Acknowledgement

First and foremost I thank Dr. Sham Abeyratne, the lecturer for the module Managerial
Economics, for sharing his knowledge and for the guidance, support and advice given in order to
make this assignment a success.
I also wish to thank my friends, family and fellow students for their encouragement and
motivation.

Page | 1

Executive Summary
The objective of this assignment was to understand, analyse and evaluate the theoretical
economic concepts of Market Mechanism, Perfect Competition, Market Imperfections and
Market Failure.
The report initially discusses the basic economic problem of Scarcity and introduces the
economic systems which have been developed over time, such as the Traditional Economy,
Market Economy, Command Economy, Mixed Economy, and Open and Closed Economies.
The Market Mechanism has been discussed in detail, including an in-depth analysis of its
features. The Price mechanism and its role in the Market system has also been discussed with
appropriate graphical illustrations.
The concept of Perfect Competition, including its features, assumptions and behaviour has been
analysed, along with the practical application of such a market in the real world, in the context of
developed and developing nations.
The report also discusses the instances of Market Failure and its impact, with suitable practical
examples. Finally, the report concludes with an assessment of the practical usefulness of these
economic theories, and the governments role in reducing its negative effects.

Page | 2

Table of Contents
1.

Introduction ............................................................................................................................. 5

2.

Market Mechanism .................................................................................................................. 6

3.

4.

5.

2.1

Features of a Market Mechanism ..................................................................................... 7

2.2

Price Mechanism .............................................................................................................. 7

Perfect Competition ................................................................................................................. 8

3.1

Features of a Perfectly Competitive Market .................................................................... 8

3.2

Assumptions ................................................................................................................... 11

3.3

Benefits of a Perfectly Competitive Market ................................................................... 12

3.3.1

The Producer ........................................................................................................... 12

3.3.2

The Consumer ......................................................................................................... 13

Market Imperfections ............................................................................................................ 13

4.1

Developed Countries ...................................................................................................... 13

4.2

Developing Countries ..................................................................................................... 14

Market Failure and Constraints ............................................................................................. 15

5.1

Positive Externalities ...................................................................................................... 15

5.2

Negative Externalities .................................................................................................... 16

6.

Conclusion ............................................................................................................................. 17

7.

References ............................................................................................................................. 18

Page | 3

Table of Figures
Figure 1: Demand and Supply ...................................................................................................................... 8
Figure 2: Price Mechanism of Perfect Competition ...................................................................................... 9
Figure 3: Short Run Profit........................................................................................................................... 10
Figure 4: Long Run Loss ............................................................................................................................ 11

Page | 4

1. Introduction
In economic theory, the fundamental challenge facing all nations and individuals is Scarcity. The
concept of Scarcity has prevailed since the beginning of time, andthe question of how to provide
all the needs and wants of individuals using these scarce resources has resulted in the three basic
economic questions:
1. What to produce?
2. How to produce?
3. For whom to produce?
This has shaped the social systems and economic systems countries follow today, and has led to
the development of various types of economic systems over time. They are:
The Traditional Economy
This economy functions under traditional, religious, and ethnic beliefs and cultures, and derives
most of its products and services from these beliefs. This type of economy is seen in rural
regions or underdeveloped countries, but its practice is fading fast.
The Command (Planned) Economy
The central role in this economy is performed by the Government of the country. It is a highly
centralized system, where government decides on which commodities should be produced and
which resources should be utilized for this purpose. The command economy follows some of the
rules of a Socialist Economy such as the equality of the social classes and the high degree of
Government control, including ownership of businesses (www.udemy.com).
Free-Market Economy
This type of economy has the opposite features to a Command economy, in that the government
control is virtually non-existent and the production of commodities are decided by the private
organizations (the features of a Market Mechanism are explained in the following chapter).

Page | 5

Mixed Economy
This is the practical application of both Market and Command economies, where the production
of commodities by private organizations are monitored by the Government. This type of
economy, in theory, should achieve the balance between the two extremes of Market and
Command economies.
Closed Economy
Also known as Import Substitution Industrialization (ISI), this economy is closed from foreign
nations. Usually adopted by developing nations, the main focus of an ISI Closed economy is to
reduce the dependency on developed countries and become self-sufficient by encouraging
domestic production (www.investopedia.com).
Open Economy
This type of economy has the opposite features to that of a Closed economy, where the country is
open to foreign exchange and foreign trade. Also known as Export Oriented Industrialization, it
aims to boost economic growth through the exchange of commodities between countries.

2. Market Mechanism
As mentioned above, a Free Market Economy is one type of economic structure which had
developed to solve the problem of Scarcity.The market mechanism functions according to the
forces of Demand and Supply. Jain and Sandhu, (2008) discuss, the three basic questions of
economics are solved in a market mechanism as follows:

What to produce is determined by the consumers, and the producers of goods and
services only produce what is demanded by the consumers.

How to produce is determined by the level of Land, Labour, Capital and Enterprise
available.

For whom to produce is determined through the market mechanism where the producers
will supply to those who have the willingness and ability to purchase the goods and
services.

Page | 6

2.1 Features of a Market Mechanism

The main features of a Market Mechanism are as follows:

Market Forces Production and consumption is determined by the Forces of Demand

and Supply. The producers will supply what is demanded by the consumers, to those who
are willing and able to purchase it.

Consumer Sovereignty In the market mechanism, what is produced is determined by

the consumers. In this case there is consumer Sovereignty. This means that ultimately it is
the consumers who have the power in a market system.

Private Business All Land and Capital are privately owned in this system, and it is
private individuals or firms that produce the commodities that are demanded by the
consumers.

No Government Intervention In this system there is no government influence or

intervention on the Market Forces. The main role of a government in this system is
limited to the provision of public goods and services, imposition of Taxes and
maintenance of the legal system. The government is only able to oversee the market
forces at play, and cannot intervene or influence.

2.2 Price Mechanism

The price mechanism, also known as the Invisible Hand, was introduced by Adam Smith in 1778
(Smith, 1982), and is, theoretically, the core of the Market Mechanism. The price mechanism is
the Invisible force by which the Demand and Supply in a free market determines the optimal
or Equilibrium Price which is beneficial to both the producers and consumers.

Page | 7

Figure 1: Demand and Supply

(Source: Authors Work)
The above illustration depicts a basic linear demand and supply diagram. A high price is
preferred by the producers of a commodity, but not the consumers whose demand increases as
price falls. Therefore the price mechanism determines the price, and the market will come to an
equilibrium price where both the producer and the consumer will benefit.

3. Perfect Competition
A theoretical example of an efficiently functioning Market Mechanism is seen though the
concept of a Perfectly Competitive market. This concept was introduced by Adam Smith in 1778
(Smith, 1982) in an attempt to illustrate that a market mechanism can function efficiently, given
certain criteria and assumption.

3.1 Features of a Perfectly Competitive Market

The features of a perfectly competitive market are as follows:

Many buyers and sellers In a perfectly competitive market there are many
consumers and producers of a product. As a result no single producer has a high
degree of power or influence in the market, and each producer only produces a
small fraction of the entire market supply. Similarly no single consumer has a
high degree of control or influence in the market (Jain and Sandhu, 2008).
Page | 8

Price Taker As a result of the large number of producers in the market, each
firm is a price taker, and not a price maker. This means that the firms must accept
the equilibrium price set by the market forces, and no single firm can influence
the price by increasing or decreasing the quantity supplied (Dwivedi 2006).

Homogeneous Products In this market system, all firms produce the same or
similar product (homogeneous). There is no differentiation between products of
various suppliers, therefore if one supplier raises his price even by the smallest
margin the consumers will immediately switch to another producer of the product.

Free entry and exit There are no rules or barriers restricting entry into or exit
from the market. This means that firms are free to join or leave as and when they
desire.

The Demand curve for a perfectly competitive firm is perfectly elastic (horizontal). This reflects
the concept of price taking where the firm must sell at the price determined by the market
forces (Hall and Lieberman, 2012).

Figure 2: Price Mechanism of Perfect Competition

(Source: Authors Work)

Page | 9

The above diagram shows the price as determined through the forces of demand and supply in a
perfect market. The equilibrium price is determined at the point where the market demand meets
the market supply. This price then becomes fixed for the individual firm. As a result, the firms
price is the same as its Marginal Revenue and Average Revenue (D=MR=AR=P). The individual
firm will then function on this perfectly elastic demand curve.
Like any private firm, a producer in a perfectly competitive market seeks to maximize profit.
Due to the inherent features of a perfect market such as price taking and free entry and exit, firms
can only earn a profit in the Short Run.

Figure 3: Short Run Profit

(Source: Authors Work)
The profit maximizing firm will set the optimal output level (Q) at the point where MC=MR. In
the short run a firm can either earn excess profit (as seen in diagram A) or zero profit (as seen in
diagram B). In the above illustration, diagram A shows a firm whose revenue (D=AR=MR=P) is
higher than the Average Total Cost of production (ATC). As a result this firm will earn an excess
profit in the short run (PSRT). Diagram B shows a firm earning Zero profit, where the revenue
equals the cost pf production of the firm. Either way, a firm will continue to produce in the short
run as long as the revenue earned is greater than the short run average variable cost of production
(Wessels, 2012).

Page | 10

Figure 4: Long Run Loss

(Source: Authors Work)
As per Baumol and Blinder (2008), the short run profit will attract more producers into the
industry in the long run, and this increase in the market supply will reduce the market price
(D=AR=MR=P). This will result in the firm incurring a loss in the long run, depicted by LMNP1
(Hall and Leiberman, 2012).These loss making firms will leave the industry, leaving room for
new entrants, thus driving the price up again.

3.2 Assumptions
The theoretical concept of a perfectly competitive market functions based on several key
assumptions. These are as follows:

Perfect knowledge and information - A main assumption of a perfectly competitive

market is the perfect availability of and access to information. In this type of market, it is
assumed that all the consumers have all the information regarding the producers and
market conditions (Wessels, 2012).

Availability of Infrastructure This market also assumes that there is perfect

infrastructure, systems and structures in place to facilitate the smooth functioning of the
market.
Page | 11

No Transaction or Transport costs Another main assumption is that there are no

transport costs and transaction costs in the market. The only cost to the producer and
consumer is the cost of production and price of the product respectively (Goodwin et al,
2008).

Consumers are rational The consumers in this market are assumed to be rational
individuals who take rational decisions based on the information available.

Factor Mobility This market also assumes that there is perfect mobility between
factors of production (land, labour, capital and enterprise), where the factors can be
switched with changes in market conditions (www.tutor2u.net)

3.3 Benefits of a Perfectly Competitive Market

In theory, a perfectly competitive market can result in Economic Efficiency, since the questions
of What, How and For Whom are answered by the market forces of Demand and Supply and the
Price Mechanism. This means that the perfect market will achieve:
Productive Efficiency: Where firms are encouraged to produce at the lowest total cost (lowest
point of the ATC curve). This results in increased efficiency in production of each individual
firm, and thus the industry as a whole (Sexton 2012).
Allocative Efficiency The market functions effectively and efficiently in allocating scarce
resources. This means that the resources are allocated based on the needs and wants of the
consumers, hence there is no wastage of resources (Sexton 2012).
An efficiently functioning Perfectly Competitive Market can benefit both the producers and the
consumers as follows:
3.3.1 The Producer

Lower Costs The perfectly competitive market assumes that firms do not incur any
transportation or selling costs, and this enables the producers to keep costs to a minimum.

Higher Profits Due to competition, the producer is encouraged to increase efficiency

and reduce costs of production in order to maintain the ATC below the market set price.

Page | 12

This as mentioned above leads to Productive and Allocative efficiency, as there is

minimum wastage, and allows the producers to earn high profits in the Short run.
3.3.2 The Consumer

Lower Prices Consumers will benefit from lower prices as firms compete to keep cost
of production low. As individual producers have no power, the price cannot be influenced
or inflated to earn higher profits.

High Quality Products Also due to the homogeneity of products, the only way firms
can attract customers is through better quality products than its competitors, and this in
turn will benefit the consumer.

4. Market Imperfections
The Perfectly Competitive Model is only a theoretical concept of how a market could function,
based on several assumptions as stated above. However these assumptions are unrealistic and
such perfect markets cannot be found in the real world. This is due to imperfections in the
market. For instance when considering the homogeneity of products, no two firms have the same
product, as every firm differentiates and brands its product in some way.Many firms in both
developed and developing countries depend on product innovation which is not allowed by the
rules of a perfect market.
Also the assumption that a perfect market has no transportation or selling costs cannot be seen in
the market for an actual product, as all suppliers must incur some kind of advertising and
logistical expense.
Not all Markets have many buyers and sellers. A Monopoly market (one supplier in the market)
for a product may exist for goods such as Electricity. This also restricts the freedom of entry into
the market and exit from the market. A monopoly producer can also influence the price of the
product, making it a Price Maker (Price Setter).

4.1Developed Countries
Markets in Developed countries possess some of the assumptions required for a perfect market to
function such as proper infrastructure and communication networks than those in developing

Page | 13

countries. Developed countries also have skilled labour in most markets, unlike developing
countries, and these countries have the financial resources to train the labour force. Developed
countries also have a high technological capacity, and these sophisticated technical processes
allow high efficiency and low costs of production. However even among developed countries
there may not be perfect market as some of theassumptions cannot be found. For instance, Factor
Mobility may be present in the European Union to some extent, where labour, capital and
enterprise can be moved between countries but this not present in all developed countries. There
may not be perfect information, as there is no way for all the consumers and producers to have
all the information pertaining to a market. The assumption that there are no transaction and
transport costs is also highly unrealistic, as all producers in both developed and developing
countries incur some kind of selling and distribution cost.

4.2Developing Countries
Market Imperfections are more prevalent in developing countries whose low living conditions
cannot facilitate the requirements of a perfect market. There is little infrastructure development
and a lack of communication and transport networks. This in turn increases the costs of
transportation, which again goes against the assumptions of a Perfect market. Developing
countries have little or no factor mobility. Also developing countries have a higher level of
corruption and bureaucracy and this influences the markets for certain products. These countries
also have a low level of skilled labour, and not enough financial resources to provide training to
the workers. Developing countries also have low technology level as well as low capital to invest
in such technology, and this results in primitive production processes and low technical skills.
Waud (1980) explained that a perfectly competitive market, despite its benefits to both the
producer and the consumer, has several weaknesses:

No Innovation Due to product homogeneity and fixed prices producers have no

incentive to innovate, and thus firms cannot gain a competitive advantage in the industry.
This also leads to a lack of variety and choice for the consumer, which is one of the

Lack of Product Choice A main reason for the encouragement of competition in a

market is the advantage of choice for the consumer. In a perfectly competitive market
there is product homogeneity and therefore no consumer choice and variety.

Page | 14

Unequal Distribution of Income Some critics argue that this type of market results in
the unequal distribution of income within the society. Although perfect competition
should theoretically result in economic efficiency it does not correct any inequalities
already present in society.

In addition to the above, the governments of nations influence and intervene in the functioning of
a market. This is seen in both developed and developing nations. Government intervention is
sometimes necessary in order to correct market imperfections and allow the markets to function
smoothly.

5. Market Failure and Constraints

Imperfections in the market, such as those mentioned above can lead to Market Failure. Market
Failure refers to a situation where the market mechanism is inefficient in allocating resources,
leading to an undesirable outcome (Goodwin et al 2008). For instance a financial market such as
the Stock Market relies on the availability of perfect information, and Agricultural markets
depend on good infrastructure and road networks. The absence of perfect information and proper
infrastructure facilities in this case may result in market failure.
According to Waud (1980), a main failure of the perfect market is that it fails to take into
account the Spillover Effect of production. This is because business activities affect not only
the producer and the consumer of a commodity but also those not directly involved in the
production or consumption of the commodity. This is the basic definition of an
Externality.Externalities occur when the market fails to facilitate the efficient allocation of
resources due to various market imperfections. This means that the production or consumption of
a commodity affects a third party. Externalities can be Positive or Negative.

5.1 Positive Externalities

Positive externalities occur when the spillover effect has an unintended overall positive effect on
the society. This means that the Social Benefit of a commodity (benefit to society as a whole) is
greater than its Private Benefit (benefit to only the producer). For instance, in the case of a

Page | 15

Higher Education Institute, a positive externality may be the benefit gained by companies in
future when employing the graduates of the Institute.
Since the Private Benefit (benefit to the producer) of such a commodity is less than its Social
Benefit, producers tend to produce less of commodities generating positive externalities. This
results in an underproduction of socially beneficial products (Wessels, 2012). In other words, the
producers do not gain as much from the provision of such products as the society, therefore the
producers do not have an incentive to produce these products.
Some common examples of goods which are under-produced due to Positive Externalities are
Education and Training of labour, and Healthcare provision. Education and Training increases
the skill level of the labour force in a country, and this improves the living standards of the
society. However this is under-produced since these services cannot be provided to all the
members of society. This is also the case for Healthcare provision. Better healthcare results in a
more active and productive workforce and is beneficial to the society as a whole, however this
too is under-produced.

5.2 Negative Externalities

Negative Externalities occur when the spillover effect has an overall negative impact on society
as a whole. In this case, the production or consumption of a good or service causes has a low
Social Benefit, that is, it causes more harm to the society than good. However since the producer
does not take this external cost into account, the producer will continue to produce the
commodity. This results in an overproduction of a socially undesirable product, leading to a
negative effect on society.
An example of a negative externality is the Pollution caused by a production process. The
harmful chemicals and waste emitted by the production of a commodity is not included in the
cost of production of the producer, therefore he will continue to produce. However this has a
negative impact on the surrounding area.
In order to reduce these positive and negative externalities which occur due to Market
Imperfections, government intervention in the free market mechanism is necessary. The
government of a country can influence the producers or consumers to correct these market
imperfections and failures. For instance the government can encourage the production and
Page | 16

consumption of goods generating a positive externality by providing subsidies to the producers.

This will reduce the cost of production of the producer and enable the producer to supply more
of the socially beneficial product. Similarly, the government can impose taxes on products with
negative externalities to increase the cost of production of the producer and restrict the supply of
such negative products.

6. Conclusion
In theory, the concept of a Market Mechanism and a Perfectly Competitive Market results in
economic efficiency, the fair determinacy of an equilibrium price, and results in great benefits to
both the producer and the consumer.
However in the real world, this concept cannot function due to market imperfections as seen in
developed and developing countries, such as the lack of information, lack of technology, lack of
infrastructure and high level of corruption and bureaucracy.
Due to this, the government of a country must intervene and correct these market failures in
order to ensure the effective functioning of such markets, enhance the equitable distribution of
resources and wealth, restrict negative influences on society and improve the living conditions.

Page | 17

7. References

Baumol, W. J. and Blinder, A. S. (2008). Microeconomics: Principles and Policy. 11th

Edition, Cengage Learning.

D N Dwivedi, (2006), Microeconomics : theory and applications, New Delhi : Pearson

Education.

Goodwin, N., Nelson, J. A., Ackerman, F. and Weisskopf, T. (2008). Microeconomics in

Context. 2nd Edition, M.E. Sharpe.

Hall, R. E and Lieberman, M. (2012).Microeconomics: Principles and Applications. 6th

Edition, Cengage Learning.

Import Substitution Industrialization - ISI Definition | Investopedia. 2014 [ONLINE] Available

at:http://www.investopedia.com/terms/i/importsubstitutionindustrialization.asp.

[Accessed

02

October 2014].

Jain, T. R. and Sandhu, A. S. (2008). Microeconomics: for BBA. Edition. V K

Publications.

Perfect Competition - Economics of Competitive Markets. 2014. [ONLINE] Available

at:http://www.tutor2u.net/economics/revision-notes/a2-micro-perfect-competition.html.
[Accessed 02 October 2014].

Sexton, R. L. (2012). Exploring Economics. 6th Edition, Cengage Learning.

Smith, A. (1982). An Inquiry into the Nature and Causes of the Wealth of Nations.
Vol. 1 Edition. Liberty Fund.

Page | 18

The

Types

Of

Economic

Systems

Explained.

2014

[ONLINE]

Available

at:https://www.udemy.com/blog/types-of-economic-systems/. [Accessed 02 October 2014].

Waud, R. N. (1980). Microeconomics. Harper & Row, New York.

Wessels, W. J. (2012). Economics (Barron's Business Review Series). 5th Edition,

Barron's Educational Series.

Page | 19