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Market Economy : Concept, Features and Functions of Market Economy

Concept of Market Economy

The resources are limited in the society. Hence, throughout history, every society has faced the fundamental economic problem of deciding what to produce, and for whom. According to R.G. Lipsey and C. Harbury, "the term economic system refers to a distinctive set of social and institutional arrangements within which answers are provided by determining how resources are allocated."

In the 20th century, two competing economic systems were used for the solution of these problems: command economies directed by a centralized government and market economies based on private enterprise. The market economies are prevalent in North America, Western Europe and Japan. The command economies were prevalent in the former Soviet Union, Eastern Europe and parts of Asia over the past half-century.

At present in the last decade of 20th century, the command economy has been found to be a failure. It has "failed to sustain economic growth, to achieve a measure of prosperity, or even to provide economic security for its citizens."

The market economies are, by nature, decentralized, flexible, practical and changeable. The central fact about market economies is that there is no center. The 'invisible hand' works in the private market place. The market economies are based on the principle of individual freedom: freedom as a consumer to choose among competing products and services, freedom as a producer to start or expand business and share its risks and rewards, freedom to choose a job, join a labor union or change employers.

According to R.G. Lipsey and C. Harbury, "In a type of economic system all decisions about resource allocation are made without any central direction but, instead, as a result of innumerable independent decisions taken by individual producers and consumers: such a system is known as a market economy."

Functioning of Market Economy

The functioning of a market economy may be described as follows:

Production

Decision in command economies the economic planners, production experts and political officials establish production levels of goods and designate which factories will produce them. The central planning committees establish the prices of the products and wages for the workers who produce them. It is the set of central decisions that determines the quantity, variety and prices of products. Due to this, there either shortages or surpluses of the products in the economy. The planning authorities are unable to make efficient decisions when number of people, products increase and the production technologies change rapidly.

The phenomenon of command economies does not happen in the market economy. In a market economy, government ministry, or planners do not decide the quantity, quality, and design of the products. Anyone individual or company, can decide and sell products. This leads to direct competition between different firms producing the products. Competition is the heart of market economies. Due to competition there are different products available to the consumers.

Pricing Decision

Another key point about market economies is that the planning committee does not fix the prices of products. The sellers are free to raise or lower prices according to changing market conditions. When products become scarce, the price usually rises. The price increase accomplishes two things at the same time.

The price rise makes the product more expensive compared to other products. Hence, some consumers will choose fewer of them.

The higher price goes directly to the producers and sellers. Hence the higher price increases the profits of the firms enabling them to produce and sell more goods. Attracted by high price, other firms will also begin to make the popular product.

Incentives

The higher prices give every consumer and producer incentive to respond. Because, they are allowed to reap the benefits of their own decisions while also bearing the associated risks and costs. For example, the consumers willing to pay the higher prices can get the popular product. But they have to give up more money and other goods and services to do so.

On the production side, the firms making popular products can sell them at competitive prices and earn profits. The producers who make unwanted products or produce inefficiently incur losses. Eventually, they must either learn to produce efficiently or will go out of business. In sum, the economic incentives work in a market economy.

Efficient Resource Allocation

The consumers, producers and workers all work in their own self-interest in open and competitive markets. They use their economic resources in ways that have the greatest value to the national economy. They are useful in satisfying more of people's wants. The first person to point out this fact in a systematic way was the great classical economist Adam Smith. He published his famous book 'An Enquiry Into The Nature and Causes of Wealth of Nations,’ in 1776. He was first to describe how an economy based on a system of market could promote economic efficiency and individual freedom.

Smith described the feature of market economics in these words, "People are led as if by an invisible hand" to work and behave in ways that use resources efficiently, in terms of producing things that other people want and are willing to pay for, even though that may have been "no part of their original intentions". In market economies, with a decentralized system of private markets, resources are efficiently allocated to satisfy consumer demands.

Despite many benefits of market economy, it provides no magic solutions. "The market economies are by no means immune to issues such as inflation, unemployment, pollution, poverty and barriers to international trade". Hence, the government will have to play a critical role in helping correct problems that cannot be fully solved by a system of private markets.

Features of Market Economy

Two major types of economic system are command and market economies. In command economies, resources are allocated by decisions taken by central planners. In market economies, the allocation of resources is determined by decentralized decisions coordinated through the price mechanism.

The basic features of market economy are as follows:

Decentralized decision-taking: In a market economy, decisions relating to basic economic issues are decentralized. But they are coordinated. The main coordinating device is the set of market-determined prices.
Freedom of enterprise: People are free to choose nay occupation or take up any business according to self-interest.
Profit motive: The economic activities are undertaken with the aim of earning profit. People themselves borne the risk and return of business.
Consumer's sovereignty: The consumer is the king in the sense that they have complete freedom in making choice of the products.
Price mechanism: The price mechanism guides producers and consumers in making production and consumption decisions. The price system is the coordinator of decisions. Every day millions of people independently make millions of decisions relating to consumption and production. Most of these decisions are not motivated by a desire to contribute to the social good, but by the consideration of self-interest. The price system coordinates these decentralized decisions. Due to this the whole system is sensitive to whishes of the individuals who compose it. Price is a signaling device, which give signals about scarcities and surpluses.
Perfect competition: There is perfect competition in the market between producers, consumers and consumers and producers.
Specialization in production: There is specialization in production. It is accompanied by freedom to exchange what is produced among individuals.
Market-determined prices: The most remarkable feature of the market economy is that it requires no planning authority to allocate resources. The key to the whole process is to be found in the role of prices. The prices perform the crucial function of providing signals that help to determine the allocation of resources.
Lack of conscious direction: The market economy fulfills its function of coordinating decisions without any one having to understand how it works. For example, a farmer need not know how many people eat rice and where they live. He needs to know only the cost of production and price of rice. By responding to such public signals as the costs and prices of what he buys and sells, the farmer helps the whole economy fit together, to produce what people want, and to provide it where and when they want it.
Laissez-faire: There is what is called laissez-faire in the market economy. This French expression describes the belief that the market economy would perform most efficiently if left free from government intervention. Adam Smith opined that the 'hidden hand' of market forces should be allowed to govern the economy.

The evil effects of cyclical fluctuations of business firms

Certain effects of business cycles on individual concern are favorable. During revival and expansion, demand increases, selling prices rise more rapidly than costs, profits increase and individual manufacturer and merchants generally feel happy.

Business cycles, however, land individual business firms into a number of disabilities and difficulties. Even during revival and the beginning of expansion phase, certain ill effects start appearing. The increase in raw materials price, labor costs and routs, and the higher rates charged for credits accommodation increase the costs of carrying on business when the situation becomes more difficult, the evil of cancellation develops.
The businessman that his customers are refusing to take goods, which they have ordered, and that there is a decline in the volume of orders.
During the later stages of expansion, business enterprises are confirmed by much more severe competition. Prices are maintained with difficulty.
The decline in prices, which is characteristics of the period of recession, usually finds merchants and manufacturers with large inventories, which depreciate material value at this time. These excessive inventories are usually made up of finished goods rather than raw materials.
The individual businessman usually suffers through being compelled to sell his goods at a loss in order to meet his obligations. This may result in either at least a sacrifice of profits, or possibly necessitating the carrying on of business at an actual loss.
During contraction, one of the most important reasons for financial loss during such a period is found in the continuation of fixed charges of all sorts. It is possible during contraction for an individual concern to reduce its direct costs by the discharges of labor and the reduction of purchases of raw materials, but most of the elements of overhead cost cannot be so reduced.

Economies of Scale and Natural Monopolies

A natural monopoly is a declining average total cost curve. ATC declines as more is produced because fixed costs are very large compared to variable costs. A large initial expenditure is necessary to lay the main water pipes at main electrical lines but therefore the cost is relatively low. The more houses that are hooked up, the less the ATC is relatively low. When the long-run average total cost curve declines, there are economies of scale. It can be shown in the figure as:

The figure shows that why one firm can always produce more cheaply than more firm which ATC curve is downward sloping. If two firms divide up the market then the ATC is higher than if one firm produces for the entire market. It is more costly for more firms to produce a given quantity in case of a declining ATC curve than for one firm.

Alternative Methods of Regulation

The question arises what may be the best government policy toward a natural monopoly. Having one firm in an industry lowers the cost of production, but there will be inefficiencies associated with a monopoly, price will be higher than marginal cost and there will be dead weight loss. To get both the advantages of one firm producing and competition like behavior, the government can either run the firm or regulate the firm.

The monopoly price and quantity of a natural monopoly with declining ATC are shown in the figure below. The monopoly quantity occurs where MR equals MC, the profit maximizing point for the monopolist. The monopoly price is above MC. If the firm’s price was regulated, then the government could require the firm to set a lower price, thereby raising output and eliminating some of the dead-weight loss associated with the monopoly. There are three ways for the government to regulate the price as below.

a) Marginal Cost Pricing

The process of setting monopoly price equals to marginal cost is said to be marginal cost pricing. The declining ATC, the MC is lower than ATC. It is shown in the figure as below:

MC is constant in the above figure. Thus, if price were equal to MC, the price would be less than ATC and the monopoly’s profits would be negative. Therefore, there would be no incentive for any firm to come into the market.

As shown in figure, two alternatives marginal cost pricing and average total cost pricing are compared with the monopoly price. Marginal cost pricing gives the greatest quantity supplied, but because price is less than ATC, the firm comes to negative profits. ATC pricing results in a larger growth supplied and the firm earns zero economic profits.

b) Average Total Cost Pricing (ATC)

This is the method of regulation in which the firm set the price equal to ATC. It is also represented in the above figure. When price is equal to ATC, the economic profits will be equal to zero; there will be enough to pay the managers and the investors in the firm according to their opportunity costs. Although price is still above MC, it is less than the monopoly price and dead weight loss will be smaller.

But there are some serious problems with ATC pricing. Suppose the firm knows that whatever its ATC is, it will be allowed to change a price equal to ATC. In that situation, there is no incentive to reduce costs. With the regulatory scheme which the price equals ATC, the price would rise by any increase in cost. Inefficiencies could occur with no penalty whatever. This approach provides neither an incentive to reduce costs nor a penalty to avoid increasing costs on the part of the management and the workers of the regulated firm.

c) Incentive Regulations

There is third regulation method endeavors to deal with the problem that ATC pricing provides to little incentive to keep cost low. It is a relatively new idea but it is quickly spreading and most predicted in the way of the future. The method project a regulated price out over a number of years. The price can be based on an estimates of ATC. The regulated firm is said that the projected price will not be revised upward or downward for a number of years. If the regulated firm achieves ATC lower than the price, it will be able to keep the profits, on perhaps pass on some of profits to a worker who came up with the idea for the innovation. Similarly, if supply management causes ATC to rise, then profits will fall because the regulatory agency will not revise the price.

Thus, under incentive regulation, the regulated price is only imperfectly related to ATC. The firm has a profit incentive to reduce costs if a firm does poorly pays the penalty in terms of lower profits or losses. Under incentive regulation, the incentives can be adjusted. Incentive regulation is sometimes made difficult by asymmetric information problems. The regulated firm knows more than the regulator about its equipment, technology and workers. Thus, the firm can mislead the regulator and say its ATC is higher than it actually in order to get a higher price as shown in the following figure.

d) Price Discrimination

Many natural monopolies are allowed to price discriminate. Monopolists can increase their TR and profits for a given level of output by practicing price discrimination. One form of price discrimination occurs when the monopolist charges different prices for the same commodity in different markets in such a way that the last unit of the commodity sold in each market gives the same MR.

Sometimes, the government can run natural monopoly itself rather than regulate a private firm. Nepal Government has natural monopoly in utilities sectors.

1) Role of the Government in a Capitalist / Market Economy

A market economy is known as a capitalist economy. There is no central authority to guide production and solve central problems. The individual buyers and sellers decide the nature and amount of goods and services to be produced. Every worker is free to offer his services to anyone who promises highest reward. Thus, there is freedom of contract. Similarly, every person has the right to own property and use it in any way he thinks most profitable. Under the conditions, price system tries to solve the central problems of an economy. What the central authority does in a socialist economy is done by price mechanism in capitalist economy. The price system operates in completely impersonal way through which all central problems get solved.

In a market economy, each person is guided by self-interest. The producer tries to get maximum profit. The employees prefer to work where they get maximum salary. Likewise, consumers want to get maximum satisfaction from their limited income. The place where this drama is interacted is called a market. It is the price mechanism through which such aims are achieved. There are markets for every commodity and factor service known as commodity market wherein firms are sellers and the households are buyers.

Generally, the sellers sell more at higher prices and the buyers buy more at lower prices. As a result of competition among buyers and sellers, a price gets determined where demand for the commodity is equal to the supply of the commodity. This is called the equilibrium price of that commodity.

In the capitalist system, the primary roles of the government are essentially:

To restore and develop the free market mechanism wherever it is possible to ensure workable competitive conditions.
To remove all unnecessary restrictions on the operation of free competitive market, and
To provide a background through necessary government interventions, and controls in which free competition can work effectively. Besides, government intervention and its economic activities should deliver what the free market mechanism cannot.

Meade has recommended the following eight kinds of activities for the state to perform:

Control of inflation and deflation mainly through indirect measures, like fiscal and monetary regulations;
Control and regulation of monopolistic powers to large corporate undertakings with a view to avoiding inefficiency, unemployment and wastage of resources;
Ownership and state monopoly of essential goods and services. E.g., railway transport and generation and distribution of electricity and such other services on the ground of efficiency and economies of scale;
Promoting equality of opportunity by providing equal access of education opportunities and restricting the restrictive trade practice and activities of trade unions, etc.;
Administration of justice and maintenance of law and order, and ensuring freedom of activities;
Aiding private planning in view of the uncertainties of the future by some measure of government indicative planning;
Making central planning for large structural changes in the economy; and
Tackling the problems of environmental controls, of the use of exhaustible resources, and of population growth.

It may be inferred from these propositions that the government’s role in a capitalist society is supposed to be limited to (a) restoration and promotion of necessary conditions for efficient working of the free market mechanism; and (b) to enter those areas of production and distribution in which private entrepreneurship is lacking or is inefficient. Any planning by the government is indicative and should supplements the private plans for safeguard against future uncertainties.

2) Government Role in a Socialist Economy

The role of the government in a socialist economy is all pervasive. While in the former, the government is supposed to play a corrective and complementary role in the economic sphere, in the latter, it exercises comprehensive control on almost all economic activities. In the socialist system, not only is there a complete disregard for private ownership of property beyond the permissible limit, free enterprises and market mechanism, but also these institutions are abolished by law. The private ownership of factors of production is replaced by state ownership. All economic activities are centrally planned, controlled and regulated by the state. All decisions regarding production, allocation of resources, employment, pricing etc., are centralized in the hands of the government or its Central Planning Authority. The individual freedom of choice and decision-making in regard to economic activities is drastically curtailed. Individuals are provided freedom of choice, but within the policy framework of the socialist economy. Prior to the disintegration of the Soviet Union in 1989, the Soviet economy was the most prominent example of the socialist economic system. The other countries with socialist economic system are China, Poland, Czechoslovakia and Yugoslavia.

The social aim of the socialist economic system is the same as in the free enterprise system, viz., efficiency growth, social justice and maximization of social welfare. But, their methods of achieving these goals are totally different. The motivating force in a capitalist economy is private profit, whereas in the socialist economy, it is maximization of social welfare. Socialist way of management of the economy eliminates many evils of the capitalist system. E.g., exploitation of labor by capitalists, forces generating economic fluctuations, unemployment and social and economic inequality. The socialist economic system in its classical form in, however, disappearing from the economic scene.

3) Government Role in Mixed Economy

A mixed economy is one which combines the features of both free enterprise and socialist (centrally planned) economic systems. A mixed economy is essentially an admixture of private and public undertaking. In this system, the major part of the economy, the private sector, is allowed to function on the principle of free enterprise system or free market mechanism within a broad political and economic policy framework of the government. The other part of the economy, the public sector is constituted of industries and utilities promoted, owned and managed by the government largely on the principles of a socialist economy. The public sector is created by reserving certain industries, trade, services and activities for government ownership, management and operation. The government prevents by the law to enter private capital into the industries reserved for the public sector in the nationalization of private sector industries. The nationalization of private commercial banks and insurance companies are prominent examples of the public sector extension in India. The promotion, control and management of the public sector industries is the sole responsibility of the state.

Apart from controlling and managing the public sector industries, the government controls and regulates the private sector through its industrial, monetary and fiscal policies. If necessary, direct control is also imposed.

The mixed economies of free enterprises system can, however, be distinguished from the mixed economies of ‘socialist pattern’ on the basis of the rationale of public sector in the two systems. The public sector in a free-enterprise system is a matter of pure economic necessarily and is complementary to the free market mechanism. It functions with the objectives of aiding, supplementing and strengthening the free enterprises system. On the other hand, creation of the public sector is a mixed economy like India, is a matter of ideological and social choice. Its creation and functioning are aimed at creating a ‘socialist pattern of society’ through the market mechanism. It is another thing that India has failed to achieve any of these social goals. Another point of destruction is that the public sector of the socialist pattern of society has comprehensive economic planning whereas in a free enterprise system such plans are mostly indicative.

In the mixed economy or a socialist pattern of society, the role and responsibilities of the government are much wider than in the free enterprise system, and much less than in the socialist society. The government in this system undertakes to perform all the functions that the state performs in a free enterprise economy. In addition, it assumed the responsibility of making and implementing the plans for economic development of the country. The government has also to perform the task of coordinating private sector activities with the public sector, and controlling and regulating the former to bring it in true with public sector policies.

Pages

Functioning of Market Economy

Production

Pricing Decision

Incentives

Efficient Resource Allocation

Features of Market Economy

You may also like to read:

i) Changes in capital expenditures

ii) Innovation and imitation

iii) Credit and loan policies

iv) External shocks

v) Political business cycles

The evil effects of cyclical fluctuations of business firms

You may also like to read:

You may also like to read:

Economies of Scale and Natural Monopolies

Alternative Methods of Regulation

a) Marginal Cost Pricing

b) Average Total Cost Pricing (ATC)

c) Incentive Regulations

d) Price Discrimination

You may also like to read:

1) Role of the Government in a Capitalist / Market Economy

2) Government Role in a Socialist Economy

3) Government Role in Mixed Economy

You may also like to read:

1) Supply of public goods

2) Management of the external effects

3) Corrective polity for market imperfections

4) Public policies against unemployment

5) Redistribute policies

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