Adam Smith, usually referred to as the father of economics, expounded the theory

Question

Adam Smith, usually referred to as the father of economics, expounded the theory of free markets and opposed any form of concentration of economic power. He believed that any authority establishing a price that provided a fair price to the providers of the factors of production would distort the market's natural ability to determine prices and output levels. In general, he believed that competitive markets would allocate resources to their highest and best use. However, in recent times, we have seen the market mechanism fail and allocate too many or too few resources to the consumption or production of some goods and services.

What are some of the reasons for this failure?

Has government intervention into competitive markets changed the efficiency of these markets? Why or why not?

Was Smith correct or incorrect in his theories concerning the efficiency of the markets in allocation of resources? .

Explanation / Answer

Equilibrium is a situation of balance in which nobody is willing to change the state of affairs, which implies that the buyers can buy as much as they want and sellers can sell as much as they wish. This happens at the price level at which the quantity demanded becomes equal to quantity supplied.

However, this price mechanism does not work and market tends to fail when they produce inefficient output level due to the presence of some distortionary factors. A deadweight loss is created under in these events which is the cause of market failure. Government interfernce is thus required so that it can attempt to alleviate these consumption and production distortion losses by regulating price and quantity of the production entities involved.

Informational asymmetries are one of the most important and ironically, most unavoidable cause of the market failure. When one party involved in the transaction has more information than the other, it tends to utilize it in its favour which is unjustified on ethical as well as economical grounds.

Public goods, externality, imperfect competition, asymmetric information all of these are the factors that impedes the market ability to restore equilibrium and produces efficient level of output. Government can impose tax, regulate their pricing, distribute license, define propert rights and can itself provide some goods (that is, public goods) to correct the market failure.

Government intervention into competitive markets has definitley changed the efficiency of these markets espcially in case of negative externalities by imposing restrictions on carbon emissions, distributing premits and license. It has taken up the provision of roads, parks, railways, education, health and other public goods whose private provision is difficult.

Smith did not propose any solution to the cases when markets fail to perform. His theory of invisible hand works only when the market forces bring equilibrium without the presence of any distortion.

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