Authors: XÈNIA ALEMANY, SOFIA GROIZARD
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Abstract
What is a market economy and why is it so powerful? What state controls are necessary to make markets function efficiently? Who is responsible for making decisions in a market economy? How do markets determine prices, wages, and products? How does the market solve the three economic problems? Who governs the market economy? Are companies like Apple or Tesla the ones leading the way? Or is it rather the Congress and the president? How does the state perform its functions?
Those are some questions raised in this essay, where the authors do a systematic review of the main characteristics of a market economy. The article introduces the discussion on the necessity of state regulation of the market through a micro level and at a macro level using mainly the statements of Keynes and Friedman, two opposite economists on the topic. The essay goes through the pros and cons of each part and ends up on a state intervention position.
Introduction
Mixed economy is a combination of private enterprises operating in a market where there is regulation, a tax system, and government programs.
What is a market economy and why is it so powerful? What state controls are necessary to make markets function efficiently? Who is responsible for making decisions in a market economy?
There is no individual, organization, or government responsible for solving economic problems in a market economy. Instead, millions of businesses and consumers participate in voluntary trade, seeking to improve their respective economic situations. Their actions are invisibly coordinated by a mechanism of prices and markets.
But how do markets determine prices, wages, and products?
A market is a mechanism through which buyers and sellers interact to determine prices and exchange goods and services. The primary function of the market is to determine the price of goods. Prices coordinate the decisions of producers and consumers in a market. Higher prices tend to reduce consumer purchases and encourage production. Lower prices encourage consumption and discourage production. Prices are the mechanism that balances the market. As we have all learned during our years studying, market equilibrium is the point where supply and demand intersect. This equilibrium represents the balance between all buyers and sellers.
How does the market solve the three economic problems?
By balancing sellers and buyers in all existing and potential markets (supply and demand), markets simultaneously solve the three economic problems of what, how, and for whom.
- What goods and services are produced is determined by the monetary votes of consumers in their daily purchasing decisions. Companies are motivated by the desire to maximize profits. Therefore, companies pursue high-profit production of goods in high demand while abandoning low-profit production.
- How they are produced is determined by competition among different producers. The best way for them to compete in prices and maximize profits is to keep costs to a minimum by adopting the most efficient production methods.
- For whom they are produced (who consumes and how much) largely depends on supply and demand in factor markets. Factor markets determine wage rates, land rents, interest rates, and profits. These prices are called factor prices. For example, the same person may receive wages from a job, stock dividends, bond interest, and rent from a property. From the total factor income, a person’s market income can be calculated. Therefore, the distribution of income in the population is determined by the quantity of factor services and factor prices Matienzo (1990).
But who governs the market economy? Are companies like Apple or Tesla the ones leading the way? Or is it rather the congress and the president?
All these individuals and institutions affect each other, but ultimately, the main forces influencing the way the economy is structured are two ”monarchs”: preferences and technology. An essential determinant is the population’s preferences, which guide the use of society’s resources. They determine the point on the production possibilities frontier (PPF). Another important factor is the resources and technology available to a society. The economy cannot go beyond its PPF. The market system allocates profits and losses to induce firms to efficiently produce desired goods.
The Invisible Hand
Adam Smith was the first to discuss how a market economy organizes the complex forces of supply and demand. As he wrote in ”The Wealth of Nations” (1776),
”Every individual… generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it… he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain. And he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest, he frequently promotes that of the society more effectively than when he really intends to promote it.”
In the same year Smith wrote ”The Wealth of Nations,” the Declaration of Independence of the United States was also witnessed. It was a historic moment in which American revolutionaries proclaimed freedom from tyranny, and Adam Smith advocated a revolutionary doctrine that freed trade and industry from the shackles of feudal aristocracy. Smith argued that state interference in market competition was detrimental. However, after two centuries of experience and reflection, the limited scope of this doctrine becomes evident. It is known that there are ”market failures,” where the market does not always lead to the most efficient outcome. One set of market failures refers to monopolies and other forms of imperfect competition. Another failure of the ”invisible hand” is positive and negative externalities. One final consideration arises when the distribution of income is politically or ethically unacceptable. When any
of these elements are present, Adam Smith’s doctrine of the invisible hand does not work, and the state may want to intervene to correct market failures. For this reason, no government in the world, no matter how conservative, keeps its hands off the economy.
The Visible Hand
The state assumes many tasks in response to market mechanism failures. The military, the police, the construction of highways or hospitals are typical government activities. Socially beneficial enterprises, such as space or scientific research, benefit from state funding. Governments can regulate certain businesses (such as banking or pharmaceuticals) and subsidize others (such as education and healthcare).
The state also collects taxes from its citizens and redistributes part of the collected income among them.
How does the state perform its functions?
The coercive power of the state allows it to perform functions that would not be possible under voluntary exchange. Governments have three main economic functions in a market economy:
- Governments increase efficiency when they promote competition, reduce externalities such as pollution, and provide public goods.
- The state promotes equity by using tax and spending programs to redistribute income in favor of certain groups.
- The state promotes stability and macroeconomic growth by reducing unemployment and inflation while encouraging economic growth through fiscal policy and monetary policy by central banks.
Markets do not necessarily produce a fair distribution of income; they can generate an unacceptably high inequality between income and consumption. In response, the state can modify the pattern of income (for whom) generated by market wages, rents, interest, and dividends. Modern governments use tax revenue
to increase income for transfers or income support programs, which provide a financial safety net for those in need. Taxes are necessary for the state, as it needs to obtain the relevant income to pay for its public goods and finance income redistribution programs. The latter come from taxes on personal and corporate income, wages, sales of consumer goods, and other items. Taxes resemble any other ”price,” in this case, the one paid for any public good. But they differ from it in a fundamental aspect: they are not voluntary. Everyone is subject to tax laws; they are obliged to pay their share of the cost of public goods. Macroeconomic policies for stabilization and economic growth include fiscal policies, tax and spending
policies, and monetary policies that influence interest rates and credit conditions. Since the development of macroeconomics in the 1930s, governments have managed to contain the worst excesses of inflation and unemployment Matienzo (1990).
The debate surrounding the successes and failures of the State once again demonstrates that drawing a border line between the market and the government is a persistent problem. The tools of economics are indispensable in helping societies find the right balance between efficient market mechanisms and regulation and redistribution due to state decisions. A good mixed economy is necessarily a highly limited mixed economy. An efficient and humane society requires both halves of the mixed system: the market and the government. Operating in the modern economy without both is like trying to play soccer without a referee. After having presented and established the foundations of the market and its regulation by the
State, a brief review of the literature on this controversial topic is interesting to observe the different views that important modern economists have contributed to society. It all begins with the debate on market efficiency. We want to highlight two distinguishable opinions on the subject: the ideas advocated by John Maynard Keynes on one hand, and those held by Milton Friedman on the other.
Keynes’ ideas were based on aggregate demand. He argued that markets in their original or natural form lacked self-equilibrating systems, which caused imbalances in certain economic variables. The main examples that this author demonstrated were related to employment and prices. This school of thought
blamed market disequilibrium for causing unemployment, meaning a mismatch in aggregate demand. Furthermore, Keynes’ ideas explained that when there is low aggregate demand, the government has to increase public spending to stimulate it and reach the equilibrium point. On the other hand, during periods of high aggregate demand, which according to Keynes would result in inflation, the government would have to intervene by cutting public spending or increasing taxes to readjust aggregate demand and bring it back to equilibrium. As evidence that his theory was effective, Keynes explained and named the economic situation resulting from very low interest rates and high savings by economic agents, a liquidity trap. Keynes explained that in situations like this, monetary policies reached their limit. Even if the money supply increased and interest rates decreased, there was no way to stimulate the economy. As a solution to this problem, Keynes undoubtedly advocated for fiscal policy, increasing public spending to boost aggregate demand and restore the economy to normalcy.
So what could have gone wrong with the Keynesian model?
The limitation of the Keynesian model became evident when explaining the stagflation of the 1970s, as it couldn’t provide an efficient policy for government intervention. Stagflation, the coexistence of high inflation levels and high unemployment rates in the economy, which occurred towards the end of the last century, was the result of multiple economic situations including the crisis of the Bretton Woods system, the significant increase in money supply by the United States and the resulting inflation, oil-related crises during that time, among other causes. Keynesianism, therefore, was contradicted by the situation at that time because according to its model, inflation and unemployment could not occur simultaneously since there couldn’t be high and low aggregate demand at the same time. Keynes did believe in government intervention as he considered fiscal policies to be the most appropriate for regulating economic cycles. These policies had a rapid and effective impact on demand and, therefore, on the economy when needed. Additionally, he argued that monetary policy had little direct impact on demand and, if it did, it was an indirect and slow, long-term process. This view contradicted the perspective provided by Milton Friedman. Keynes relied on the idea that economic recessions or periods of inflation required swift approaches and effective solutions. On the other hand, Friedman’s ideas were related to monetary supply, that is, changes in the amount of money in the economy. He argued that they were the cause of economic fluctuations.
Friedman argued that when the money supply decreases, the consequence is deflation or even recession, meaning that prices decrease. Conversely, when the money supply increases, it leads to inflation. For example, during the Great Depression in 1930, the money supply decreased due to the collapse of the stock market, where a significant amount of money was ”destroyed” and became worthless. Data shows that approximately 30% Federal Reserve History (n.d.) of the money was destroyed in the United States during 1930. Additionally, Friedman didn’t believe much in government intervention because he thought that monetary policy was crucial for regulating the economy and its fluctuations, International Monetary Fund (2014).
According to Friedman, regarding the intervention or non-intervention of the state in the economy, government spending and taxes had only an erratic impact on the economy Friedman (1993), and the implementation of fiscal policies harmed the economy instead of helping it. Due to this belief, he supported the idea that monetary policy was the most efficient and should be used in times of instability,
therefore, it wasn’t the government that should intervene in cases of imbalance but rather the central bank. However, how would they have explained government intervention in the 2008 crisis, the COVID crisis, or the recession caused by the war in Ukraine? Should society change its way of thinking towards Keynesianism again, or should it understand that neither monetarism nor Keynesianism can accurately explain economic fluctuations, and therefore, there is no correct or incorrect government action plan? In the 2008 economic crisis, both the Federal Reserve (Fed) and the European Central Bank (ECB) implemented quantitative easing, disregarding the policies that M. Friedman would have recommended and focusing primarily on saving the economy through demand stimulation, as J.M. Keynes would have advised them to do so, Conerly (2012).
Given the explanations of government intervention and a brief literature review previously presented, we can conclude that, based on our formed opinion through gathered information and our own judgment, a mixed economy is the most appropriate. We believe that government intervention is crucial for improving many aspects in a country, not just economic ones. Therefore, it is a wise decision for the government to have public spending to enhance certain services that contribute to the welfare state in which we live. Furthermore, we want to emphasize the importance of considering the historical chronology of events. Friedman and the monetarists, when their economic school of thought emerged, already contemplated the potential independence of central banks from the government, a factor that Keynes did not consider since he expressed his thoughts long before this idea materialized. In other words, we believe that the studied Keynesianism lacks certain factors that would provide a better opportunity to explain economic
fluctuations.
References
- Conerly, Bill, “Keynes Vs. Friedman At The Fed,” Forbes, March 2012. Accessed on: 2023-06-05.
- Federal Reserve History, “Great Depression.”
- Friedman, Milton, Why Government is the Problem number 39. In ‘Essays in Public Policy.’, Stanford, California: Hoover Institution Press, 1993.
- International Monetary Fund, “The Basics of Keynesian Economics,” 2014. Accessed on: 2023-06-05.
- Matienzo, I, “Samuelson, Paul A.; Nordhaus, William, D.:” Economía”. 13. ª edición (Book Review),” Boletín de Estudios Económicos, 1990, 45, 626.