Economics is a social science that is chiefly concerned with how firms, individuals and governments make choices regarding the allocation of their limited resources towards the satisfaction of unlimited wants. Economics is thus a mechanism for the allocation of limited resources among competing wants with the firms, households and the government as decision makers. A market refers to that set up that facilitates acquisition of information by buyers and sellers and enables them carry out business activities with one another.
An economy refers to a social system made up of households as well as firms that are involved in the exchange of goods and services usually through the use of currency. Markets, all demanders and suppliers of goods and services and the government; if involved in the business activities, form an economy. In a market economy, such decisions as what goods and services to produce, quantities to be produced as well as the price are not subject to any central authority to decide. The interaction between buyers and sellers is what in most cases will influence these decisions.
Currently the most dominant microeconomic thought is that of the neoclassical school. Economists studying competition have considered complex models that mainly address the competitive equilibrium. This is what later on led to the discovery of failures and imperfections in markets, and to proposals about government intervention. Determinants of price movements assisted in the phenomenal understanding of markets for all goods and services. Through the theory of markets, we can be able to see how market phenomena can systematically influence decisions and preferences of market participants.
This paper will examine the Classical economists’ view about the self-regulating economy and the opposing Keynesian view. In this regard, the paper will discuss articles on economic theory by John Maynard Keynes and Adam Smith who come from the two schools. Adam Smith’s ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ delves into the subject matter of economic theory from the Classical point of view, whereas Keynes’ writing, ‘The General Theory of Employment, Interest, and Money’ addresses the theory of price and the market mechanism from the Keynesian perspective. Alfred Marshall’s theoretical works concerned with the organization of markets is also discussed.
Background
The nature of competition, as well as the degree, is what entails a market structure. In the history of economic thought, the concept of market structures was brought to the fore by Alfred Marshall when he first gave definitions of a market structure befitting a perfect competition market structure. However, this was a continuation of aspects discovered by Adam Smith in his observations in 1776. Adam Smith observed that markets have a tendency of being efficient if nothing interferes with their operation in his analysis of sellers and producers in a market that is unregulated.
He thus concluded that there was an invisible hand that consists of demand and supply forces that ensures efficiency in production, distribution and consumption of goods. This provided an important basis for economic theory. Alfred Marshall therefore built upon this knowledge to develop the theory of markets. Marshall went ahead to state that even those markets in which free choice transcended free competition would still be classified as markets even if they weren’t perfect markets.
Marshall mentioned general demand to imply free entry, cognizable goods to mean standardized products and the portable ability of products to show no barriers to entry by producers. According to Marshall, perfect competition is where there exists perfect and complete information and thus a tendency of prices being uniform. While explaining the organization of markets, he mentions the terms bargaining and marketing. By bargaining, he implies the mechanism through which price is regulated and speculated, ways through which information is diffused, the money unit and the role of intermediaries. On the other hand, marketing entails the organization of business transactions, which is based on trust and goodwill relationships between and among firms and their networks.
He examined the shifts in prices or quantities of commodities produced or bought by looking at their supply and demand, and made his contribution to the economic thought. In Principles of Economics, he examines how the supply and demand curves come together like a pair of scissors’ blades to give the best market conditions, a point where the equilibrium price and quantity are attained and stay this way until such a time when disequilibrium occurs. He dwelt much on this idea and brought in the notion of time, explaining that time vital in determining how markets adjusted to changes in demand and supply.
Alfred Marshall in the Classical School of thought
This was during the neoclassical period, and Marshall was a neoclassical economist. In neoclassical production theory, application of better technologies was characterized by increasing returns to scale and according to Marshall this leads to an awkward problem. A competitive market was based on the premises that an individual seller would be denied market power as there are sufficiently numerous firms that produce the same product; this, however, faces the above challenge. Despite this, Marshall tried to develop an analysis that would ensure the essentials of perfect competition equilibrium model are preserved.
On one hand, Marshall was a formal theorist and on the other an observer of events. Being the theorist that he was, he saw a danger facing the competitive framework as there were more and more large firms with relatively huge market power. However, in his capacity as observer, he opined that certain factors had a tendency of moderating the economic and social impacts of these types of concentrations. He asserted that in cases when descriptive realism and analytical tidiness seemed to disagree then ordinary observation should supersede. He outlined two types of markets; the special market, where individual firms were free to operate in isolation to a large extent without interference from immediate competitors and the general market.
Article Summaries
Adam Smith’s ‘An Inquiry into the Nature and Causes of the Wealth of Nations’
Adam Smith’s theory was mainly based on the natural tendency by humans to satisfy self-interest. In his writing, he advocates for the extension of freedom to every individual to produce and also exchange goods and services as he or she pleases thus allowing competition to set in in all markets. Through the people’s natural ambition to satisfy self-interest, equilibrium would be attained without much help from the government. This is what he referred to as the invisible hand.
The government’s role should be limited and properly defined in a free economy; for example, it should be charged with the provision of public goods, national defense and ensuring justice is administered. These to him are essential goods and services that cannot be provided for by the free market. Smith holds the view that the way to organize a free economy is through competition with buyers and sellers having the freedom to make their choices. Sellers would tend to outdo each other so as to acquire more customers and therefore realize higher profits.
The motivation for sellers, just like every other individual is self-interest and, therefore, when they compete each imagines what is in it for him or her. So as to gain more customers and boost their returns, most sellers would opt to lower their prices, provide unique or specialized services and offer quality goods. It is not a government-controlled price that motivates them, but it is them that determine at what price to sell their products so as to realize as much gains as they can.
Whatever the buyers would demand will be offered to them by a seller who is willing to earn profit, thus buyers acquire whatever they demand without any government involvement. This, therefore, implies that the market self-regulates itself, and the free market is run by the market participants’ self-interest; herein referred to as the invisible hand. Although he understood that free markets were not perfect markets, Smith preferred them to any other existing alternatives as free markets had the ability to advance the people’s welfare and redistribute wealth.
According to Adam Smith, the market is self-regulating so that forces of competition would be triggered in case of any short run adjustments of the market price away from the long run, ultimately reversing it back to the long run market price. Smith also supported the use of currency backed with hard metals so as to deny the governing authority the power to depreciate the currency by increasing expenditure on wars and other relatively unimportant activities. He preferred the free market principles where taxes would be kept low, and tariffs eliminated so as to allow free trade to take place across borders.
Keynes’ ‘The General Theory of Employment, Interest, and Money’
Keynes regards the market as imperfect and not self-sustaining, therefore, requiring government intervention in the economy. The general equilibrium, he says, may occur even in the presence of unemployment and negative economic growth. So as to correct such a situation he suggests that consumer income, in addition to government action, would stimulate demand and thus cause economic growth. He proposes a mixed economy, whereby both the private sector and the state participate in the market by undertaking active roles.
The driving factor for the economy in this case is majorly the aggregate demand in the economy. During downturns, as experienced in the 1930s Great depression, the government could stimulate aggregate demand through a number of policies in a bid to stem deflation and ensure a reduction in the rate of unemployment. According to Keynes, there was no automatic force that would push employment as well as output toward full employment position as was assumed to be the case by Classical economists.
He argued that the rate of interest, the marginal propensity to consume and the marginal efficiency of capital are what determined the level of employment in an economy. He terms his writings general theory because, as opposed to previous economists’ who considered a full employment scenario, he concluded that resource utilization could either be low or high. It is the lack of demand that causes involuntary unemployment. Whether truly there exists an automatic tendency of the economy to rectify demand shortfalls, then it is very slow. Policies initiated by the government are far much quicker in increasing demand and thus rapid reduction in unemployment. The government action in this case cannot only be limited to the increase in money supply but also by increasing government expenditure so as to encourage increased expenditure by the private sector.
Keynes countered Say’s Law’s explanation that aggregate supply created its own aggregate demand in an economy. The explanation did not hold during the 1930s Great Depression, and Keynes postulated that both aggregate demand and aggregate supply were functions of the level of employment. He asserted that a rise in the level of employment would lead to an increase in aggregate income as well as aggregate supply, although not directly proportional. The household would exercise choice on whether to save, consume or invest.
One’s propensity to consume would be dependent on his or her current amount of saving as well as the increase in income. The current amount of saving, on the other hand, is also dependent on the existent relationship between the marginal efficiency of capital and the rates of interest on loans with different risks and periods of maturity. Under certain sets of conditions, the new employment rate set by the propensity to invest and the propensity to consume would match the level of full employment.
Conclusion
The theory of market structures as presented by the various economists is still of interest to us today. Globally people try to establish why certain industries are dominated by only a handful of firms, why in most industries is the size distribution of firms highly skewed among other related questions. Markets are one of the few economic concepts that are faced with strong empirical regularities that are linked across a wide section of industries and thus we should be keen to continue examining this line of economics.
The major approaches to economics and generally the economic thought include the Classical, Neoclassical and the Keynesian schools of thought. Markets are considered in all these approaches, and the classical economists are of the view that markets are well-functioning and quickly respond to slight changes in the equilibrium. They also have confidence in a laissez faire policy. Keynesian economists are of the opinion that markets are slow when reacting to equilibrium changes and that government regulation is at times necessary to revert the economy back to equilibrium. They also dwell on imperfect competition.
References:
Barber, William J. A History of Economic Thought. Connecticut: Wesleyan University Press, 2009.
Baumol, William J, and Alan S Blinder. Economics: Principles and Policy. 12. London: Cengage Learning, 2011.
Keynes, John Maynard. The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace and Company, 1935.
Marshall, Alfred. Principles of Economics. London: Macmillan & Co., 1890.
McConnell, Campbell R, Stanley L Brue, and S M Flynn. Microeconomics: principles, problems, and policies. 19. New York: McGraw-Hill/Irwin, 2012.
Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations. London: Creech, 1806.
