The United States: Market or Mixed Economy?

1. What is a market economy?

It is an economic system which allocates scarce economic resources using the price mechanism. In a layman term, there is a price tag for everything from the tuna we eat, the fuel we pump, the clothes we wear, the condominiums we stay in, the flight tickets for both our local and international holidays to the college tuition fees we pay for our children. It also covers the wages for different types of profession. Some of these prices fluctuate on a daily basis, a day up and the other day down. Some are relatively stable and often revised upward due to the willingness of consumers in paying them

In a more technical way, wages and prices that we pay for are all determined via the interactions of demand and supply. It also has other names such as the free market, capitalist and laissez-faire. Laissez-faire is actually a French term that translates as ‘let it be’ which means that an economy should be left operated on its own without any disturbances (government intervention). Through the greed for profits and own selfishness, scarce resources are said to be allocated in the ‘most efficient way’ since they go to the most deserving firms and individuals

2. How does a market economy solve basic economic problems?

The existence of scarcity in our world means any economic system must be able to address three fundamental questions and they are WHAT SHOULD BE PRODUCED? HOW IT SHOULD BE PRODUCED? and FOR WHOM SHOULD IT BE PRODUCED?

Source: economicsonline

What goods to produce and what services to provide depend heavily on the interactions of demand and supply and hence the final equilibrium price, higher or lower. Consider the housing market in Malaysia. Over the past few years, prices of properties have averagely spiked up by as much as 40% due to the buying interest of investors from overseas. A rise in demand has caused the new equilibrium price to increase and this sends a signal to all housing development firms to construct more houses and condominiums. The logic is, higher prices mean more money to be made. What about subjects offered by private learning institutions like HELP Academy and Taylor’s College? Well, they work the same. Higher demand for pre-U studies as a ticket to go to the top universities in the world has caused all colleges to be rushing in with the A-Levels programme

How those goods and services were to be produced will depend on the nature of the industry itself and the management skills of people appointed to run the firm. Some industries are labour intensive while others capital intensive. Whichever it is, the most cost efficient one will be considered at the end of the day. Similarly, is the firm willing to pay a little bit more to retain the most talented workers? If yes, the economic benefits for the firm are tremendous. Highly skilled and most experienced workers are not just scarce but also very productive, helping the firm to reduce costs in every way. On the other total revenue generated will be high due to their craftsmanship, teaching skills which will attract more students, ability to cook wonderful dishes and others

For whom those new luxury condominiums are built for? For whom those designer watches, shoes and bags are targeted at? How many units an individual or firm can get? Perhaps the best answer is none other than how much a person is willing and able to pay for it. Firms which are motivated by high profits will definitely sell the expensive houses, collectibles, antique cars and furniture and A-Level study to people who are prepared to pay a hefty price for it while at the same time gain satisfaction out of it. Remember, we as consumers always want to maximise our utility and well being and therefore if we are able and willing to we will always want the best for everything

3. What is a mixed economy?

It is an economic system where scarce economic resources are partially allocated via the price mechanism (as discussed earlier) and also through government interventions. Although private sectors are generally more productive, efficient, conduct more R&Ds or more innovative and do not waste resources, it is far from being perfect. In many circumstances, economic resources are not even allocated efficiently leading to net welfare loss. The drive to maximise profit and satisfaction has eventually led to series of economic problems. To increase annual profits and please the shareholders, thousands of jobs in a factory may need to go and where will all these unemployed people end up in? The most cost efficient method to start up farming may not even be the best. For instance, plantation firms in Indonesia chose to burn down trees rather than cutting them down resulting in deterioration of air quality, increase in respiratory illnesses, tourists shunning away from Malaysian and Singapore, decline in GDP and others

What about alcohol consumption? Consumers just want to maximise their own utility and in most cases do not consider much of the wider implications of binge drinking. The same goes for cigarettes. Do you think cigarette manufacturing companies will think of public’s health? No, they only think of ways to fatten their margin. What about education and healthcare? Some private schools and colleges are extremely expensive because consumers are willing to pay for it but what about those cannot afford? Isn’t education is universal right? The same with access to healthcare treatment. With all these arguments, clearly free market economy is highly preferred but there must also be measures to regulate the behaviour of firms and consumers

4. How does a mixed economy solve basic economic problems?

Source: economicsonline

The discussion here will focus on government interventions. What goods and services to be produced will all depend on what the government perceives to be in the best interest of the general public. For instance private universities and hospitals may be too expensive and so not everyone will be able to gain access and this is why we have government schools and hospitals all over the world. Equally national defence which is a form of public good that will never be provided under the pure market system. The main reason is the existence of free riders and hence the difficulty to maximise profits. Once again, the government feels that national defence cannot be absent and therefore undertakes to provide it. Also, it can be quite dangerous if national interest lies in the hand of greedy entrepreneurs

The government seeks to maximise welfare and hence will consider methods of production which will benefit more people. This partly explains why all governments are the largest employer and also more inefficient compared to the private. To maximise welfare within the society, jobs are purposely created to absorb those unemployed people resulting in non-necessary departments, more paper works and layers of bureaucracy. They shouldn’t even be there in the first place

To address the last question, government will always try to seek equity or fairness. Goods and services produced will always go to those that need it the most rather than on a discrimination of who can afford to pay for it. This is why there are affordable housing schemes, healthcare treatments and national schools. On top of that, there are many ways in which the government can regulate the economy. I will discuss this in another separated post

5. Is USA a market or mixed economy?

In textbooks, USA is always being regarded as a market economy but in reality it would be better if one says that the States is a better proxy of capitalism rather than being one. As a matter of fact, there is no pure capitalist or socialist in the real world. Every economy is in fact mixed and the key issue is the degree of mix from one country than the other. As for the USA, it is definitely a mixed economy but rather one with larger roles from capitalism. The credit crunch crisis and the near collapse of Ford and GM are some of the good examples which prove that pure market system cannot survive on its own. The greed for profits has caused the banks to ‘misbehave’ and finally they collapse and require the government to intervene by pumping in tax payers’ money. On top of that, there are minimum wage, carbon tax, progressive income and corporate tax, Social Security, Medicare and a lot more which are not even possible under market economy

Haze and its Negative Externalities

1. What is the meaning of market failure?

The word ‘market’ refers to capitalist/ free market/ market economy while the word ‘failure’ means not functioning well. Putting it all together, in a way that is much easier to understand is the free market economy fails to function properly/ has too many problems. This is the layman way of understanding. I always tell my students not to be afraid with all these economics jargon. In fact most of them can be easily understood and remembered, so long as we try to understand them PART-BY-PART

The more technical definition would be the interaction of price mechanism / demand and supply fails to allocate economic resources in the most efficient way resulting in net welfare loss (more costs than benefits)

2. What are some of the examples of market failure?

Before getting there, we need to basically understand the essence of a market economy. Under such system, it is always assumed that the role of government is limited or perhaps to some degree none. Cash is king and those who are able and willing to pay will decide how the scarce economic resources will be directed to provide what they want. Consumers just want to maximise their utility (satisfaction). Meanwhile, firms are crazy over figures e.g. lowest cost and highest price possible to widen their margin of profits. The most responsive ones in a dynamic business environment will thrive while those which are slow to react will slowly perish

These have often caused some goods and services to be either under provided and hence under consumed or over provided and hence over consumed. In one or two cases, some goods/ services are not even provided despite it bring economic benefits

Consider merit goods/ goods that create positive externalities like education and healthcare. In a free market, these two will only be provided to a small group of consumers who are willing and able to pay for it, despite some argue that they are both universal rights and shouldn’t be abused to that extent. Now, I hope you can see why private colleges and hospitals are so expensive. Fees and charges are often revised upward between 5%-10% on annual basis. If there is no government intervention to fix such market failure, knowledge and health inequality between the rich and poor would have widened

Now, consider demerit goods/ goods that create negative externalities such as cigarettes, alcohol and fatty foods. In a free market, cigarette manufacturers will only consider their profits and nothing else. They will go to all extent to push young adults to indulge in smoking despite its costs far outweigh its benefits. They are not concern with consumers’ health, risks of fire in the building, litters all over the place and many more. Equally, McDonalds cares very little over issues like obesity, heart failure, diabetes and others. Profit is number one goal. This explains why the government needs to intervene with measures like awareness campaign and fatty tax

There are obviously many more problems e.g. absence of public goods, income inequality, information failure, private monopolies and others. I will talk about these in other posts

3. What about the recent haze in Singapore and Malaysia?

The haze which peaked in early July 2013 is a perfect example of negative externality/ external cost. It is defined as a negative third party effect/ spill over from production/ costs which the price mechanism fails to take into account or social costs minus private costs

We didn’t start the forest burning but since our neighbour is so insensitive, eventually we are affected by it too. The private cost (PC) to firms involved is technically zero since it costs nothing other than to start with a small fire. The external costs (EC) are tremendous especially to Singapore which is closer to the Indonesia. Health problem e.g. respiratory illnesses will escalate, tourists will temporarily shy away and spend their money elsewhere, hotels getting all the booking cancellation and street food operators are all affected because people choose to spend more time indoor. If this persist for a quarter (July-September), then I wouldn’t be surprised that the Singapore’s national income will contract this financial year

4. How can this be illustrated on a cost-benefit diagram?

Private firms will only take into account their own private benefits and private costs when they operate. This is why open burning is so rampant at Q1 where MPB = MPC. However, from the society’s point of view open-burning is a public nuisance and therefore should be reduced to a more tolerable level which is Q2 where MSB = MSC. Welfare loss is resulted as can be seen from the shaded red triangle. This is because there is an over-production of haze by the amount of Q1Q2. We assume that there are no external benefits involved and so MEB = 0. This explains why the MPB = MSB. The purpose is to make the analysis simpler. In reality, there are external benefits e.g. higher profits to the private hospitals and of course masks provider

The Impact of the Recent Falling Trade on Chinese Economy (Keynesian 45 degree line analysis)

1. What is meant by national income?

In a layman term, it refers to the total income generated by an economy/ a country over a period of time. Somehow, there are two popular indicators of national income. First is the GDP (Gross Domestic Product) which is most widely used. It is the market value for all final goods and services which are produced within the country. If I lecture in one of the UK universities, the value of my service contributes to UK’s GDP. Similarly, Toyota’s car assembly plant in Burnaston, Derbyshire will also add to the GDP. In short, it does not matter who or which firm and from where, as long as the production of goods and services takes place within the UK, it must be included in the GDP. There are three ways to calculate GDP, namely the output, income and expenditure method. In theory, all these three methods will eventually yield the same value. The logic is simple. If a person produces an output (output method) worth £100 for another person, then the first person must be paid with an income (income method) of £100. With this money, he/ she will then have the ability to spend (expenditure) that much money back into the economy. That is why output = income = expenditure

I will discuss this in greater details in a separate post in near future

Second is the GNP (Gross National Product) or GNI (Gross National Income). Again, whichever it is, output will be the same as income. It is the market value of all final goods and services produced by the factors of production owned by a country. For example, if UK firms have business interest in other parts of the world, the repatriation of profits will add up to the UK’s GNP. Similarly, if Toyota and Ford repatriate some of their profits back to Japan and USA respectively, this will add to their GNP. In short, we need to take into account both inflow and outflow of money from the UK. As such GNP = GDP + Net property income from abroad (NPIA)

Between these two, GDP is the more popular one and so the rests of our discussion will solely focus on GDP

2. What can contribute to the national income (GDP)?

This is very simple. As long as there is money flowing into the economy, then it will contribute to the national income. When you spend money buying goods and services produced within the country e.g. attending to hospital service, sending your child to a local college, eating in a restaurant etc these will all go under CONSUMPTION (C)

When a firm purchases machineries which are produced locally, again this adds up to the GDP. If a firm is expanding its chain of outlets or building a new factory to cater for its expansion plan, then again this will increase the national output. For instance, HELP University’s (the place where I work) new state-of-the-art campus in Subang Bestari 2 is part of INVESTMENT (I)

The third component is government/ public spending (G). One good example would be the up-coming MRT project based in Klang Valley. Other types of government expenditure include construction of new schools, hospitals, road works, airport regeneration etc

Last but not least is the NET EXPORT (X-M). The word ‘net’ is used to indicate that ‘OVERALL’ exports are greater than imports and there will be more inflow than outflow of money into the nation’s circular flow of income GDP will increase

In short, GDP = AD (aggregate demand) = AE (aggregate expenditure) = C + + + G + (X-M)

3. How can a fall in exports affect the national income?

 In the most recent report (10^th July 2013), China is taken by surprise with its ‘unexpected’ decline in exports. Assuming (ceteris paribus) that imports are unaffected, a fall in exports will lead to a fall in GDP or national income from Y0 to Y1. This can be illustrated using the Keynesian’s 45 degree line analysis as seen above. The macroeconomic implications are not just that. In fact it is more than one would have thought of. First China is an export-driven economy just like Taiwan and Singapore. So, a fall in demand for Chinese manufactured goods would have a large impact onto its growth and labour market, particularly those industries that are labour-intensive. Through the negative multiplier effect, house prices will fall and share prices of companies affected will swing to the down side

 

 The only good news is, a fall in AD = AE will at least remove some inflationary pressure off the economy as can be seen from the falling price level from P1 to P2 .The poorest households will be less burdened by the regressive effect

4. Why do exports fall?

China’s main market are the United States and European Union and with ongoing uncertainties and sluggish recovery in Western economies, I personally think that China should reduce its over-dependency on international trade. Pursuing consumption-led growth is not that bad either considering the demographic structure of its people which is largely made up of young working class.  

Secondly, labour costs are fast rising over the past few years. Since all firms have a desired margin of profit, some of these costs that cannot be cut elsewhere will have to be inevitably passed to international market. China is gradually losing out in terms of price competitiveness

My third argument is related to the second. Since costs are rising, many foreign firms have left for other countries such as Vietnam, which is now known as the second China of the Asia. With fewer firms left, obviously the total volume of exports would have fallen thus explaining for the narrowing of trade surplus

Rising Crime Rate and Economic Growth (A Malaysian Perspective)

1. What is economic growth?

There are two ways we can look at this. First, growth is achieved whenever there is an increase in the real GDP. Put it simple, as long as your monthly income has increased, you have more money to go shopping on a frequent basis and more output/ goods and services are produced for you, then there is growth (GDP is measurement of income, expenditure and output)

Another one is a little bit hard to measure but its fundamental is easy to be understood. It measures how much a country can produce if all the productive resources are employed in the most efficient way which means rise in productivity of workers due to training, less wastage during a production process, firms replace old equipments with a new one of better durability and technology and so forth. As such, it is known a rise in the potential capacity of an economy

2. Malaysian economy expands every quarter, so does that indicate that all of us are better off?

This is true to some extent. Money talks! With greater income, everyone can afford more goods and services of better quality. Parents can provide best education for their children, protect their family from unforeseen events with life and medical insurance, buy the latest gadgets, play golf everyday and this list can go indefinitely 

However, GDP is quite a flawed measurement of our standards of living over the time:

a) It fails to consider how income is distributed within the country. Just because the real GDP per capita (per person) has increased it does not mean that everyone within the country is equally better off and in fact it is nothing more than a simple average. In fact a country can have few super rich individuals (Robert Kuok, Ananda Krishnan, Syed Mokhtar etc) with the rest being in low-middle income range and yet the GDP is artificially high. Those with high income can distort the accuracy of the GDP

b) Most adults in fact work more beyond than the normal office hours. While it is true that their income level has increased but this comes at the expense of lesser leisure hours. Less quality time is spent for families and friends. So, how can the well-being increase?

c) When the income increases, there will be greater aggregate demand (total demand/ AD) for goods and services to be produced for households. This means, factories may operate longer than usual and also there will be more cars on the road leading to air pollution, water pollution and congestion. These are known as negative externalities that GDP fails to account for

d) It also does not consider the composition of output that is produced. A rise in government's budget for police and armed forces also contributes to the GDP simply because it is one of the components of spending. Again, income level increases but then this is because of soaring crime rate like robberies in restaurants, snatch thefts in the broad daylights and others. Recently a restaurant in Ara Damansara has employed security guards as a crime prevention measure. WHAT IS ECONOMIC SUCCESS WHEN WE EAT IN FEAR?

Tsunami and PPC (Production Possibility Curve)

1. What is a production possibility curve?

It is a curve that shows the maximum combination of two output that can be produced in an economy if all economic resources are fully and efficiently utilsed. Consider an imaginary economy where there is no one who is unemployed, all the capital equipments in the factories are employed and operating at its full capacity, no lands left and all have been used up to build houses, factories, shopping malls and parking lot and natural resources are almost dried up. This is the situation where a country can land on the PPC

However, in practice this is not possible. Therefore what an economy can best do is to make sure all the productive resources are employed in the most efficient way and hence can operate close to the boundary. Sometimes, the word 'curve' is replaced with frontier which basically means the same (e.g. PPF).

2. How can the tsunami be related with PPC? 

Such natural disaster will destroy factors of production like land, labour and capital. Land flooded with salt water will cause the soil to be contaminated with high levels of saline thus causing it to be no longer suitable for cultivation. Casualties will reduce the quantity of workforce and destruction of buildings and capital equipments will have impact onto total output that can be produced within the economy

 

In the short to medium term, Japan's PPC will shift inward. The logic is, even if Japan makes full use of its remaining productive resources, there is no way where they can still produce the same maximum combination of output as before