss of hundreds of jobs can have a large negative multiplier effect on both the local and regional economy. One person’s spending is another’s income so to lose well-paid jobs can lead to a drop in demand for local services, downward pressure on house prices and ‘second-round employment effects’ for businesses supplying the factor or plant that closed down.

Fiscal costs
The government loses out because of a fall in tax revenues and higher spending on welfare payments for families with people out of work. The result can be an increase in the budget deficit which then increases the risk that the government will have to raise taxation or scale back plans for public spending on public and merit goods.


Next topic: Gross Domestic Product(GDP)

International Trade

International Goods
Our local shopping malls and marts are packed with goods imported from countries all over the world. We are enjoying the goods made in other countries. We are also exporting canned fish, smoked fish. We are also exporting services like tourism. In fact, every one of us is doing international trade daily.

What Is International Trade?

International trade is the exchange of goods and services between countries. This type of trade gives rise to a world economy, in which prices, or supply and demand, affect and are affected by global events. Political change in Asia, for example, could result in an increase in the cost of labour, thereby increasing the manufacturing costs for an American sneaker company based in Malaysia, which would then result in an increase in the price that you have to pay to buy the tennis shoes at your local mall. A decrease in the cost of labour, on the other hand, would result in you having to pay less for your new shoes.

No country can produce everything it wants. Therefore, doing international trade helps the countries to enjoy goods and services that otherwise would not be available in the country, and thus increasing the standard of living.

International trade can happen in two ways. It is either an import or an export. When we buy good and services from abroad, we are importing those goods and services and we pay for them. When we are selling goods and services to other countries, we are exporting them and we receive payments for them.

Increased Efficiency

Different countries are efficient in producing different goods and services. For example Japan and Taiwan are efficient and advanced in producing electronic goods. Certain countries are good in producing agricultural goods. Because of international trade, these countries can specialize in those goods they are best in producing.

Let’s take a simple example. Country A and Country B both produce cotton sweaters and cars. Country A produces 10 sweaters and six cars a year while Country B produces six sweaters and 10 cars a year. Both can produce a total of 16 units. Country A, however, takes three hours to produce the 10 sweaters and two hours to produce the six cars (total of five hours). Country B, on the other hand, takes one hour to produce 10 sweaters and three hours to produce six cars (total of four hours).

But these two countries realize that they could produce more by focusing on those products with which they have a comparative advantage. Country A then begins to produce only cars and Country B produces only cotton sweaters. Each country can now create a specialized output of 20 units per year and trade equal proportions of both products. As such, each country now has access to 20 units of both products.

We can see then that for both countries, the opportunity cost of producing both products is greater than the cost of specializing. More specifically, for each country, the opportunity cost of producing 16 units of both sweaters and cars is 20 units of both products (after trading). Specialization reduces their opportunity cost and therefore maximizes their efficiency in acquiring the goods they need. With the greater supply, the price of each product would decrease, thus giving an advantage to the end consumer as well.

Competition

With international trade, countries can compete in the global market. Local companies are exposed to competition from foreign companies. In addition, local companies have a wider market, allowing them to grow and become efficient. It also helps to reduce the prices of goods and services.

However, it can also be argued that competition from larger foreign companies could force the smaller local companies out of business. Therefore many governments put restrictions on international trade. This is called protectionism.

Examples of such restrictions are tariffs, quotas, and embargoes.

Theories of International Trade

1. Absolute advantage theory.
Absolute advantage says that countries should specialize in those good in which they have an absolute advantage. An absolute advantage means a country is able to produce more of a good than other countries using the same amount of resources. In this way, each country can specialize, and countries can trade with each other and enjoy greater output than they would if they opted for self-sufficiency.

2. Comparative advantage theory
The principle of comparative advantage states that a country should specialise in producing and exporting those products in which it has a comparative advantage compared with other countries and should import those goods in which it has a comparative disadvantage.
A comparative advantage means a country’s opportunity cost of producing a good or a service is lower than other countries. In this way a country can still specialize in producing a particular product even if another country enjoys absolute advantage in producing that product.

Watch the following video for a clear understanding.

Topics from Cambridge O Level Unit 8: International Aspects

  1. Benefits and disadvantages of specialisation at regional and national levels
  2. Structure of the current account of the balance of payments

Exchange Rate Systems

Exchange rate or foreign exchange rate is the rate at which one currency is exchanged for another. It is the price at which one currency is traded for another.
Currencies can be bought and sold at foreign exchange market, just like any other commodity is traded at the market. This is necessary because we need foreign currency to do trade with other countries. Countries do international trade because no country can produce everything it needs.
For example, Bank of Maldives currently sells Maldivian Rufiyaa at MRF15.42 per US$.

Floating Exchange rate system

If a country has a floating exchange rate system, the value of the currency is determined freely by the forces of demand and supply. However, the government can still try to stabilize its currency by buying and selling foreign currencies thereby affecting demand and supply. But it is still the forces of the market which determines the exchange rate.
When the value of the local currency goes down in a floating exchange rate system, it is known as a depreciation. An increase in the value of the local currency in a floating exchange rate system is known as an appreciation.

The factors affecting the exchange rate:

      1. Changes in the balance of trade.

A sustained balance of trade deficit over the years will lead to depreciation of the currency because more currency needs to be supplied to pay for the imports while the currency earned from the exports are not able to match that of the leakage due to imports.

      1. The changes in interest rates.

If the local interest rates are higher, people will be encouraged to save more at the banks. This will take money out of the circulation. Furthermore, foreigners too maybe keen to save and invest in local banks. This could lead to the appreciation of the local currency.

      1. Speculators

Speculators try to gain profit from predicting what might happen to the value of the money in the future. Speculation itself affects the value of the currency. For example, if speculators think that the price of US$ in terms of MRF will go up in the future, they will try to buy more US$ and hold whatever US$ they have. This actually creates a still higher demand for US Dollars.

      1. The price of imported raw materials and essential goods

When the prices of raw materials such as construction materials and essential commodities like oil and food products goes up, the demand for foreign currencies goes up. This leads to a depreciation of the local currency.

Fixed Exchange rate system

In a fixed exchange rate system, a country pegs the local currency to a foreign currency or a basket of currencies. This is also called a ‘pegged’ exchange rate system. Until very recently, Maldives had a fixed exchange rate system.
A country may adopt this system to avoid the uncertainty created by the free floating system.
To adopt this kind of a system, the central bank holds an exchange equalization account to buy and sell foreign currency in order to compensate for the excess demand and supply.
When the central bank raises the value of the currency, it is known as a ‘revaluation’. When the central bank lowers the value of the local currency, it is known as‘devaluation’.

Managed/Dirty Floating

A managed floating rate systems is a hybrid of a fixed exchange rate and a free floating exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market.

Unlike in a fixed exchange rate regime, the central bank does not have an explicit set value for the currency; however, unlike in a floating exchange rate regime, it doesn’t allow the market to freely determine the value of the currency.

Instead, the central bank has either an implicit target value or an explicit range of target values for their currency: it intervenes in the foreign exchange market by buying and selling domestic and foreign currency to keep the exchange rate close to this desired implicit value or within the desired target values.

Example: Suppose that Thailand had a managed floating rate system and that the Thai central bank wants to keep the value of the Baht close to 30 Baht/$. In a managed floating regime, the Thai central bank is willing to tolerate small fluctuations in the exchange rate (say from 28.75 to 34.25) without getting involved in the market.

If, however, there is excess demand for Baht in the rest of the market causing appreciation below the 24.75 level the Central Bank increases the supply of Baht by selling Baht for dollars and acquiring holdings of U.S dollars. Similarly if there is excess supply of Baht causing depreciation above the 25.25 level, the Central Bank increases the demand for Baht by exchanging dollars for Baht and running down its holdings of U.S dollars.

So, under a managed floating system, the central bank holds stocks of foreign currency: these holdings are known as foreign exchange reserves. It is important to realize that a managed float can only work when the implicit target is close to the equilibrium rate that would prevail in the absence of central bank intervention. Otherwise, the central bank will deplete its foreign exchange reserves and the country will soon be in a free floating exchange rate system because they can no longer intervene.

Some managed floating regimes use an explicit range of target values instead of using an implicit range of values. For example, in the early 1990s, many European countries participated in an arrangement called the “Exchange Rate Mechanism” (ERM) in which they set a range of values (a band that was 2.25 percentage points wide on either side of a central value) in which their currencies were free to move in but agreed to intervene to prevent currencies from moving outside that range.
Maldives currently has a managed floating system in which MRF is allowed to float within such a band.

Next Topic: International Trade