Explain the Workings of Market Mechanism

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23 November 2009

Business Environments Assignment #1
Explain the workings of market mechanism. What can cause markets to fail?

Economists have to deal with a range of economic problems when studying an economy. But the basic economic problem is: “Scarce resources in relation to unlimited wants” – Bamford, 2001 Because there are unlimited wants and limited resources, societies have to confront three basic questions What to produce? Everything cannot be produced so we need to decide what goods should be produced and in what quantities. Here comes the concept of Opportunity Cost . How to produce? Economics demands the most efficient use of resources, hence the concept of economic efficiency was introduced. Here we need to consider how we can get the maximum use out of the given resources and use them efficiently. For whom to produce? Because of scarce resources, all wants cannot be satisfied so again choices need to be made. A market is where buyers and sellers interact to exchange goods and services. “The essence of any market is trade. So, whenever people come together for the purposes of exchange or trade, we have a market.” - Bamford, 2001 These markets work on the basis of demand and supply. Demand refers to the quantities of a product that consumers are willing and able to buy at a given price, ceteris paribus.

Demand Curve.
Price

40

30

20

Quantity

D

40

80

60

The diagram shows that there is an inverse and causal relationship between price and quantity demanded. P QD
P QD
Price is one determinant of demand. Others include changes in tastes and fashion, prices of substitutes and complements and expectations of further price changes. Changes in these factors cause shifts in the demand curve. A rightward shift indicates an increase: Price

P 2
P 1
D 1
D 2
Q 2
Q 1
Quantity

Price
A leftward shift indicates a decrease:
P 1
P 2
D 2
D 1
Q 1
Q 2
Quantity

Price
S
Supply refers to the quantities of a product that suppliers are willing and able to sell at a given price per period of time, ceteris paribus. It is presented diagrammatically through the supply curve: P 2

P 1
Q 2
Q 1
Quantity

The diagram shows a positive causal direct relationship between price and supply: P QS
P QS

As with the demand curve, a rightward shift in supply curve means an increase: Price
P 2
P 1
S 1
Q 2
Q 1
Quantity
S 2

S 2
A leftward shift in the supply curve means a decrease:
Price

P 2
P 1
Q 2
Q 1
Quantity
S 1

The causes of shifts in the supply curve are the costs associated with supplying the product, the size, structure and nature of industry and government policy. When demand and supply interact, equilibrium point is reached: Price

Equilibrium
S
D
Quantity

“economic equilibrium is simply a state of the world where economic forces are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal” - http://en.wikipedia.org/wiki/Economic_equilibrium

The market equilibrium, price determination, shifts and movements in the demand and supply curves are collectively known as the market mechanism which is a distinctive feature of the market economy. “A market structure is the description of the behavior of buyers and sellers” - http://www.lse.co.uk/financeglossary.asp?searchTerm=&iArticleID=2126&definition=market_structure There are 4 common types of market structures:

* Perfect Competition
* A large number of numerous firms
* homogenous product
* firms and consumers have perfect knowledge about the product * firms are price takers therefore PED = infinity
* market mechanism
* only normal profit
* no barriers to entry or exit
* in the long run, some firms may exit the industry causing a rise in market price and new firms may enter causing a...
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