A Free Market Economy Is An Economy System Economics Essay

Published: 2021-06-28 14:10:04
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Category: Economics

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There are certain attributes which differentiate the free market system and other system of economy. First and most importantly, government intervention is not present in the economy whereby all economic activities are carried out by the private sector. Besides, consumer sovereignty exists in the free market since consumers are in control in determining and influencing the goods and services to be produced. Consumers’ decision is crucial in terms of influencing the production of goods as the producers’ decisions of what to produce reflects their profitability. Mobility of labour also exists both geographically and occupationally as labours are able to move around and switch jobs with less restrictions. Since there is no government intervention in the economy, both consumers and producers have the right to own property as they can buy land and own other goods.
Since allocation of resources in this economy is via ‘price mechanism’ or forces of demand and supply, in such a way it is always efficient. This is due to the fact people influence the decisions made by the producers in production of goods since the consumers themselves consuming the goods. Hence, producers produce demanded goods only. Thus, resources are allocatively and productively efficient.
Firms or the producers will produce any goods consumers demanded for as they are more profit motivated. Since there is no government to intervene economic activities, the firms will have no restrictions in production of goods as long as they are able to maximize their revenue. As long there is demand for the product, they will continue production of the goodz. As a result, there will be a wider variety of goods and services in a free market economy compared to other system of economy.
A competitive attitude is beneficial to firms as it encourages research and development (R & D). This is important in achieving economic growth. Producers will be constantly looking at new techniques and innovations to capture the market. Suppliers will do whatever they can to be a step ahead of their competitors. The profit motive is a great incentive as it forces firms and producers to reduce production costs and be more innovative in producing better quality products.
A free market may seem like a perfect system. However, there are disadvantages since government intervention is absent.
Public goods are essential goods which are produced only by the government to aid people in general. However, there is a setback due to its non-excludability and non-rivalry characteristics. The usage of public goods cannot be excluded from anyone and at the same time the quantity is non-perishable. These characteristics of public goods are not profitable for private firms, thus, production of such goods do not exist in a free market economy. Besides, private sector is not willing to supply public goods because of "free riders". These are people who want to use the goods but refuse to pay for the goods. Furthermore, it is difficult and almost impossible to price out certain products such as road signs, street lights and national defence. As a result, public goods are absent in a free market economy.
Since government is absent, society’s sovereignty is severely affected. Due to the fact policy of non-intervention by the government, the wealthy people will only get wealthier and the poor will be poorer. This will result in huge inequality of income distribution and can be represented in pyramid-shaped income distribution pattern. Only the minorities, which are the producers, will enjoy an exceptionally big share of the national income of the country.
There are three sources of market failures in a free market which are negative and positive externalities, missing markets as well as market imperfections. Market failure exists whenever a market is left on its own and completely free from any form of government intervention and fail to allocate scarce resources.
Positive externalities arise when social benefits are greater than private benefits. Positive externalities can be classified into three categories which are private, external and social benefits. Private benefits are benefits gained by the individual himself such as visiting a doctor when the individual is sick. As a result, the individual will directly enjoy the benefit from the doctor’s treatment. External benefits are gained by the third party when they are not directly involved in the consumption or production of the goods or services. Social benefits are benefits comprising a combination of both private and external whereby everyone can enjoy the goods and services. These benefits can only be fulfilled if the market is producing goods and services which are beneficial to the society. These goods are termed as merit goods such as education and health and will be under produced in a this system of economy. This is because society is lack of information about the advantages can be gained to individuals from consumption of such goods. Hence, insufficient demand for merit goods occurs. With the presence of positive externalities, welfare loss will happen since the tendency of under-production of merit goods such as healthcare and education, will occur. This can be shown below:
Based on the Diagram (i), the supply curve represents the benefits as a whole whereby marginal social costs equals to marginal private costs (MSC = MPC+ external costs) since the focus is on benefits. Individual will only consume only up to point where marginal private cost is equals to marginal private benefit (MSC = MPB). This can be achieved at Qo. However, there is a setback since social optimality is achieved at output Q1 where marginal social cost is equals to marginal social benefit (MSC = MSB). Thus, welfare loss occurs due to under-production of goods, as shown by the area where the MSB is greater than MSC.
To solve this problem, government needs to intervene. The main objective is to increase demand for merit goods as well as increase in supply so that output will increase. The production and consumption of merit goods are highly desirable. Hence, the provision of subsidies by the government may be essential to tackle the problem as the objective is to improve benefits (MSB) and to reduce costs (MSC). This can be shown on the diagram below:
By providing subsidies, MPC=MSC, which represents the supply curve of producers, will shift to the right to MPC1= MSC1. Hence, welfare loss is reduced from ACE to BCD.
In terms of production of goods, by imposing subsidies costs of production will be cheaper allowing the producers to be able to produce more. When a subsidy is imposed, the supply curve will shift to the right (SSo to SS1), representing an increase of production. As a result, demand for goods will also increase as prices of goods are cheaper now. Hence, quantity demanded increased (Qo to Q1).
Negative externalities arise when social costs are greater than private costs.
There are three sources of negative externalities which are the private costs, external costs as well as social costs. Private costs are costs incurred by the individual itself whether as a producer or consumer. For example, the cost of buying a bottle of liquor is incurred by the consumer itself. External costs are costs incurred by third party or individuals which are not directly involved in the production of goods. For example, the public transport commuters who are not buying cars but still have to face traffic congestion. Social costs are combination of both private and external costs which are incurred to the society. Negative externality is mainly caused by goods which are harmful and detrimental to the society. These goods are termed as demerit goods such as tobacco and liquor. Due to lack of information among the society, there tend to be over-production of demerit goods such as tobacco and alcohol, hence, welfare loss occurs in the market. This can be depicted as below:
Based on Diagram (ii), the downward sloping which represents the demand curve is the marginal private benefit equals to marginal social benefit (MPB) = MSB) whereby it represents the sum of benefits in the society as a whole. The marginal private cost (MPC) is seen as upward sloping since the supply curved represents the costs to suppliers of producing a given output. Hence, individual will only consume up to marginal private benefit (MPB) = marginal private cost (MPC). It can be shown at the point where Qo=Po. The marginal social cost represents as a supply curve to the left of marginal private cost curve and the difference will give the external cost. Social optimality is achieved when marginal social benefit is equal to marginal social cost, hence, production must be at the point where P1=Q1. As a result, there is a welfare loss resulting from overproduction of demerit words. This can be shown at the area where marginal social cost (MSC) is greater than marginal social benefit (MSB). The difference will show the amount of suffering and welfare loss to the society.
Therefore, government needs to intervene to tackle the market failures associating with negative externalities and demerit goods. This can be done by imposing taxes, specifically indirect taxes.
Based on the diagram above, by imposing indirect taxes to demerit goods, marginal private cost (MPCo), which is depicted as the supply curve of the producers, will shift to the left ( MPC1). As a result, negative externality is reduced from ACD to ABE.
In terms of production of goods, by imposing taxes, costs of production will be higher forcing the producers to produce less. When a tax is imposed, the supply curve will shift to the left (SSo to SS1), representing a decrease of production. As a result, demand for goods will also decrease as prices of goods are more expensive now. Hence, quantity demanded decreased (Qo to Q1).
Market failures also occur because producers and consumers fail to take into consideration of the negative external costs of their actions. This kind of externality is defined as market imperfections. The main problem from this particular externality is wastage of resources. With differentiated products, there is a need for advertisings which is considered as wastage of resources. Since there are no restrictions in producing goods and services, environment is affected severely as producers can produce goods even if its harmful to the environment.
In conclusion, a free market economy has its own benefits and costs. A free market economy is definitely not an ideal market system for a country to implement into their economy as the problems caused by this particular system will affect the society drastically. Nonetheless, a fully governed economy is also not desirable to the society either. Hence, cooperation between government and private sectors should be implemented as government intervention is essential in tackling problems within the economy as they do not seek profit and revenue but to seek a better economy as a whole and the private firms should aim in production of goods.

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