Intro to Econ: Market Economic System
Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices on allocating resources to satisfy their wants and needs, trying to determine how these groups should organize and coordinate efforts to achieve maximum output.
Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the aggregate economy, and microeconomics, which focuses on individual consumers and businesses.
One of the earliest recorded economic thinkers was the 8th-century B.C. Greek farmer/poet Hesiod, who wrote that labor, materials, and time needed to be allocated efficiently to overcome scarcity. But the founding of modern Western economics occurred much later, generally credited to the publication of Scottish philosopher Adam Smith’s 1776 book, An Inquiry Into the Nature and Causes of the Wealth of Nations.
The principle (and problem) of economics is that human beings have unlimited wants and occupy a world of limited means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased productivity and a more efficient use of resources, they argue, could lead to a higher standard of living.
Despite this view, economics has been pejoratively known as the “dismal science,” a term coined by Scottish historian Thomas Carlyle in 1849. He used it to criticize the liberal views on race and social equality of contemporary economists like John Stuart Mill, though some sources suggest Carlyle was actually describing the gloomy predictions by Thomas Robert Malthus that population growth would always outstrip the food supply.
Market Economic System
A market economy is a system where the laws of supply and those of demand direct the production of goods and services. Supply includes natural resources, capital, and labor. Demand includes purchases by consumers, businesses, and the government.
Businesses sell their wares at the highest price consumers will pay. At the same time, shoppers look for the lowest prices for the goods and services they want. Workers bid their services at the highest possible wages that their skills allow. Employers seek to get the best employees at the lowest possible price.
Capitalism requires a market economy to set prices and distribute goods and services. Socialism and communism need a command economy to create a central plan that guides economic decisions. Market economies evolve from traditional economies. Most societies in the modern world have elements of all three types of economies. That makes them mixed economies.
The free market means that economic decisions are taken by private individuals and firms. Everything is owned and operated by private individuals. In a pure free market there would be no government intervention in the economy. However, in practice governments usually involve themselves in the implementation of certain laws and certain public services, even if only national defense and the protection of private property. We often speak about America having a free market economy because most businesses are left to private enterprise. But, even in America the government spends about 35% of GDP.
Theoretical support for a free market was strongly supported by Adam Smith in his book, ‘The Wealth of Nations’. The wealth of nations tried to explain that; when people try to maximise their individual utility it actually leads to the best outcome for the rest of society.
However, Adam Smith was aware of some limitations of the free market. For example, he was aware of how monopoly power could be abused. But, basically his theories crystallized the theoretical underpinnings of a free market approach. Many of his arguments remain relevant today.
Definition of a Market Economy
The following six characteristics define a market economy:
- Private Property – Most goods and services are privately-owned. The owners can make legally binding contracts to buy, sell, or lease their property. Their assets give them the right to profit from ownership. There are some assets U.S. law excludes. Since 1865, for example, you cannot legally buy and sell human beings.
- Freedom of Choice – Owners are free to produce, sell, and purchase goods and services in a competitive market. They only have two constraints. First is the price at which they are willing to buy or sell. Second is the amount of capital they have.
- Motive of Self-Interest – Everyone sells their wares to the highest bidder while negotiating the lowest price for their purchases. Although the reason is selfish, it benefits the economy over the long run. This auction system sets prices for goods and services that reflect their market value. It gives an accurate picture of supply and demand at any given moment.
- Competition – The force of competitive pressure keeps prices low. It also ensures that society provides goods and services most efficiently. As soon as demand increases for a particular item, prices rise thanks to the law of demand. Competitors see they can enhance their profit by producing it, adding to supply. That lowers prices to a level where only the best competitors remain. This competitive pressure also applies to workers and consumers. Employees vie with each other for the highest-paying jobs. Buyers compete for the best product at the lowest price.
- System of Markets and Prices – A market economy relies on an efficient market in which to sell goods and services. That’s where all buyers and sellers have equal access to the same information. Price changes are pure reflections of the laws of supply and demand. There are five determinants of demand: product price, buyer’s income, prices of related goods, consumer taste, buyer’s expectations.
- Limited Government – The role of government is to ensure that the markets are open and working. For example, it is in charge of national defense to protect the markets. It also makes sure that everyone has equal access to the markets. The government penalizes monopolies that restrict competition. It makes sure no one is manipulating the markets and that everyone has equal access to information.
- Since a market economy allows the free interplay of supply and demand, it ensures that the most desired goods and services are produced. Consumers are willing to pay the highest price for the things they want the most. Businesses will only create those things that return a profit.
- Goods and services are produced in the most efficient way possible. The most productive companies will earn more than less productive ones.
- It rewards innovation. Creative new products will meet the needs of consumers in better ways that existing goods and services. These cutting-edge technologies will spread to other competitors so they, too, can be more profitable. This sharing of knowledge illustrates why Silicon Valley is America’s innovative advantage.
- Fourth, the most successful businesses invest in other top-notch companies. That gives them a leg up and leads to increased quality of production.
- It avoids the bureaucracy often involved in government intervention.
A free market has various problems. The mnemonic PIMM FACED will help you remember them:
- P – Public Goods are not provided in a free market. A public good is a good with the characteristics of non rivalry and non excludability. Examples include street lighting and national defense.
- I – Inequality. A free market provides no social security net for those who are unemployed or on low income. Furthermore the nature of a free market is that the benefits tend to accrue to a small number of people who have the advantage of property and monopoly power.
- M – Monopoly. In an unchecked free market, monopolies can easily develop. This means the owners are in a position to set high prices and exploit both consumers and workers.
- M – Merit Good – Education and health care. Under-provided because people underestimate the benefits of going to school e.t.c.
- F – Factor immobility. Geographical unemployment. Occupational unemployment through lack of skills
- A – Agriculture. – Agriculture is prone to market failure e.g. weather can harm crops
- C – Cyclical Instability – economic recessions and the corresponding unemployment
- E – Externalities – Over-consumption of goods like tobacco with negative externalities
- D – De merit goods – Overconsumption of goods like alcohol, where people overestimate the personal benefits, underestimate the costs of getting drunk.
If it decides it is, society will grant the government a significant role in redistributing resources. That is why many market economies are also mixed economies. Most so-called market economies are mixed economies.
The Constitution and the Economy
The United States is the world’s premier market economy. One reason for its success is the U.S. Constitution. It has provisions that facilitate and protect the market economy’s six characteristics. Here are the most important:
- Article I, Section 8, protects innovation as property by establishing a copyright clause.
- Article I, Sections 9 and 10, protects free enterprise and freedom of choice by prohibiting states from taxing each other’s goods and services.
- Amendment IV protects private property and limits government powers by protecting people from unreasonable searches and seizures.
- Amendment V protects the ownership of private property.
- Amendment XIV prohibits the state from taking away property without due process of law.
- Amendments IX and X limit the government’s power to interfere in any rights not expressly outlined in the Constitution.
- The Preamble of the Constitution includes a goal to “promote the general welfare.”
The government could take a larger role than what a market economy prescribes. This expansionary governmental role led to many social safety programs, such as Social Security, food stamps, and Medicare.
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