How the use of different theoretical perspectives can help us in understanding how markets function

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The aim of this essay is to answer the 2 parts of the provided question. In the first part I will discuss the different markets models and how those different models describe the way markets function. While the second part will discuss how and why markets are limited and failure cases happens. An example case of a market failure is to be provided to assist this part of the discussion, and for this purpose I chose the affect of SARS in the airline and tourism markets as an example.

How the use of different theoretical perspectives can help us in understanding how markets function

Markets are a mechanism which allows people to trade normally, governed by the Law of Supply and Demand. Markets have different structures or models, all function under the view of competition.

Competition in economic terms is understood to be the situation in market where the monopoly power is absent or very limited and no power is influencing product price or quality. Hence a competitive market is the one in which none of the participants possess market power. A competitive market achieves efficiency in the allocation of scarce resources if there are not other market failures present.

The major four known competitive market models are:

1- Dynamic Competition put forward by J. Schumpeter.

2- Perfect Competition put forward by the Neo-classical followers.

3- Competition as a process of adjustment to change, put forward by F. Hayek; and

4- Competition as a power struggle, put forward by Sen.

The main characteristics that define a market model are:

1- The number of firms in a market.

2- The ease of entry and exit from the market; and

3- The type of products and to what degree it is differentiated.

Dynamic Competition:

Schumpeter’s view of this model of competitive markets stands on the basis of competition over innovations in products and process and not price competition. So firms that do not move ahead faster than their competitors will fall behind and eventually will go out of business. This process of “innovate or go bust” is what Schumpeter calls “creative destruction”.

The result of such creative destruction would be a regular changing structure of the economy and improving living standards over the years.

According to Schumpeter we should not put too much emphasis on static efficiency related to perfect competition because this tends to kill technological change. Instead we should recognize that some degree of monopoly power is a necessity to keep going the process of infrastructure growth and development.

The main features of this model are:

– Short term monopolies are useful to enable firms to accumulate the required resources.

– Large firms are important in the evolutionary procedure of the economy; and

– Markets operate under this view achieve reduction in cost and improvement in quality which results from two sources:

* Technological advances

* Economies of scale.

Some opposing argument would be that this model does allow a problem of monopoly, which governments need to regulate to limit the abuse of power.

Perfect Competition – Neo-classical model:

While the dynamic competition model recognizes competition in the presence of powerful innovative organization, the neo-classical model depends on the absence of such organization’s power. Hence while Schumpeterian model consists of few large corporations, the neo-classical counts on the easiness of entry to the market and the presence of large number of small firms.

So, the main features of the “perfect competition model” are:

– The role player is the “market” itself and not the firms. The “invisible hand” notion.

– All firms are price takers.

– Perfect competition is achieved when the market supply and market demand reach the equilibrium.

– Large number of firms; no corporate power; and competition over a standardized product through out an industry.

– Perfect knowledge of market conditions and instantaneous resource mobility.

The argument about this model is the fact that it does not explain the process of achieving the equilibrium. It assumes that markets and individual act rationally oppose to human behavior which might be far from realism.

Information competition – Hayek model:

Hayek on the other hand believes that the most important factor which the perfect competition model ignores is information. He argues that individuals never have complete information when responding to economic changes. Hence, the change in prices is a mechanism for transmitting information between individuals in the market (signals). The emphasis of the Hayekian model is on the process of the competition instead of the outcome of it as neo-classical model is.

Although the above difference with neo-classical model, Hayek shared them the strong believe in free markets and to give individuals the freedom to make their own economic choices. He also believed in the invisible hand ant its role of bringing markets to coordination.

The main characters of this model are:

– Market never in equilibrium.

– Markets are a coordinator.

– Change in prices gives information about preferences of consumers and conditions of production faced by suppliers.

– Justice and injustice are not relevant to the outcomes of market events, as the outcomes are the result of human action but not human design.

But this model yet has its weaknesses such as the fact that price signaling is not free of cost, sometimes prices can carry the wrong information or highly incomplete information.

Externalities are another example of the weakness of thinking that prices can provide perfect information. Prices can not demonstrate the social costs and benefits from an economic activity.

Monopolistic competition – Sens’s model:

Sens’s model disagree totally with the neo-classical balance of supply and demand, he views competition as a power struggle markets characterized by conflict rather than by harmony or interests.

The main features of this model are:

– Emphasis on the unequal nature of the gains and losses of efficiency.

– Firms and organizations are part of the struggle for economic power.

– Markets do not ensure positive freedom.

In general, Sen’s argues that economic power is distributed unevenly and that this too is an aspect of competitive market relations.


Though the four market models adopt the liberalism/ capitalism tradition of thought still there are differences between them in how each model view the type of competition in the market.

However the boundaries between one type of market and another are blurred and a market can apply one or more of the models in it without being able to easily distinguish them.

Still it is important to understand the description of each model as it does support and help understanding how markets function through the effect on prices, costs, and the law of Supply and Demand, as well as the levels of monopoly in the market. Market competition contributes towards efficiency and productiveness of the economy.

Discuss why markets may fail to generate socially desirable outcomes.

We would start by explaining what is meant by market failure. A market failure is a situation in which market outcomes are not efficient or the costs and benefits are not distributed equally. Serious market failures provide a rationale for government intervention.

There are many reasons why the normal activity of market forces may not lead to economic efficiency and what economists call “market failure”:

The case of common property, as resources are used by everyone bun belongs to no one. In the case of common property the major problem is not being able to control use, which leads to over exploitation.

The only two ways of limiting the problem of common property is by policies and restrictions. Yet it is not easy to enforce those policies in the case of common property. Another solution would be privatizing the property, which should be also price and efficiency controlled by law and regulation to provide exploitation of private sectors.

Public goods: Public goods are not provided by the free market because of their two main characteristics. They are non-excludable and non rivalrous.

Once a public good is provided for an individual, there is no additional cost associated with it being enjoyed by an addition individual or group of individuals. In addition, once a public good is provided for one person, it is not possible to prevent its enjoyment by other people. Hence, and because the benefits from a public good are always less than the cost of producing it, the market does not provide public goods. Examples of common goods would be public pars, roads, public education.

The failure of competition (monopolies):

For the market to produce efficient outcomes there must be completion. When competition does not exist, then monopolies exist. Monopolies cause the market to fail because monopolists tend to restrict production of goods or provision of services and increase prices for customers above the natural market level under competition.

However some monopolies are allowed to exist or facilitated by government. This is applicable when one supplier does provide the market successfully and efficiently with its needs that there is no need to another supplier.


There are circumstances when individuals or firms do not bear all of the costs for the benefits they enjoy, and someone other than the recipient of the benefit bear the costs of its precaution. This is called externalities, where the market fails to distribute costs and benefits efficiently.

Such cases are obvious in the environmental issues and pollution occurred by manufacturers. (Negative externalities)

Not all externalities are negative, however. In some cases, all of the benefits of an activity are not captured by the individual or firm who pays for them, e.g. inventions.

Information Failures (Asymmetric information).

Another market failure stems form the market’s inadequate provision of information. Not everybody has the same access to information, there are some circumstances under which the market will not provide the information consumers need to make good choices.

Missing/ Incomplete markets:

There are some good and services which may not be “pure” public goods which are nonetheless under supplied by the market. There are numerous goods and services that have the potential to improve the economic fortunes of individuals and of society that are not widely available. In such circumstances, the need or demand for a particular good or services is higher than the available supply of that good or service, hence there is an incomplete market.

Above were some of the main factors that lead to market failure. To explain in details a sample of a market failure I choose to discuss the case of Mad Cow disease and its influence on the livestock market and, socially and by force, changing the taste of people. This case would explain the externalities effect.

Mad Cows Crises:

The reason of Mad Cow disease as farmers using organic items in feeding cattle, in order to reduce costs and obtain a close-loop production (not wasting anything).

The first thing to discuss is how the outburst of the disease caused government and governmental institutions to issue new regulations for using organic and biological items, but for which price?

From an economical point of view, the outburst of the disease caused the livestock market to drop down dramatically. Importing countries banned livestock imports from most of the European countries as well as USA – where the disease outburst – leading to major losses. Cattle were slaughtered in order to stop the disease, as well as recalling meat from the markets.

Cattle prices dropped down demand on meat transferred from European and American to Asian countries, although the overall consumption of the beef market dropped down. Employment in this sector of industry was cut down as a lot of the specialized butchers did not find customers any more.

Not only farms, livestock market and beef retailers got hurt; but also the fast food industry got harmed, MacDonals for example shifted to marketing non-beef products like Chicken Nuggets and Vegi Sandwiches. This is because of the general fear the spread among public, which shifted the taste to alternative items for meat. A social effect which continued to some extent even after the threat has almost disappeared.

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