According to economics.about (n.d), a market is any place where the sellers of a particular good or service can meet with buyers of that goods and service where there is a potential for a transaction to take place. The buyers must have something they can offer in exchange for there to be a potential transaction. A market is any convenient set of arrangements by which buyers and sellers communicate to exchange goods and services (Alain, 2008).
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MEANING OF MARKET SYSTEM
According to businessdictionary (n.d), the market system is the social network that permits interaction between buyers and sellers. It includes all the rules and regulations, the reputation and credentials of the companies and individuals involved. The market system is where market players bid and ask. Auctions, rationing, black market and free market, real estate market, stock market and others are types of market system.
According to dictionary.reference (n.d), a free market system is an economic system in which prices and wages are determined by unrestricted competition between businesses, without government regulation or fear of monopolies. Also, a free market economic system is an economic system that allows supply and demand to regulate prices, wages and salaries rather than government policy. A free market economy is the production and exchange of goods and services or from monopolies.
Adam Smith, in his book An Enquiry into the Nature and Causes of the Wealth of Nations, attacked the economic system of his day. It was a system founded upon protectionism, economic restrictions and numerous legal barriers. He represented a powerful case for a free market system in which the â€˜invisible handâ€™ of the market would allocate resources to everyoneâ€™s advantage. There are three main types of actor or agent in the market system, which are the consumer, the firm and owners of the factors of production (Alain, 2008).
THE MAIN ACTORS IN THE MARKET
The consumer: In a pure free market system it is the consumer who is all powerful. Consumers are free to spend their money however they want and the market offers a wide choice of products. It is assumed that consumers will allocate their scarce resources so as to maximise their welfare, satisfaction or utility (Alain, 2008).
The firm: In a pure free market, firms are servants of the consumer. They are motivated by making as high a profit as possible. This means maximising the difference between revenues and costs.
Revenues: If they fail to produce goods and consumers wish to buy, they would not be able to sell them. Consumers will buy from companies which produce the goods they want. Successful companies will have high revenues; unsuccessful ones will have low revenues.
Cost: If firms fail to maximise cost, then they will fail to make profit. Other more efficient firms will be able to take their market away from them by selling at a lower price.
The price of failure, making insufficient profit to retain resources and preventing factor owners from allocating their resources in more profitable ways will be the exit of the firm from its industry. On the other hand, in the long run firms cannot make higher than average levels of profit. If they did, new competitors would enter the industry by the high profits, driving down prices and profits and increasing output (Alain 2008).
Owners of the factors of production: Owners of land, labour and capital, rentiers, workers and capitalists are motivated by the desire to maximise their returns. Landowners wish to rent their land at the highest possible price. Workers wish to hire themselves out at the highest possible wage, all other things being equal. Capitalists wish to receive the highest rate of return on capital. These owners will search in the market place for the highest possible reward and only when they have found it will they offer their factor for employment. Firms on the other hand, will be seeking to minimise cost. They will only be prepared to pay the owner the value of the factor in the production process (Alain, 2008).
CHARACTERISTICS OF MARKET
The essential features of a market are;
An Area: In economics, a market does not mean a particular place but the whole region where sellers and buyers of a product are spread. Modern mode communication and transport have made the market area for a product very wide (Jhingan, 2007).
One commodity: In economics, a market is not related to a place but particular product. Hence, there are separate markets for clothes, grains, jewellery, and so on (Jhingan, 2007).
Buyers and Sellers: The attendance of buyers and sellers is necessary for the sale and purchase of a product in the market. In the modern age, the attendance of buyers and sellers is not necessary in the market because they can do transaction of goods through letters, telephones, business representatives and internet (Jhingan, 2007).
Free competition: There should be free competition among buyers and sellers in the market. This competition is in relation to the price determination of a product among buyers and sellers (Jhingan, 2007).
One price: The price of a product is not changed in the market because of free competition among buyers and sellers (Jhingan, 2007).
JUDGING THE MARKET
Markets are one way of allocating resources. There are alternatives. For instance, the government could allocate resources as it does with defence, education or the police. Economists are interested in knowing how to judge whether markets are the best way of allocating resources. There are two main ways in which they do this; first, they consider whether markets are efficient ways of allocating resources. By this, we mean whether firms produce at lowest cost and are responsive to the needs of consumers. Second, they consider issues of equity. Efficiency takes income distribution for granted. However, is income and wealth in society distributed in an acceptable way? If resources are allocated inefficiently and inequitably, then there may be a case for government to intervene, either by altering conditions in the market or by removing production from the market mechanism altogether (Alain, 2008).
REASONS WHY MARKET SYSTEM IS NOT ABLE TO ALLOCATE THE RESOURCES EFFICIENTLY
Market though does not necessarily lead to economic efficiency. Market failure occurs when markets lead to an inefficient allocation of resources. In some markets, there is partial market failure where the market exists but there is over production or under production of goods. In the real world, there is non-attainment of optimality (or optimum welfare) due to a number of limiting factors in the working of perfect competition. These lead to market failure. Therefore, market failure refers to the circumstances under which market fail to allocate resources efficiently. These are discussed under: (Jhingan, 2007)
The presence of externalities in consumption and production also lead to market failure. Externalities are market imperfections where the market does not offer price for service or disservice. These externalities lead to misallocation of resources and then cause the consumption or production to fall short. Externalities, also known as external economies and diseconomies, lead to the divergence of social costs from private costs and of social benefits from private benefits. When social costs and private costs and benefits diverge, perfect competition will not achieve optimality. Because under perfect competition Private Marginal Cost (PMC) is equated to Private Marginal Benefit (that is, the price of the product) (Jhingan, 2007).
Prices and profits should be in accurate signals, allowing markets to allocate resources efficiently. In reality, market prices and profits can be misleading because they may not reflect the true prices and profits to society of economic activities. These differences are known as the externalities of an economic activity. For instance, in Brazil it makes commercial sense to cut down the rain forest to create grazing land for cattle sold to the west as meat for hamburgers. However, this could lead to economic catastrophe in the long term because of global warming. The market is putting out of wrong signals, leading to a misallocation of resources (Nwehinne et al, 2011).
Market failure is not just caused by economic efficiency. It can also be caused by inequality in the economy. In a market economy, the ability of individuals to consume goods depends upon the income of the household in which they live. Household income comes from a variety of sources (Alain, 2008).
Wages are paid to those who work outside the household. In the labour market, different wages are paid to different workers depending on factors such as education, training skill and location (Alain, 2008).
Interest, rent and dividends are earned from the wealth of the household. Wealth may include money in bank and building society accounts, stock and shares, and property (Alain, 2008).
Private pensions are another type of unearned income. Private pensions represent income from a pension fund which can be valued and is a form of wealth (Alain, 2008).
Other income includes state benefits such as unemployment benefit, child benefit and state pensions (Alain, 2008).
The market mechanism may lead to distribution of income which is undesirable or unacceptable. For instance, income levels may be so low that a household is unable to afford basic necessities such as food, shelter or clothing. If healthcare is only provided by the private sector, a household may not be able to afford medical care. The state may then need to intervene, either to provide income in the form of benefits, or goods and services such as healthcare to increase consumption levels (Alain, 2008).
The optimality is based on the assumption of complete divisibility of produce and factors used in consumption and production. In real existence, goods and factors are not infinitely divisible. Instead, they are indivisible. The problem of indivisibility arises in the production of those goods and services that are used jointly by more than one person. An important example is the use of a particular road. But the problem is how to share the cost of repairs and maintenance of the social costs and marginal social benefits which will diverge from each other and optimality will not be achieved (Jhingan, 2007).
4) Common Property Right
Another cause of market failure is a common property resource. The example commonly used is fish in a lake. Any one catches and eats it but no one has an exclusive property right over it. It means that a common property resource is non-excludable (any one can use it) and non-rivalrous (no one has an exclusive right over it). The lake is a common property for all fishermen. When a fisherman catches more fish, he reduces the catch of other fishermen. But he does not count this as a cost, yet it is a cost to society. Because the lake is a common property resource where there is no mechanism to restrict entry and to catch fish. The fishermen who catch more fish impose a negative externality on other fishermen so that the lake is over exploited. This is called the tragedy of the commons which leads to the elimination of social gains due to the overuse of common property. Thus when property rights are common, indefinite or non-existent, social costs will be more than private costs and there will not be optimality (Nwehinne et al, 2011).
5) Incomplete Markets
Markets for certain things are incomplete or missing under perfect competition. The absence of markets for things such as public goods and common property resources is a cause of market failure. There is no way to equate their social and private benefits and costs either in the present or in the future because their markets are incomplete or missing (Alain, 2008).
MEASURES TO CORRECT MARKET FAILURE
For market failure to be corrected, economists suggest the following measures.
In order for optimal allocation of resources to be achieved in the face of externalities, Pigou suggested social control measures and the use of taxes and subsidies. The state can interfere in all situations of external diseconomies of production to remove the divergence between private and social costs and benefits. For instance, it can ask the factory owner to move out of the accommodation area by providing suitable facilities to the smoke emitting factory. In the case of external diseconomy of consumption, the state can put an end to noise pollution by banning the use of loud speakers except for special occasions during specific hours with prior permission (Jhingan, 2007).
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Another measure commonly suggested is internalisation or unitisation of externalities in production. For example, firms that are engaged in oil operations in the same field lead to inefficient over-drilling and over-pumping. With unitisation or merger of firms, oil is produced most efficiently without diseconomies of production (Jhingan, 2007). http://welkerswikinomics.com/students/wp-content/uploads/2009/05/graph2.bmp
Source: welkerswikinomics (2009) (online)
From the graph, when subsidies are granted to the firms in these oil operation the price reduces from P1 to P(S.O) and the quantity demanded increases from Q1 to Q(S.O).
2) Increasing returns to scale
For the problem of increasing returns to scale (or decreasing costs) opinions differ concerning governmentâ€™s role in providing solution to market failure. Some economists opine that government should nationalise such industries which operate under decreasing cost and lead to overproduction. Others do not approve of it because they feel that government control would make conditions worse. Still others suggest that private firms should produce goods and government should enforce price regulation and tax them in order for social and private costs and benefits to be equalised (Jhingan, 2007).
The solution to the problem of indivisibility in the case of goods and services used jointly by more than one person such as street lighting or road, the local body such as Municipal Corporation should either spend on its repairs and maintenance or tax the residents or users of the road or street lighting (Jhingan, 2007).
4) Incomplete information
Market failure can be eliminated when rules are framed by regulating authorities by requiring producers to describe correctly about their products and prices. This will provide people with correct and relevant information about products. Market failure can also be corrected if producers produce high quality standard products and offer guarantees and warranties to buyers. This requires widespread publicity on the part of sellers so as to provide correct information to consumers (Jhingan, 2007).
In case where ignorance is the reason for incomplete information, the direct provision of information by the government may help to correct market failure. For example, employment exchanges provide information on jobs to those looking for work and ask firms to get in touch with them for the supply of suitable labour. This will help the labour market to work efficiently. Similarly, government providing statistics on prices, costs, employment, sales trends, exports and imports, help firms to plan their production with greater certainty. Some private organisations can also help in providing useful data on them (Jhingan, 2007).
5) Missing market
For market failure to be corrected in the case of missing or incomplete markets where two goods are jointly produced, two Nobel laureates K. Arrow and G. Debreu suggest a separate market for each in which each good and service can be traded to the point where the social and private marginal benefit equals the social and private marginal cost and this condition will lead to optimal allocation of resources (Jhingan, 2007).
Market may lead to an efficient allocation of resources. However, there are some goods and services which economists recognise are unlikely to be best produced in free market. Market can fail, they may under provide public and merit goods, they may lead to externalities in production and consumption and there may be wild fluctuations in price which harm both producers and consumers. Therefore, the market system is actually not able to allocate the resources efficiently.