Chapter 13

Market economic system

 Learning objectives
• By the end of this chapter you will be able to:

Define a market economic system

Explain the difference between private and public sectors
Discuss the advantages and disadvantages of the market
economic system
Recognise how efficiency can be assessed
Describe the role of market forces in different countries
13.1 The market economic system
Resources move automatically as a result of
changes in price. In turn, price changes are
determined by the interaction of demand and
supply. The use of resources is changing all the
time in response to changes in consumer
demand and the costs of production.
• P increase = Demand decrease
• P decrease = demand increase
• P increase = Supply increase
• P decraese = Supply decrease
• Cost of production = labour, rent,
wages,insurance, security, bills, cost of
material(reduce)
13.1 The market economic system
• Resources move towards those products
whose demand is rising and away from those
which are becoming less popular Figure 13.1
shows an increase in demand for air travel and
a decrease in demand for sea travel.
Answer
Answer
 Answer
B The market for onions responded to the
shortage caused by an increase in price. The
higher price rationed out the onions and
restored the market to equilibrium.
The higher demand for tomatoes raised their
price and encouraged the producers to supply
more
 The importance of competition and
incentives
The advantages of a market economic system rely in
large part. on competitive pressures One of the
benefits claimed for a market system is choice. If there
is a large number of firms producing a product,
consumers will have a choice of producers. This should
increase the prospects of consumers deciding what is
made, with producers competing with each other to
meet their demand In such a case consumers are said
to be sovereign.
 Answer
• 2 a Higher wages.
 Private and public sectors
The private sector covers business organisations
which are owned by shareholders or individuals
These organisations respond to changes with
market forces and are profit motivated.The public
sector is controlled by the government It covers
government run services and state-owned
enterprises (SOEs) also called nationalised
industries.
 TIP
Be careful with the word public Sometimes it
refers to the government as in public
expenditure and public sector It can. however,
also refer to people as a whole as in the
general public or open to all people as in a
public limited company .
 Answer
1 a A firm may perform better in the private
sector due to the profit incentive and
competitive pressure.
B A firm in the public sector may do better than
the one in the private sector, as it may base its
production decisions on the full costs and
benefits of those decisions.
13.2 The advantages of a market economic
system
A market economic system has the potential to
provide some significant, connected
advantages.
 Power to determine
A market economic system should be very
responsive to changes in consumer demand.
In fact in this economic system, consumers are
said to be sovereign. This means that it is
consumers who have the power to determine
what is produced .
 Increasing in demand and falling in
demand
• Resources should change automatically and
quickly to reflect changes in consumer
demand. This is for three reasons.
• One is that the price mechanism in a market
economic system provides information on
which products are increasing in demand and
which ones are falling in demand.
 Incentive for resources to move
• The second is that the market economic system
provides an incentive for resources to move in
response to changes in demand. For example, if
demand for books is increasing, whilst the
demand for cinema tickets is falling, profits and
wages will be rising in the publishing industry,
while they will be falling in the film industry.
These changes will encourage some firms to
switch production and some workers to change
their jobs.
 Punishment
• The third reason is that the market economic
system punishes those firms, workers and
owners of capital and land who do not
respond to changing demand.
• For example, if a firm continues to produce a
product which is falling in demand, it will
make a loss.
 Consumers choice
• There is choice Consumers can choose which
products to buy and which firms to buy from.
Firms can also decide what they want to
produce and workers can choose who to work
for.
 Costs and prices
• Costs and prices may be low. The profit motive
and competition promote efficiency Those
firms which produce at the lowest costs. and
so which are able to charge the lowest prices,
are likely to sell more and earn more profit.
 Cost per unit
• In contrast, those firms which produce
products of the same quality at a higher price
are likely to go out of business .Indeed, by
rewarding efficiency, and punishing
inefficiency, the market economic system
should encourage the production of the goods
and services that consumers want and are
prepared to pay for, in the right quantities and
at the lowest possible cost per unit.
 Quality may be high
• Quality may be high, Market forces can promote
the improvement of methods of production and
a rise in the quality of products made. It does
this by putting competitive pressure on firms,
and by providing them with the profit incentive
to try to gain more sales by making their
products more attractive to consumers.
 13.3 The disadvantages of a market
economic system
There is a risk that the market forces of
demand and supply may not work well. In fact,
market failure may occur, with market forces
failing to ensure the maximum benefit for
society. There are a number of reasons for
this.
 Costs and benefits
• Consumers and private sector firms may only take into
account the costs and benefits to themselves, and not
the costs and benefits of their decisions to others.
• For example, some people may smoke, even if it
annoys and endangers their health of those around
them. Another example is that to keep their costs and
prices down, firms may dump waste material in local
rivers rather than process it.
 Competition between firms
• Competition between firms should ensure
efficiency but, in practice, there may be little
competition A market may become dominated by
one or a few firms. These firms have considerable
market power leading to limited or no choice for
consumers. They can raise the prices of their
products and produce poor quality products. as
people have no choice but to buy from them.
 Lack of right skills
• Even when there is competition and firms
want to respond to desires of consumers, they
may not be able to do this This may be
because they cannot attract more workers as
workers lack the right skills or are
geographically immobile
 Financial incentive
• Firms will not make products unless they think they can
charge for them. There are some products, such as
defence, which most people may want, but know that if
they are provided for some, they will have to be
provided for all. In such cases, people can act as free
riders. They can benefit from the product even if they
do not pay for it. When it is not possible to exclude non-
payers, private sector firms do not have the financial
incentive to produce the product
 Advertising
• Advertising can distort consumer choice. It can
persuade people to buy products they would
not otherwise have wanted or encourage
them to buy larger quantities. Consumers and
producers may also lack information and
hence may make inefficient choices.
 Failing to achieve Efficiency
• As well as market forces sometimes failing to achieve
efficiency, they can also result in what may be regarded to
be inequitable (unfair) outcomes. In a market economic
system, some consumers will have a lack of income. There
can be a very uneven distribution of income, with some
people being very rich, and others being very poor. The sick
and disabled may find at difficult to earn incomes. The old
may not have made adequate financial provision for their
retirement. Some workers may become unemployed and
may find it difficult to find new jobs
 Differences in income
• Differences in income will increase over time. Those
earning high incomes can afford to save and buy shares.
Their savings and shares will earn them interest and
dividends (a share of profits). In contrast, the poor cannot
afford to save. The children of the rich will be more likely
than the children of the poor, to earn high incomes. This as
because their parents are able to spend more on their
education, provide better equipment such as computers at
home for them and thus they have high hopes of what they
can achieve .
 Answer
2 1 a Those people whose labour skills are in
high demand are well paid. Entrepreneurs,
who produce what consumers want, can make
high profits. Those with high incomes can save
and earn income from their savings.
B The sick, disabled and old will find it hard to
earn an income.
 Answer
2 a and b are found in a planned economy. c and
d – the profit motive and private ownership of
land are key features of a market economy.
 13.4 Allocative efficiency
Allocative efficiency occurs when resources
are allocated in a way that maximises
consumers satisfaction. This means that firms
produce the products that consumers demand
in the right quantities .
 13.4 Allocative efficiency
• Figure 132a shows allocative efficiency being
achieved with supply matching consumers demand.
• In contrast, Figures 132b and 13.2c depict allocative
inefficiency.
• In the case of 132b there are too few resources
being devoted to the product, which results in a
shortage. In 13.2c. too many resources are allocated
for producing the product and there is a surplus.
Allocative Efficiency
Allocative Inefficiency
Under Production
Allocative Inefficiency
Over Production
 Answer
3 a A fall in demand would be likely to lower the
price.
B The evidence is that resources moved out of
the crisps industry, in response to a decrease
in demand.
 13.5 Productive efficiency
A firm is said to be productively efficient when
it produces at the lowest possible cost per
unit.
 13.5 Productive efficiency
• Again, in a competitive market, a firm has
both an incentive and a threat of punishment
which should drive it towards being
productively efficient. If it can drive its costs
down to the lowest possible level, it may
capture more sales and gain more profit.
If,however, its costs per unit are higher than
its rivals, it will lose market share and possibly
all of its sales.
 Production Possibility Curve
• If a firm is productively efficient it means that
it is not wasting resources. If all producers in a
country are productively efficient, the
economy will be able to make full use of its
resources and hence will be producing on its
production possibility curve.
 Production point
• In Figure 13.3. production point A is productively efficient
With its given resources and technology, the economy is
making as many products as possible Point B is productively
inefficient as some resources are either not being used or
not being put to good use For example. some workers may
be unemployed, some workers may be tying idle, and some
factory and office space may be empty. Also, there may be
some workers involved in jobs to which they are not best
suited and the capabilities of some capital goods may not
be fully exploited.
Fig. 13.3: Productive efficiency (A) and
inefficiency (B)
 13.6 Dynamic efficiency
Dynamic efficiency arises when resources are used
efficiently, over a period of time .
The profit incentive, and threat of going out of business, can
encourage firms in a market system to spend money on
research and development, and to Innovate Those firms
that introduce new methods of production and bring out
new. improved products, increase their chance of gaining
high profits. Those that do not seek to keep up with new
ideas to produce products and do not develop new
products. run the risk of being driven out of the market.
 Answer
3 a Bata is likely to have chosen to produce
handbags because of rising consumer
demand.
B Consumers may benefit from the firm
spending more on research and development
and investment, as this would improve the
quality and quantity of its existing products
and also stimulate the introduction of new
products.
13.7 Examples of the different economic
systems
To a certain extent all economies are mixed
economies This is because there is some
government intervention in all economies and
some private sector production.
 Mixed economy
• The term mixed economy, or mixed economic
system. however, is largely used to describe an
economy which has private and public sectors
of reasonably similar sizes. An example of such
an economy is Sweden.
 Market Economy
• Whilst there is no economy without a public sector.
the USA is often described as a market economy. The
US government does carry out some functions, for
example providing defence. The economy is
nevertheless, considered to be a market economy as
most capital and land is owned by individuals, and
groups of individuals, and market forces play the key
role in deciding the fundamental economic questions.
 Planned Economy
• In North Korea, there is a very limited degree
of small scale private sector agricultural
production but the economy is largely a
planned economy. Most land and capital is
owned by the government and it makes most
of the decisions as to what to produce. how to
produce it and who receives the output .
 Changes in economic systems
In the 1980s and 1990s a number of economies.
including the UK and New Zealand, moved from
being largely mixed economies to being mainly
market economies. The role of the government
was reduced by removing a number of
government regulations, selling off SOEs and
parts of SOEs (privatisation) and lowering
taxation .
 Multiple choice questions
I What is an advantage of a market economy?
A An absence of poverty
B Consumer sovereignty
C Firms having considerable market power
D Full employment
 Multiple choice questions
2 What encourages firms to produce what
consumers demand?
A The chance to earn a high profit
B The chance to experience high unit costs of
production
C The desire to attract new firms into the
industry
D The desire to keep revenue as low as possible
 Multiple choice questions
• 3 The diagram below shows the current position in a
market How will market forces move the situation
towards allocative efficiency?
 Multiple choice questions
• 4 In a market system, what encourages firms
to keep their costs low?
A Competition
B Government regulations
C Subsidies
D Taxation
 Multiple choice questions
5 In the diagram below, which movement shows
an increase in productive efficiency?
 Answer
• 1B
Consumers determine what is produced in a
market economy. Poverty and unemployment
can occur in a market economy. Firms having
considerable market power may be a
disadvantage, as they would be able to charge
high prices.
 Answer
• 2A
Firms that produce what consumers want are
likely to sell more products and earn higher
profits.
 Answer
• 3B
Supply is exceeding demand. The surplus will
cause the price to fall. A lower price will result
in a contraction in supply and an extension in
demand.
 Answer
• 4A
• In a competitive market, firms have to keep
costs down to retain their customers.
 Answer
• 5C
Production points C and D are both inefficient
but C is less efficient than D. D is closer to the
production possibility curve and hence closer
to productive efficiency. The movement from
production point B to C and from A to D both
represent a reduction in productive efficiency.
Points A and B are equally efficient.
 Four-part question
a Identify two differences between the private
sector and the public sector. (2)
b Explain why consumers are said to be sovereign
in a market economic system. (4)
c Analyse me role of profit in a market economic
system. (6)
d Discuss whether or not prices will be low in a
market economic system. (8)
 Answers
A One difference is that firms in the private
sector are owned by shareholders or
individuals whereas firms in the public sector
are owned by the government. Another
difference is that profit is the main aim
followed by firms in the private sector
whereas the public sector may seek to
improve the welfare of the country’s
population.
 Answers
B Consumers are said to be sovereign in a market
economic system as they determine what is
produced. They signal their choices by means of
the price mechanism. If they want to buy more of a
product, they will bid up its price which will
encourage firms to allocate more resources to its
production. If they want to buy less of a product,
the price they are willing to pay will fall. The
reduction in price will result in fewer resources
being allocated to its production.
 Answers
C Profit plays a key role in a market economic
system. Profit is the incentive firms have to
respond to the signals that consumers send
via price changes. The opportunity to earn a
profit encourages firms to produce the
products consumers are willing and able to
buy, using the most efficient methods of
production. If consumers demand more of a
product, its price will be bid up.
 Answers
More revenue will be earned by making the
product, which may increase their profit. If firms
can cut the costs of production by, for instance,
introducing new, more productive capital
equipment, their profit will again rise. Those
firms that are the most efficient will gain the
highest profits. They will have the finance to
expand, while those firms that are inefficient and
cannot make a profit may go out of business.
 Answers
D Prices may be low in a market economic system.
This is because there may be a high level of
competition in such a system and because profit
plays a key role. If there are a high number of firms
competing for the custom of consumers, they will
have to keep their prices low. To make a profit when
prices are low, costs will have to be lower. This
means that firms will have to use the most efficient
methods of production, which keep cost per unit
low and so enable them to charge low prices.
 Answers
• A market economic system, however, does not
mean that all prices will be low. Indeed, if a
market economic system is working efficiently,
the prices of products that are in high demand
will be high relative to those products that are
less popular.
 Answers
• This difference in price will encourage more
resources to be devoted to those products
that are most in demand. The prices of the
popular products may still be lower than
might exist in other types of economic
systems if there is a quick and full response to
changes in market conditions.
 Answers
There is, however, no guarantee that a market
economic system will always work efficiently.
There may not be a high level of competition
in all markets. If one firm dominates a market,
it will have more power than consumers. It
will be able to raise the price it charges
because consumers will not be able to switch
to substitutes.
 Answers
There are a number of other reasons why
inefficiency may occur in a market economic
system, causing prices to be high. For instance,
firms may want to respond to an increase in
consumer demand by producing more.
 Answers
If, however, they have difficulty recruiting
more workers due to the occupational and/or
geographical immobility of labour, they may
not be able to adjust their supply by much.
Inelastic supply will mean an increase in
demand that will result in a higher rise in price
than would have been the case with elastic
supply.
 Answers
A market economic system has the potential to
keep prices low if there is, for instance, a high
level of competition and mobility of factors of
production. In practice, this does not always
occur in all markets.