How Does Price Serve as a Rationing Mechanism in a Market Economy - Coursework Example

ECO101 ASSESSMENT I Chapter 3 How does price serve as a rationing mechanism in a market economy Explain. In a market economy the price system acts as automatic hand in the market. The equilibrium price and quantity is determined by the interaction of demand and supply. The demand curve of a consumer for a product reflects the behaviour of its marginal utility. By the horizontal summation of the individual demand curve we get the market demand curve. On the other hand the supply curve of each producer reflects the behaviour of his marginal cost. The lateral summation of the individual supply curves determines the market supply curve. The intersection of market demand and supply curves determines the equilibrium price and quantity. Dd A B S P** P* E Q In a market economy the price system automatically acts as a rationing instrument. With the help of the diagram given above we can easily explain the determination of market price and at the given demand and supply functions and the system will not allow either of the agents to exploit other. The horizontal and vertical axes measure quantity and price respectively. D is the market demand curve showing the one to one correspondence between price and market demand. S is the market supply curve that reflects the producers’ behaviour. S is nothing but the one to one correspondence between market price and supply of it. Equilibrium is achieved at point E where market demand equals market supply. The equilibrium level of price is OP* and quantity is OQ*. Now we consider that producers want to exploit the consumers by charging higher price. What will be the impact$2 Let’s consider that the producer charges new price OP**. At that price level the producers will be willing to supply OQ** amount of output while the consumers are willing to purchase OQd amount of the product. Hence at price OP** the market will face excess demand to the extent AB. This excess demand would cause a downward pressure on price as the producers have the unsold stock in the hand. Price fall would be followed by contraction in supply (movement from B to E) and extension in demand (movement from A to E). This process is continued unless the previous equilibrium is achieved. Here automatic adjustment of price will control the quantity in the market. (Stonier and Hague, 38-39) Chapter 1 1. Producing goods can add to net wealth, but rendering services cannot. Explain. To answer the aforesaid question we need to know what wealth is. Generally wealth can be defined as something that can generate income or can satisfy human wants. Wealth must be measurable tangible, transferable and scarce in nature. When the goods are produced through the production process it adds to the stock of wealth of the nation. As good is measurable, tangible and transferable we can say that production of good means generation of wealth and addition to the stock of net wealth. The goods can be used in two ways: either it is use in further production of something else in that case the good is called a capital good or investment good. The example is a machine tool. It has the capacity to create wealth. On the other hand goods can be used to satisfy human wants in the form of utility. The best example is food, which can satisfy human hunger. In both way goods are said wealth and production of goods mean addition to the stock of wealth. Now we can consider services. Services are intangible. Whenever the services are produced that is not considered as an addition to the stock. The factors of production receive the reward certainly. But that is not generation of wealth; rather it can be called a transfer of income. So the production of service does not mean the addition to the stock of wealth. But in the modern concept the meaning of wealth has been broadened. If a service generates some income it can be considered to be a wealth component. In modern age we have the concept of human capital i.e. the efficiency in production or the managerial or administrative efficiency of a human being can be considered as wealth though those are non tangible. For example in the educational institutions or training centers the service that the students get increases their efficiency which, in future would be reflected in higher productivity and higher generation of wealth. So services are also included in the modern concept. 2. Explain and Identify some problems or issues that are both economic and political. There are different issues, which are economic, and there are many issues, which are hardcore economic issues. But there are some issues in economics in which the political aspects and the economic aspects are interrelated to each other. For example we can use the long celebrated debate over the interventionist and non interventionist approach. One of the most famous issues of political economy is the dependency theory of economics. The economists who belong to dependency school are in favour of the argument that the emergence of capitalism in the developed countries through global trade has always exploited the underdeveloped countries. The incorporation of capitalism in these countries has drained out the surplus from the underdeveloped countries. That’s why they have marked underdevelopment as a historical process. For example Paul Baran has mentioned that by colonizing India the British could enjoy the opportunity to sell their product at a large market to drain out the surplus. This is an example in which political power is used for economic gain of a country. This colonization drained out the surplus from India to Britain and India became an underdeveloped country. On the other hand the economists like Frank, Dos Santos etc believe that the long term trading relationship between a developed and underdeveloped countries makes the underdeveloped countries dependent upon the developed countries. So the developed countries have used their political and economic power to exploit the underdeveloped ones. A centre (developed) periphery (underdeveloped) relationship is created. ( Thirlwall 132-134) On the other hand, in case of a country the suffering from balance of payments crisis and unemployment. The orthodox economist prescribes hands off policy by the government so that the market forces could automatically lead towards the situation characterized by internal as well as external balance. But the immediate deterioration of the unemployment situation may lead towards public opinion against government. That’s why the populist government adopts the policy of stabilization being forced by the political aspects. 3. Explain why economics is a science, and how it differs from a physical science. Science means logic. Each and every branch of science is based on some strong logic, reasoning and basic foundation. Economics is also a science in this context. It is based on some sound logic, strong reasoning and some analyses. So economics is included into the set of science. But there remains the question what type of science it is. In economics we deal with human behaviour. The social and economic interaction among the people is considered. We consider the nature and strength of different social, economic and political forces, the interaction between the nations, the market forces, the strategies of government, welfare of the people etc. Human being, human welfare especially social welfare is the main concerns of economics. Hence economics may be called a social science which is based on the behaviour of the individual and society. Here analysis is made on the behaviour of individual and society under different circumstances, states of conditioning and the policy by the state. As we see the human behaviour many times our obtained result does not match the assumed result. This is simply because of various differences in the psychology, the environment and many other subtle matters. Economics is quite difference from other physical sciences. In physical science we analyze what actually is. But in the study of economics we deal with what should be. We are concerned with what the ideal situation should be and how we can obtain such situations. That’s why we define economics as a normative science. Chapter 2 1. Relate the declaration of war by the United States against terrorism to the production possibilities curve. Whenever any country engages in a war it is certain to face some social, economic and political problem. Here we would like to consider the impact of the America’s anti terrorism wars on its economic circumstances. The famous or long debated America’s war against terrorism has generated enough economic problem of the country. First of all the public has bear to the war expenditure either directly or indirectly. Direct burden that the consumer has to face is tax. Higher tax burden would be reflected in lower saving. Lower saving causes a fall in the supply of the lendable fund, which would, in turn, pull up the interest rate. Consequently the private investment would choke off causing a decline in the productivity. On the other hand even if the government does not introduce any war tax the increased public expenditure on war also puts upward pressure on the rate of interest and the private investment. So the productive capacity would decline which would be reflected by a change in the production possibility frontier of the economy. (NAFTA) T T* O T* T TT=Production Possibility frontier in normal time T*T*= Production Possibility frontier in war time In the figure the horizontal axis measures the production of X and the vertical axis measures the production of commodity Y. Production possibility curve is the locus of different combinations of two commodities that can be produced given the factor endowment and technology with the assumption of fullest utilization of capacity. Here TT is the PPC of the country at normal time. But in the war period the productive capacity declines sharply due to the disturbance. Hence PPC shifts from TT to T*T*. For the sake of diagrammatic convenience we have taken a two commodity space. So we can see a decline in supply side. On the other hand enhanced public expenditure on war would not let the aggregate demand fall. So the aggregate supply at the existing price falls shorter than aggregate demand. The economy faces a stagflation (stagnation +inflation). . 2. The North American Free Trade Agreement signed in 1993 lowered tariffs among the United States, Canada, and Mexico. What would proponents of the treaty consider to be the likely benefits$3 The North American Free Trade Agreement (NAFTA) took place among Canada, Mexico and the United States in December 1992. The proponents of the treaties assumed that the participants would be able to enjoy the following benefits. 1. As the trade barriers were proposed to be removed the agreement was supposed to promote an environment of a fare competition, which would increase the efficiency of the system. The consumers would be highly benefited by this free flow of goods and services. 2. The fare competition would be reflected in most cost effective modes of production. 3. There would be sufficient investment opportunities within the territory that would provide more room for employment and generation of income. The sustainable investment opportunities would increase the profitability. 4. The intellectual property rights would be subject to enforcement that would provide stimuli for research and development which would ultimately increase the overall welfare of the participant countries. 5. The disputes regarding trade could easily be resolved. That would strengthen the market system. 6. The success of this treaty would encourage further multilateral cooperation and formation of trading blocks. That would be healthy for further trade expansion. ( NAFTA) 3. Assume that you have won a prize of $10,000. Make a list of how you would spend and save the money, from most important to least important. As an individual I have some basic needs for life. My basic needs are food, cloth, shelter, health facilities, education, recreation and quality of life etc. When I will have some extra money in windfall gain I will certainly try to do something that would increase my welfare and benefit. The first part of my spending would be to secure my basic needs of life. This money would help me to be better fed better clothed. Of course I will spend sufficient amount of money to have better food and cloth. I will try to spend some money in the maintenance of my home. After consumption we have two options left in my hand i.e. either I can save the excess money in form of some bank deposit it may be a saving deposit or it may be a time deposit, or I can spend my money to make money out of it. I can opt for further investment either in share or equity or debenture or mutual fund. In this way money can be made out of money. On the other hand I can invest it in form of education. I may spend the money to attend any training course that would enable me to secure a good job in future, which would provide me higher amount of money, perquisites and opportunity to reach a high level of success. Actually options are many for an individual to spend money but the ultimate usage would depend upon the taste and preference and the utility pattern of the person who has it. It may be used for long term gains may be for short term ones. It may be used in present consumption may be on future consumption. The ultimate decision depends upon the person who owns it. 4. Give some examples of the operation of the principle of comparative advantage. Famous British economist David Ricardo propounded the famous theory of comparative advantage. His theory is based on a two-country two commodity single factor framework. Ricardo assumed the perfect mobility of factor only in national boundary and fullest utilization of existing capacity. The comparative advantage is nothing but the difference in opportunity cost of one product in terms of another between countries. For example if the opportunity cost of commodity X in terms of Y is lower in country A than that in B we can say country A enjoys comparative advantage in production of X over country B and vice versa. Ricardo used the example of England and Portugal both producing wine and cloth. The labour hours required to produce 1 unit of cloth is 90 and to produce 1 unit of wine is 80 in Portugal. In England those are 120 and 100 respectively. In this situation Portugal enjoys advantageous position in both lines of production. But still trade is mutually beneficial. Under full employment situation Portugal has to shift 80 labour hours from cloth to wine industry to produce 1 additional unit of wine. The production of cloth is hampered by 80/90 units=8/9=units=0.88 units. This is the opportunity cost of wine in terms of cloth in Portugal. This is the autarkic exchange rate of Portugal. On the other hand in England 120 labour hours should be transferred towards cloth to wine industries. The production of cloth is hampered by 120/100 unit=1.2 units. Hence Portugal enjoys comparative advantage over England in production of wine. Now if the global exchange rate is 1:1 then Portugal sells wine and England sells cloth. By selling 1 unit of wine Portugal receives 1 unit of cloth while under autarky it was 0.88 units. On the other hand now England has to spend only 1 unit of cloth to get 1 unit of wine. Both enjoy some benefit from trade. (Caves, Frankel and Jones, 73-75) Chapter 3 2. What are some differences between a command economy and a market economy$4 In a command economy a central planning authority makes all the decisions. The market forces have no role to play in the decisions like what to produce how to produce and for whom to produce. Here the central authority owns all the factors of production. The authority determines the prices of the commodities. All the goods and services are owned by the state and state distributes it according to the need of the people. (Todaro and Smith, 680-682 and 696-698) On the other hand a market economy refers to an economic system in which the state plays no role in the economic action and reactions within the economy. The government only intervenes in securing the national sovereignty (defence), in maintaining the law and order etc. the market forces dominate. The production, consumption and distribution pattern are controlled by the demand and supply (the market forces) the producers are guided by the objective of profit maximization and the consumers are directed by the objective of the maximization of utility. The state does not intervene in the market mechanism. The former United States of Soviet Union was an example of a command economy. On the other hand United States of America is an example of a market economy or Capitalist Economy. 3. What are the five main economic goals of the United States$5 The economic goals of any country generally targets at the development of the country in a sustained path. This is true for both developed and underdeveloped economies. The United States has also its economic goals. We may discuss those in the following paragraphs: 1. The first goal is to attain and maintain the full employment situation in which any labour that is willing to work at existing wage gets the opportunity to work, any capital owner who wants to lend his capital at existing rate of return can get an opportunity of it. The landowner gets a fair return from land. It is a macroeconomic indicator. To do this we require the conditioning of a whole economy instead of concentration on a single region. This goal is the responsibility of the US government. In United States the government uses an employment act for securing the level of full employment. Desired unemployment rate is 0% in this country. Most of the economists favour the required government intervention to secure 100% employment. 2. After securing employment the next goal of the federal government is to maintain price stability. Price stability refers to the absence of inflation or a very mild rate of inflation. Inflation refers to the consistent rise in the price level. In United States the consumer price index is the measurement of inflation. Whenever the inflation takes place at an excessive rate it causes a decline in the standard of living in the country. The interest of the consumers is hampered. On the other hand whenever inflation takes place the domestic products lose their competitiveness in the global market which may in turn lead towards a balance of trade deficit. That may lead towards stagnation. On the other hand, during the inflation there is a redistribution of wealth. The poor become poorer and the rich become richer which would lead towards mal distribution. On the other hand the goal to control inflation and unemployment are sometimes contradictory to each other. 3. To maintain a sustainable rate of economic growth is another main economic goal of America. The growth means a rise in the gross domestic product of the country. Higher the rate of rise in GDP higher would be the growth rate. The economic growth is generally followed by an increased standard of living of the people of the country. But one condition is required. The growth rate of gross domestic product should exceed the growth rate of population. That would lead towards a growth in per capita income which is an indicator of economic development. 4. Another major goal of the country is to promote free trade among the nations. The free trade refers to the abolition of the trade barriers and speed up the rate of the international flow of goods and services. This will enhance the competition and efficiency in domestic market. The consumers’ welfare would also be enhanced. Free trade would also help the country to earn huge foreign currency which would enrich the country and help to increase the growth rate. 5. Another major economic goal is to secure an even distribution of income within the country. The fair distribution of income is an indicator of economic development. The government has to adopt the measures to ensure an equitable distribution. (Economic Goals) References 1. “Economic Goals”, 2008, retrieved on June 19, 2008, from: http://www.sbea.mtu.edu/jrgale/EC3001/ECONOMICGOALS.htm 2. Micheal P Todaro and Stephen C. Smith, Economic Development, Eighth Edition,2003, Pearson Education, Inc 3. NAFTA, “Organisation of American States”, 2008, retrieved on June 19, 2008, from: http://www-old.itcilo.org/actrav/actrav-english/telearn/global/ilo/blokit/nafta.htm#Chapter%20One%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20%20Objectives 4. Richard E Caves, Jeffrey A. Frankel and Ronald W. Jones, World Trade and Payments: An Introduction, 9th Edition , Pearson Education, Inc 5. Stonier, Alfred.W and Hague,C.Hague ; A Textbook of Economic Theory. English Language Book Society, Year-1980, Fifth Edition 6. Thirlwall A.P, Growth and Development: With Special Reference to Developing Countries, Fifth Edition, 1994, Published By- English Language Book Society \ Read More