The Failings of Price Mechanism

The free market is defined by the allocation of resources based upon the functioning of the price mechanism. This takes into account the equilibrium between demand and supply schedules. In this essay I will argue that while the price mechanism may be efficient, there are cases where it fails. Specifically focusing on the case of monopolies and then market failure whereby there are externalities.

The price mechanism does provide efficiency, through the price signaling created by demand and supply schedules. This brings us to a point of equilibrium that is Pareto optimal as neither consumer or producer can be better off without the other being worse off. Furthermore, at this equilibrium we also achieve allocative efficiency, suggesting that there is the best allocation of resources possible. This is shown through the diagram below, at the equilibrium of Qe – Pe.

Equilibrium

We may note that there is producer and consumer surplus, this defines our parameters of Pareto efficiency, any move from the market clearing equilibrium either the producer or consumer may be worse-off. This is limited by not considering the type of market structure that is present.

The monopoly market structure provides evidence for the possible inefficiency that may be incurred through the price mechanism system. This is a consequence of monopolies being able to set their prices, and looking to profit maximise at the point where MC=MR as seen below:

P2The scenario above takes the market away from away from allocative efficiency, and incurs a deadweight loss. This is a result of there being social welfare, which is not taken by the consumer or producer (shown below).

P3

This prices out a range of consumers, so the deadweight loss represents transactions that could have occurred and would have been socially beneficial, but have not occurred. This point is not Pareto optimal as the consumer is worse-off, nor is it allocatively efficient. Allocative efficiency and Pareto optimality could be achieved if the monopoly were to go to the equilibrium of Qe-Pe, this would mean the firm prices at the point where MC=AR, returning to market clearing.

It is important to note that a monopoly may achieve dynamic efficiency, which is unlikely for a perfectly competitive firm as a consequence of having normal profit. The monopoly gains abnormal profit (as shown by the profit margin in graph 2) that can be used for research and development. Taking the example of pharmaceutical companies, it can be noted that this abnormal profit is required for new drugs to be developed, otherwise at the cost of innovation perfectly competitive firms would not be able to supply new or better drugs which may benefit society.

We must also consider inefficiency incurred through firms pursuing aggressive tactics such as using the abnormal profit to set up legal barriers, attempt to takeover smaller firms, and abuse the economics of scale to lower the price in order to stop firms entering the market. This generates greater inefficiency in terms of reducing consumer’s welfare while also ensuring future inefficiency as barriers to entry. An example of this behaviour was shown by the De Beers diamond cartel in the 1980s, where it had a market share of up to 90% (Zimnisky, Paul). This was achieved through persuading independent mines to join the cartel; if they chose not to they would flood the market with diamonds reducing their price thereby pricing them out. They also dictated price through stockpiling in order to limit supply (Zimnisky, Paul). Exemplifying firm behaviour through the price mechanism that yields inefficiency in terms of societies welfare.

The price mechanism may also fail to provide efficiency as a consequence of externalities, which are an effect on a third-party that was not involved in the original transaction that is not accounted for in the price. The degree of inefficiency tends to correlate with the typology of the good in question. The manner in which the market forces operate suggests that the price mechanism is still operating efficiently due to the market clearing, as the externality is not directly shown. We must also consider that there can also be a deadweight loss in this scenario. The externality as an inefficiency may be shown through considering marginal private cost and marginal social cost, in that the market equilibrium is at the price and quantity that corresponds with marginal private cost, not accounting for the social cost:

P4

However, this can be countered by the efficiency stated through the Coase theorem. Suggesting that if bargaining in regards to an externality can occur, then an efficient outcome will be reached, providing there are negligible transaction costs. This scenario is shown below:

P5

In this the net social gain is a result of bargaining in regards to the externality between the two parties, which results in net social gain. This is due to the loss of profit, take for the conventional example used of wind turbines and noise. The turbine company is willing to compensate people suffering from the noise due to the greater gain of using the wind turbines. There is also the opportunity to be Pareto optimal at Q1. However, this theory is limited by assuming the negligible transaction costs, which in reality tends to not be the case.

Consequently, we may examine methods of dealing with externalities, such as taxation and compensation. The case of tax effectively raises the cost of the good or service in order to account for the cost of the externality. Depending on the elasticity of demand we may note a change in the quantity consumed, regardless of that the price is “corrected”. Shown below:

P6

Here the red highlighted area represents the active externality. With the size of the tax shown through the shifting upwards of price. Now at Q1 we operate at a Pareto optimal point, while the cost is at C2, when originally at the cost of C2 there would have been Q2 consumed. When we consider compensation, the total compensation paid is up to the point where cost first meets marginal social cost. With the Pareto optimal quantity at Q1, this makes up for the cost that is unaccounted for in the original transaction, as shown below:

P7

Even though these are theoretically capable of dealing with an externality in order to yield an efficient outcome, we must consider that the government carries them out. Therefore, there is government inefficiency that may be carried through the initial inefficiency of the price mechanism, this is due to the inability to determine the degree of compensation or tax that is required to bring price to the point of market clearing.

Take for example the externality present with industrial fishing. While fishing occurs we may assume that the amount of fishing occurring is so that there is supply to meet demand in order for the market to clear at equilibrium. However, this does not account for the negative effect on fish stocks. Due to the demand for fish exceeding the reproductive rate of fish there is a strain on fish stock. Furthermore, the methods by which fishing occurs such as trawling may adversely affect other sea life. Quotas can prove inefficient in dealing with this problem due to the lack of infrastructure related to dealing with each fishing boat and the policing required. Moreover, this can lead to fisherman using the same methods then stock dumping which also carries negative effects towards the health of sea life. We would not consider tax, as it is not in the government’s interest to raise the cost of living for the population, this leaves compensation. This may be towards subsidising fish farms, reducing the burden on natural fish stocks. Additionally, it could go towards subsiding the fisherman to the decrease in revenue if they were to fish by less efficient but more environmentally friendly means.

In conclusion, we may note that the price mechanism can at times be relied upon for providing efficiency. However, it may fail when we consider market structures such as monopolies, or the case of externalities where there are inefficiencies that are unaccounted for in the market equilibrium. To refine this analysis of price mechanism efficiency we would consider the typology of the goods in services in question such as merit and normal goods, or common access resources.

Almog Adir


 

Bibliography

Zimnisky, Paul. “A Diamond Market No Longer Controlled By De Beers.” Kitco Commentary. 06 June 2013. Web. 02 Nov. 2014.

Copyright Almog Adir © 2014 · All Rights Reserved · My Website

Exchange Rates: Float or Fixed?

money bags

Throughout history countries have adopted both fixed and floating exchange rate systems, usually depending upon the condition of the domestic economy. The value of a currency was traditionally based on a fixed system of gold, which was known as the gold standard. However, due to the limitations incurred by the gold standard such as a restriction on growth through the lack of monetary expansion, free floating systems were adopted. Currently, most developed countries maintain a managed float system which combines aspects of a fixed rate with those of the floating rate.

Free floating exchange rate is where the market forces of supply and demand determine a currency’s value relative to another currency. There are many advantages to the use of this system, as it supports trade and achieves accurate pricing of the currency as the market forces provide price signalling. Nevertheless, the free floating system ensures no government involvement, and this reduces the possibility of market failure. With the absence of government control it is unlikely that the currency will be held at an artificially achieved price which is either over or under valued. Through letting market forces clear the exchange market events such as Black Wednesday can be avoided. Black Wednesday was when the Sterling was pegged to the Deutschmark; there was market speculation that at this exchange rate that the Sterling was being over-valued. This led onto currency traders such as George Soros to undercut the currency by short selling. This had forced the Bank of England to unpeg the currency to allow market forces to clear the market and restore the sterling to a stable value. This exemplifies the danger of fixing the currency, and how this can be easily be avoided by simply letting supply and demand determine the value. This is limited in the fact that speculation can still occur, and developing countries may want to avoid free floating as foreign investors may “bet” either way on the currency and this has national repercussions.

A fixed exchange rate system is where the value of one currency is pegged onto the value of another currency or as mentioned gold; this is done in order to maintain the value of the currency within a given band. Two mechanisms may be used to keep the currency’s value within the band, and these take the form of interest rates and foreign reserves. In a free floating system the interest rate can be varied to any degree in the interest of pursuing monetary policy, whereas in a fixed system the interest rate is only manipulate to ensure the currency’s value stays within its respective band. If the interest rate were to be kept too high, the currency would attract foreign investment leading the currency to strengthen, while the opposite can occur if the interest rate were to be lowered. This means that the government has finite ability in manipulating in the currency for domestic reasons, restricting the pursuit of monetary policies. Furthermore, in order to control the value of a currency a central bank most hold sizeable foreign reserves. The central bank must be able to freely buy and sell the currency in question, and this requires access to foreign reserves. This introduces the possibility of government failure as it is difficult to know how much a foreign currency must be held, and the possible market repercussions of having a preferred reserve currency. In the free floating system these controls are not needed, reducing the possibility of government induced failure, and the free floating system also allows greater monetary flexibility.

The free floating exchange rate system provides an automatic readjustment for an economy’s balance of payments. When a country is running a trade deficit imports are exceeding exports, prompting leakages out of the economy without introducing some kind of injection. Furthermore, as the country maintains a high demand for imports this means that there is a considerable demand for foreign currency, prompting the domestic currency to be supplied. This eventually reaches the point where the domestic currency is supplied to the extent that there is downward pressure on the currency causing it to depreciate in value. This depreciation in value means that the relative price of exports abroad decreases, making them competitive in the foreign markets. It also leads to the relative price increase of imports, as now the domestic currency is less able to purchase foreign currency. This counteracts the trade deficit as now exports will exceed imports closing the trade deficit gap. This is all achieved through the market clearing forces, rather than government intervention which may misallocate resources in an attempt to control the balance of payments. However, this does lead to a cyclical effect where the currency will have stronger and weaker periods. The main limitation in the dependency of the automatic readjustment is that it depends on the type of imports, some developing countries may have staple goods (e.g. gasoline, water, etc.) as their imports, and regardless of currency change their exports may still not be attractive, thus the adjustment does not occur or does not occur to the same extent as it would for a developed country.

Fixed exchange rate systems do promote long run stability, which can be undermined if the market is left to determine the value of the currency. It is beneficial for developing countries to maintain a peg as it helps them plan for the long run, and they need dependable trade flows. As previously mentioned the imports undertaken by developing countries may be basic necessities, so a free floating system may destabilise their ability to import the essentials. With a fixed exchange rate the developing countries can make trade agreements that will be sustainable for a length of time, and ensure some kind of economic stability. Furthermore, there is the removal of administrative costs that are persistent with the free floating system, such as futures contracts, and other types of hedging. Through running a fixed system the currency can be protected from the fluctuations of free floating currencies, which also contributes to the long term planning of developing countries, and a degree of economic stability. One key advantage of the fixed system is that it encourages firms to maintain productive and allocative efficiency so that they can compete in international trade. When a currency is pegged it is difficult to depreciate its value to make exports more competitive, thus producers are driven to allocate their resources wisely and ensure efficiency in order to cut down operational and productive costs.

When comparing the two systems it is clear that a mix of the two is suitable for many developed countries, whereas a fixed rate system has more direct benefits to developing countries who aim for stable growth. In a managed float the two fixing mechanisms can be employed in order to manipulate the value of the currency, but as the currency remains unpegged the overriding market force is that of supply and demand so it is unlikely that the currency will be over or under valued even with the use of fixed system controls. The free floating system has quite considerable benefits, as it not only reduces government intervention but also provides the automatic adjustment of the balance of payments, and monetary flexibility which has become integral in a post financial crisis economic climate.

Overfishing (Market Failure)

What are the main causes and consequences of the market failure in fishing?

The main cause of the market failure in fishing is the over-consumption and demand for all varieties of fish and seafood.  This is driven by government subsidies aimed to help the fishing industry as they are a considerable part of the economy, as some towns and cities are dependent on fisherman traffic. Governments are also contributing subsidies in the interest of keep food prices down, in foods such as fish which have become common in global diets.

The consequence of this over-consumption is the clear over-fishing and exploitation of the varieties of fish that can be consumed. There is now a growing dependence on fish farms to supply for the demand of fish.

The central external costs of the supply in fish contributing to market failure are:

  • The eventual extinction of specific species of fish
  • Accidental catch of other unwanted fish, reducing general population
  • Algal blooms, caused by dead fish left in sea and ocean
  • Weakening ecosystems, to near collapse
  • Loss of large fish i.e. Tuna
  • Forced government subsidisation
  • Less beautiful underwater cultures for tourism
  • Depleting natural resources
  • Driving small businesses out

The cause of the over-fishing is difficult to pin on a single source as it is both the demand of consumers, as well as the argument “well there will be no difference if the fish are taken now or in a months’ time”.

There is the developing issue of illegal fishing, even though laws and regulations have been set in place to only allow fishing within certain areas it is costly and difficult to actually enforce these laws and regulations. This issue develops on the point that companies now go to other countries to fish as there are less restrictions on quotas, such as the Senegal example where local fishing business is beginning to be taken by corporations.

A cause of over-fishing can be attributed to the methods used to obtain fish, even though they are the most effective and efficient there is a lot of unwanted catch in fine mesh nets and trawling methods. This is why there is a major breakup in the food chain of the species, and has a residing effect on the ecosystem of the fish whether big or small.

Facts:

Globally, some 75 per cent of wild marine fish are now said to be either fully-exploited or overfished, according to the United Nations’ Food and Agriculture Organisation (UN FAO)

Fish farming, now provides almost half of all the fish consumed by humans.

Development of crime in areas such as Somalia, and Senegal

Have the government solutions to over-fishing made the situation worse?

Overall, it can be argued that the government has not really made a clear attempt for a solution and if anything has made the situation worse. Governments throughout Europe, Asia, and American have made it a prerogative to subsidise the fishing industries.  This is an attempt to keep the industries alive even though they are catching less wanted fish then in the late 19th century and throughout the 20th century.  Governments have made it more worthwhile for fisherman to try and scavenge for what is out there rather than protect fish stocks for the future, and this is what the subsidies have achieved.

In regards to further failure by the government is the inability to abide or follow advice on quotas on the amount of fish that can be fished per day to ensure that there is no complete collapse of a species or ecosystem. Most quotas that governments set range between 20%-40% higher than what scientists advise. There is also the issue of policing this which the government is not completely committed too.  This is because the market failure is heavier on the government and producer side than the consumer. As consumers have not been offered viable alternatives to fish, there is the continued over-consumption.

In a sense government solutions have not done enough as over-fishing is only one cause for the general decline in fish stocks as there is also global warming, and illegal fishing. Global warming has had serious implications on the quality of sea life, and has encouraged the dependency on fish farms to provide common fish. The issue here is that the fish farms still fish to provide smaller fish to larger fish such as tuna.  This has started a vicious cycle which the government has not successfully intervened, and if anything encouraged fisherman to not follow quotas.

There is also the ban of catching certain fish; again this government intervention further contributes to the market failure as it simply makes those fish more desirable. There is also a lower price on farmed fish as they are considered a lesser good than natural fish. There has been no attempt to tax depending on unwanted fish taken, or hand out certain areas of water where companies have to personally decide how to take care of the land.

Facts:

Unfair Fisheries Partnership Agreements that allow foreign fleets to overfish in the waters of developing countries.

The cost of mismanagement, in lost economic output, is huge: some $50 billion a year, according to the World Bank.

 

What action would you suggest to reduce the damage done by overfishing while supporting those who depend on the fishing industry?

There needs to be a clear change in government policy as well as the manner in which fishing is done. There should be a greater stress on achievable regulation, and possibly an increase in prices.

Governments may choose to continue subsidising the fish industry, but should begin to subsidise fish farms that grow all the fish needed to feed bigger carnivorous fish. This will produce self-sustaining fish farms that are no longer reliant on the fishing of small fish to provide feed.

Governments should agree that only local fish is not taxed within a country, so in the case of salmon being supplied in Scotland has no tax, whereas if it was exported to another country there would be an export tax in the country of origin, and an import tax in the receiving country. This would accurately price the cost of the fish, and especially rarer fish.

Industry standards have to change; this can be done by introducing time frames that fishing is allowed within the season. Beyond this if a boat goes out to fish for a week then it may only actively fish on 4 of those 7 days, ensuring that quotas are met not over reached. Also in the equipment used for fishing to ban the use of trawling, and fine mesh nets. The method of trawling has adverse effects to the ecosystems, and fine mesh nets produce a lot of unwanted catch of small juvenile fish therefore further reducing the chances of endangered species.

No fish zones need to be created in areas where the ecosystem has suffered or there is the chance of a fish becoming extinct, this is done today but I would call for an international body to police these zones to ensure there is no illegal fishing whether industrial or local.

For a time temporary bans on certain fish would have to be placed, this would reduce the number of jobs and profitability of the industry, however this ensures job safety in the future by allowing the fish populations to naturally increase without intervention.

Facts:

Restoring these stocks could deliver up to £14.62 billion per year in gross revenues. This is 2.7 times the current (2010) value of their landings

The size of investment required to achieve this is £10.4 billion over the entire transition period (9.4 years) – £9.16 billion in present value terms

What Are The Best Methods For Stopping People Smoking?

In class we went through this question in a format of open discussion. We initially got distracted by our favorite economists (I having a thing for Milton Friedman) and then the so called “devil” of economics Alan Greenspan. I have respect for Greenspan and his intellect with economics, but his role in the sub-prime mortgage crisis was clear. Ironically Greenspan wrote his PhD dissertation with comments on soaring house prices and effects on consumer spending as well as anticipating a burst of the housing bubble.

In class we had a discussion based upon this question. Immediately we were separated into two camps, how inelastic or elastic was the demand for cigarettes. I put forward my opinion that the demand for cigarettes is more inelastic then elastic, many because those that smoke tend to continue to smoke and factors such as addiction help maintain the demand. From personal experience I know that people who smoke will buy cigarettes at any price, because they feel they need them.

In regards to the question, we came up with a list of several methods to stop people smoking.

Change in Cost:

  • Raise Excise Tax (duty)
  • Sales Tax (we considered it more effective as it is direct and the consumer notices)
  • Goods and Services Tax (direct)
  • VAT
  • Tax on the production of tobacco, and the production of cigarettes

Change in Branding & Advertising:

  • Blank Packaging (no picture, white box, and small lettering for brand name)
  • Gore Images (pictures on the boxes of people in hospital or tar in lungs)
  • Laws on Advertising (ban on advertising tobacco products on television & radio)
  • Supermarkets & General Stores Must Hide Tobacco Products

Public Restrictions:

  • No Smoking Inside or Workplaces (fines)
  • No Smoking on Public Transport (fines)
  • No Smoking in Public Places e.g. Trafalgar Square (fines)
  • No Smoking Around Minors (Under 18)

 

Our ideas regarding cost brought up an interesting question, at what price will people stop buying cigarettes due to the major increase in opportunity cost? This is a problem with changing the price of cigarettes that due to factors such as addiction people still may consume them at the greater price, which just means the government is making money from the tax and not helping the people.

I would argue that introducing greater public restrictions would dramatically change the elasticity of the demand for cigarettes. This is because even though smokers see cigarettes as a need, they will be restricted where they can smoke, making it harder for them too smoke. The change in branding and advertising may just lead to a downward shift in demand but not too dramatic.

Towards the end of the harkness discussion we all clearly agreed that the prohibition of smoking would be preposterous idea as it would introduce a black market (greater than the current one). I personally do not believe it is the role of the government to stop people smoking; all the government must do is offer people assistance in stopping smoking and make decisions while aware of the health implications of smoking. We cannot simply bury the tobacco companies as they are a considerable part of economy. If people want to make bad decisions then let them, we are all ultimately responsible for ourselves. This is why I am in favor of public restrictions on smoking, such as no smoking inside, because that way others do not have to suffer from others problems.

While on the note of prohibition, I brought up the example of the legalization of marijuana. Currently marijuana being illegal leaves it on the black market, unregulated and easier to purchase by minors than tobacco and alcohol. Strict regulation and smart policies can help us control so called “sin” products such as tobacco, alcohol, and marijuana. I believe that this would be a more effective war on drugs, than the United States attempt.