SMART Classes First Year Chapter (2) The Modern Mixed Economy

Learning Objectives This chapter represents the basis or foundation for the analysis of a market economy, through the following points: (A) The Market Mechanism (B) Trade, Money, and Capital (C) The Visible Hand of Government (The role of government in the market economy)

(A) The Market Mechanism A market economy is a mechanism for coordinating people, activities, and businesses through a system of prices and markets. So, in a market economy, no single individual or organization is responsible for production, consumption, distribution, or pricing. A market “is a mechanism through which buyers and sellers interact to determine prices and exchange goods, services, and assets”.

(A) The Market Mechanism In a market economy, prices serve as signals to producers and consumers. If consumers want more of any good, the price will increase, sending a signal to producers that more supply is needed. This is true in both product markets and factor markets. So prices coordinate the decisions of producers and consumers in a market. Higher prices discourage and encourage production. Lower prices encourage consumption and discourage production. Prices are the balance wheel of the market mechanism.

(A) The Market Mechanism Markets achieve equilibrium the market mechanism by balancing supply and demand forces, at those prices for which buyers desire to buy exactly the quantity that sellers desire to sell, that is the quantity demanded is equal to the quantity supplied. Markets also can solve the three economic problems (what, how, and for whom) through the market mechanism.

How Markets Solve the Three Economic problems? The way in which markets solve the three economic problems (trio of economic problems) can be illustrated by the circular flow of economic life. This diagram provides an overview of how consumers and producers interact in the product markets and factor markets to determine prices and quantities for both outputs and inputs. In this circular flow, there are two fundamental forces that shape the market economy: tastes and technology.

How Markets Solve the Three Economic problems?

How Markets Solve the Three Economic problems? In this circular flow, the three problems are solved in the following way: 1- What goods and services will be produced is determined by the dollar votes of consumers that interact with the business supply in the product markets and determine prices. This is because tastes of consumers are expressed in the dollar votes of consumer demands. Firms, in turn are motivated by the desire to maximize profits (the difference between total sales and total costs).

How Markets Solve the Three Economic problems? 2- How things are produced is determined by the competition among different producers. The best way for producers to compete and maximize profits is to keep costs at a minimum by using the most efficient methods of production, and this will depend largely on the resources and technology available to a society. 3- For whom things are produced depend largely on the factor prices (wages, rents, interest rates, and profits) that are determined by household supply and business demand in the factor markets.

The Invisible Hand Adam Smith was the first who recognized how a market economy organizes the forces of supply and demand, through what he called the invisible hand. The invisible hand “states that private interest can lead to public gain when it takes place in a well-functioning market mechanism”. But the functioning of the invisible hand requires a perfectly competitive economy with no market failures. Market failures like monopolies or pollution will require government interference.

(B) Trade, Money, and Capital Modern economies have enjoyed rapid economic growth as increasing specialization has allowed workers to become highly productive in particular occupations and then to trade their output for the goods they need. Specialization “occurs when people and countries concentrate their efforts on a particular set of tasks”. In this way, there will be a division of labor dividing production into a number of specialized tasks or steps.

(B) Trade, Money, and Capital Each country will specialize in the production of the goods in which it has advantage, and then international trade will allow different countries to exchange what they produce for what they need. So trade can benefit all countries by increasing the range and quality of consumption and raising everyone’s living standards. But trade will require a lubricant. Money can be considered the lubricant of exchange, as it allows people and countries to trade their specialized outputs for those produced by others.

(B) Trade, Money, and Capital Money “is the means of payment in the form of currency and checks used to buy things”. Money acts as a matchmaker between buyers and sellers matching their interests billions of times everyday. But the increase in the future productivity requires decreasing current consumption to increase the country’s capital and also the future consumption. The benefits from this capital will depend on the ability of individuals to own (have private property of capital) and profit from capital.

(C) The Visible Hand of Government In reality, no economy conforms totally to the idealized world of the invisible hand. There are flaws in the market mechanism that requires government intervention such as pollution, unemployment, and extremes of wealth and poverty. Governments operate by requiring people to pay taxes, obey regulations, and consume certain collective goods and services. Therefore, Governments have three main economic functions in a market economy: to increase efficiency, promote equity, and foster macroeconomic growth and stability.

(C) The Visible Hand of Government 1- Efficiency: Adam Smith recognized that the benefits of the market mechanism are achieved only when perfect competition is present and so the economy is efficiently producing. Perfect competition “refers to a market in which no firm or consumer is large enough to affect the market price”. For example: the wheat market. There are many ways that markets cannot achieve perfect competition such as: imperfect competition, externalities, and public goods.

(C) The Visible Hand of Government Imperfect competition “occurs when a buyer or seller can affect a good’s price”. In this case, the society may move inside its PPF. Imperfect competition leads to inefficiencies as it results in too high prices and too low output. Monopolies such as Microsoft are the extreme case of imperfect competition. Governments can face imperfect competition by regulating the price and profits of monopolies, antitrust laws, and opening of markets to competitors (deregulation).

(C) The Visible Hand of Government Externalities (spillover effects) “occur when firms or people impose costs or benefits on others outside the market place”. That is , externalities mean that there was an economic transaction without an economic payment. Examples of externalities are pollution (negative) and research and development (positive). Government regulations such as antipollution laws can be used to control externalities.

(C) The Visible Hand of Government Public goods “are commodities which can be enjoyed by everyone and from which no one can be excluded, such as national defense”. In providing public goods, governments behave exactly like any other large spender. 2- Equity: The market economy may not produce fair distribution of income, even if the market system worked perfectly. In this case, government can use progressive taxation and make transfer payments or subsidize consumption.

(C) The Visible Hand of Government Governments can engage in progressive taxation by taxing large incomes at a higher rate than small ones. Then, governments can make transfer payments (money payments to people) to the elderly, blind, disabled, and unemployed. Sometimes, the governments subsidize the consumption of low-income groups by providing food stamps, subsidized medical care, and low-cost housing.

(C) The Visible Hand of Government 3- Macroeconomic growth and stability: Since its origins, capitalism has experienced periodic fluctuations of inflation (rising prices) and recession (high unemployment). These fluctuations are known as the business cycle. Governments can stabilize economic growth and face these fluctuations by using fiscal policies (taxing and spending) along with monetary policies (interest rates and credit conditions). Such government intervention in the market economy explains why most economies are now mixed economies.