Question

explain how a market economy allocates resources to produce goods and services. As part of your answer, discuss (a) how prices and quantities are determined, (b) how markets respond to external shocks, and (c) how we evaluate market outcomes.

Answer 1

Market Economy refers to a mechanism through which economy operates. In a free market situation, there is no regulation by the government. In free market all the resources are owned privately. Resources are allocated based on two players in the market, i.e. consumers and producers. What to produce is determined by consumer’s preferences and how to produce is determined by producers. These two players in market interact through pricing mechanism. Or in other words, it is determined by demand and supply function.

Demand function is determined by consumers. If price increases quantity demanded by consumer’s falls and if price decreases quantity demanded by consumers rises, given all other factor constant.

Supply fiction is determined by producers. If price increases quantity supplied by producers will increase and if price falls quantity supplied by producers will decrease.

In market economy there are few characteristics which price systems follow.

Price is neutral. It is determined through interaction in the market. And price changes accordingly.

So, through price system in the market, equilibrium price and quantity are determined. If price is higher at P1, then there will be excess supply. Hence producers will supply less which will lead to equilibrium price P*. If the price is lower than that, say P2, then there will be excess demand. Therefore consumers will demand more which will lead to price increase to the equilibrium price level.

External shock is referred to various situations in which other factors changes. Say, consumers’ taste and preference, consumers’ income, input cost etc.

If there is change from demand side then equilibrium price and quantity changes from P! to P2 and Q1 to Q2 as follows below

When there is change from supply side, then equilibrium price and quantity changes from P! to P2 and Q1 to Q2 as follows below

There are debate regarding free market economy which has pros and cons.

Competition leads to better optimization. On the contrary it also leads to accumulation of wealth in few hands. Higher inequality. And unstable market in different circumstances. While it also provide greater freedom to the consumers and producers