Competitive Markets Promote Efficiency
A market exists whenever people get together to make an exchange. A competitive market is one that brings large numbers of buyers and sellers together for purposes of exchange. Buyers in competitive markets, it is assumed, are rational decision makers. That is, these buyers carefully weigh the costs and benefits of their buying decisions. The cost in this case is the price of the product as well as the lost opportunity to purchase other items with the same money—that is, the opportunity cost. The benefit is the amount of satisfaction they expect to receive from the product. Similarly, it is assumed that sellers—often referred to as producers or business firms—also make rational decisions. From the seller's perspective, the ultimate goal of producing products is to earn profits, or, to be more precise, to maximize profits. Recall that no one forces buyers or sellers to make a market transaction. The decision to buy or to sell is voluntary and is based on the principle of mutual benefit—each side in the exchange expects to be better off as a result of the transaction.
Economists consider competitive markets to be the most efficient type of market structure. Generally speaking, economic efficiency is achieved when a society is able to produce goods and services that people want to buy, at the lowest possible costs of production. Allocative efficiency occurs when society's resources are channeled into enterprises where consumer demand is strong. It would be allocatively inefficient, however, to use society's resources to produce goods that nobody wants to buy. Technical efficiency occurs when a producer gets the highest possible output while using the fewest or the least costly mix of inputs—natural resources, human resources, and capital goods. Technical efficiency is enhanced by sophisticated capital goods, applied research and development, skilled human capital, and innovative entrepreneurs.
Investments in sophisticated equipment increase a country's capital stock and improve the productivity of its labor force.
Government Interventions Address Market Shortcomings
While competitive markets are the most efficient way to allocate society's scarce resources, competitive markets do not always produce socially desirable outcomes. Prior to the Great Depression of the 1930s, the concept of limited government severely restricted the role of government in the economy. This hands-off policy was referred to as the laissez-faire doctrine. The government provided some public goods such as schools and roads, and enforced certain rules that protected private property, patents and copyrights, and contracts. But the economic well-being of individuals was very much a personal responsibility, not the responsibility of the federal government.
Government interventions since the Great Depression have expanded to provide additional public goods, support economic security and equity for the vulnerable, regulate businesses, and stabilize the macroeconomy. Today, for example, the government provides a far broader range of public goods than it did a century ago. These public goods are deemed necessary for a well-ordered economy mainly because such projects would be underproduced by the private sector. Similarly, with government intervention, certain essential services for the poor, the sick, or the elderly would be underproduced. Finally, government interventions have also reined in the excesses of private enterprises, helping to improve the treatment of workers and the quality of the natural environment.
Specialization Promotes Productivity and Economic Interdependence
Specialization occurs when an individual, business, or region produces a specific product or narrow range of products. An individual artisan, for example, might specialize in the production of fine jewelry. A large business might specialize in the production of automobiles. An economic region might specialize in the production of a crop such as cocoa or bananas. Specialization, when applied to workers' tasks, is often referred to as the division of labor. The main goal of a division of labor is to increase the firm's productivity. The division of labor within a production facility often creates focused, defined tasks for workers that are matched to workers' abilities or talents. Specialization is often credited with increasing the productivity of individual business firms and entire regions or countries.
Specialization promotes business productivity by encouraging the most efficient use of available resources. Productivity occurs when a business firm is able to increase the amount of output per unit of input. The most common measure of productivity is the amount of output produced per unit of labor. One way producers increase the productivity of labor is by investing in their workers through work-related education or training. Producers also increase worker productivity through investments in real capital such as machinery and software.
Regional specialization occurs when firms in a certain geographic location develop one or a few key resources or products for commercial purposes. Naturally, these economic regions produce goods most suited to their local resources. For example, Saudi Arabia, Kuwait, and the United Arab Emirates specialize in the production of petroleum products because these countries sit on large reserves of crude oil. They produce enough petroleum to satisfy their own needs and to export surpluses to foreign buyers. The cross-border trade and investment opportunities for these and other countries create strong and mutually beneficial economic bonds among nations. In this way, regional specialization promotes an efficient use of the world's scarce resources, generates greater global output, and encourages economic interdependence in the global economy.