Question

Essay Topics3: Write a short essay on each of the topics, answering all questions in each topic in a clear, coherent, and concise essays.

A. The Convertibiliy Plan Explain the Argentinean experiment with the Convertibility

Plan. What were the conditions that prompted the Plan? What was the central piece

of the Plan? What were consequences of the Plan in the late 1990s and early 2000s?

B. Market Economic System List and explain three strengths of a market system.

Then, explain the concept of market failure (one of the weaknesses). What are the

four major market failures we have covered in class? Explain each in detail and give a

brief example of how the government would get involved to fix (or at least try to fix)

each particular market failure.

Answer 1

Part A

Background:-

Between the period of 1975 and 1990 Argentina had been experiencing massive hyperinflation with reached a staggering average of 325% per year.The dismal consequences of hyperinflation was very much evident as the production dropped dramatically and the GDP was about 10% lower in 1989 than in 1980 which was towards the peak of the high inflation era in Argentina and the per capita GDP during this time had decreased over 20%. Capital and fixed investment fell significantly during 1989 and as a result production and labor demand consequently decreased as well especially in the industrial sector. Real wages dropped by about half of their peak stage during 1974 and poverty rate was also one of the worst that the country ever experienced during 1989.

The main attribute of this prolonged hyperinflation was unrestrained money supply by the central government in order to combat increasing fiscal deficit for multiple successions of government.Rising tax evasions by private enterprises and the shutting down of most state owned establishments led to amassive fiscal deficit which reached 10% of GDP in 1983.Government expenditure on industrial and infrastructural development became almost stagnant as the production level and the labor market suffered immensely.Consumer confidence and confidence on central bank were at their record lows.Therefore, to finance the increasing fiscal gap the government continually implemented growth in money supply.

Secondly, to avoid liquidity crisis impelled by the Argentinian banking crisis of 1990, the central bank took over the deposits of the commercial banks which was marked by a huge financial crisis in the country as most commercial banks were suffering from this liquidity issue.Limiting of domestic credit was only applicable to public sector and the outstanding loans started declining for private sector financial institutions during the 1989 crisis.

Lastly, additional factors such as constant interest rate fluctuations during 1980s also impelled the currency crisis in Argentina.In response to the rigid monetary policies imposed by the US for its financial institutions thereby making it more expensive for banks to borrow money as they were required to maintain high levels of liquidity or reserve requirements., the drastic monetary measures taken by the Argentinian central further intensified the crisis.

Argentinian Convertibility Plan:-

Keeping into account all these issues mentioned above, the Argentinian government officially proclaimed its Convertibility Plan in 1991 with the objective to stabilize the macroeconomic conditions of the country and improve policy formulation.Under this plan,a currency board was established which legislated a pegged exchange rate policy against the US dollar and it was fixed at 10,000 Australes per US Dollar. Any new modifications in the exchange rate policy could only be enacted through new legislation approved by the central government and the currency board.The Convertibility plan was primarily intended to limit the monetary and fiscal instability in the country through strict and rigid exchange rate policies which was fixed.The currency board was committed to restrict unrestrained money supply by the government to finance the ever growing fiscal deifict thereby controlling inflation and the erratic interest rate policies by the central government which essentially led to the currency crisis and also financial crisis.

Consequences:-

Despite some of the internal flaws the currency board under the convertibility plan was successfully able to bring down the inflation rate from a staggering 3000% in 1989 to only 4% in 1994.The plan was also able to achieve higher production levels and GDP growth during the 1990s which became almost stagnant during the mid and late 80s.Even after the Mexican Peso Crisis in 1998 Argentina was able to maintain a commendable GDP growth rate of 8%. Another notable accomplishment of the plan was evident in the international trade which increased dramatically in the 90s and early 2000s.Both imports and exports increased from $11.6 billion in 1991 to 32.2 billion in 2000 and 12.2 billion in 1991 to $30.7 billion in 2000 respectively.

However, despite some its notable success, the plan also reflected some its shortcomings in controlling unemployment which was still showing an increasing pattern, unequal income distribution and decreasing wage rates especially in the industrial sector.

Part B

Major Strenghts of Market Economy:-

1) Competitive markets and market efficieny: Free market economy ensures more competitive markets in all sectors as lack of administrative and other restrictions can cause more small and medium businesses to enter the market and grow independently.The firms can enjoy more equitable cost structures leading to higher competition and more efficient market outcomes for the consumers in terms of price and social welfare.

2) More variety of goods and services in the market: Competitive situations in the market leads to the growth of more businesses thereby encouraging more variations in goods and services in the market. New and improved product ideas can be generated according to consumer habits and preferences in affordable prices which can lead to greater social welfare and desirable economic outcomes for the firms.Therefore, the scope of product variations and innovation is higher in market economies than other types of markets such as monopoly or oligopoly with absolute market power.

3) Higher levels of economic activity: Market economy provides the freedom for many small and medium businesses to develop. With favorable administrative and economic conditions new firms can start operating and earn business success through higher consumer demand,scope of innovation and less market restrictions.This could certainly lead to higher levels of production, employment and GDP thereby reflecting economic growth as many countries have evidently achieved through market economy and policy liberalization.

Major market failures:-

a) Negative Externalities: Negative externalities occur when one party in the market causes an undesirable or detrimental effect on any other party in the market and does not compensate for such action.As an example, we can mention about the air pollution caused by many manufacturing plants/firms which is causing health detriments to the residents living nearby but the firm does not compensate to the residents for such negative health impact.In this case the production by the firm will be higher than the socially optimal level as it is not accounting for the externality cost that is incurred due to this detrimental conduct.

b) Monopoly: Monopoly is theoretically described as a market with only single seller.In a monopoly market, the seller usually produces at Marginal Revenue (MR)=Marginal Cost(MC) and charges a price(P) higher than the MR thereby maximizing its profit and earning positive economic profits.On the contrary, in a competitive market, the firms have identical cost structure and produce at P=MR thereby maximizing profit and earning zero economic profit in the long run.Therefore, monopoly charges higher prices than the competitive firms which is higher than the socially optimal level.

c) Improper market information: This can happen when any party in the market does not provide perfect information to the other party to gain some economic benefits.It characterizes market failure as imperfect information can lead to undesirable welfare consequences in the market.

d) Property Rights: Lack of proper property rights allocation can also lead to market inefficieny. Lack of property rights assigned to producers or consumers can restrict a proper market formation.

Possible Government Measures to fix Market Failures:

• Externality tax: In the case of negative externality the government can impose an additional externality tax which has to be paid by the party causing the negative externality for example, the manufacturing firm causing air pollution.As the firm will have to pay the additional cost it will essentially increase its Marginal Cost (MC) of production thereby restoring the socially optimal production level which is less than the level with externality.Therefore,at the socially optimal level the party causing the negative externality is compensating for the damage it is causing.
• Removing market barriers and restrictions: The goverment can intervene and abolish someof the restrictions or barriers to entry for new firms which might be causing monopoly formation.In this case, the government can modify licensing and registration policies, provide some tax reductions or benefits,remove or reduce administrative barriers to entry and so forth.This could effectively lead to a more competitive market.
• Ensuring facilities to provide proper market information: Following the advancement of technology and increased digitalization, governments, merchandizers, retailers etc are utilizing technology to disseminate market information for all concerned parties in the market.Through various retail portals such as amazon,flipkart,ebay and other tools in internet different parties in the market such as supply chain agents,final consumers,retailers, wholesalers etc are able to obtain necessary market information such price,product variety,product features and much more.