2.4 - Pros + Cons + Eval - Free Market Flashcards
What are the key assumptions for the analysis of how prices work to allocate scarce resources?
The key assumptions for the analysis of how prices allocate scarce resources are: 1) Perfect information for both consumers and producers; 2) Competition exists between suppliers with no dominant firm; 3) Entry and exit into the market is costless of firms; 4) Consumers are rational utility maximisers; 5) Firms are profit maximisers; 6) There is perfect mobility of factors of production.
What is market failure?
Market failure occurs when the market fails to allocate resources at socially optimum levels, resulting in society surplus not being maximised.
What is allocative efficiency?
Allocative efficiency is when resources are allocated in such a way that the sum of consumer and producer surplus is maximised.
How does the price mechanism allocate goods and services?
The price mechanism allocates goods and services through its functions of rationing, signalling, and incentivising. It is an effective and efficient way of preventing shortages and surpluses, and resources perfectly follow consumer demand to reach the socially optimum level of output.
Efficient allocation of resources
What is Point 1 in favour of free markets?
Point 1 is that competitive free markets allow for an efficient allocation of resources, allocative efficiency, where society surplus is maximised (the sum of consumer and producer surplus). Given the basic economic problem, the price mechanism through its functions of rationing, signalling and incentivising is an effective and efficient way of allocating goods and services preventing shortages (excess demand) and surpluses (excess supply). This way, resources perfectly follow consumer demand as the socially optimum level of output is reached.
Competition, entrepneurship and innovation
What is Point 2 in favour of free markets?
Point 2 is that free markets encourage competition, entrepreneurship and innovation through the profit motive, signalling and incentivising firms to enter the market if large profits are being made thus responding to consumer tastes and needs. When competition is promoted and new firms enter, this can mean higher quality, new innovative products but certainly will mean, lower costs of production, lower prices and higher quantity/choice for consumers, raising consumer surplus.
Dynamic efficiency
What is Point 3 in favour of free markets?
Point 3 is that competitive free markets can lead to dynamic efficiency given the profit motive of private firms. This is where high profits are re-invested back into the company in the form of R&D, innovation, new or upgraded capital machinery, technology advances, factory expansion etc. Such re-investment can improve living standards and affordability for consumers whilst increasing profit margins, reducing costs of production and potentially resulting in monopoly power for firms over time.
Large number of jobs
What is Point 4 in favour of free markets?
Point 4 is that competitive markets create a large number of jobs in the economy. This is because quantity is maximised at the socially optimum level and with many competing firms, the need for labour as a derived demand is high. Such employment creation allows greater opportunities for individuals to work and earn to improve material and non-material living standards.
No government intervention
What is Point 5 in favour of free markets?
Point 5 is that free competitive markets mean no government intervention to distort market outcomes, which could reduce society welfare and could create shortages/surpluses. This is because the effect of government involvement when markets are allocating resources well is inefficiency, deadweight welfare losses and government failure. As a consequence, one the biggest benefits of the market remains whereby individuals have liberty and are free to make their own choices without coercion or undue paternalism by the government.
government failure
What is Point 6 in favour of free markets?
Point 6 is that the risk of government failure through intervention is large even if markets are failing to allocate resources efficiently. This is because state officials often lack information when setting policies to intervene in a market resulting in destructive unintended consequences, where the costs of intervention outweigh the benefits. Given this significant risk, free markets are most likely to allocate resources as efficiently as possible and should be left alone, especially when paternalistic and nanny state intervention impacts on liberty, freedom and choice.
Markets can fail
What is Point 1 against free markets?
Point 1 is that markets can fail in efficiently allocating scarce resources. This can occur in a variety of ways, for example due to the existence of externalities, public goods, information failure and monopoly power. As a consequence, government intervention may be necessary to improve resource allocation and society welfare, especially if effective policies to solve market failures exist.
Exclude individuals on low incomes
What is Point 2 against free markets?
Point 2 is that allocating resources through the market can exclude individuals on low incomes. This is because the functions of the price mechanism only work in allocating scarce resources by taking away shortages and surpluses rather than considering affordability or the necessity nature of goods and services. As a consequence, inequity can result, as individuals may be unable to access the most basic life-sustaining goods and services like healthcare, education, pharmaceutical drugs, housing, food, and water. A significant risk is for individuals to then seek alternative supply sources such as the black market for food or drugs where the quality of the product cannot be trusted.
icentives profit seeking
What is Point 3 against free markets?
Point 3 is that the free market incentivises profit-seeking, which may be to the detriment of consumers as quality suffers when costs are driven down. The market for blood is a good example where the quality of blood supplied for transplants may fall or even be tainted as providers seek to maximise profits. As a consequence, individuals and workers can be harmed with poor product safety and health and safety at work whilst the environment can suffer from widespread damage if costs are cut in this regard with regulation through government intervention potentially necessary to combat this concern.
creative destruction
What is Point 4 against free markets?
Point 4 is that new firms entering a market can destroy pre-existing firms due to their innovation and superior efficiency, creating job losses and unemployment. Whilst consumers benefit from efficiency gains and regular price reductions over time, existing firms shutting down will increase unemployment worsening living standards. This argument is weak, however, as the benefits of competition with new efficient firms entering a market outweighs the costs, with workers able to seek new jobs created in the market overall.
volatile prices
What is Point 5 against free markets?
Point 5 is that volatile prices cause problems in some markets when left free from government intervention. The market for primary commodities is a good example where demand and supply are often affected due to changes in the economic cycle and changes in weather conditions; as demand and supply are both significantly price inelastic, the resultant price alteration is significant. This destroys incentives to invest if price changes are unpredictable whilst harming individual producers who lose a source of stable income when prices fall. Furthermore, sudden price reductions can lead to decline of industries and structural issues particularly when factor mobility is limited.
