MBA

COURSE

Core module: Business

Economics (MBALN611)
Assignment 1
Submitted to :
Mr Richard Graham

Submitted by:
Mrs. Varsha Seewoogobin
(Student ID number R1506D829852)

DATE: 14 DECEMBER 2015

INTRODUCTION

The assignment is divided into three main parts as follows:

The first part will define the “free market system” with the description of its major attributes or
characteristics. It further critically evaluates how the free market system is the best and only
alternative for determination of resources allocation with supporting evidences.

The second part will discuss how Mauritius faces the three basic economic decisions and
how the availability of resources influences the economic decision for individuals,
organizations and government.

The third part will define “market efficiency” and compare/contrast the similarities and
differences between the characteristics of various types of market structures. For each
market structure, an industry example will be provided with the evaluation of their economic
efficiency and their effects on the industry’s consumers.

The purpose of the assignment is to highlight the important concepts in microeconomics in a

real economic setting.

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 1. FREE MARKET SYSTEM

1.1 Definition

A free market system is an economic system in which prices for goods and services are
determined by the forces of demand and supply with no government intervention or control.
The market is said to be “free” as choices, at each step, are made freely and voluntarily. In
a free market economy, the law of supply and demand, rather than a central government,
regulates production and labour. Companies sell goods and services at the highest price
consumers are willing to pay, while workers demand the highest wages companies are willing
to pay for their services. A free market economy also known as a purely capitalist economy
is driven by profit motive which forces businesses to operate as efficiently as possible to
avoid losing market share to competitors.

1.2 Major attributes

 Private Property

Most property in a free market is private as the individuals, instead of the government,
own the factors of production, that is, land, labour and capital used in the production of
goods and services. Being the owner, individuals have sole rights over the profits
generated from any business activity; this in turn motivates them to invest their time,
energy and money to embark into risky and innovative projects.

 Freedom of choice and exchange

Everyone is free to make their own decisions and can choose what to do, buy or sell.
In fact, people are motivated to do things that benefit themselves. They will only
conclude a transaction according to their self-interest.

 Competitive market

A free market is characterized by a large number of sellers that offer identical products
for sale and everyone is knowledgeable about making a rational choice regarding a
potential exchange of the goods for money. If all products are the same, this will entail
competitive drive, thus offering competitive prices with higher quality and more variety.

 Limited Government Intervention

The government generally does not set the prices of goods or services; rather the
price is set by the market. The government role is limited to ensuring that there is a
level and fair playing field so that everyone has an equitable advantage in the market.

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 1.3 Is free market system the best and only alternative in allocation of resources?

In fact, supporters of free market system argue that free market system encourages
efficiency, stability of output, employment and economic growth. Moreover, through
competition, the free market also inspires and invigorates technological innovation that
satisfies consumer wants in a new and creative way. On the other hand, Critics believe that
a free market or capitalist economy will enable concentration of wealth in the hands of a few,
which is untenable in the long run. The firms will be able to gain monopoly power that can
exploit the market by charging higher prices, pay lower wages, ignore negative externalities,
such as pollution from production and be more concerned about their own profit rather than
social welfare. Another common charge against the free market system is that it brings about
“the law of the jungle” that is the need of the sole outweighs the need of the many.

During the collapse of the Soviet Union and the capitalist revolution in China, the free
capitalism had emerged to be a clear winner. However, in the wake of the 2008 financial
crisis, the debate over the proper role of the state in a modern economy has been reopened.
The breakdown of the American housing market in 2006 and 2007 had an acute effect on the
U.S. and global banking systems. However, while government intervention prevented the
collapse of the banking system, it did little to restore economic growth, and the U.S. entered a
deep recession in December 2007. So, as the market economies of the West stumble, the
question as to whether “state capitalism,” the mix of market forces and state control, can
produce better economic results than the free market economic models came forward.

It is therefore debatable that free market system is the best system for allocation of
resources. Even countries like China which is converging towards capitalism, still conserves
some form of socialism as Government plays a major role in controlling and regulating the
market.

Economists argue that a completely free market or pure capitalism is a fallacy as in most
countries, the relationships between private and public sectors vary in multiple dimensions,
thereby adopting mixed market economies. For e.g. even in advanced countries such as US
and UK, Government provide certain public goods such as national defense, basic education,
and legal systems and intervene to regulate some market activities, and oversee programs
that redistribute income from one group of society to another.
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The emerging countries in the world like Hong Kong, Singapore, Australia and the United
States had proved to be economically stable with high GDP growth and high per capita
incomes. They feature low tax rates, minimal regulation on businesses, few restrictions on
investment and international trade and strong private property rights. However, free market
economies and command economies exist more as theoretical concepts than as tangible
realities; almost all of these world's economies feature elements of both systems. For
example, while the U.S. allows companies to set prices, and workers negotiate wages, the
government establishes parameters, such as minimum wages and antitrust laws, which must
be adhered to.

The famous economist, Adam Smith also saw a place for governmental regulation in a
healthy marketplace. For instance, without government regulation, companies such as British
Airways would have had free lead to collude with their rivals and fix prices when setting their
fuel surcharges and Microsoft could continue its anti-competitive practices in Europe, thereby
allowing it to maintain artificially high prices for its Office products (BBC News). Or, in the
case of the South Korean shipping industry, you don't want the market to kill off all its
customers (New York Times).

It is therefore argued that putting the free market system along with government regulation
and government ownership of certain industries as in the case of mixed economies will
provide a more stable basis of economics. For example, certain industries like police and
education will remain stable even if the market fluctuates as Government will not shut down
the police department in a recession. Hence, the allocation of resources in a regulated free
market system works better than the two extreme economic models of unrestricted capitalist
economy or a completely socialist economy.

2. MAURITIUS: ITS ECONOMIC MODEL

Many firms in Mauritius is owned by private companies while other facilities are offered by
Government such as health, education, police and other public services. Hence, economic
decisions are made by individuals and private firms, but some are also made by government,
either through rules and regulations or through government-owned firms.

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Mauritius is classified among the capitalist countries, but it is not a completely free economy.
Mauritius has built its success towards a free market economy, as Government has brought
radical reforms to facilitate trade, investment, tariff, and income tax regulations to simplify the
framework for doing business. Trade licenses and many other bureaucratic impediments
have also been abolished.

Individuals and businesses own productive resources and make the decisions about what to
produce, how to produce and to whom goods and services will be allocated. The customers
are free to make their choices, and will therefore refuse to pay higher prices, if they perceive
the quality of the goods to be worse or inferior than the others. It’s obvious that the choice
what to buy lies with customers and therefore the forces of demand and supply prevails as in
any free market in its moderate form. However, Government does play a role as well. For
example, it may seek to encourage greater consumption of some goods and discourage
consumption of others. For example, taxes are imposed on cigarettes to discourage
smoking, while interest rates are reduced on home loan to encourage home ownership.
Government also intervenes to regulate the price of basic necessities, such as bread, rice
and flour so that it is affordable to the poorest segment of the population as well.

Mauritius, as in almost all countries, reliance is placed on government to provide defense,

enforce laws, and redistribute income. Even market economies rely on government to
regulate the activities of private firms, to protect the environment, to provide education, and to
produce a wide range of other goods and services which private companies will not be willing
to produce since they do not reap any profit or low profit.

Mauritius enjoys a stable economic growth and a high per capita income which can be
attributable to the degree of economic freedom it has. With a well-developed legal and
commercial infrastructure, Mauritius has so far strike the right balance between private and
public sector ownership while allowing the private sector to effectively voice its views on the
development strategy of the country. On the other hand, companies in Mauritius are
regulated by various laws such as Companies Act of 2001, Competition Act, Customer
Protection Act, Fair Trading Act, Labour Laws among other to safeguard the interest of
individuals, consumers, and organizations.

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 3. ECONOMIC EFFICIENCY OF DIFFERENT MARKET STRUCTURES

3.1 Market efficiency

Market efficiency is the measure of the availability of all relevant information to all participants
in a market that allows maximum opportunities to buyers and sellers to effect transactions
with minimum transaction costs.
Market efficiency was developed in 1970 by Economist, Eugene Fama whose
theory, Efficient Market Hypothesis (EMH), stated that it is not possible for an investor to do
better than the market because all available information is already incorporated in stock
prices. Since, everyone has the same information about a stock, the price should mirror the
knowledge and expectations of all investors. However, investors and researchers have
conflicting viewpoints on how efficient the market actually is, as there is sufficient evidence to
challenge the fundamental claims of this theory, and most investors therefore don’t trust it.
The presence of the following anomalies, amid other things, has slayed the efficient market
theory:
 The January effect which is a hypothesis that there is a seasonal anomaly in the
financial market where securities' prices increase in the month of January more than in
any other month;
 The constantly superior risk-adjusted returns of small and mid-cap stocks;
 The presence of insider trading, getting hold of inside information though insider
trading is illegal;
 The outperformance of some managers over time; and
 The inefficiency of fixed income and foreign markets.

At the other end of the spectrum from Fama and his followers is the Value Investing, which is
the strategy of selecting stocks which are priced below what they are actually worth.
Successful value investors make their money by purchasing stocks when they
are undervalued and selling them when their price rises to meet or exceed their intrinsic
values.

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 3.2 Types of market structures, and their characteristics

An industry consists of all firms making similar or identical products. An industry’s market
structure depends on the number of firms in the industry and how they compete. The
following are the four basic market structures:

1. Perfect competition

Perfect competition is a theoretical market structure that features no barriers to entry and
exit, homogeneous products, large number of buyers and sellers who have perfect
knowledge of the market and perfect mobility of factors of production. It consists of
numerous small firms competing against each other. In reality, only near perfect
competition can exist. The stock exchange has many of the characteristic of perfectly
competitive markets.

2. Monopoly

A monopoly is a firm that has no competitors in its industry as it is the only provider of a
product or service. It is mostly state-owned companies where entry for other players is
not allowed through legal prohibition, patents or copyrights. Example, Post Office has a
monopoly of postal service under the Post Office Act. A monopoly benefits from
increased economies of scale which also acts as a major barrier. Example is public
utilities. Monopolist may also have the exclusive rights to a natural resource. For
example, in Saudi Arabia the government has sole control over the oil industry.

3. Oligopoly

An oligopoly is an industry with only a few firms that together control the majority of the
market share. There may be other smaller or specialized companies but there will be few
who dominate that particular industry. Here, Buyers are many, sellers are few and
competition is high. If they collude, they reduce output and drive up profits the way a
monopoly does. However, because of strong incentives to cheat on collusive
agreements, oligopoly firms often end up competing against each other. Example in
Mauritius is the telecommunication industry such as orange, Emtel, and Chilli.

4. Monopolistic competition

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In monopolistic competition, an industry contains many competing firms, each having a
small proportion of the market share. It features many buyers and seller, almost similar
product but different branding with fierce competition. Examples are restaurants and
clothing store.

The four market structures can be compared and distinguished based on their
characteristics as follows:

 Number of firms and their size

Perfect competition is characterized by large number of sellers of small size. However,

apart from pure monopoly, where there is one large firm, there may be an important
number of firms in other market structures but what set apart others is the number of
dominant firms in the market, i.e. the degree of industrial concentration. In monopolistic
competition, there are many firms of a similar size whilst oligopoly has few large firms
dominating the market.

 Freedom of entry

In a perfect competition, there are freedom of entry and exit as in a monopolistic

competition. Contrary to monopoly, where the entry of new firms and exit of old firms is
restricted due to high costs or other barriers such as legal, economic, social or political.
Similarly, in Oligopoly, there are significant barriers to entry such as high start up costs or
limited resources. For example, it is very expensive to set up a new automobile firm.

 Nature of product

In a perfect competition, products offered are identical in nature and, as a result, has
many substitutes as compared to monopoly where products are unique with no close
substitute. Both monopolistic competition and oligopoly provide closely related but
differentiated products. . Product is differentiated through its unique style, brand name,
location, advertisement, packaging, and pricing strategies.

 Nature of demand curve

The demand curve for a perfectly competitive firm is horizontal, i.e. perfectly elastic as it
has to accept the price fixed by the market forces of demand and supply and do not have
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 any leverage. For example, in a perfectly competitive market, if a firm decides to increase
its selling price, the consumers can just turn to the nearest competitor for a better price,
causing any firm that increases its prices to lose market share and profits.

Monopoly, monopolistic firm and oligopoly face a downward sloping demand curve as
more quantity can be sold at a lower price. However, the demand curve in monopolistic
competition is more elastic because of the presence of close substitute. In Oligopoly, the
demand curve is rather indeterminate as the exact behavior of a producer cannot be
determined with certainty. Firms believe their demands as inelastic for price cuts, and
elastic for price rise, hence, facing a kinked demand curve.

 Degree of price control and profit-making

A firm under perfect competition is a price taker, which means that it has no control over
the price as the latter is determined by the market forces of demand and supply as
compared to a monopoly firm that has complete control over the price, thus it a price-
maker. Monopolistic firm is neither a price-taker nor a price-maker as it has only partial
control over the price. It can, however, influence the price by creating a separate image
of its product by means of huge selling costs through advertisement. On the other hand,
firm under oligopoly follows the policy of price rigidity. Though, it can influence the price,
it prefers to maintain its price so as to avoid a price war.

Hence, the possibilities of profit making is high in monopoly and oligopoly in contrast to
perfect competition and monopolistic competition, where profit generation is low and
moderate to high respectively.

 Impact on other firms

The average size of the firm in a perfect competition is so small that its behavior has no
impact on the decisions of other firms operating in the market as compared to an oligopoly
where each firm’s behavior has significant influence on the activities of other firm and with
monopolistic firm, where the impact is less. For monopoly, the question of reaction from
other firms does not arise as it the only firm in the industry.

3.3 Economic efficiency and effect of each market structure on the industry’s
consumers
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Economics is a science of efficiency in the use of scarce resources. Efficiency requires
optimum use and employment of available resources which can be measured in three main
forms as follows:

Productive efficiency: Productive efficiency occurs when the equilibrium output is produced
at minimum average cost, that is where, MC=AC. Firms with high unit costs may not be able
to justify remaining in the industry as the market price is driven down by the forces of
competition.

X efficiency: This is attainable when average and marginal costs are as low as possible.
This occurs as forces of competition will drive down costs.

Allocative efficiency: Productive and x efficiencies are concerned with how products are
produced whilst allocative efficiency is concerned with the quantity produced. It is achieved
where price (AR) = MC.

Full efficiency therefore means producing the “right” amount (allocative efficiency) in the right
“way” (productive and x efficiency).

Perfect Competition

A perfect competitive market meets all three criteria of economic efficiency and can therefore
be used as a benchmark to compare with other market structures. Example of perfect
competition is the agricultural industries.

Productive efficiency occurs where price is equal to the minimum average total cost. To
achieve productive efficiency, firms must use the least costly production techniques in order
to survive in the industry. Allocative efficiency occurs where price is equal to marginal cost
(MC).

Even though economic efficiencies are achieved in this system, the consumers are faced with
standard products, with no special characteristics based on different consumer taste or
preferences. On the other hand, the consumers will receive the highest consumer surplus in
this structure as the long run market price will be at the min ATC. Producers will receive the
lowest producer surplus as consumers can easily find substitutes.
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Monopoly

Example under this economic model is the public utilities industry such as electricity supply.

Monopoly firms will not achieve productive efficiency as firms will produce at an output which
is less than the output of min ATC. X-inefficiency may occur since there is no competitive
pressure to produce at the minimum possible costs.

The monopolist is extracting a price from consumers that is above the cost of resources used
in making the product and, consumers' needs and wants are not being satisfied, as the
product is being under-consumed. The lack of competition may give a monopolist less
incentive to invest in new ideas and therefore providing poor quality and service.

If the industry is taken over by a monopolist then the monopolist is able to charge a higher
price restrict total output and thereby reduce welfare because the rise in price reduces
consumer surplus. Some of this reduction in welfare is a pure transfer to the producer
through higher profits, but some of the loss is not reassigned to any other agent. This is
known as the deadweight welfare loss or the social cost of monopoly. The higher average
cost if there are inefficiencies in production means that the firm is not making optimum use of
scarce resources. Under these conditions, there may be a case for government intervention
for example through competition policy or market deregulation.

The traditional argument against market power is that monopolists can earn abnormal
(supernormal) profits at the expense of efficiency and the welfare of consumers and society.

Monopolistic Competition

Example of an industry under this model is the clothing industry.

Firms producing under monopolistic competition do not produce at the bottom of average
cost curve and so do not achieve productive efficiency. They might even be producing with
spare capacity. Most monopolistic competitive firms should experience break-even in the
long run theoretically. In reality, some firms experience profit as they are able to distinguish
themselves from the others and build a loyal customer base. Some firms experience loss in
long run but may continue the business as they are still earning normal profit.

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Price exceeds marginal cost in the long run, suggesting that society values additional units
which are not being produced. Average costs may also be higher than under pure
competition, due to advertising cost involved to attract customers from competitors. The
various types, styles, brands and quality of products offers consumers choices and variety.
However, economic inefficiency is the result. The excess capacity (producing at the quantity
that a firm produces is less than the quantity at which ATC is a minimum) exists in this
industry.

Oligopoly

An example of industry under oligopoly is the paint industry.

Firms under oligopoly will not achieve productive efficiency as firms will produce at an output
which is less than the output of minimum average total cost. Product differentiation is the
major cause of excess capacity. X inefficiency will occur as average cost and marginal cost
curves are higher than they could be. X inefficiency occurs partly due to complacency as
production methods become slack. All these features will push down the AC curve.

Allocative efficiency is not achieved because price (what product is worth to consumers) is
above MC (opportunity cost of product). This means that they could produce more of the
product at a cost below the value that consumers place on it. However, firms intentionally
restrict output in order to keep price and profits high.

Advertisement is very crucial for each firm in this market structure as firms need exposure to
get consumer's attention. Consumers can therefore make their choices based on their
personal taste; price and can easily shift in case of price rise by one firm.

References:

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