The market system in action

The market system in action

The free market comprises a series of interconnected markets. These markets are

assumed to be highly competitive and to operate free of government interference.

This is an initial simplifying assumption, which will be relaxed in later chapters.

In reality, many markets are subject to monopolistic influences, and government

intervention in the market system is a feature of even the most enthusiastically

capitalist society. Indeed, in some circumstances, such intervention can be shown

to be a necessary condition for achieving economic efficiency. Additionally, we

assume a stable institutional framework of law and order within which market

transactions can be conducted in an orderly and predictable way.

Given these conditions, the market system allocates resources between different

uses and among different people. It acts as an equilibrating mechanism between

supply and demand. Prices act as signals; and the price system is the coordinating

mechanism which ensures that markets ‘clear’, i.e. that supply equals demand in

each market.

The operation of the price system is by no means obvious. The fact that a free

market system works at all may be considered, if one stops to think about it, as

somewhat miraculous. Millions of individual decisions are taken daily in a market

economy by producers and consumers. These decisions are independent and

uncoordinated. Yet, by and large, goods and services are available in the shops to

meet consumer demands as they arise. The market system is the mechanism

which brings this about in an automatic and efficient manner.

The market system

The market system can be sketched by reference to three major markets – the

product market, the labour market and the capital market – and two primary sets

of participants: firms and households  The product market comprises

the markets for individual goods and services; the labour market involves

the buying and selling of labour; and the capital market deals with the lending and

borrowing of capital. Each market involves the participation of firms and households.

Thus, households sell their labour to firms; and, with the salaries so earned,they buy goods and services from firms. Firms produce goods and services byhiring labour and capital from households .Households andfirms also interact on the capital market. If individuals choose not to spend alltheir income, their savings are channelled to firms by intermediaries such asbanks and pension funds. If they choose to spend more than their income, loanswill be supplied by the same intermediaries. The lines in Figure 3.1 run bothways. However, the savings arrow from households to firms is thicker thanthe reverse arrow from firms to households in recognition of the fact that thecorporate sector is the key investor and borrower in an economy. Households aregenerally net suppliers of funds to firms.

This is a much simplified conceptualisation of the market system as we know itin the real world, but it is sufficient to illustrate the strong interconnectionsbetween markets. Households need to sell their labour to firms in order to be ableto buy goods. Unless households spend their incomes on purchases of goods andservices, there will not be any demand for their labour. Or, to take another example, if firms do not invest, there will be no demand for household savings: savings are useful only in so far as there is an investor somewhere ready and willing to use them for investment. Clearly, a mechanism must exist to bring these disparate and independent decisions into equilibrium. A sustained disequilibriumin one part of this closely interconnected market system can have serious repercussions on other parts of the system. The market system is, in other words, a general equilibrium system. If anything goes wrong with the market mechanism, an economy could run into serious trouble.

Two other market participants must be considered – the foreign sector and the

government sector. Firms do not have to sell their entire output to domestic consumers.They also have the option of exporting. Likewise, households can

import goods and services instead of buying the output of domestic firms.

Imports, exports and the foreign trade market are an integral part of an analysis

of the market system. Factors of production such as capital and labour can also

be traded internationally. The rise in global capital mobility, especially between

developed countries, has meant that the domestic economy is no longer

restricted to domestic savings for its supply of investment funds. The foreign

sector has been growing rapidly in relative importance during the postwar

period.

The government is also an important participant in the market. Government

spending amounts to about 40 per cent of total national expenditure in industrial

countries generally and exceeds 50 per cent in a number of European countries.

Sweden’s ratio is 50 per cent Even in an economy as free market-oriented as the US, the government’s share of total spending ratio is 30 per cent .The spending ratio, however, gives only a rough impression of the extent of government influence in the market system. Public intervention takes many forms in addition to government spending. Official regulations impinge on all areas of economic life – planning requirements for new buildings, health and safety regulations and environmental restrictions, for example. State-owned commercial companies are another vehicle of government influence not reflected in the spending:GDP ratio.